Unit: 1-9

Course Code: 9302

PRINCIPLES OF
MACROECONOMICS

ALLAMA IQBAL OPEN UNIVERSITY

www.aiou.edu.pk
 STUDY GUIDE
BS Economics (4 Years)

Principles of Macroeconomics

Course Code: 9302 Units: 1–9

Credit Hours: 03

DEPARTMENT OF ECONOMICS
FACULTY OF SOCIAL SCIENCES AND HUMANITIES
ALLAMA IQBAL OPEN UNIVERSITY, ISLAMABAD
 (All rights reserved with the publisher)

First Printing ..................................... 2021

Price .................................................. Rs.

Printer ............................................... AIOU-Printing Press, Sector H-8, Islamabad.

Publisher ........................................... Allama Iqbal Open University, H-8, Islamabad.

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 COURSE TEAM

Incharge: Dr. Fouzia Jamshaid

Course Team: Dr. Fouzia Jamshaid

Dr. Muhammad Ilyas
Mr. Rizwan Satti

Course Development
Coordinator: Dr. Fouzia Jamshaid

Writers: Dr. Fouzia Jamshaid

Mr. Sarafat Afzal
Ms. Bibi Fozia
Ms. Saima Ali

Reviewer: Dr. Fouzia Jamshaid

Editor: Fazal Karim

Typed by: Dr. Fouzia Jamshaid

Layout: Asrar ul Haque Malik

iii
 PREFACE

The curriculum at AIOU is designed on modern parameters using latest information,

trends, theories and techniques. An extensive consultative process is also a basic
component of the activity. Development of the study material to help students located
throughout the country is taken as challenge; AIOU takes pride in undertaking this major
task for an effective learning of the students.

The BS Economics (4 Years) is being offered by the Department of Economics of Allama

Iqbal Open University for the students who are interested in the fields of economics. The
scheme of study for BS Economics (4 Years) has been designed and the courses are
developed to make them relevant to the emerging national and global trends and to meet
needs of the society in this domain. The study material provides a comprehensive
coverage of the core contents for BS Economics (4 Years) Program. The selection of, and
the treatment of study materials have been designed to meet both the general and specific
aims set out by the Higher Education Commission (HEC) through its National
Curriculum Revision Committee (NCRC).

In the end, I am happy to extend my gratitude to the course team chairman, course
development coordinator, unit-writers, and editors for the development of the course.
Any suggestions for the improvement in the course will be warmly welcomed by the
Department of Economics.

Prof. Dr. Zia Ul-Qayyaum

Vice Chancellor

iv
 CONTENTS

Unit No. Page #

Introduction to the Course .......................................................................................... vi

Course Learning Outcomes......................................................................................... vii

Structure of the Study Guide....................................................................................... viii

How to Use the Study Guide ...................................................................................... x

Course Outlines........................................................................................................... xiii

Unit 1: An Overview of Macroeconomics .............................................................. 1

Unit 2: Measuring National Income and the Cost of Living .................................. 13

Unit 3: Productivity, Output and Employment ....................................................... 27

Unit 4: Saving, Investment and the Financial System ............................................ 39

Unit 5: Monetary System, Money Growth and Inflation ........................................ 51

Unit 6: The Macroeconomics of Open Economy ................................................... 67

Unit 7: Aggregate Demand and Aggregate Supply ................................................ 79

Unit 8: The Influence of Monetary and Fiscal Policy on Aggregate Demand........ 93

Unit 9: Unemployment and Trade-off between Inflation and Unemployment ....... 105

v
 INTRODUCTION TO THE COURSE

Welcome to course ECO 9302 “Principles of Macroeconomics” which is a part of BS

Economics (4: Years) scheme of study of Department of Economics, Faculty of Social
Sciences and Humanities available through the Allama Iqbal Open University Islamabad
Pakistan.

This course, basically deals with the question of what is economics and mainly what is
macroeconomics? Economics is the branch of social science which deals with human
behavior according to the Robbins. The Economists divided economic discipline into two
areas of study: (e.g. microeconomics and macroeconomics).In microeconomics we focus
on individual human behavior, price theory, demand and supply of individual market,
consumption and production. Macroeconomics is a branch of the economics that studies
how the aggregate economy behaves. In macroeconomics, a variety of economy-wide
phenomena is thoroughly examined such as inflation, price levels, rate of growth,
national income, gross domestic product (GDP) and changes in unemployment rate.

In this course we introduce you to the Principles of Macroeconomics, the study of how a
country’s economy broadly works. Macroeconomic performance relies on measures of
economic activity, such as variables and data at the national level, within a specific
period of time. Macroeconomics analyzes aggregate measures, such as national income,
national output, unemployment and inflation rates, and business cycle fluctuations. The
power of Macroeconomics analysis, as a basis for economic policy, seems to become
clear with the passage of time. After completion and thoroughly studying this course, it is
hoped that students will be able to understand the major economic issues on the
instruments that are available to them.

In this Macroeconomics course, following our Principles of Microeconomics, you’ll

continue to explore the economic way of thinking and the role of incentives play in all
our lives. Keeping in view this course is designed to introduce the learner to the most
influential and compelling theories devised by macroeconomists in order to explain
issues related to the determination of output, unemployment and inflation. Through this
course you will acquire a logical and consistent framework for understanding the main
macroeconomic facts and events and develop the ability to employ the correct
macroeconomic tool(s) to explain specific macroeconomic issues and justify policy
proposals. We hope that the study of this course will prove helpful to the students and
will make up an important contribution to education in economics.

Advanced Macroeconomics courses will be offered in the coming semesters. We hope

you will find this course useful and interesting for your quest towards BS Economics
(4: Years) program. Suggestions for the improvement of this study guide/course will be
highly appreciated.

Course Coordinator
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 COURSE LEARNING OUTCOMES
The course is designed for the beginners with no formal background or little contact with
economics. The main purpose of this course is to familiarize the learners of BS
Economics (4: Years) Program the basic concepts, tools of analysis and terminologies
used in macroeconomics and prepare them for advance courses or study in the field of
Economics. The teacher or tutor is expected to draw examples from the surrounding
world to clarify the concepts.

Upon successful completion of this course, learner will be able to:

• know an overview of macroeconomics including definition, development,
objectives, concerns, issues, variables and tools of macroeconomics.
• familiarize with various concepts of national incomes, including method of national
income accounting, price indexes, inflation and unemployment rate.
• describe the productivity and its determinants, production function and labor
market equilibrium.
• analyze saving, investment and the financial system of entire economy.
• find the association among monetary system, money growth and rate of inflation.
• generalize the economic concepts on open economic system.
• conceptualize the key measurement of economic parameters with the help of
aggregate demand and aggregate supply concepts.
• evaluate how a government uses its fiscal policy and monetary policy to influence
key variables in order to achieve economic growth, price stability, full employment
and other goals;
• formulize the economic concepts with the help of observation, where the
correlation between inflation and unemployment exist.

Throughout this course, you'll also see related learning outcomes identified in each unit.
You can use the learning outcomes to help organize your learning and gauge your
progress.

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 STRUCTURE OF THE STUDY GUIDE
The course “Principles of Macroeconomics” a three credit hours course consists of nine
units. A unit is a study of 12–16 hours of course works for two weeks. The course work
of one unit will include study of compulsory reading materials and suggested books. You
should make a timetable for studies to complete the work within the allocated time.

This study guide/course has been organized to enable you to acquire the skill of self-
learning. For each unit an introduction is given, to help you to develop an objective
analysis of the major and sub-themes, discussed in the prescribed reading materials.
Besides this, learning outcomes of each unit are very specifically laid down to facilitate
in developing logical analytical approach. Brief summary of main topics has also been
included in the contents to understand the topics. We have given you few self-
assessments questions and activities which are not only meant to facilitate you in
understanding the required reading materials but to provide you an opportunity to assess
yourself. Recommended books and important links have been given to understand the
main topics. Key terms have also been included in the study guide.

For this course, tutorial meetings are arranged in the University’s approved Regional
Study Centers to provide students an opportunity for mutual discussion/ interaction in
groups and with the tutor concerned. Instead of formal lectures the tutorial meetings and
workshops are meant to solve students’ problems individually in their studies.

Every course has a study package including study guides, assignments and tutorial
schedule posted by the mailing sections of the University. For the books suggested at the
end of each unit you can visit online resources, a nearby library/study center or the
Central Library at main campus in AIOU.

Course Materials
The primary learning materials for this course are:
• Readings (e.g. study guides, recommended books, online links and scholarly
articles)
• Lectures, (tutorial and workshops)
• Video lectures with presentations, (online on AIOU web TV and CD)
• Other resources.

All course materials are free to access and can be found through the links provided in
each unit and sub-unit of the course. Pay close attention to the notes that accompany
these course materials, as they will instruct you as to what specifically to read or watch at
a given point in the course, and help you to understand how these individual materials fit
into the course as a whole. You can also access a list all the materials used in this course
by clicking on resources mentioned in each unit.

viii
Technical Requirements:
This course is delivered online also. You will be required to have access to a computer or
web-capable mobile device and have consistent access to the internet to either view or
download the necessary course resources and to attempt any auto-graded course
assessments and the final exam.

Method of Instruction:
Following are the methods for directing this guide and course also and then you will be
able to understand the macroeconomics course through.
• Lecture (tutorials)
• Mandatory workshops
• Class discussion during workshops
• Individual, paired and small-group exercises
• Use of library for research projects
• Use of videos lectures
• Use of the internet

Types of Assignments:
• Students must complete assignments from the recommended books and other
sources also.
• Students must be able to research and complete the assignments, which will include
library, Internet, and another media research.

Activities:
In most unit different types of activates are mentioned for better understanding the
course. If you will thoroughly study the materials and follow the links and videos, then
you will be able to understand the course in easiest way.

ix
 HOW TO USE THE STUDY GUIDE
Before attending a tutorial meeting, it is imperative to prepare yourself in the following
manner to get a maximum benefit of it.

You are required to follow the following steps: -

Step 1
Go through the;
1. Course Outlines
2. Course Introduction
3. Course Objectives
4. Structure of the Course
5. Assessment Methods
6. Recommended Books
7. Suggested Readings

Step 2
Read the whole unit and make notes of those points which you could not fully understand
or wish to discuss with your course tutor.

Step 3
Go through the self-assessment questions at the end of each unit. If you find any
difficulty in comprehension or locating relevant material, discuss it with your tutor.

Step 4
Study the compulsory recommended books at least for three hours in a week included in
your study package sent to you by the Department of Economics, AIOU. Try to read it
with the help of specific study guide for the course. You can raise questions on both
during your tutorial meetings.

Step 5
First go through assignments, which are mandatory to solve/complete for this course.
Highlight all the points you consider it difficult to tackle, and then discuss in detail with
your tutor. This exercise will keep you regular and ensure good results in the form of
higher grades.

Assessment
For each three credit hours course a student will be assessed as follow:
• Two Assignments (continuous assessment during semester).
• Final Examination (three-hours written examination will take place at the end of
each semester)
• Mandatory participation in the workshop (as per AIOU policy)
• Group discussion in the tutorial meetings
• Presentation

x
The condition to qualify each component is given below;
• A minimum of 50% marks in each assignment.
• A minimum of 50% of the final written examination.
• An aggregate of 50% of both the components i.e., assignments and final
examination are required to pass the course.
• A student has to pass in both components i.e. assignments and final exams in a
particular course. These two components contribute 30:70 to each student’s final
course grade.

Assignments
• Assignments are written exercises that are required to complete at home or place of
work after having studied 9 units/study guides with the help of compulsory and
suggested reading material within the scheduled study period. (See the assignments
scheduled).
• For this course you will receive 02 assignments in the mailing package. You are
advised to complete your assignments within the required time and send it to your
assigned tutor.
• This is a compulsory course work and its successful completion will make you
eligible to take final examination at the end of the semester.
• You are provided tutorial support at approved study centers.
• You will send your assignments to your appointed tutor, whose name is notified to
you for assessment and necessary guidance through concerned Regional Office of
AIOU. You can also locate your tutor through AIOU website. Your tutor will
return your assignments after marking and providing necessary academic guidance
and supervision.

Note: The students are informed about the names of tutors and study centers in the
beginning of the semester. If you do not receive such information, please contact your
nearest Regional Office of AIOU and concerned department.

Workshops
• The workshops of Bachelor Studies BS Economics (4: Years) courses will be held
during each semester in the main Regional Campuses and as-per AIOU policy;

• Attendance is compulsory in workshops. A student will not be declared pass until

he/she attends the workshop satisfactorily and actively.
• The duration of a workshop for each 03-credit course is three days.

Revision before the Final Examination

It is very important that you revise the course as systematically as you have been
studying.

You may find the following suggestions helpful.

xi
• Go through the course unit one by one, using your notes during tutorial meetings to
remind you of the key concepts or theories. If you have not already made notes, do
so now.
• Prepare a chronology with short notes on the topics/events/personalities included in
all units.
• Go through your assignments and check your weak areas in each case.
• Test yourself on each of the main topics, write down the main points or go through
all the notes.
• Make sure to attend the last tutorial and revise all the points that you find difficult
to comprehend.
• Try to prepare various questions with your fellow-students during last few tutorial
meetings. A group activity in this regard is helpful. Each student should be given a
topic and revise his topics intensively, summarize it and revise in group, then all
members raise queries and questions. This approach will make your studies
interesting and provide you an opportunity to revise thoroughly.
• For the final exam paper, go through last semesters’ papers. This can clarify
questions and deciding how to frame an answer.
• Before your final exams, make sure that,
➢ you get your roll-number slip
➢ you know the exact location of the examination center
➢ you know the date and time of the examination.

Note:
This study guide has been developed to guide the students about the course” Principles of
Macroeconomics”. In this context we want to make it clear that you are not bound to
depend entirely upon the recommended books in the study guide. In case you are unable
to find any recommended book, please free to consult any other book which covers the
main contents of the course.

Moreover, you can get information regarding your Assignments, Workshop

Schedule, Assignment Results, Tutors and Final Examination from the AIOU
website: www.aiou.edu.pk. You are advised to regularly visit the university website
to update yourself about the activities.

COURSE OUTLINES
This course is comprised of the following units:
Unit 1: An Overview of Macroeconomics
• Introduction and Definition of Macro Economics
• Development/Evolution of Macroeconomics
• Scope/Importance of Macroeconomics

xii
 • Objectives of Macro Economics
• Macro-Economic Issues or Concerns
• Macroeconomic Variables and Their Relationship
• Economic Models
• The Tools of Macroeconomic Policy
• Macro-Economic Policy Framework
Unit 2: Measuring National Income and the Cost of Living
• Concepts of National Income: GDP, GNP, NNP, Disposable Income, etc.
• Methods of Computing National Income
• The Gross Domestic Product
• Intermediate and Final Goods
• Saving and Wealth
• Circular Flow of National Income
• Real GDP, Prices Indexes and Inflation
• GDP and Economic Well-Being
• The Consumer Price Index (Measuring the Cost of Living)
• The Unemployment Rate (Measuring Joblessness
Unit 3: Productivity Output and Employment
• Productivity: Its Role and Determinants
• Economic Growth and Public Policy
• The Production Function
• The Demand for Labor
• The Supply of Labor
• Labor Market Equilibrium
• Unemployment
• Okun’s Law
Unit 4: Saving, Investment and the Financial System
• Financial System in the Economies
• Saving and Investment in the National Income Accounting
• The Market for Loanable Funds
• The Basic Tools of Finance
• Measuring Value: Measuring the Time Value of Money
• Managing Risk
• Asset Valuation
Unit 5: Monetary System, Money Growth and Inflation
• The Meaning Functions and Kinds of Money
• The Federal Reserve System
• Banks and Money Supply
• The Fed’s Tools of Money Supply
• The Classical Theory of Inflation
• The Cost of Inflation

xiii
Unit 6: The Macroeconomics of Open Economy
• Basic Concepts of Open Economy
• The International Flows of Goods and Services
• The Prices for International Transactions: Real and Nominal Exchange Rate
• A First Theory of Exchange Rate Determination: Purchasing Power Parity
• A Macroeconomic Theory of the Open Economy Trade in effecting
National Income
Unit 7: Aggregate Demand and Aggregate Supply
• Three Key Facts about Economic Fluctuations
• Explaining Short-run Economic Fluctuations
• The Aggregate Demand Curve
• The Aggregate Supply Curve
• Two Causes of Economic Fluctuations
Unit 8: The Influence of Monetary and Fiscal Policy on Aggregate Demand
• Influences of Monetary Policy on Aggregate Demand
• Influences of Fiscal Policy on Aggregate Demand
• Using Policy to Stabilize the Economy
Unit 9: Unemployment and Trade-off between Inflation and Unemployment
• Identifying Unemployment
• Job Search and Minimum Wage Laws
• Union and Collective Bargaining
• The Theory of Efficiency Wages
• The Philips Curve
• Shifts in the Philips Curve: The Role of Expectations
• Shifts in the Philips Curve: The Role of Supply Shocks
• The Cost of Reduction Inflation
Recommended Texts:
1. Mankiw, G–Principles of Economics- Latest Edition.
2. Abel, Andrew, B, Bernanke, Ben S. & Croushore D. (2010) Macroeconomics-
Seventh Edition. Addison-Wesley.
3. Richard T. Froyen. Macroeconomics –Latest Edition
Additional Texts:
1. Parkin, Michael - Macroeconomics, Latest Edition
2. Miller, R.L.– Economics Today – Latest Edition

xiv
UNIT-1

AN OVERVIEW OF
MACROECONOMICS

Written by: Mr. Sharafat Afzal

Reviewed by: Dr. Fouzia Jamshaid

1
 CONTENTS

1.1 Introduction ..................................................................................................3

1.2 Learning Outcomes ......................................................................................3

1.3 Main Topics to Discuss ................................................................................4

1.4 Self-Assessment Questions ........................................................................10

1.5 Key Terms ..................................................................................................10

1.6 Recommended Books ................................................................................10

1.7 Links/Bibliography ....................................................................................11

2
1.1 Introduction
In the begging of this unit we look at Ten Principles of Economics, outlines by Gregory
Mankive in his book “Principles of Economics”. These principles give you an overview
about economics and help to understand what economics all is about.

Ten Principles of Economics:

1) People face trade-offs
2) The cost of something is what you give up getting it
3) Rational people think at the margin
4) People respond to incentives
5) Trade can make everyone better off
6) Markets are usually a good way to organize economic activity
7) Governments can sometimes improve market outcomes
8) A country's standard of living depends on its ability to produce goods and services
9) Prices rise when the government prints too much money
10) Society faces a short-run tradeoff between Inflation and unemployment.

For further detail see the chapter: 1 Ten Principles of Economics by Gregory
Mankive in books “Principles of Economics” and watch the video lecture.

The field of economics is traditionally divided into two broad areas microeconomics and
macroeconomics. This unit relates with study of macroeconomics. After having concept
of economics in this unit, now you will learn some of the major concepts of
macroeconomics, such as definition and meaning of macroeconomics, evolution of
macroeconomics (e.g. classical and new classical treatment about the recession, J.M
Keynes views about macroeconomic with new thinking and thoughts of modern
macroeconomist). Moreover, scope of macroeconomics and its issues like
unemployment, inflation and economic growth will be discussed. The macroeconomics
tackles these issues with the help of Models. These models contain the macroeconomic
variables which are associated with one another through causal relations. These estimated
models such as inflation and unemployment, money supply and demand, saving and
investment are helpful for economist to make policies such as fiscal and monetary,
through using their tools goods market (IS) and money market (LM).

1.2 Learning Outcomes

By the end of this unit, and having completed the essential readings and activities, you
should be able to:
 familiarize with the key concepts of macroeconomics.
 evaluate the importance of macroeconomics.
 explore the objectives of macroeconomics
 highlights the main issues of macroeconomics
 identify the mutual relationship among economic variables.

3
 familiarize a wide range of economic models to analyze existing and past
macroeconomic events.
 use the tools of macroeconomic policy.
 recognize the macroeconomic policy framework.

1.3 Main Topics to Discuss

1.3.1 Introduction and Definition of Macroeconomics
The word macroeconomics is obtained from Greek language “Makros meaning “Large”.
The term macroeconomic applies to the study of relations between broad economic
aggregates. So, macroeconomics is a branch of economics dealing with the performance,
structure, behavior and decision-making of an economy as a whole. Macroeconomists
study aggregated (sum ) indicators such as Gross Domestic Product (GDP),
unemployment rates, national income, price indices, and the interrelations among the
different sectors of the economy to better understand how the whole economy perform.
Economists also develop models that explain the relationship between such factors as
national income, output, consumption, unemployment, inflation, savings, investment,
international trade and international finance. Macroeconomics concerns primarily with
the forecasting of national income and inflation through the analysis of major economic
factors that show their predictable patterns and trends, their influence on one another.
These major macroeconomics indicators are given bellow in more detail:
 Economic Growth/National Output:
National output is the total amount of everything a country produces in a given
period of time. Everything that is produced and sold generates an equal amount of
income. The total output of the economy is measured Gross Domestic Product
(GDP) per person. GDP is defined as the market value of goods and services
produce in a country within one year.
 Unemployment:
The amount of unemployment in an economy is measured by the unemployment
rate, i.e. the percentage of workers without jobs in the labor force. The
unemployment rate in the labor force includes workers actively looking for jobs.
 Inflation:
Persistent (gradually) rise the general price level of goods and services across the
entire economy of the country is called inflation.

1.3.2 Development/Evolution of Macroeconomics

It is hard to imagine that anyone who lived during the Great Depression was not
profoundly affected by it. From the beginning of the Depression in 1929 to the time the
economy hit bottom in 1933, real GDP plunged nearly 30%. Real per capita disposable
income sank nearly 40%. More than 12 million people were thrown out of work; the
unemployment rate soared from 3% in 1929 to 25% in 1933. Some 85,000 businesses
failed. Hundreds of thousands of families lost their homes. The collapse seemed to defy
the logic of the dominant economic view that economies should be able to reach full
employment through a process of self-correction. The old ideas of macroeconomics did

4
not seem to work, and it was not clear what new ideas should replace them. In Britain,
Cambridge University economist John Maynard Keynes struggled with ideas that his
thoughts will stand the conventional wisdom on its head. He was confident that he has
found the key not only to understand the Great Depression, but also to correct it. To
understand the macroeconomics in a better way we discuss here the evaluation of
macroeconomics with detail in different school of thoughts.

Classical Macroeconomics
Classical economists like Adam Smith, Ricardo, Say and Marshal etc. discussed the
working of the economy till 1930’s “Great Depression”. The main focus of these
economists was on:
 Flexibility of prices
 Flexibility of wages
 Flexibility of interest
 Constant velocity of circulation of money
 There is always full employment in the economy

J.M Keynes Macroeconomics

Keynesian approach is relatively recent as compared with classical approach. The British
economist John Maynard Keynes wrote a book in 1930 “Theory of Employment, Interest
and Money”. He disagreed with classical theory of full employment and presented theory
of income and employment. Keynes assumed that:
 Wages and prices adjust slowly or flexible
 There is not always full employment equilibrium in the economy
 There are inflation and unemployment in the economy
 To remove problems government intervention may help.

Development of Modern Macroeconomics

Monetarist
The Monetarist school is largely credited to the works of Milton Friedman. Monetarist
economists believe that the role of government is to control inflation by controlling the
money supply. Monetarists believe that markets are typically clear and that participants
have rational expectations. Monetarists reject the Keynesian notion that governments can
"manage" demand and that attempts to do so are destabilizing and likely to lead to
inflation.

New Keynesian
The New Keynesian school attempts to add microeconomic foundations to traditional
Keynesian economic theories. While New Keynesians do accept that households and
firms operate based on rational expectations, they still maintain that there are a variety of
market failures, including sticky prices and wages. Because of this "stickiness", the
government can improve macroeconomic conditions through fiscal and monetary policy.

5
Neoclassical
Neo classical economics assumes that people have rational expectations and strive to
maximize their utility. This school presumes that people act independently based on all
the information they can attain. The idea of marginalist and maximizing marginal
utility is attributed to the neoclassical school, as well as the notion that economic agents
act on the basis of rational expectations. Since neoclassical economists believe the market
is always in equilibrium, macroeconomics focuses on the growth of supply factors and
the influence of money supply on price levels.

New Classical
The New Classical School is built largely on the neoclassical school. The New Classical
School emphasizes the importance of microeconomics and models based on that behavior.
New Classical economists assume that all agents try to maximize their utility and
have rational expectations. They also believe that the market always clears. New Classical
economists believe that unemployment is largely voluntary, and that discretionary fiscal
policy is destabilizing, while inflation can be controlled with monetary policy.

1.3.3 Scope and Importance of Macroeconomics

Macroeconomists use their expertise to do:
a) Macroeconomic Forecasting
b) Macroeconomic Analysis
c) Macroeconomic Research
d) Develop and Test an Economic Theory
e) Collect Data

a) Macroeconomic Forecasting
Forecasting is the process of making predictions about the economy. Forecasts can
be carried out at a high level of aggregation for example for GDP, inflation,
unemployment or the fiscal deficit or at a more disaggregated level, for specific
sectors of the economy or even specific firms.
b) Macroeconomic Analysis
Macroeconomic analysis comprises economic trend analysis, long-term
macroeconomic projections, analysis of alternative trends, impact of fiscal and
monetary measures and counterfactual simulations of the economy.
c) Macroeconomic Research
The basic definition of macroeconomic research means to explore the something
new in economy. The general insights about the economy may be gained from
successful research form the basis for the analyses of specific economic problems,
policies or situations. For example, the fields of inflation rate, growth rate and
unemployment rate.
d) Develop and Test an Economic Theory
Macroeconomic research proceeds primarily through the formulation and testing of
theories. Following are the main steps in developing and testing an economic
theory or model.
i) State the research question

6
 ii) Make provisional assumption
iii) Work out the implication of theory
iv) Conduct an empirical analysis
v) valuation of the results.
e) Collect data
Data collection is the process of gathering and measuring data, information or any
variables of interest in a standardized and established manner that enables the
collector to answer or test hypothesis and evaluate outcomes of the collection.

1.3.4 Objectives of Macroeconomics

Among the vital objectives of macroeconomics to be achieved are:
 Achieving Full Employment
This does not mean that there will be no unemployment at all or that the rate of
unemployment will be zero in a country. Basically, economists agree that there can
still be unemployment although the economy is at a level where it has achieved full
employment, meaning that where those who are able and willing to have a job can
get one.
 Price Stability
Generally, price stability means there are no changes in general price levels. This
also means that the prices of some goods and services may increase, while some
other prices may drop at the same time. When prices remain largely stable, there is
no rapid inflation or deflation.
 Good Economic Growth
Achieving good economic growth is also one of the aims of macroeconomics. This
would mean there is an increase in the real per capita income from year to year.

1.3.5 Macroeconomic Issues or Concern

The issues in macroeconomic analysis are:
i) Low Economic Growth and Living Standards in a Country
One of the main issues in the economy since a century ago, developed countries
(e.g. America, England and Australia) have achieved a high rate of economic
growth which in turn raised their people standard of living. Macroeconomics
examine the reasons behind the speedy economic growth in the developed nations
and understands the reason why this growth is different between the various
countries.
ii) Productivity
The average labor productivity or the output of a single worker is important to
determine the standard of living. Macroeconomics will question the factors which
decide on the employee productivity growth rate.
iii) What is the Cause of Decline and Growth in an Economy?
Any economy will surely go through decline and growth. In relation to this,
macroeconomics will look at the causes of these changes in the economy and the
government policies that can be implemented to overcome an economic problem.
iv) What are Factors Affecting Unemployment?

7
 Rate of unemployment means there is an available work force that wants to work
but has no jobs. The rate of unemployment will increase when there is a decline in
the economy, but unemployment also happens when the economic situation is
good. Macroeconomics will examine the reasons for unemployment, types of
unemployment and ways to overcome unemployment.
v) What are Factors that Cause the General Price Levels or Inflation to Rise?
Inflation is an increase in the general price level which is usually measured by
changes in the Consumer Price Index. The questions asked in a macroeconomics
analysis are:
 What are the factors affecting inflation?
 Why does inflation rate differ from time to time?
 Why does inflation rate differ from one country to another?

1.3.6 Macroeconomic Variables and their Relationships

A variable is a quantity which goes on to change and may assume different values. There
are main macroeconomic variables such as Income, Consumption, Saving, Investment,
Government expenditure, Demand for money, Supply of money, Balance of Payments,
Inflation, Economic Growth and Unemployment.

This can be easily remembered using the followings abbreviations:

 I: Inflation
 G: (Economic)Growth
 E: Employment
 I: International Trade
 M&F: Monetary and Fiscal Policy
 INT: Interest rate
 SM: Stock Market
 ER: Foreign Exchange Rate etc.

All these variables are interrelated for their functional relationship. The detail about of
these, macroeconomic basic concepts please see Mankive Book chapter #1

1.3.7 Economic Models

Economic modelling is at the heart of economic theory. Modelling provides a logical,
abstract template to help organize the analyst's thoughts. The model helps the economist
logically isolate and sort out complicated chains of cause and effect and influence
between the numerous interacting elements in an economy. Using a model, the economist
can experiment, at least logically, producing different scenarios, attempting to evaluate
the effect of alternative policy options, or weighing the logical integrity of arguments
presented in prose. An economic model is a simplified version of reality that allows us to
observe, understand, and make predictions about economic behaviour. The purpose of a
model is to take a complex, real-world situation and pare it down to the essentials. If
designed well, a model can give the analyst a better understanding of the situation and
any related problems. A good model is simple enough to be understood while complex

8
enough to capture key information. Sometimes economists use the term theory instead
of model. Strictly speaking, a theory is a more abstract representation, while a model is a
more applied or empirical representation. Often, models are used to test theories. In this
course, however, we will use the terms interchangeably.

1.3.8 Tools of Macroeconomic Policy and Macroeconomic Framework

The study of macroeconomics relates to the economic growth of a country. Although
many factors contribute towards economic growth such as natural resources, human
resources, capital stocks, technology, and people’s choice of economy, government
policies also play an important role in this aspect. Therefore, it is also important for you
to understand the effects of the many policies and the need to develop a better policy as
this is an important aim in macroeconomics. Macroeconomic policies affect the overall
performance of the economy. Two main macroeconomics policies are the financial policy
or monetary policy and fiscal policy.

As our macroeconomic goals are not typically confined to full employment, price
stability, rapid growth, balance of payment equilibrium and stability in foreign exchange
rate, so our macroeconomic policy instruments include monetary policy, fiscal policy,
income policy in a narrow sense. But, in a broader sense, these instruments should
include policies relating to labor, tariff, agriculture, anti-monopoly and other relevant
ones that influence the macroeconomic goals of a country. Confining our attention in a
restricted way we intend to consider two types of policy instruments the two “giants of
the industry” monetary (credit) policy and fiscal (budgetary) policy. These two policies
are employed toward altering aggregate demand to bring about a change in aggregate
output (GNP/GDP) and prices, wages and interest rates, etc., throughout the economy.
Monetary policy attempts to stabilize aggregate demand in the economy by influencing
the availability or price of money, i.e., the rate of interest, in an economy.

 Monetary Policy
Economists believe that changes in the money supply will influence important
macroeconomics variables such as national output, labour force, interest rate,
inflation, share prices and foreign currency exchange. Financial policy is controlled
by the central bank which acts as a government agency (in Pakistan, it is dealt with
by State Bank of Pakistan). Monetary policy attempts to stabilise aggregate
demand in the economy by influencing the availability or price of money, i.e., the
rate of interest, in an economy.
 Fiscal Policy
A good balance between government expenditure and government revenue is
important. When government spends more than the income tax collected, it suffers
a budget deficit. Meanwhile, if the government revenue is more than its
expenditure, then the government will have a budget surplus. Fiscal policy, on the
other hand, aims at influencing aggregate demand by altering tax- expenditure-debt
programme of the government. The credit for using this kind of fiscal policy in the
1930s goes to J.M. Keynes who discredited the monetary policy as a means of
attaining some of the macro- economic goals such as the goal of full employment.

9
 As fiscal policy has come into scrutiny in terms of its effectiveness in achieving the
desired macroeconomic objectives, the same is true about the monetary policy.

1.4 Self-Assessment Questions

1. What is the difference between the macroeconomics and microeconomics?
Illustrate by citing two applications for each course.
2. Classical school of thought emphasize on supply side of economy is it true?
Explain.
3. Explain the concept and evolution of macroeconomics.
4. Discuss the relationship between different macroeconomic variables.
5. Which type of policy is more effective in great depression?
6. Which type of policy is followed in case of Pakistan?

1.5 Key Terms

Microeconomics: Study of small economic units such as individuals, firms, and
industries (competitive markets, labour markets, personal decision making, etc)
Macroeconomics: Study of the large economy or in its basic subdivisions (National
Economic Growth, Government Spending, Inflation, Unemployment, etc)
Rational Behavior: This is a part of decision-making practice wherein an
individual/company exercises sensible choice making, which provides him with the
optimum amount of benefit.
Employment: Employment is a specific form of work, in which the worker performs
their labor for someone else in return for a money wage or salary.
Exchange Rate: The “price” at which the currency of one country can be converted into
the currency of another country.
Fiscal Policy: The spending and taxing activities of government constitute its fiscal
policy.
Investment: Investment represents production, which is not consumed, but rather is
utilized in the production of other additional output. Investment also represents an
addition to the capital stock of an economy.
Money: Money is anything that can be used as a means of payment (for example, to
settle a debt). It includes actual currency, bank deposits, credit cards and lines of credit,
and various modern electronic means of payment.
Inflation: A process whereby the average price level in an economy increases over time.

1.6 Recommended Books

1. Mankive, N. Gregory. Principles of Macroeconomics (Chapters 1&2)
2. Able, Andrew, B., Bernanke, BenS. & Croushore, D. Macroeconomics (Chapter 1)
3. Richard T. Froyen. Macroeconomics (Chapter 1)

10
Additional Books:
1. Parkin, Michael - Macroeconomics, Latest Edition
2. Miller, R.L.– Economics Today – Latest Edition

1.7 Links/Bibliography
For further information on topics in this unit, additional problems, applications,
examples, online quizzes, and more, please visit the following websites.

Note: These websites were viewed, when the study guide has been developed.

 Viewed on 18/2/2019 at: www.cengage.com/economics/mankiw.

 Viewed on 18/2/2019 at: www.economicsdiscussion.net/microeconomics/
macroeconomic-policy
 Viewed on 20/2/2019 at: https://science.blurtit.com/107177/what-are-the-tools-of-
macroeconomic- policy
 Viewed on 20/2/2019 at: www.economicsdiscussion.net/macroeconomics/
development...macro-economics.
 Viewed on 22/2/2019 at: https://www.quora.com/Why-do-people-study-
macroeconomics
 https://tophat.com/marketplace/social-science/economics/textbooks/oer-openstax-
macroeconomics-openstax-content/82/4018
 Viewed on 21/2/2019 at: www.sbp.edu.pk
 Viewed on 23/2/2019 at www.esp.edu.pk:
 Viewed on 23/2/2019 at www.pbs.edu.pk:

11
12
UNIT-2

MEASURING NATIONAL INCOME

AND THE COST OF LIVING

Written by: Mr. Sharafat Afzal

Reviewed by: Dr. Fouzia Jamshaid

13
 CONTENTS

2.1 Introduction ................................................................................................15

2.2 Learning Outcomes ....................................................................................15

2.3 Main Topics to Discuss ..............................................................................16

2.4 Self-Assessment Questions ........................................................................24

2.5 Key Terms ..................................................................................................24

2.6 Recommended Books ................................................................................24

2.7 Links/Bibliography ....................................................................................25

14
2.1 Introduction
This unit presents an overview of national income accounts or national account systems
(NAS) are the implementation of complete and consistent accounting techniques for
measuring the economic activity of a nation. These include detailed underlying measures
that rely on double-entry accounting. By design, such accounting makes the totals on
both sides of an account equal even though they each measure different characteristics,
for example production and the income from it. As a method, the subject is
termed national accounting or, more generally, social accounting. Stated otherwise,
national accounts as systems may be distinguished from the economic data associated
with those systems. While sharing many common principles with business accounting,
national accounts are based on economic concepts one conceptual construct for
representing flows of all economic transactions that take place in an economy is a social
accounting matrix with accounts in each respective row-column entry.

National accounting has developed in tandem with macroeconomics from the 1930s with
its relation of aggregate demand to total output through interaction of such broad
expenditure categories as consumption and investment. Economic data from national
accounts are also used for empirical analysis of economic growth and development.

National accounts broadly present output, expenditure, and income activities of the
economic actors (households, corporations, government) in an economy, including their
relations with other countries' economies, and their wealth (net worth). There are a
number of aggregate measures in the national accounts, notably including gross domestic
product or GDP, perhaps the most widely cited measure of aggregate economic activity.
Ways of breaking down GDP include as types of income (wages, profits, etc.) or
expenditure (consumption, investment/saving, etc.). Measures of these are examples of
macroeconomic data. Such aggregate measures and their change over time are generally
of strongest interest to economic policymakers.

2.2 Learning Outcomes

By the end of this unit, and having completed the essential readings and activities, you
should be able to:
 familiarize with the key concepts of national income: GDP, GNP, NNP, Disposable
Income, etc.
 use main methods to compute national income or outcome.
 define Gross Domestic Product (GDP) and its difference with entire other measures.
 differentiate between intermediate and Final Goods.
 understand the concept circular flow of national income.
 help to distinguished between GDP, price indexes and inflation.
 enable to understand the relationship between GDP and economic well-being.
 calculate the unemployment rate in the economy.
 justify his/herself that what types of method and key terminologies used in
economic studies.

15
2.3 Main Topics to Discuss
2.3.1 Introduction and Key Concepts of National Income
National income is a very basic concept in macroeconomics about which we should know
how much output our economy is producing over a given period. National income
statistics give us much information about how a nation’s economic growth and related
objectives such as: quality of life, standard of living of one country compared to another.
In this unit, we have a closer look in measuring national income and its significance on a
nation’s well-being.

Various measures of the nation’s income or output exist but the most frequently cited
measures are: National income, as known as Gross Domestic Product (GDP), is the
money value of total goods and services produced within a country over a twelve-month
period. This annual figure is very helpful to the economists to track the economic
growth’s rate, average living standard in one country as well as the distribution of income
between different groups of population (i.e. inequality gap). Three major components of
national income accounts are: output, spending expenditure and income; which
respectively represent three methods of measuring GDP.

Firstly, GDP value can be measured by adding up the total final value of goods and
services that are manufactured within an economy, industry by industry using the concept
is value added. Value added is defined as the increase in the value of a product at each
consecutive stage of the production process. The reason for this approach is to avoid the
problems of double counting the value of intermediate inputs. There are three productive
sectors in an economy: primary (agriculture goods), secondary (manufactured goods) and
tertiary (services), quaternary (research and development). Second, we can also generate
national income level by adding up total incomes of each individual household from
production in form of wages, salaries, profits, rents and interest. It is important to take
notice that only those incomes that are generated from production activities count for the
GDP calculation. By that we must exclude: Income that is not registered with the Inland
Revenue or Customs and Excise (underground economy earned income), transfer
payment from Government (income support, unemployed benefit, state pension…)

2.3.2 Main Factors to Determine National Account

Gross Domestic Product (GDP)
Gross domestic product (GDP) is a monetary measure of the market value of all the final
goods and services produced in a period of time, often annually or quarterly. It means
Size of GDP Gross domestic product (GDP) is the standard measure of the value of final
goods and services produced by a country during a period. While GDP is the single most
important indicator to capture these economic activities, it is not a good measure of
societies’ well-being and only a limited measure of people’s material living standards.
The sections and indicators that follow better address this and other related issues and this
is one of the primary purposes of this publication. Countries calculate GDP in their own
currencies. In order to compare across countries these estimates must be converted into a
common currency. Often the conversion is made using current exchange rates, but these

16
can give a misleading comparison of the true volumes of final goods and services in
GDP. A better approach is to use purchasing power parities (PPPs). PPPs are currency
converters that control for differences in the price levels of products between countries
and so allow an international comparison of the volumes of GDP and of the size of
economies

Gross National Product (GNP)

Gross national product (GNP) is the market value of all the goods and services produced
in one year by labor and property supplied by the citizens of a country. Unlike gross
domestic product (GDP), which defines production based on the geographical location of
production, GNP indicates allocated production based on location of ownership. In fact, it
calculates income by the location of ownership and residence, and so its name is also the
less ambiguous gross national income.

GNP is an economic statistic that is equal to GDP plus any income earned by residents
from overseas investments minus income earned within the domestic economy by
overseas residents. GNP does not distinguish between qualitative improvements in the
state of the technical arts (e.g., increasing computer processing speeds), and quantitative
increases in goods (e.g., number of computers produced), and considers both to be forms
of "economic growth"

Comparison of GNP and GDP

The main difference is that GNP (Gross National Product) considers net income receipts
from abroad. GDP (Gross Domestic Product) is a measure of national income / national
output and national expenditure produce in a country. GNP = GDP + Net Factors income
from abroad (NFIA).

Difference between the GDP and GNP

Comparison GDP GNP

Meaning The worth of goods and services produced The worth of goods and services
within the geographical limits of the country produced by the country's citizens
is known as Gross Domestic Product (GDP) irrespective of the geographical location is
known as Gross National Product (GNP)
What is it? Production of products within the country's Production of products by the enterprises
boundary. owned by the residents of the country.
Calculation GDP = Consumption + Investment + GNP = GDP – NFIA
Government Spending + Net Export
The productivity scale On a local scale On international scale

2.3.3 Methods of Computing the National Income

GDP can be determined in three ways, all of which should, in principle, give the same
result. They are the production (or output or value added) approach, the income approach,
or the speculated expenditure approach.

17
1. Production approach
This approach mirrors the OECD definition given above.
 Estimate the gross value of domestic output out of the many various
economic activities;
 Determine the [intermediate consumption], i.e., the cost of material, supplies
and services used to produce final goods or services.
 Deduct intermediate consumption from gross value to obtain the gross value
added.
Gross value added = gross value of output – value of intermediate consumption.
Value of output = value of the total sales of goods and services plus value of
changes in the inventory.
2. Income approach
The second way of estimating GDP is to use the sum of primary incomes
distributed by resident producer units. If GDP is calculated this way it is sometimes
called gross domestic income (GDI), or GDP (I). GDI should provide the same
amount as the expenditure method described later. GDI is equal to GDP. In
practice, however, measurement errors will make the two figures slightly off when
reported by national statistical agencies. This method measures GDP by adding
incomes that firms pay households for factors of production they hire wages for
labor, interest for capital, rent for land and profits for entrepreneurship.
The US “National Income and Expenditure Accounts” divide incomes into five
categories:
 Wages, salaries, and supplementary labor income
 Corporate profits
 Interest and miscellaneous investment income
 Farmers' incomes
 Income from non-farm unincorporated businesses
These five income components sum to net domestic income at factor cost.
3. Expenditure approach
The third way to estimate GDP is to calculate the sum of the final uses of goods
and services (all uses except intermediate consumption) measured in purchasers'
prices. Produced market goods are purchased by someone. In the case where a
good is produced and unsold, the standard accounting convention is that the
producer has bought the good from themselves. Therefore, measuring the total
expenditure used to buy things is a way of measuring production. This is known as
the expenditure method of calculating GDP.

Components of GDP by Expenditure

GDP (Y) is the sum of consumption (C), investment (I), government spending
(G) and net exports (X – M).
Y = C + I + G + (X – M)

18
Here is a description of each GDP component:

a. Consumption
Consumption is normally the largest GDP component in the economy, consisting
of private expenditures in the economy (household final consumption expenditure).
These personal expenditures fall under one of the following categories: durable
goods, nondurable goods, and services. Examples include food, rent, jewelry,
gasoline, and medical expenses, but not the purchase of new housing.
b. Investment
Investment includes, for instance, business investment in equipment, but does not
include exchanges of existing assets. Examples include construction of a new mine,
purchase of software, or purchase of machinery and equipment for a factory.
Spending by households (not government) on new houses is also included in
investment. In contrast to its colloquial meaning, "investment" in GDP does not
mean purchases of financial products. Buying financial products is classed as
'saving', as opposed to investment. This avoids double-counting: if one buys shares
in a company, and the company uses the money received to buy plant, equipment,
etc., the amount will be counted toward GDP when the company spends the money
on those things; to also count it when one gives it to the company would be to
count two times an amount that only corresponds to one group of products.
Buying bonds or stocks is a swapping of deeds, a transfer of claims on future
production, not directly an expenditure on products.
c. Government Spending
Government spending is the sum of government expenditures on final goods and
services. It includes salaries of public servants, purchases of weapons for the
military and any investment expenditure by a government. It does not include
any transfer payments, such as social security or unemployment benefits.
d. Exports
Exports represent gross exports. GDP captures the amount a country produces,
including goods and services produced for other nations' consumption, therefore
exports are added.
e. Imports
Imports represent gross imports. Imports are subtracted since imported goods will
be included in the terms G, I, or C, and must be deducted to avoid counting
foreign supply as domestic.

2.3.4 Intermediate and Final Goods

i. Final Goods:
Final goods refer to those goods which are used either for consumption or for
investment. Final Goods include:
 Goods purchased by consumer households as they are meant for final
consumption (like milk purchased by households).
 Goods purchased by firms for capital formation or investment (like
machinery purchased by a firm).

19
 It must be noted that final goods are neither resold nor used for any further
transformation in the process of production.
ii. Intermediate Goods:
Intermediate goods refer to those goods which are used either for resale or for
further production in the same year. Intermediate Goods include:
 Goods purchased for resale (like milk purchased by a Dairy Shop).
 Goods used for further production (like milk used for making sweets).
iii. National Income includes only Final Goods:
Only final goods are included in national income. The intermediate goods are not
included in the national income as they are already included in the final goods. If
their value is added again, it will lead to double counting, like out of wheat and
flour, only flour (final good) is included in National Income as value of flour
already includes the value of wheat (intermediate good).

2.3.5 Saving and Wealth

 Saving
Saving is income not spent, or deferred consumption. Methods of saving include
putting money aside in, for example, a deposit account, a pension account,
an investment fund, or as cash. Saving also involves reducing expenditures, such as
recurring costs. In terms of personal finance, saving generally specifies low risk
preservation of money, as in a deposit account, versus investment, wherein risk is a
lot higher; in economics more broadly, it refers to any income not used for
immediate consumption.

Wealth
Household wealth = a household’s assets minus its liability’s National wealth = sum of
all households’, firms’, and governments’ wealth within the nation saving by individuals,
businesses, and government determine wealth. Wealth is a stock variable; saving is a
flow variable.

2.3.6 The Circular Flow of National Income

i. Two Sector Model
The circular flow of income is a concept for better understanding of
the economy as a whole and for example the National Income and Product
Accounts (NIPAs). In its most basic form it considers a simple economy consisting
solely of businesses and individuals, and can be represented in a so-called "circular
flow diagram." In this simple economy, individuals provide the labor that enables
businesses to produce goods and services. These activities are represented by the
green lines in the figure: 2.1.

20
Model of the circular flow of income and expenditure

Alternatively, one can think of these transactions in terms of the monetary flows that occur.
Businesses provide individuals with income (in the form of compensation) in exchange for
their labor. That income is spent on the goods and services businesses produce. These
activities are represented by the blue lines in the diagram above. The circular flow diagram
illustrates the interdependence of the “flows,” or activities, that occur in the economy, such as
the production of goods and services (or the “output” of the economy) and the income
generated from that production. The circular flow also illustrates the equality between the
income earned from production and the value of goods and services produced.
ii. Three Sector Model
It includes household sector, producing sector and government sector. It will study
a circular flow income in these sectors excluding rest of the world i.e. closed
economy income. Here flows from household sector and producing sector to
government sector are in the form of taxes. The income received from the
government sector flows to produce and household sector in the form of payments
for government purchases of goods and services as well as payment of subsidies
and transfer payments. Every payment has a receipt in response of it by
which aggregate expenditure of an economy becomes identical to aggregate income
and makes this circular flow unending.

21
2.3.7 Real Vs Nominal (GDP), Inflation and Prices Indices

Difference between Real and Nominal Gross Domestic Product

Comparison Real GDP Nominal GDP

Meaning Sum of the output produce in market at The sum of output produces in market at current
base year price level year price level.
Based on Based year market price Current year market price
Popularity Most popular Less popular
Complexity Its calculation is most complex to Its calculation is less complex for computation
computation

The Inflation and Price Indices

What is meant by Inflation?
Inflation is the rate at which the general level of prices for goods and services rise. As for
price increase, this leads to falling in purchasing power of the currency. It is very much
necessary to keep inflation rate within permissible limits for the smooth functioning of an
economy.

What is Meant by Index?

An index number is an economic data figure reflecting price or quantity compared with a
standard or base value. The base usually equals 100 and the index number is usually
expressed as 100 times the ratio to the base value. For example, if a commodity costs
twice as much in 2020 as it did in 2010, its index number would be 200 relative to 2010.
Index numbers are used, especially to compare business activity, the cost of living,
and employment. They enable economists to reduce unwieldy business data into easily
understood terms.

2.3.8 GDP and Economic Wellbeing

The market value of all the goods and products produced or provided within a country at
a given moment in time. This identifies the first issue in which GDP fails to accurately
measure the welfare of an economy. GDP should be considered as an indicator of
economic activity. It is also necessary to know whether the policy will affect other
aspects of economic well-being that are not captured in GDP.

Environmental regulations may reduce production of steel, for example, which reduces
the GDP. As a result, air quality improves. But the regulations should be adopted if the
benefits of cleaner air are worth more to people than the costs of the regulations in terms
of lost output and lost jobs. Real GDP per person tends to be positively associated with
various things which are of much value to people such as a high material standard of
living, better health and life expectations and better education. We may now discuss
some of the ways in which higher real GDP implies greater economic well-being.

2.3.9 The consumer Price Index (CPI)

CPI measures changes in the prices of goods and services purchased by households for
consumption. The five broad components of CPI involve Food Beverages and Tobacco,

22
Fuel and Light, Housing, Clothing bedding and footwear, miscellaneous. The prices of
the representative items are collected at regular intervals and used for computing the
index. CPI can also be used to index the real value of salaries, wages and pensions to
gauge the increase in price. The SBP widely uses CPI numbers as a macroeconomic
indicator of inflation and for the purpose of supervising the price stability.

The CPI is a statistical estimate constructed using the prices of a sample of representative
items whose prices are collected periodically. Sub-indices and sub-sub-indices are
computed for different categories and sub-categories of goods and services, being
combined to produce the overall index with weights reflecting their shares in the total of
the consumer expenditures covered by the index. It is one of several price
indices calculated by most national statistical agencies. The annual percentage change in
a CPI is used as a measure of inflation. A CPI can be used to index (i.e. adjust for the
effect of inflation) the real value of wages, salaries, pensions, for regulating prices and
for deflating monetary magnitudes to show changes in real values. In most countries, the
CPI, along with the population census, is one of the most closely watched national
economic statistics.

2.3.10 The Unemployment Rate

The unemployment rate is a measure of the prevalence of unemployment and it is
calculated as a percentage by dividing the number of unemployed individuals by all
individuals currently in the labor force. During periods of recession, an economy usually
experiences a relatively high unemployment rate. Millions of people globally or 6% of
the world's workforce are without a job currently.

The causes of unemployment are heavily debated. Economists argued that market
mechanisms are reliable means of resolving unemployment. These theories argue against
interventions imposed on the labor market from the outside, such as unionization,
bureaucratic work rules, minimum wage laws, taxes and other regulations that they claim
discourage the hiring of workers. Keynesian economics emphasizes the cyclical nature of
unemployment and recommends government interventions in the economy that it claims
will reduce unemployment during recessions. This theory focuses on
recurrent shocks that suddenly reduce aggregate demand for goods and services and thus
reduce demand for workers. Keynesian models recommend government interventions
designed to increase demand for workers; these can include financial stimuli, publicly
funded job creation, and expansionist monetary policies. Keynes believed that the root
cause of unemployment is the desire of investors to receive more money rather than
produce more products, which is not possible without public bodies producing new
money. A third group of theories emphasize the need for a stable supply of capital and
investment to maintain full employment.

23
The unemployment rate: Labor Force Participation Rate= Labor Force/Adult
Population.

2.4 Self-Assessment Questions

1. Do higher incomes and more output always equal a higher quality of life for the
people experiencing such growth? Explain.
2. Under what circumstances would an increase in a nation's average income not lead
to an increase in the income of the typical, median household?
3. Choose an alternative measure of well-being and describe what it includes.

2.5 Key Terms

Gross Domestic Income (GDI): Gross domestic income (GDI) is the sum of all income
earned while producing goods and services within a nation's borders.

Personal Income and Outlays: Personal Income and Outlays is a group of two data
points produced by the Bureau of Economic Analysis that track personal income and
monthly spending.
Gross National Income (GNI): Gross National Income is the sum of a nation's Gross
Domestic Product and net income it receives from overseas. See how it differs from GDP
and GNP.

Macro Accounting: Macro accounting is the compilation of national accounts, or

macroeconomic data, of a country.

Per Capita: Per capita is a Latin term that translates to "by head" and that is interpreted
as meaning per person. It is the average per person and is often used in place of per
person in statistical observances.

Income Statement Definition: An income statement is one of the three major financial
statements that reports a company's financial performance over a specific accounting
period.

2.6 Recommended Books

1. Mankive, N. Gregory. Principles of Macroeconomics (Chapters 10&11)
2. Able, Andrew, B., Bernanke, Ben S. & Croushore, D. Macroeconomics (Chapter 2)
3. Richard T. Froyen. Macroeconomics (Chapter 2)

Additional Books:
1. Parkin, Michael - Macroeconomics, Latest Edition
2. Miller, R.L.– Economics Today – Latest Edition

24
2.7 Links/Bibliography
For further information on topics in this unit, additional problems, applications,
examples, online quizzes, and more, please visit the following websites.

Note: These websites were viewed, when the study guide has been developed.

 Viewed on 30/2/2019 at: www.cengage.com/economics/mankiw.

 Viewed on 30/2/2019 at: https://www.quora.com/Why-do-people-study-
 Viewed on 3/3/2019 at: macroeconomics
 Viewed on 5/3/2019 at: www.sbp.edu.pk
 Viewed on 5/3/2019 at: www.esp.edu.pk
 Viewed on 5/3/2019 at: www.pbs.edu.pk

25
26
UNIT-3

PRODUCTIVITY, OUTPUT
AND EMPLOYMENT

Written by: Ms. Samia Ali

Reviewed by: Dr. Fouzia Jamshaid

27
 CONTENTS

3.1 Introduction ................................................................................................29

3.2 Learning Outcomes ....................................................................................30

3.3 Main Topics to Discuss ..............................................................................30

3.4 Self Assessment Questions ........................................................................36

3.5 Key Terms ..................................................................................................37

3.6 Recommended Books ................................................................................37

3.7 Links/Bibliography ....................................................................................38

28
3.1 Introduction
In Unit two, we have discussed measurement of national income, cost of living and
different concept of national income in detail. Unit 3 of this study guide begins with the
discussion about how economy works with what is perhaps the most fundamental
determinant of economic well-being in a society: the economy’s productive capacity. The
economy will produce more goods and services the more people will consume it. This
unit also describes factors that determine the level of output produced in an economy and
develop theory of the economy.

Economics is the way that how people live their life or it is the study of our wants that
how it comes to fulfill. Economics study the behavior of a person how he consumes the
different things and how he economically behaves. Looking through the history, we find
that economics has gone through different stages and it’s every stage gave the new
concepts to it. For example, people of the distant past knew well that if demand of
something increases then its price also increases when supply increases then price comes
to fall. They understood the importance of saving and investment for generating the more
income in future.

Human beings take more interest in satisfying their needs and wants by consuming more
goods, but goods cannot be in market until they are produced. Production of goods and
services is the most important requirement in the process of satisfying our desires.
Productivity, in economics, measures output per unit of input, such as labor, capital or
any other resource and is typically calculated for the economy as a whole, as a ratio
of gross domestic product (GDP) to hours worked. Labor productivity may be further
broken down by sector to examine trends in labor growth, wage level.

An increase in the amount of goods and services produced per head of the population
over a period is and technological improvement. A way to generate economic growth is
to grow the labor force. All else equal, more workers generate more economic goods and
services.
After going through the study of productivity and employment in economics, you can
easily approach roles and law of productivity and employment circle in economics of any
trade. Productivity directly links to the power of our willingness to do and ability to
purchase. Productivity has positive relationship with employment. Employment level of a
firm or industry doesn’t increase level of production unless there are not enough
resources to purchase new or more quantity of goods and services.

Now production is the result of four factor production, and they are labor land capital
organization. This is fact that no single commodity can be produced without any help of
any factor of production. Therefore, the producer combines this factor in a technical way
that he can produce more goods in less cost and earn more profit. In simple words
production function explain the functional relationship between the quantity of a good
produced (output) and factors of production (input).

29
3.2 Learning Outcomes
After studying this unit, and having completed the essential readings and activities, you
should be able to:
• understand the concept of productivity and its role in economic activities.
• describe the determinants of productivity.
• show how public policies effect economic growth.
• define production function.
• analyze the labor market equilibrium with the help of labor demand and supply.
• explain the concept of unemployment and its different types.
• illustrate and explain Okun’s Law.

3.3 Main Topics to Discuss

3.3.1 Productivity: Its Role and Determinants of Productivity
Productivity is a measure of the efficiency of production. It is a ratio of actual output
(production) to what is required to produce it (inputs). Productivity is measured as a total
output per one unit of a total input.

Role of Productivity
• Productivity is a crucial factor in production performance of firms and nations.
• Increasing national productivity can raise living standards because more real
income improves people's ability to purchase goods and services, enjoy leisure,
improve housing and education and contribute to social and environmental
programs.
• Productivity growth also helps businesses to be more profitable.
• Productivity is very important factor for any society’s collective growth. As much
productive people are their economy will grow with the same proportion.
• Increased productivity creates economic growth.
• Increase in productivity allow firms to produce greater output for the same level of
input, earn higher revenues, and ultimate generate higher Gross Domestic Product.

Determinants of Productivity
• Physical capital: consists of knowledge and skill that’s workers acquire through
education, skills and training experiences.
• Human capital: is the stock of equipment’s and structure that are used to produce
goods and services.
• Natural resources: which are inputs into production that are provided by nature.
• Technological Knowledge: is the society’s best way understanding to produce
goods and services.

30
3.3.2 Economic Growth and Public Policy
Economic growth
Economic growth is an increase in the capacity of an economy to produce goods and
services, compared from one period to another. In simplest terms, economic growth
refers to an increase in aggregate productivity. Often, but not necessarily, aggregate gains
in productivity correlate with increased average marginal productivity. This means the
average laborer in a given economy becomes, on average, more productive. It is also
possible to achieve aggregate economic growth without an increased average marginal
productivity through extra immigration or higher birth rates. Economic growth has a
ripple effect. By expanding the economy, businesses start to see a surge in profits, which
means stock prices also see growth. Companies can then raise more money in order to
invest more, therefore adding more jobs to the labor force. That leads to an increase
in incomes, inspiring consumers to open up their wallets and buy more.

Public Policy
Public policy is a process of making strategies and rules for running the system in a
proper way. Public policy making include some steps getting of agenda, policy
formulation, policy adoptions and policy implementation. Example: When lawmakers
pass legislation protecting workers, instituting wage-and-hour laws and providing
enforcement for wage-and-hour laws, this is a public policy decision. The policy is to
protect the rights of workers within the state.

Economic growth defines the living standard of the country and it base how our resources
that’s how they are utilized. The economic growth is also defined as the increase in GDP
as it will increase the per capita income as well as increase. There are numerous forces
that function together to enhance economic growth and development. The role of public
policy has been one of those forces that can have either a positive or negative impact. The
public policy helps to address public issues to the government.

3.3.3 The Production Function

Production function is defined as the transformation of physical input into physical output
where output is the function of input.

It can be expressed mathematically as:

Q=f (K, L)
Where
Q is the output quantity produced in the specific time period, K and L are factors of
production. Figure 3.1 presents the production function. Production or output is the result
of co-operation of four factors of production viz., land, labor, capital and organization.
This is evident from the fact that no single commodity can be produced without the help
of any one of these four factors of production.

31
3.3.4 The Demand for Labor
When producing goods and services, businesses require labor and capital as inputs to
their production process. The demand for labor is an economic principle derived from the
demand for a firm's output. That is, if demand for a firm's output increases, the firm will
demand more labor, thus hiring more staff. And if demand for the firm's output of goods
and services decreases, in turn, it will require less labor and its demand for labor will fall,
and less staff will be retained. In Figure 3.2 D L is demand for labor.

Common Reasons for a Shift in Labor Demand

• Changes in the marginal productivity of labor, such as technological advances
brought on by computers
• Changes in the prices of other factors of production, including shifts in the relative
prices of labor and capital stock
• Changes in the price of an entity’s output, usually from an entity charging more for
their product or service

3.3.5 The Supply of Labor

Labor supply is the total hours that workers or employees are willing to work at a given
wage rate. Figure: 3.3 shows the supply curve of labor which is positively sloped. When

32
wages increase; quantity (Q) supply of labor also increases. Changes in income,
population, work-leisure preference, prices of related goods and services, and
expectations about the future can also cause the labor supply to shift to the right or left.

Key Factors Affecting Labor Supply

• The real wage rate on offer in the industry itself:
• Overtime
• Substitute occupations
• Barriers to entry
• Improvements in the occupational mobility of labor
• Non-monetary characteristics of specific jobs –security, working conditions Net
migration of labor–

3.3.6 Labor Market Equilibrium

In Figure: 3.4 “e” is the equilibrium point where quantity demanded and quantity
supplied is equal at a given time and price. There is no surplus or shortage in this
situation and the market would be considered stable. In other words, consumers are
willing and able to purchase all the products that suppliers are willing and able to
produce. Everyone wins.

33
3.3.7 Unemployment
Unemployment or joblessness is the situation of actively looking for employment but not
being currently employed. The unemployment rate is a measure of the prevalence of
unemployment and it is calculated as a percentage by dividing the number of unemployed
individuals by all individuals currently in the labor force. Unemployment, also called
joblessness, occurs when people are without work and are actively seeking employment.
Unemployment is measured in order to determine the unemployment rate. The rate is a
percentage that is calculated by dividing the number of unemployed individuals by the
number of individuals currently employed in the labor force. Unemployment statistics are
probably one of the most closely monitored indicators of the labor market. In Singapore,
unemployment data are obtained from the Labor Force Survey.

Unemployment Rate and Number give us quick measurements of the health of the labor
market. A deeper analysis of the unemployment rate by demographic and socio-economic
characteristics highlight vulnerable groups who might find it harder to secure employment.
The number of unemployed persons provides a measurement of the magnitude of the
problem. Characteristics most often studied include age and educational attainment.
Long-term Unemployment Rate and Number capture information on those who are
unemployed for prolonged periods and thus suffer greater hardship. They provide an
indication of unemployment arising from mismatch in job seekers and job openings
available, often referred to as structural unemployment.

Measurements
In order to find the rate of unemployment, four methods are used:
i) Labor Force Sample Surveys: provide the most comprehensive results. It calculates
unemployment by different categories such as race and gender. This method is the
most internationally comparable.
ii) Official Estimates: combines information from the three other methods. The
method is not the preferred method to use when calculating the rate of
unemployment.
iii) Social Insurance Statistics: these statistics are calculated based on the number of
individuals receiving unemployment benefits. The method is criticized because
unemployment benefits can expire before an individual finds employment which
makes the calculations inaccurate.
iv) Employment Office Statistics: only include a monthly total of unemployed
individuals who enter unemployment offices.

Types of Unemployment
i) Frictional unemployment is when a person does not have a job due to the process
of moving from one job to another. Furthermore, it could also be the time period
which the worker is searching for job. Many people suffer from frictional
unemployment such as university graduates who are searching for a job after
graduating from university (depending on their grades) actors/ theatre actors who
are searching for role in movie/theatre.

34
ii) Structural unemployment is when a person is unemployed because there is a lack of
demand for worker as the firms are looking for specific worker who has the
specific skills. Structural unemployment happens for several reasons such as: due
to changes in technology. Some workers are fired because they do not know how to
use some new technology, or they can’t adapt to it.
iii) Cyclical unemployment is when there is a greater availability of workers than there
is of job vacancies. Cyclical unemployment happens when there is lower demand
for products due to the lack of consumer confidence, disinterest or reduction in the
consumer spending due to less disposable income.
iv) Seasonal unemployment is a working agreement where a worker is employed for a
certain part of the year, however after that time of the year has passed then the
worker is left unemployed. Examples of people who suffer from seasonal
unemployment are people who work with weather related jobs such as summer
tourism jobs, beach lifeguards or snow related jobs in a certain region.
v) Casual unemployment is simply when people can work but they choose not to work
because they have enough cash so there is no need for them to work. However, this
causes some problems because they add to the unemployment figures which make
it higher in the economy. Some people who are contractors or self-employed can
choose when not to work or choose not to work at the end of their contract because
they feel they have made enough cash.

3.3.8 Okun’s Law

What it is?
Named after economist Arthur Okun, Okun’s law states that for every 1% increase in the
employment rate, gross domestic product increases 3%.

Okun's Law: The Basics

In its most basic form, Okun's law investigates the statistical relationship between a
country's unemployment rate and the growth rate of its economy. The economics research
arm of the Federal Reserve Bank of St. Louis explains that Okun's law "is intended to tell
us how much of a country's gross domestic product (GDP) may be lost when the
unemployment rate is above its natural rate." It goes on to explain that "the logic behind
Okun's law is simple. Output depends on the amount of labor used in the production
process, so there is a positive relationship between output and employment. Total
employment equals the labor force minus the unemployed, so there is a negative
relationship between output and unemployment (conditional on the labor force)."

How it works (example)

Let's say the unemployment rate decreases by 2% (that is, employment increases by 2%).
According to Okun's law, GDP will increase by 6%.Okun's law, however, only applies to the
U.S. economy and only applies when the unemployment rate is between 3% and 7.5%.

Why it matters?
Okun's law reinforces the notion that a country's output depends on labor. It is also a way
to measure the effectiveness of monetary policy. Although the law only applies in the

35
United States, the concept applies in all economies (that is, when more people have jobs,
the economy is stimulated). Accordingly, a 1% change in employment may result in a
different degree of increased output in other countries. Figure: 3.5 shows the relationship
between unemployment rate and GDP.

3.4 Self-Assessment Questions

1. List and describe four determinants of productivity.
2. What is a production function? What are some factors that can cause a nations’
production functions to shift over time?
3. The production function slopes upward, but its slope declines from left to right.
Give an economic interpretation of each of these properties of production function.
4. What is frictional unemployment? Why is a certain amount of frictional
unemployment probably necessary in a well- functioning economy?
5. Example:

Labor productivity is the value of goods produced in an hour of work. It can be calculated
for a nation, industry, firm, team or individual using the productivity formula. The
following are illustrative examples of labor productivity calculations. Nations Labor
productivity can be calculated for a nation using GDP and total hours worked. Labor
productivity = GDP / total hours worked. For example, a nation with GDP per worker of
Rs.100,000 and average hours worked of 1550: labor productivity = Rs.100,000 / 1550 =
Rs.64.52 / hour.

Growth Rate National labor productivity is often represented as a year-over-year growth rate
using the formula: labor productivity growth rate = ((current year productivity / previous year
productivity) -1) × 100. For example, a nation with productivity of Rs.1000,000 this year and
Rs.900,000 last year: labor productivity growth rate = [1,000,000
900,000
− 1] 𝑥100 = 11.11.1

36
It is common to discuss the productivity of nations in terms of the growth rate. For
example, when people say that productivity is falling, they often mean that the growth
rate of productivity is falling.

Self-task:
Now you all students will take some practical example from market and will solve like
above example.

3.5 Key Terms

Labor: It refers to the human efforts, mental or physical, undertaken to receive some
income or monetary reward. Labor is the most important factor in production of goods
and services.
Land: All the gift of nature (natural resources) available for human use. Mainly includes
land surface for framing and building minerals, forest mountains, rivers seas, location,
climate etc. Production of goods for economic activity needs land resources
Unemployment: A situation in which workers are jobless, either because of non-availability
of jobs because workers are not accepting jobs at the going low wage rate.
Unemployment: The state of being jobless and looking for work.
Demand: Demand is the quantity of a good that consumers are willing and able to
purchase at various prices during a given period.
Demand Curve: is a graph that shows the relationship between price of a good and
quantity demanded.
Supply: Supply is a fundamental economic concept that describes the total amount of a
specific good or service that is available to consumers.
Supply Curve: is a graph that shows relationship between the price of a good and the
quantity supplied
Market: is place where buyers and seller exchange goods and services.
Market Equilibrium: is the point where demand and supply of product are equal, and
the prices settle which both buyer and seller accept
Labor Force: The collective group of people who are available for employment, i.e.
including both the employed and the unemployed.

3.6 Recommended Books

1. Mankive, N. Gregory. Principles of Macroeconomics (Chapter 12)
2. Able, Andrew, B., Bernanke, BenS. & Croushore, D. Macroeconomics (Chapter 3)

Additional Books:
1. Parkin, Michael - Macroeconomics, Latest edition
2. Miller, R.L.– Economics Today – Latest edition

37
3.7 Links/Bibliography
For further information on topics in this unit, additional problems, applications,
examples, online quizzes, and more, please visit the following websites.
Note: These websites were viewed, when the study guide has been developed.
• Viewed on 15/7/2019 at: www.cengage.com/economics/mankiw.
• Viewed on 15/7/2019 at: www.economicsdiscussion.net/production-function/
production-function...and.../6892
• Viewed on 15/7/2019 at: Viewed on 30/2/2019 at:
https://www.investopedia.com/terms/d/demand_for_labor.asp#ixzz5X6xzqbLv
• Viewed on 15/7/2019 at: https://www.tutor2u.net/business/reference/labour-
productivity
• Viewed on 16/7/2019 at: https://www.isixsigma.com/community/blogs/
productivity-and-employment
• Viewed on 16/7/2019 at: https://www.investopedia.com/terms/u/unemployment.
• Viewed on 16/7/2019 at: https://en.wikipedia.org/wiki/Productivity
• Viewed on 16/7/2019 at: https://study.com/.../market-equilibrium-in-economics-
• Viewed on 16/7/2019 at: https://www.investopedia.com/terms/p/productivity.asp
• Viewed on 16/7/2019 at: www.sbp.edu.pk
• Viewed on 16/7/2019 at: www.esp.edu.pk
• Viewed on 16/7/2019 at: www.pbs.edu

38
UNIT-4

SAVING, INVESTMENT AND

THE FINANCIAL SYSTEM

Written by: Ms. Bibi Fouzia

Reviewed by: Dr. Fouzia Jamshaid

39
 CONTENTS

4.1 Introduction ................................................................................................41

4.2 Learning Outcomes ....................................................................................41

4.3 Main Topics to Discuss ..............................................................................41

4.4 Self Assessment Questions ........................................................................46

4.5 Key Terms ..................................................................................................47

4.6 Recommended Books ................................................................................48

4.7 Links/Bibliography ....................................................................................48

40
4.1 Introduction
This unit will give you an overview of the relationship between saving and investment. It
will also help to understand the importance of saving and investment in our daily life.
When a country saves a large fraction of its income, more resources are available for
investment in capital, and higher capital raises the economy’s productivity, raising living
standards still further. But within that country, at any given point in time, some people
will want to save some of their income for the future, while others will want to borrow to
finance investments in physical capital. How are savers and investors coordinated? The
financial system consists of those institutions in the economy that helps to match one
person’s savings with another person’s investment.

4.2 Learning Outcomes

By the end of this unit, and having completed the essential readings and activities, you
should be able to:
 explain the variety of institutions that make up the financial system
 describes the relationship between the financial system and these key
macroeconomic variables: saving and investment.
 develop a model that describes how the interest rate adjusts so as to equate the
demand for and supply of funds in the financial system
 use the model to show how various government policies affect the interest rate,
saving, and investment.

4.3 Main Topics to Discuss

4.3.1 Financial System in Economics
The main role of the financial system is to move funds from savers to borrowers. Savers
supply funds with the expectation that they will get those funds back with interest later.
Borrowers demand funds with the expectation that they will have to repay those funds
with interest later. Financial institutions play an important role for the coordination of the
savers and borrowers. Financial institutions include financial markets and financial
intermediaries.

Financial Markets
Financial markets are institutions through which savers supply funds directly to
borrowers. Hence, borrowing and lending activity in financial markets is often referred to
as direct finance. The two most important financial markets are the bond market and the
stock market.

The Bond Market

A bond is a certificate of indebtedness that specifies the obligations of the borrower to the
holder of the bond. A bond typically specifies the date of maturity, when the principal or
amount borrowed is to be repaid and the rate of interest that will be paid periodically until

41
the date of maturity. For example, General Motors issue a Rs.1000 bond on 2010,
December with a maturity date of December 2028 and a 5% rate of interest. This bond
will make annual interest payments of Rs.50 each year until the end 2028, when the final
interest payment is made and the Rs.1000 returned.

Three characteristics of bonds: Firstly, the bond’s terms the length of time until the bond
matures. Some bonds have short terms of only a few months, other bonds have long
terms of up to 30 years. Typically, longer term bond pays higher interest rates than
shorter terms bonds, to compensate bond holders for having to wait longer to get their
principal back. Secondly, the bond’s credit risk refers to the probability that the borrower
will be unable to make interest payments and/or repay principal. When this happens, the
borrower is said to default by entering bankruptcy. Typically, low risk bonds like those
issued by the Government pay lower interest rates than higher risk bonds issued by
corporations: borrowers receive a higher interest rate to compensate them for taking on
more risk. Junk bonds, issued by financially shaky corporations, pay the highest rates of
interest. Thirdly, bonds also differ in the tax treatment of their interest payments.
Municipal bonds, issued by state and local governments, pay interest that is exempt from
the federal income tax. Because of this tax advantage, municipal bonds pay lower interest
rates than bonds issued by private corporations or even the Government.

The Stock Market

A stock is a certificate that represents a claim to partial ownership in a firm and hence a
share of the profits that the firm makes. The firm pays out some of its profits as dividends
to its stockholders. Example: if a corporation issues 1,000,000 shares of stock, then each
share represents a claim to 1/1,000,000 of the business. From the borrower’s point of
view, the sale of stock to raise money is called equity finance, while the sale of bonds to
raise money is called debt finance. From the saver’s point of view:

The advantage to buying a bond is that it pays a fixed rate of interest and returns the
principal for sure, except in the rare care of bankruptcy. The disadvantage to buying a
bond is that its payments are fixed, even if the firm earns higher and higher profits.

The advantage to buying a stock is that its dividends, and therefore its price, will rise
when the firm earns higher profits. The disadvantage to buying a stock is that its
dividends, and therefore its price, will fall when the firm earns lower profits.

Financial Intermediaries
Financial intermediaries are institutions through which savers supply funds indirectly to
borrowers. Hence, borrowing and lending activity through financial intermediaries is
often referred to as indirect finance. Two of the most important financial intermediaries
are banks and mutual funds.
i) Banks accept deposits from savers and make loans to borrowers. Banks cover their
costs and make profits by charging a higher interest rate on their loans than they
pay on their deposits. Banks are also special; in that they allow savers to write

42
 checks on some types of deposits. That is, bank deposits serve as a medium of
exchange as well as a store of value.
ii) Mutual Funds sell shares to savers and use the proceeds to buy a collection or
portfolio of stocks and/or bonds. Mutual funds help with diversification by
investing in many stocks and bonds, a sharp decline in the price of any one stock or
a default on any one bond becomes less important. Mutual funds also allow savers
to delegate stock and bond selection to a professional money manager.

4.3.2 Saving and Investment in the National Income Accounts

Recall that GDP can be broken down into four components: consumption, investment,
government purchases and net exports:
Y=C+I+G+NX

This equation is an identity: it always holds true, given how the variables are defined.
A closed economy is one that does not trade with the rest of the world and an open
economy is one that does trade with the rest of the world. For now, let’s simplify the
analysis by considering a closed economy in which, by assumption, NX = 0 and so
Y=C+I+G

Again, this equation is an identity: it just says that each unit of output is consumed,
invested, or purchased by the government. Rearrange the equation as
Y-C-G=I

The amount on the left‐hand side equals national saving, the amount of income that is not
consumed by households or purchased by the government:
S=Y-C-G
Therefore, in a closed economy, saving must always equal investment:
S=I

Next, let T denotes the amount of tax revenue the government receives, net of transfer
payments (like Social Security) that it returns to households. Then the equation for
national saving
S=Y-C-G

Can be rewritten as
S=(Y-T-C) + (T-G)

This divides national saving into two components:

Private Saving=Y-T-C
Public Saving=T-G

Private saving is the income that households have left after paying for taxes and
consumption. Public saving is the amount of tax revenue that the government has left
after paying for its purchases:

43
4.3.3 The Market for Loanable Funds
The market in which savers supplies loanable funds to borrowers and determines the
equilibrium interest rate. Like any other market, an analysis of the market for loanable
funds revolves around supply and demand.
 The supply of loanable funds comes from individuals who have saved and want to
lend the funds out, either directly in the stock and bond markets or indirectly
through a bank or mutual fund. When the interest rate rises, saving becomes more
attractive, so the supply of loanable funds goes up.
 The demand for loanable funds comes from individuals who need funds and want
to invest and firms who need funds and want to invest. When the interest rate rises,
borrowing becomes less attractive, so the demand for loanable funds goes down.

In equilibrium, the quantity of funds supplied equals the quantity of funds demanded.
The interest rate adjusts to equalize savings and borrowing. If the interest rate is higher
than equilibrium, the quantity of savings supplied greater than the quantity of savings
demanded, creating a surplus. With a surplus of savings, suppliers will bid the interest
rate down as they compete to lend. In this way the market for loanable funds coordinates
individual’s decisions so that saving, and investment are always equal in the aggregate.

4.3.4 The Basic Tools of Finance

Financial system coordinates the economy’s saving and investment. It concerns decisions
we make today that will affect our lives in the future. But the future is unknown as
when a person decides to allocate some saving, or a firm decides to undertake an
investment, the decision is based on a guess about the likely future result. The result
could end up being very different. The uncertainty about future result of a current
decision is called risk.
Finance is the field of economics that studies how people make decisions regarding the
allocation of resources over time and the handling of risk. It deals with questions like
how to compare sums of money at different points in time?

How to manage risk? Future Value: Measuring the Time

Receiving a given sum of money in the present is preferred to receive the same sum in
the future. If r is the interest rate, then in N years an amount of Y today will have future
value of:
X=Y*(1 + r) N

The amount of money in the future that an amount of money today will yield, given
prevailing interest rates, is called the future value.

4.3.6 Present Value: Measuring the Time

Present value refers to the amount of money today that would be needed to produce,
using prevailing interest rates, a given future amount of money. In order to compare
values at different points in time, compare their present values. Firms undertake

44
investment projects if the present value of the project exceeds the cost. If r is the interest
rate, then in N years an amount of Y today will have future value of:
X=Y*(1 + r) N

4.3.6 Managing Risk

A person is said to be risk averse if she exhibits a dislike of uncertainty. Individuals can
reduce risk choosing any of the following:

Markets for Insurance

One way to deal with risk is to buy insurance. The general feature of insurance contracts
is that a person facing a risk pays a fee to an insurance company, which in return agrees
to accept all or part of the risk. Markets for insurance face two types of problems:
 Adverse selection arises because high‐risk people are more likely than low risk
people to buy insurance.
 Moral hazard arises because once somebody has insurance, he or she will be less
careful.

Diversify
Diversification refers to the reduction of risk achieved by replacing a single risk with
many smaller unrelated risks. Diversification cannot remove aggregate risk.

4.3.7 Asset Valuation

Since a firm can pay larger dividends to its stockholders when its profits are high, the
price of a share of stock in that firm will rise when the firm’s profit outlook improves.
Fundamental analysis refers to the detailed analysis of a company’s business outlook,
applied to determine the value of its stock. The efficient markets hypothesis asserts that
the price of a stock will reflect all publicly available information about the company’s
prospects:
 Those companies that are likely to earn higher profits will have shares that sell at a
higher price.
 Those companies that are likely to earn lower profits will have shares that sell at a
lower price.
 The price of an individual firm’s shares will change, but only when new
information becomes available.
 One implication of the efficient market’s hypothesis, therefore, is that the price of a
stock should follow a random walk: its changes should be impossible to predict.
 A related implication is that there is little point in trying to outsmart the market by
buying individual stocks. The best an individual investor can do is to hold a
diversified portfolio of stocks, to eliminate firm‐specific risk.

Evidence to support the efficient markets hypothesis comes from the fact that actively
managed mutual funds, that pick individual stocks in an attempt to provide higher
returns, tend to perform no better (and often worse than) index funds that simply hold all
of the stocks in a broad index or average, like the Standard and Poor’s 500.

45
4.4 Self-Assessment Questions
1. Suppose that you are an investment advisor and, after checking the latest interest
rates in the bond market, you collect the following information:

Issuer Maturity Date Interest Rate (per year)

US Government December 2008 1.75%
US Government December 2028 4.50%
General Motors February 2038 11.00%
General Electric February 2038 6.25%
State of Massachusetts December 2028 3.25%

Explain briefly (no more than a sentence or two for each case) which of these bonds you
would recommend, and why, to a client who tells you:
a) “I’m saving for retirement, so I won’t need the money for many years, but above
all I don’t want to risk losing my money.”
b) “I’m saving to buy a new house. I may need the money next year, and I don’t want
to take any risk either.”
c) “I’m in a high federal income tax bracket and would really benefit from a tax break
on the income from my savings.”
d) “I want to aim for a high return and don’t care if that means taking on a lot of risk.”
e) “I want a decent return and willing to tolerate some risk, but not too much risk.”

2. Suppose that you are the CEO of a large corporation, and one of your vice
presidents finds an investment project that costs Rs.100 million today, but promises
to pay off Rs.200 million 7 years from now.
a. Write down a formula for the present value of the Rs.200 million that your
firm stands to receive from the project 7 years from now, assuming that the
interest rate is 10 percent per year.
b. Suppose the present value from part (a) turns out to be greater than Rs.100
million. Should you use your corporation’s funds to undertake the project?
c. Suppose that the interest rate falls to 5 percent per year between the times
that the vice president alerts you to the project and the time at which you
have to make the decision of whether to undertake the project. Would that
change the answer that you gave in part (b) above: yes, no, or maybe?
3. Legend has it that Peter Minuit, a Dutch official working in the colony of New
Netherland, which stretched along the Northeast US coastline from what is now
Rhode Island down to what is now New Jersey, purchased the island of Manhattan
from a group of Native Americans 382 years ago, in 1626, for the equivalent of
$24. Assuming that those $24 were invested at an interest rate of 7 percent per
year, write down a formula that shows how much money the Native American
sellers would have today, if they took advantage of compounding by leaving all of

46
 the money in the bank, earning interest over time on the previous years’ interest
payments as well as the original amount deposited.
4. A salesperson offers you two possible deals on a new big‐screen TV: (i) pay
Rs.15000 in cash today or (ii) buy on credit and pay Rs.17000 two years from now.
Having taken “Principles of Macroeconomics” this term, you know that in order to
decide which deal to take, you need to check on interest rates first. So suppose that
having done this, you already know that by keeping your money in the bank, you
can earn interest at the rate of 6 percent per year for the next two years.
a. Write down a formula for the present value of the Rs.17000 that you would
pay two years from now, assuming that you buy the TV on credit today.
b. Suppose that your present value from part (a) turns out to be more than the
Rs.15000 that you’d pay if you decide to buy the TV with cash today. What
should you do: pay Rs.15000 today or Rs.17000 two years from now?
5. In 1980, the nominal interest rate in the US economy was 10 percent and the
inflation rate was 8 percent. In 1990, the nominal interest rate was 7 percent and
the inflation rate was 3 percent.
a. If the nominal interest rates quoted above apply to both borrowing and
saving, during which year was it more costly in real terms to borrow: 1980 or
1990?
b. During which year was it more rewarding in real terms to save: 1980 or
1990?

4.5 Key Terms

Financial system: The set of institutions that connect savers with borrowers.

Financial intermediary: An institution that transforms the savings from individuals into
financial assets (for the saver) and liabilities (for the borrower); the financial intermediary
that people have the most experience with is a bank, which converts the savings and other
deposits of many depositors into loans for borrowers.

Asset: Some item of value that is expected to provide the holder some future benefit;
factories are an asset because they can be used to produce goods that provide income to a
firm in the future, and a bond is an asset to a bondholder because it will provide income
in the future.

Real asset: (sometimes called a physical asset) A claim on a tangible object that gives the
owner the right to use it as they wish. A house is a real asset that its owner can sell or rent
out, and a factory is a real asset that a business can use to earn profits.

Financial asset: A contractual claim to something of value; modern economies have four
main types of financial assets: bank deposits, stocks, bonds, and loans. There are many
more types of financial assets (like derivatives, calls, puts, and so on), but you only need
to know the basics of these four types for this course.

47
Financial risk: When there is any uncertainty about the future value of an asset; for
example, if you don't know how many lime smoothies you can buy with the money in
your savings account next week, the value of your savings account has risk, because
inflation can reduce its value.

Bank Deposits: (also called demand deposits) Money kept in a bank, like checking
accounts; we call these "demand deposits" because banks are usually required to provide
access to the money in those accounts immediately on request (in other words, on
demand).

Liquidity: How easily an asset converts to cash without loss of purchasing power; a
house might be a store of value, but it's not a very liquid asset because you can't
immediately buy a bowl of ice cream with it very easily. Cash is the most liquid asset
because you can use it immediately.

Return: The profit made on an asset, usually expressed as a percentage; for example, a
stock that is purchased for Rs.1000 and sold for Rs.1100 has a return of percent.

Bonds: Bonds are a form of an IOUs (a promise to pay back some amount in the future);
bonds have three key features: the bond’s par, the bond’s maturity, and the bond’s
coupon payments.
Stock: A slice of ownership in a company; if you own one share of a company that has a
total of 100 shares, you own of that company. Stocks derive their value
from their ability to appreciate and the payment of dividends.

4.6 Recommended Books:

1. Mankive, N. Gregory. Principles of Macroeconomics (Chapters 13 &14)
2. Abel, Andrew, B, Bernanke, Ben S.&Croushore, D. Macreconomics (Chapter 4)

Additional Texts:
1. Parkin, Michael- Macroeconomics, 10thEdition, Chapter 7
2. Alex, C-Modern Principles of Economies, 4th Edition, Chapter 29
3. Samuelson, P.A. Economics, (Mc Grow Hill) 9thEdition, Chapter 21.

4.7 Links/Bibliography
For further information on topics in this unit, additional problems, applications,
examples, online quizzes, and more, please visit the following websites.

Note: These websites were viewed, when the study guide has been developed.

 Viewed on 15/9/2019 at: www.cengage.com/economics/mankiw.

48
 Viewed on 15/9/2019 at: www.economicsdiscussion.net/microeconomics/
macroeconomic-policy
 Viewed on 16/9/2019 at: https://science.blurtit.com/107177/what-are-the-tools-of-
macroeconomic-policy
 Viewed on 15/9/2019 at:
www.economicsdiscussion.net/macroeconomics/development ...macro-economics.
 Viewed on 16/9/2019 at: https://www.quora.com/Why-do-people-study-
macroeconomics
 Viewed on 15/9/2019 at: http://www2.bc.edu/peter-ireland/ec132.html
 Viewed on 16/9/2019 at: www.sbp.edu.pk
 Viewed on 16/9/2019 at: www.esp.edu.pk
 Viewed on 16/9/2019 at: www.pbs.edu.pk

49
50
UNIT-5

MONETARY SYSTEM, MONEY

GROWTH AND INFLATION

Written by: Ms. Bibi Fouzia

Reviewed by: Dr. Fouzia Jamshaid

51
 CONTENTS

5.1 Introduction ................................................................................................53

5.2 Learning Outcomes ....................................................................................53

5.3 Main Topics to Discuss ..............................................................................53

5.4 Self Assessment Questions ........................................................................61

5.5 Key Terms ..................................................................................................64

5.6 Recommended Books ................................................................................64

5.7 Links/Bibliography ....................................................................................65

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5.1 Introduction
This unit will give you an overview of the importance of monetary system in our daily
life. This will help to understand the relationship between money growth and inflation
and their impacts in our daily life. In the absence of money, people would have to
exchange goods and services through barter. The problem with barter lies in finding a
double coincidence of wants: a successful trade requires (i) you to want what your trading
partner has and (ii) your trading partner to want what you have. Money overcomes this
problem, since everyone will accept it in exchange for goods and services.

5.2 Learning Outcomes

After studying this unit, and having completed the essential readings and activities, you
should be able to:
 define the meaning of money, functions and kinds of money
 understand the functioning of Federal reserve system
 discuss the Fed’s Tools of Monetary Control
 describe the role of banks in the money supply process
 explain the Classical theory of inflation
 elaborate the costs of inflation

5.3 Main Topics to Discuss

5.3.1The Meaning, Functions and Kinds of Money

The Meaning of Money

Sometimes people will say, “Bill Gates has a lot of money.” But what they really mean is
that Bill Gates has a lot of wealth. Economists use the term “money” in a more specific
sense, to refer to the set of assets that people use regularly to buy goods and services from
other people.

Functions of Money
There are three functions of money:
i) Money is a medium of exchange, that is, an item that buyers give to sellers in exchange
for goods and services. Closely associated with the concept of money is that of
liquidity: the ease with which an asset can be converted into the economy’s medium of
exchange. Money is the most liquid asset. Stocks and bonds are easy to buy and sell.
They are highly liquid assets. Houses, valuable paintings and antiques take more time
and effort to sell. They are less liquid. Notice that the first two items on this list
highlight a trade‐off. Money is the most liquid asset, but currency does not pay interest.
Bonds are less liquid but pay interest. This trade‐off will become important later in our
analysis of how changes in the money supply affect the economy.
ii) Money is a unit of account, that is, the units or yardstick in which prices are measured.
A car dealer tells you that a car costs Rs.500,000 and the car price is equal to the cost

53
 of 4000 shirts (even though it may amount to the same thing). Similarly, most debts
require the debtor to deliver a specified number of rupees in the future, not a specified
amount of some commodity.
iii) Money is a store of value, that is, an object that people can use to carry wealth from
the present into the future. If I work today and earn Rs.1000, I can hold the money
and spend it tomorrow, next week, or next month. Of course, money is an
imperfect store of value: if prices are rising, the amount you can buy with any
given quantity of money is falling.

Kinds of Money
The two kinds of money are commodity money and fiat money.
i) Commodity money: takes the form of a commodity with intrinsic value. Examples
are gold coins, cigarettes in Prisoners of War (POW) camps.
ii) Fiat money: money without intrinsic value used as money because of government
decree for example the U.S. dollar.
5.3.2 The Federal Reserve System
The Federal Reserve (Fed) is the central bank of the US: the institution responsible for
overseeing the banking system and regulating the quantity of money in the economy.

As a central bank, the Fed has two jobs:

 It regulates banks, assists in check processing (clearing), and acts as a bank for
banks – taking their deposits and, when other sources of credit dry up, making
loans to banks. In this last role, the Fed is said to be the lender of last resort.
 It regulates the money supply: the quantity of money in the economy. That is, it
conducts monetary policy.

5.3.3 Banks and the Money Supply

The money supply is the quantity of money available in the economy. Currency and
demand deposits are assets which are considered part of the money supply.
 Currency: the paper bills and coins in the hands of the(non-bank) public
 Demand deposits: balances in bank accounts that depositors can access on demand
by writing a check

There are two measures of the money supply M1 and M2.M1. Include only those assets
that are clearly used as a medium of exchange: currency, demand deposits, traveler’s
checks and other checkable deposits. M2. Include everything in M1 plus other highly
liquid assets: savings deposits, money market mutual funds and small (under Rs.100,000)
time deposits.

The Simple Case of 100 Percent Reserve Banking

Start by considering an economy without banks, where all money consists of currency.
Suppose for simplicity that the total quantity of currency in circulation is Rs.1000. Now

54
suppose that someone opens a bank: call it the First National Bank. But instead of making
loans, all this bank does is to safeguard people’s money: it accepts deposits and keeps the
currency in its vault until the depositor either asks for the currency back or writes a check
against his or her balance.

Deposits that the bank receives but does not loan out are called reserves. So, this simple
form of banking without loans is called 100‐percent‐reserve banking, for the obviously
reason that 100 percent of all deposits are held as reserves. We can use a T‐account (a
simplified balance sheet), to show what happens if the entire Rs.1000 of currency in
circulation is deposited in the bank:

First National Bank

Assists Liabilities
Reserves Rs.1000 Deposits Rs.1000

What has happened to the M1 money supply as a result of this transaction? Nothing!
Currency in circulation declines by Rs.1000. But demand deposits rise by Rs.1000. This
first example illustrates that in an economy with 100‐percent‐reserve banking, banks do
not influence the money supply.
Money Creation with Fractional Reserve Banking
Now suppose that the managers of the First National Bank notice that not all the bank’s
depositors ask for the money back on any given day. In fact, most customers are content
to leave their money in the bank. What if the bank lends out some of the money it
receives from deposits? Now we’ll consider a fractional‐reserve banking system, in
which banks hold only a fraction of the funds they receive from depositors as reserves.
The reserve ratio measures the fraction of deposits that banks hold as reserves. Although
banks want to lend funds out, in order to earn interest, they will always hold at least some
reserves because they are required to by law. The Fed sets a minimum reserve ratio that
each bank must maintain. Reserves held to satisfy this legal requirement are called
required reserves.
Let’s suppose that First National Bank decides on a reserve ratio of 10 percent. Then it
holds Rs.10 (or 10 percent) of its deposits as reserves and lends the rest out. The
T‐account now becomes

First National Bank

Assists Liabilities
Reserves Rs.10 Loans Rs.900 Deposits Rs.1000

What’s happened to the money supply as a result of this transaction? It has increased and
depositors still hold Rs.1000 in demand deposits. But now the people who receive the
loans hold Rs.900 in currency and the total money supply is Rs.1900.
This second example illustrates that in a fractional reserve system, banks can create
money. Notice, however, that while the money supply has gone up because of this

55
transaction, people aren’t wealthier. The depositors have Rs.1000 in deposits, just as
before. The borrowers have Rs.900 in currency, but now they owe that Rs.900 to the
bank. So that balances out too. Another way to think about this is that people aren’t
wealthier, but they are more liquid.

5.3.4 The Fed’s Tools of Money Supply

The Fed must take banks’ role into account when making monetary policy decisions.

Open Market Operations

Recall that open market operations occur when the Fed buys or sells US Government
bonds from or to private investors. When the Fed buys US Government bonds, each
newly created rupee held as currency increases the money supply by Rs.100. But each
newly created rupee held as a deposit increases the money supply by even more, because
of the money multiplier. If the seller pays for the bond with currency when the Fed sells
US Government bonds, the money supply decreases by Rs.100. But if the seller pays for
the bond using funds from a bank deposit, the money supply decreases by even more, as
the process of multiple deposit creation works in reverse.
Open market operations can also be used to change the money supply by large or small
amounts. Because of these advantages, open market operations are the Fed’s most
frequently used policy tool.
Reserve Requirements
Reserve requirements are the legally imposed minimum amount of reserves that banks
must hold against their deposits. We’ve already seen that a higher reserve ratio leads to a
smaller money multiplier. The same reasoning implies that when the Fed increases
reserve requirements, the money supply will fall. But changes in reserve requirements
disrupt bank business. To avoid these disruptions, the Fed rarely uses changes in reserve
requirements to affect the money supply.
The Discount Rate
The Fed also acts as a lender of last resort for banks that cannot obtain funds through
other sources. The discount rate is the interest rate that Fed charges on its loans to banks.
When the Fed makes a loan to a bank, in effect it lends newly created money to that bank.
The bank has more reserves, some of which it can lend out. Through the process of
multiple deposit creation, the money supply will rise. Hence, when the Fed lowers the
discount rate, inducing more banks to borrow from the Fed, the money supply will rise.
But the Fed rarely uses discount lending to control the money supply. Instead, it uses its
role as lender of last resort to help banks when they are in financial trouble.
5.3.5 The Classical Theory of Inflation
Before starting the topic of classical theory of inflation first we briefly define inflation.
Inflation is a sustained increase in the general price level of goods and services in an
economy over a period of time. When the general price level rises, each unit of currency
buys fewer goods and services; consequently, inflation reflects a reduction in the
purchasing power per unit of money – a loss of real value in the medium of exchange and
unit of account within the economy.

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The quantity theory is often called the classical theory of inflation, because it can be
traced back to Hume and other early writers on economics.

The Level of Prices and the Value of Money

We’ve observed that, for example, an ice cream cone costs a lot more today than it did in
the 1980s. Is this because ice cream cones are so much better today, that people are
willing to pay more for them? Probably not but more likely, the rise in the price of an ice
cream cone indicates that dollars have become less valuable, not that ice cream cones
have become more valuable. That’s what the quantity theory is all about: the value of
money as opposed to the value of goods.
To make this idea concrete, let P denote the price level, as measured by the CPI or the
GDP deflator: P = number of dollars needed to purchase a basket of goods and services

Now flip the reasoning around:

1/P = number of baskets of goods required to “purchase” a rupee.

This last equation highlights that inflation, an increase in P, represents a decline in the
value of money. Another way to think about this idea P is the “rupee price of goods”
and1/P is the “goods price”.

Money Supply, Money Demand and Monetary Equilibrium

Let’s build on this idea that 1/P measures the goods price of a rupee. The goods price of
money 1/P is determined by the intersection between demand and supply. When the
goods price of money is below its equilibrium value, there is excess demand for money,
putting upward pressure on the goods price of money until equilibrium is restored. When
the goods price of money is above its equilibrium value, there is excess supply of money,
putting downward pressure on the goods price of money until equilibrium is restored.

The Effects of a Monetary Injection

What happens when the Fed acts to increase the money supply, either by using open
market operations to increase the supply of reserves to the banking system, which then
increases the money supply working through the money multiplier, or lowering its target
for the federal funds rate, which requires it to use open market operations to increase the
supply of reserves to the banking system. When the supply curve shifts, a new
equilibrium occurs at a lower goods price of money 1/P and hence a higher price level P.

The upshot is that inflation, a rising price level, is associated with a policy of money
creation. This theory is called the quantity theory of money, as it asserts that the quantity
of money available determines the price level and the growth rate of money available
determines the inflation rate.

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The Classical Dichotomy and Monetary Neutrality
The quantity theory of money describes how changes in the money supply affect the price
level. But how do those changes affect other economic variables, like GDP,
unemployment, and interest rates? David Hume and his contemporaries suggested that
economic variables be divided into two groups.
 Nominal variables that are measured in units of money (monetary units).
 Real variables that are measured in units of goods (physical units).

According to this classification nominal GDP is a nominal variable because it measures

the dollar value of an economy’s output of goods and services. Real GDP is a real
variable because it measures the value of an economy’s output of goods and services
correcting for inflation that is, eliminating the effects of changes in the value of money.
The CPI is a nominal variable because it measures the number of dollars that are required
to purchase a basket of goods and services. The unemployment rate is a real variable
because it measures the percentage of the labor force that is unemployed.

This theoretical separation of nominal and real variables is called the classical dichotomy.
The quantity theory of money implies that changes in the money supply affect nominal
variables. The theory of monetary neutrality goes a step further and says that changes in
the money supply do not affect real variables.
Velocity and the Quantity Equation
A complementary perspective on the quantity theory of money builds on the idea of the
velocity of money, defined as the rate at which money changes hands, as measured by the
number of times each dollar in the economy gets spent during a year.
Mathematically, the velocity of money V is defined as

Where Y is real GDP, P is the GDP deflator, P x Y is nominal GDP – recall that nominal
GDP measures the dollar value of expenditures in the economy, and M is the quantity of
money. For examples suppose that an economy produces only a single good, pizza. The
economy produces 100 pizzas per year, so that Y = 100. Each pizza costs Rs.1000, so that
P = 1000. The quantity of money is Rs.5000, so that P = 5000. In math, V = (P x Y)/M =
(1000 x 100)/5000 = = 20. In words, total spending is Rs.1000 x 100 = Rs.100000.
But the money is Rs.5000. So, each rupee has to be spent = 20 times.

Rearranging the equation defining the velocity of money leads to the so‐called quantity
equation:

Velocity V has remained relatively stable. Hence, long‐run increase in M has been
paralleled by a long‐run increase in nominal GDP.

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The Inflation Tax
Why do some economies experience hyperinflation? Almost always, it is because the
government needs to raise revenue to finance spending, but for political reasons cannot
obtain that revenue through standard income taxation. Hence, it must pay for the goods
and services it purchases not with existing money collected through taxes, but instead
using newly created money. Since money creation leads to inflation, the inflation tax
refers to the revenue that the government raises through money creation. Historically,
many cases of hyperinflation occur during or after a war, when the government needs
large amounts of revenue to finance high levels of spending and may not have the ability
to raise this revenue through standard income taxation.

The Fisher Effect

Another application of the classical dichotomy is to interest rates:
 The nominal interest rates the interest rate measured without correcting for inflation.
 The real interest rates the interest rate measured after correction for inflation.

Real Interest Rate = Nominal Interest rate – Inflation Rate

For example, a bank pays interest at the rate of 7 percent per year. You deposit Rs.1000
today and have Rs.1070 at the end of one year. But the inflation rate is 3 percent, so your
money next year buys 3 percent less. Your real, or inflation‐adjusted, return, is 7 percent
– 3 percent = 4 percent.
We can rearrange this equation to read
Nominal Interest Rate = Real Interest Rate + Inflation Rate

Under monetary neutrality, an increase in the rate of money growth will increase the rate
of inflation but leave the real interest rate unchanged. Hence, under monetary neutrality,
an increase in the rate of money growth will lead to a higher nominal interest rate as well
as a higher rate of inflation. This application of monetary neutrality to interest rates is
associated with the economist Irving Fisher, and the predicted association of the nominal
interest rate and the inflation rate is called the Fisher effect.

5.3.6 The Costs of Inflation

Generally, economists and non‐economists alike believe that inflation is costly for the
economy. There are reasons for that to believe.

A Fall in Purchasing Power

Many people dislike inflation because they believe it erodes the purchasing power of
their income.

Inflation leads to an increase in the dollar prices of goods and services, it also leads to an
increase in nominal (dollar‐denominated) wages and incomes. Real (inflation‐adjusted)
wages and incomes should, according to the principle of monetary neutrality, remain
unaffected.

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Shoe Leather Costs
But inflation does erode the value of money that each person holds in his or her wallet.
Thus, when inflation rises, people make greater efforts to reduce the amounts of money
that they hold, for example, by going to the bank or the ATM more often but withdrawing
smaller amounts each time. The costs that are associated with these efforts are called shoe
leather costs, based on the imagery of someone wearing out his or her shoes walking to
the bank more often. Generally, under moderate rates of inflation like those currently
prevailing in the US, shoe leather costs appear small – may be even trivial. But these
costs can be substantial during episodes of hyperinflation.

Menu Costs
Menu costs refer to the costs that firms incur when changing their prices, based on the
imagery of a restaurant having to print up new menus. Again, these costs appear quite
small under modest rates of inflation but get much bigger as inflation rises.

Relative Price Variability and the Misallocation of Resources

Building on the menu cost story, suppose that a restaurant prints new menus with new
prices once per year, while the economy experiences continual inflation throughout the
year. At the beginning of the year, just after the new menus have been printed, the
restaurant’s prices are high relative to the overall price level. But, as the price level rises
because of inflation, the restaurant’s relative prices decline. But these changes in prices
have nothing to do with changes in the costs of preparing and serving food. In this
example, inflation interferes with the market’s ability to use prices to efficiently allocate
scarce resources.

Inflation Induced Tax Distortions

While all the costs mentioned so far appear to be minor in a low‐inflation economy like
the US, costs relating to the operation of the tax system may be more important. Consider
two economies, one in which the inflation rate is zero and the other in which the inflation
rate is 8 percent. In both economies, the real interest rate is 4 percent. The differences in
interest rates lead, through the Fisher effect, to differences in nominal interest rates. With
zero inflation, the nominal interest rate is 4 percent, but with 8 percent inflation, the
nominal interest rate is 12 percent. Suppose that interest income is taxed at the rate of 25
percent. This means that with a 4 percent before tax interest rate, the saver pays 1 percent
in taxes. But with a 12 percent before tax interest rate, the saver pays 3 percent in taxes.
With zero inflation, the after-tax real return to saving is 3 percent. But with 8 percent
inflation, the after-tax return is just 1 percent. Hence, saving may be much lower in the
economy with 8 percent inflation.

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5.4 Self-Assessment Questions
1. Consider an economy in which the following assets are available:

Asset Rupees Value Outstanding

Currency Rs.700
Demand Deposits Rs.30
Savings Deposits Rs.200
Money Market Mutual Funds Rs.80
Time Deposits (Certificates of Deposit) Rs.110
Short Term Government Bonds Rs.210
Stock Market Mutual Funds Rs.500

a. What is the value of M1 for this economy?

b. What is the value of M2 for this economy?

2. Bill has the following assets:

Asset Dollar Value

Money market mutual funds Rs.80
Stock market mutual funds Rs.500
Currency Rs.70
Certificates of deposit Rs.110
Savings deposits Rs.200
Checking deposits Rs.30
Shares of General Motors stock Rs.1000
Travelers’ checks Rs.20
a. What is the total dollar value of Bill’s assets that are considered part of M1?
b. What is the total dollar value of Bill’s assets that are considered part of M2?
c. Suppose that Bill also has a credit card, with Rs.100 in charges on his most recent
unpaid bill.
How does taking this credit card debt into account change the dollar value of Bill’s
assets that are considered part of M2?
3. Consider an economy in which there are no banks.
a. If the central bank conducts an open market operation in which it buys
Rs.1000 of previously issued government bonds from individual savers, what
happens to the money supply?
b. If, later, the central bank conducts a second open market operation in which
it buys another Rs.1000 of previously issued government bonds from
individual savers, what happens to the money supply?
c. If, after the first two open market operations described above, the central
bank conducts a third open market operation in which it sells Rs.500 in
government bonds back to individual savers, what happens to the money
supply?

61
4. Consider an economy in which the central bank has issued Rs.1000 bills.
a. If there are no banks in this economy, what is the value of the total money
supply?
b. If there are banks in this economy, if people deposit 50 of the Rs.1000 bills
in these banks and hold the rest as currency, and if all banks hold 100% of
their deposits as reserves, what is the total money supply?
c. If there are banks in this economy, if people deposit all 100 of the Rs.1 bills
in these banks and therefore hold no currency, and if all banks hold 100% of
their deposits as reserves, what is the total money supply?
d. If there are banks in this economy, if people deposit all 100 of the Rs.1000
bills in these banks and therefore hold no currency, and if all banks hold 10%
of their deposits as reserves, is the money supply going to be larger than,
smaller than, or the same as what it was in part (c), above, in the case of
100% reserve banking?
e. Comparing the last two cases from parts (c) and (d) above, is wealth created,
destroyed, or left unchanged by the activities of the banking system when
banks decide to hold only 10% of their deposits in the form of reserves
instead of holding 100% of their deposits as reserves?
5. Consider an economy in which people hold all their money in the form of deposits
and therefore do not hold currency. Suppose that all banks in this economy hold
10% of their deposits as reserves. And suppose that in this economy, the central
bank decides to conduct an open market operation in which it purchases Rs.1000 in
government bonds.
a. Will this open market operation work to increase or decrease the money
supply?
b. Once the entire process through which the banking system accepts additional
deposits and makes new loans as a result of this open market operations
comes to an end, by how much will the total amount of reserves have
changed?
c. Once the entire process through which the banking system accepts additional
deposits and makes new loans as a result of this open market operations
comes to an end, by how much will the total money supply have changed?
d. Once the entire process through which the banking system accepts additional
deposits and makes new loans as a result of this open market operations
comes to an end, by how much will the total amount of deposits have
changed?
e. Once the entire process through which the banking system accepts additional
deposits and makes new loans as a result of this open market operations
comes to an end, by how much will the total amount of loans have changed?
6. Suppose that the Federal Reserve conducts an open market operation in which it
purchases $10 million in US Government bonds.
a. Will this open market operation increase or decrease the money supply?
b. If there were no banks in the US economy, by how much will the money
supply change?

62
 c. Given that there are banks in the US economy, is the actual change in the
money supply likely to be larger or small than the answer you gave in part (a)
above?
7. Suppose that the Federal Reserve conducts monetary policy by setting a target for
the federal funds rate.
a. If the Federal Reserve wants to lower its federal funds rate target, should it
conduct an open market operation in which it purchases government bonds or
an open market operation in which it sells government bonds?
b. Assuming that households and firms hold at least some of their money in the
form of
deposits instead of currency, will this open market operation work to increase
or decrease the quantity of reserves held by banks?
c. Will the money supply increase or decrease?
d. According to liquidity preference theory, which assumes that the
economy‐wide price level is held fixed, will this change in the money supply
cause other interest rates in the economy to rise or fall?
e. Continuing to assume that the economy‐wide price level is held fixed, will
this change in interest rates work to increase or decrease the aggregate
demand for goods and services?
8. Assume throughout this next question that the velocity of money is constant and
that the Federal Reserve can control the money supply directly.
a. If real GDP is constant and the Federal Reserve wants the price level to stay
constant, what should it do with the money supply?
b. If real GDP is constant and the Federal Reserve wants the inflation rate to be
5 percent per year, what should it do with the money supply?
c. If real GDP is growing at 5 percent per year and the Federal Reserve is
holding the money supply constant, what is the inflation rate?
d. If real GDP is growing at 5 percent per year and the Federal Reserve wants
the price level to stay constant, what should it do with the money supply?
e. If real GDP is growing at 5 percent per year and the Federal Reserve wants
the inflation rate to be 5 percent per year, what should it do with the money
supply?
9. Suppose that the money supply (M) equals Rs.1000, the price level (P) equals
200, and real GDP (Y) equals 500.
a. What is the velocity of money (V) under these conditions?
b. assuming that velocity V remains constant and that “money is neutral” in
the long run, what will the price level P equal in the long run if the
Federal Reserve increases the money supply to Rs.2000?
c. Still assuming that velocity V remains constant and that money is neutral
in the long run, what will real GDP equal in the long run if the
Federal Reserve increases the money supply to Rs.2000?
10. Suppose that the Federal Reserve wants to raise its target for the federal funds
rate.
a. To make the equilibrium federal funds rate rise along with its target,
what does the Federal Reserve need to do: conduct an open market

63
 operation in which it buys US government bonds or conduct an open
market operation in which it sells US government bonds?
b. What happens to the quantity of reserves that the Federal Reserve supplies
to the banking system as a result of this open market operation: does
it rise, fall, or stay the same?
c. What happens to the total money supply as a result of this open market
operation: does it rise, fall, or stay the same?

5.5 Key Terms

Nominal Variables: That is measured in units of money (monetary units).
Real Variables: That is measured in units of goods (physical units).
Open Market Operations: Occur when the Fed buys or sells US Government bonds
from or to private investors
Velocity: The number of times in a year that an “average” dollar gets spent on goods and
services; for example, if the velocity of money is 2, then every dollar in an economy gets
used twice in a year.
Money Neutrality: The concept that money only impacts nominal variables, not real
variables, in the long run; in other words, increasing the money supply might decrease the
nominal interest rate, but it won’t have an impact on the real interest rate.
Monetarism: A way of analyzing the impact of monetary and fiscal policy actions
based on the equation of exchange
Reserve Requirements: is the legally imposed minimum amount of reserves that banks
must hold against their deposits
The Equation of Exchange: A mathematical identity that describes the relationship
between the money supply and nominal GDP
The Quantity Theory of Money: A theoretical model that when the velocity of money is
fixed and real output is limited to full employment output, any increase in the money
supply causes an increase in the price level

5.6 Recommended Books

1. Mankive, G-Principles of Economies, Latest Edition, (Chapters 16-17)
2. Abel, Andrew, B, Bernanke, Ben S.& Croushore, D. Macroeconomics (Chapter 13)

Additional Books:
1. Parkin, Michael- Macroeconomics, 10th Edition, Chapter no 8
2. Miller, R.L-Economies Today, 19th Edition, Chapter 15
3. Alex, C-Modern Principles of Economies, 4thEdition, Chapter no 31.
4. Paul Samuelson, William Nordhaus Economics 19th Edition, Chapter 23

64
5.7 Links/Bibliography
For further information on topics in this unit, additional problems, applications,
examples, online quizzes, and more, please visit the following websites.

Note: These websites were viewed, when the study guide has been developed.

 Viewed on 19/9/2019 at: www.cengage.com/economics/mankiw.

 Viewed on 19/9/2019 at:
www.economicsdiscussion.net/microeconomics/macroeconomic-policy
 Viewed on 19/9/2019 at:
 https://science.blurtit.com/107177/what-are-the-tools-of-macroeconomic-policy
 Viewed on 19/9/2019 at:
 www.economicsdiscussion.net/macroeconomics/development...macro-economics
 Viewed on 19/9/2019 at:
 https://www.quora.com/Why-do-people-study-macroeconomics
 Viewed on 20/9/2019 at:
 http://www2.bc.edu/peter-ireland/ec132.html
 Viewed on 20/9/2019 at:
 www.sbp.edu.pk Viewed on 20/9/2019 at:
 Viewed on 20/9/2019 at: www.esp.edu.pk
 Viewed on 20/9/2019 at:
www.pbs.edu.pk

65
66
UNIT-6

THE MACROECONOMICS
OF OPEN ECONOMY

Written by: Mr. Sharafat Afzal

Reviewed by: Dr. Fouzia Jamshaid

67
 CONTENTS

6.1 Introduction ................................................................................................69

6.2 Learning Outcomes ....................................................................................69

6.3 Main Topics to Discuss ..............................................................................69

6.4 Self Assessment Questions ........................................................................75

6.5 Key Terms ..................................................................................................75

6.6 Recommended Books ................................................................................76

6.7 Links/Bibliography ....................................................................................76

68
6.1 Introduction
The purpose of this unit is to develop some basic concepts that macroeconomists use to
study open economies. Openness in the economy or in the form of international trade
yields obvious payback: According to Mankiw “trade allows people to produce what
they produce best and to consume the great variety of goods and services produced
around the world”. Indeed, one of the ten Principles of Economics highlighted in Unit 1
is that trade can make everyone better off. International trade can raise living standards in
all countries by allowing each country to specialize in producing those goods and
services in which it has a comparative advantage.

So far, our development of macroeconomics has largely ignored the economy’s

interaction with other economies around the world. For most questions in
macroeconomics, international issues are peripheral. For instance, when we discussed the
natural rate of unemployment and the causes of inflation, the effects of international trade
could safely be ignored. Indeed, to keep their models simple, macroeconomists often
assume a closed economy an economy that does not interact with other economies. Yet
new macroeconomic issues arise in an open economy an economy that interacts freely
with other economies around the world. We begin this unit by discussing the concept of
open and close economy and how key macroeconomic variables that describe an open
economy’s interactions in world markets. We discuss here the methods which are used
for internal flows of goods and services. The price of international transactions by using
real verses nominal exchange rate is also determined.

6.2 Learning Outcomes

After studying this unit, and having completed the essential readings and activities, you
should be able to:
 find the definition and basic concepts of open economy.
 describe the methods used to find the internal flows of goods and services.
 analyze the price of international transaction: Real vs. Nominal Exchange rate.
 justify the types of method and key terminologies used in open economic studies
 help to better understand the economics activities.
 familiar with these minor and major terminologies and method used in open
economy.

6.3 Main Topics to Discuss

6.3.1 Basic Concepts of Open Economy
An open economy is an economy in which there are economic activities between the
domestic community and outside. People and even businesses can trade
in goods and services with other people and businesses in the international community,
and funds can flow as investments across the border. Trade can take the form of
managerial exchange, technology transfers, and all kinds of goods and services.

69
However, certain exceptions exist that cannot be exchanged; the railway services of a
country, for example, cannot be traded with another country to avail the service. A closed
economy is that in which international trade and finance cannot take place. The act of
selling goods or services to a foreign country is called exporting. The act of buying goods
or services from a foreign country is called importing. Exporting and importing are
collectively called international trade.

We can compare the open and closed Economy as follows:

 A closed economy is one that does not interact with other economies in the world.
 In closed economy there are no exports, no imports, and no capital flows.
 An open economy is one that interacts freely with other economies around the
world.
 An open economy interacts with other countries in two ways. It buys and sells
goods and services in world product markets. It buys and sells capital assets in
world financial markets.

Balance of Payments
The balance of payments of a country contains two accounts: current and capital. The
current account records exports and imports of goods and services as well as unilateral
transfers, whereas the capital account records purchase and sale transactions of foreign
assets and liabilities during a particular year.

Closed Economy
In a closed economy, all output is sold domestically, and expenditure is divided into three
components: consumption (C), investment (I) and government purchases (G).
Y= C+I+G…………………………………………………. (1)

Open Economy
In an open economy there is a flow of funds across borders due to the exchange of goods
and services. Open economy can import and export without any barriers to trade, such as
quotas and tariffs. Citizens of a country in an open economy typically have access to a
larger variety of goods and services. They also can invest savings outside of the country.

The equation used to determine the economic output of a country is

Y= Cd+ Id+Gd+ NX ………………………………………………………2

The economy’s output (Y) equals the sum of the consumption of domestic goods (Cd),
the investment in domestic goods and services (Id), the government purchase of domestic
goods and services (Gd), and the net exports of domestic goods and services (NX). The
sum of C,I and G provides the domestic spending of a country, while NX provides the
foreign sources of spending.

The amount that a country saves is total of investment and net exports:
S= I + NX ………………………………………………………………………….3

70
NX can also be considered the trade balance of a country.
Therefore, Trade Balance = NX=S−I

6.3.2 The International Flow of Goods and Services

An open economy interacts with other economies in two ways: It buys and sells goods
and services in world product markets, and it buys and sells capital assets such as stocks
and bonds in world financial markets. International trade is the exchange of capital,
goods and services across international borders or territories. In most countries, such
trade represents a significant share of gross domestic product (GDP). While international
trade has existed throughout history. Carrying out trade at an international level is a more
complex process than domestic trade. Trade takes place between two or more nations.
Factors like the economy, government policies, markets, laws, judicial system, currency,
etc. influence the trade. The political relations between two countries also influence the
trade between them. Sometimes, the obstacles in the way of trading affect the mutual
relationship adversely. To avoid these situations international economic and trade
organizations came up. To smoothen and justify the process of trade between countries of
different economic standing, some international economic organizations were formed.
These organizations work towards the facilitation and growth of international trade.

Factors that Affect Net Exports

Followings are the factors which affect the net exports.
 The tastes of consumers for domestic and foreign goods.
 The prices of goods at home and abroad.
 The exchange rates at which people can use domestic currency to buy foreign
currencies. The incomes of consumers at home and abroad.
 The costs of transporting goods from country to country.
 The policies of the government toward international trade.

6.3.3 The Price of International Transactions Real and Nominal Exchange Rate
A foreign transaction fee is a charge assessed by a financial institution to a consumer who
uses an electronic payment card to make a purchase in a foreign currency. Foreign
transaction fees usually apply to card (visa credit or debit card) purchases made in foreign
countries while traveling, but they can also apply to purchases made online from your
home country where the vendor is foreign and processes the transaction in its local
currency. Foreign transaction fees are also called “foreign purchase transaction fees” or
“foreign currency transaction fees. In finance, an exchange rate (also known as a foreign-
exchange rate, forex rate, or rate) between two currencies is the rate at which one
currency will be exchanged for another. It is also regarded as the value of one country’s
currency in terms of another currency. For example, an inter-bank exchange rate of 138
Pakistani Rs. (Pak, Rs) to the United States dollar (USD, US$) means that Rs 138 will be
exchanged for each US$1 or that US$1 will be exchanged for each Rs 138.

Exchange rates are determined in the foreign exchange market, which is open to a wide
range of buyers and sellers where currency trading is continuous. The spot exchange rate
refers to the current exchange rate. The forward exchange rate refers to an exchange rate

71
that is quoted and traded today, but for delivery and payment on a specific future date.
Currency is complicated and its value can be measured in several different ways. For
example, a currency can be measured in terms of other currencies, or it can be measured
in terms of the goods and services it can buy. An exchange rate between two currencies is
defined as the rate at which one currency will be exchanged for another. However, that
rate can be interpreted through different perspectives. Below are descriptions of the two
most common means of describing exchange rates.

i) Nominal Exchange Rate

A nominal value is an economic value expressed in monetary terms (that is, in units
of a currency). It is not influenced by the change of price or value of the goods and
services that currencies can buy. Therefore, changes in the nominal value of
currency over time can happen because of a change in the value of the currency or
because of the associated prices of the goods and services that the currency is used
to buy. When you go online to find the current exchange rate of a currency, it is
generally expressed in nominal terms. The nominal rate is set on the open market
and is based on how much of one currency another currency can buy.
ii) Real Exchange Rate
The real exchange rate is the purchasing power of a currency relative to another at
current exchange rates and prices. It is the ratio of the number of units of a given
country’s currency necessary to buy a market basket of goods in the other country,
after acquiring the other country’s currency in the foreign exchange market, to the
number of units of the given country’s currency that would be necessary to buy that
market basket directly in the given country. The real exchange rate is the nominal
rate adjusted for differences in price levels. Exchange rates are determined in the
foreign exchange market, which is open to a wide range of buyers and sellers
where currency trading is continuous. The spot exchange rate refers to the current
exchange rate. The forward exchange rate refers to an exchange rate that is quoted
and traded today, but for delivery and payment on a specific future date.

How the Foreign Exchange Market Works

In the retail currency exchange market, a different buying rate and selling rate will be
quoted by money dealers. Most trades are to or from the local currency. The buying rate
is the rate at which money dealers will buy foreign currency, and the selling rate is the
rate at which they will sell the currency. The quoted rates will incorporate an allowance
for a dealer’s margin (or profit) in trading, or else the margin may be recovered in the
form of a commission or in some other way. Different rates may also be quoted for
different kinds of exchanges, such as for cash (usually notes only), a documentary form
(such as traveler’s checks), or electronic transfers (such as a credit card purchase). There
is generally a higher exchange rate on documentary transactions (such as for traveler’s
checks) due to the additional time and cost of clearing the document, while cash is
available for resale immediately.

72
6.6.4 The First Theory of Exchange Rate: Purchasing Power Parity
Purchasing Power Parity (PPP)
A measure of the differences in price levels is Purchasing Power Parity (PPP). The
concept of purchasing power parity allows one to estimate what the exchange rate
between two currencies would have to be for the exchange to be on par with the
purchasing power of the two countries’ currencies. Using the PPP rate for hypothetical
currency conversions, a given amount of one currency has the same purchasing power
whether used directly to purchase a market basket of goods or used to convert at the PPP
rate to the other currency and then purchase the market basket using that currency.

Purchasing power parity is a way of determining the value of a product after adjusting for
price differences and the exchange rate. Indeed, it does not make sense to say that a book
costs $20 in the United State and Rs: 3100 in Pakistan: the comparison is not equivalent.
If we know that the exchange rate is Rs/$, the book in Pakistan is selling for Rs: 3100, so
the book is more expensive in Pakistan. If goods can be freely traded across borders with
no transportation costs, the Law of One Price posits that exchange rates will adjust until
the value of the goods are the same in both countries. Of course, not all products can be
traded internationally (e.g. haircuts), and there are transportation costs, so the law does
not always hold.

Purchasing power parity (PPP) is a way of measuring economic variables in different

countries so that irrelevant exchange rate variations do not distort comparisons.
Purchasing power exchange rates are such that it would cost exactly the same number of,
for example, US dollars to buy Euros and then buy a basket of goods in the market as it
would cost to purchase the same goods directly with dollars. The purchasing power
exchange rate used in this conversion equals the ratio of the currencies'
respective purchasing powers (reciprocals of their price levels).

So, we can conclude that purchasing power parity allows one to estimate what the
exchange rate between two currencies would have to be to equate the purchasing power
of the two currencies. Observed deviations of the exchange rate from purchasing power
parity are measured by deviations of the real exchange rate from its PPP value.

Law of One Price

Although it may seem as if PPPs and the law of one price are the same, there is a
difference: the law of one price applies to individual commodities, whereas PPP applies
to the general price level. If the law of one price is true for all commodities then PPP is
also therefore true; however, when discussing the validity of PPP, some argue that the
law of one price does not need to be true exactly for PPP to be valid. If the law of one
price is not true for a certain commodity, the price levels will not differ enough from the
level predicted by PPP.

The purchasing power parity theory states that the exchange rate between one currency
and another currency is in equilibrium when their domestic purchasing powers at that rate
of exchange are equivalent.

73
6.3.5 Macroeconomics Theory of Open Economy Trade Affecting the National
Income
Balance of Payments
Flexible exchange rates serve to adjust the balance of trade. When a trade deficit occurs
in an economy with a floating exchange rate, there will be increased demand for the
foreign (rather than domestic) currency which will increase the price of the foreign
currency in terms of the domestic currency. That in turn makes the price of foreign goods
less attractive to the domestic market and decreases the trade deficit. Under fixed
exchange rates, this automatic re-balancing does not occur.

Monetary and Fiscal Policy

A big drawback of adopting a fixed-rate regime is that the country cannot use its
monetary or fiscal policies with a free hand. In general, fixed rates are not established by
law, but are instead maintained through government intervention in the market. The
government does this through the buying and selling of its reserves, adjusting its interest
rates, and altering its fiscal policies. Because the government must commit its monetary
and fiscal tools to maintain the fixed rate of exchange, it cannot use these tools to address
other macroeconomics conditions such as price level, employment and recessions
resulting from the business cycle.

Impacts of Policies and Events on Equilibrium

Government policies and outside events may affect the macroeconomic equilibrium by
shifting aggregate supply or aggregate demand. The macroeconomic equilibrium is
determined by aggregate supply and aggregate demand. Much of economics focuses on
the determinants of aggregate supply and demand that are endogenous that is, internal to
the economic system. These include factors such as consumer preferences, the price of
inputs, and the level of technology. However, there are many factors that affect the
macroeconomic equilibrium that are exogenous to the economic system that is, external
to the economic model.

i) Supply Shock
One type of event that can shift the equilibrium is a supply shock. This is an event
that suddenly changes the price of a commodity or service. It may be caused by a
sudden increase or decrease in the supply of a good, which in turn affects the
equilibrium price. One extreme case of a supply shock is the 1973 Oil Crisis. When
the U.S. chose to support Israel during the Yom Kippur War, the Organization of
Arab Petroleum Exporting Countries (OAPEC) responded with an oil embargo,
which increased the market price of a barrel of oil by 400%. This supply shock in
turn contributed to stagflation and economic disorder.
ii) Inflation
Inflation can result from increased aggregate demand but can also be caused by
expansionary monetary policy or supply shocks that cause large price changes.
Changes in prices can shift aggregate demand, and therefore the macroeconomic
equilibrium, as a result of three different effects: a) The wealth effect b) The
interest rate effect c) The exchange rate effect

74
iii) Trade Policies
Trade policies can shift aggregate demand. Protectionism, for example, is a policy
that interferes with the free workings of the international marketplace. By
implementing protectionism policies such as tariffs and quotas, a government can
make foreign goods relatively more expensive and domestic goods relatively
cheaper, increasing net exports and therefore aggregate demand. Since the world
demands more goods produced in the home country, the demand for the domestic
currency increases and the exchange rate rises.
iv) Capital Flight
Capital flight occurs when assets or money rapidly flow out of a country due to an
event of economic consequence. Such events could be due to an increase in taxes
on capital or capital holders, or the government of the country defaulting on its debt
that disturbs investors and causes them to lower their valuation of the assets in that
country, or otherwise to lose confidence in its economic strength. This leads to an
increase in the supply of the local currency and is usually accompanied by a sharp
drop in the exchange rate of the affected country. This leads to dramatic decreases
in the purchasing power of the country’s assets and makes it increasingly expensive
to import goods. Net exports rise as a component of aggregate demand.

6.4 Self-Assessment Questions

1. Define net exports and net capital outflow. Explain how and why they are related.
2. Explain the relationship among saving, investment and net capital outflow.
3. If a Pakistanis car costs RS: 1000,000 a similar American car costs $200,000 and a
dollar can buy 100 rupees, what are the nominal and real exchange rates?
4. Describe the economic logic behind the theory of purchasing-power parity.
5. If the Fed started printing large quantities of U.S. dollars, what would happen to the
number of Japanese yen a dollar could buy? Why?
6. Would each of the following transactions be included in net exports or net capital
outflow? Be sure to say whether it would represent an increase or a decrease in that
variable.
 An American buys a Sony TV.
 An American buys a share of Sony stock.
 The Sony pension fund buys a bond from the U.S. Treasury.
 A worker at a Sony plant in Japan buys some Georgia peaches from an
American farmer.

6.5 Key Terms

Closed Economy: An economy that does not interact with other economies in the world
Open Economy: An economy that interacts freely with other economies around the
world
Exports: Goods and services that are produced domestically and sold abroad
Imports: Goods and services that are produced abroad and sold domestically

75
Net Exports: The value of a nation’s exports minus the value of its imports; also called
the trade balance
Trade Balance: The value of a nation’s exports minus the value of its imports; also
called net exports
Trade Surplus: An excess of exports over imports
Trade Deficit: An excess of imports over exports
Balanced Trade: A situation in which exports equal imports
Net Capital Out flow: The purchase of foreign assets by domestic residents minus the
purchase of domestic assets by foreigners
Nominal Exchange Rate: The rate at which a person can trade the currency of one
country for the currency of another
Real Exchange Rate: The rate at which a person can trade the goods and services of one
country for the goods and services of another
Purchasing-Power Parity (PPP): A theory of exchange rates whereby a unit of any
given currency should be able to buy the same quantity of goods in all countries
Trade Policy: A government policy that directly influences the quantity of goods and
services that a country imports or export.

6.6 Recommended Books

1. Mankive, N. Gregory. Principles of Macroeconomics (Chapters 18-19)
2. Able, Andrew, B., Bernanke, Ben S.& Croushore, D. Macroeconomics (Chapter
14)
3. Richard T. Froyen. Macroeconomics (Chapter 2)

Additional Books:
1. Parkin, Michael - Macroeconomics, latest edition
2. Miller, R.L.– Economics Today – latest edition

6.7 Links/Bibliography
For further information on topics in this chapter, additional problems, applications,
examples, online quizzes, and more, please visit following websites.

Note: These websites were viewed, when the study guide has been developed.

 Viewed on 15/7/2019 at: www.cengage.com/economics/mankiw.

 Viewed on 15/7/2019 at: https://www.quora.com/Why-do-people-study-
macroeconomics
 Viewed on 15/7/2019 at:
 www.economicsdiscussion.net/microeconomics/macroeconomic-policy
 Viewed on 15/7/2019 at: https://science.blurtit.com/107177/what-are-the-tools-of-
macroeconomic-policy
 Viewed on 16/7/2019 at:

76
 www.economicsdiscussion.net/macroeconomics/development...macro-economics..
 Viewed on 16/7/2019 at: https://courses.lumenlearning.com/boundless-
economics/chapter/equilibrium
 Viewed on 20/7/2019 at: www.pbs.edu.pk
 Viewed on 20/7/2019 at: www.sbp.edu.pk
 Viewed on 20/7/2019 at: www.esp.edu.pk

77
78
UNIT-7

AGGREGATE DEMAND
& AGGREGATE SUPPLY

Written by: Mr. Sharafat Afzal

Reviewed by: Dr. Fouzia Jamshaid

79
 CONTENTS

7.1 Introduction ................................................................................................81

7.2 Learning Outcomes ....................................................................................81

7.3 Main Topics to Discuss ..............................................................................82

7.4 Self Assessment Questions ........................................................................88

7.5 Key Terms ..................................................................................................90

7.6 Recommended Books ................................................................................91

7.7 Links/Bibliography ....................................................................................91

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7.1 Introduction
Economies experiences short run fluctuations in economic activity, measured most
broadly by real GDP. These fluctuations are associated with movements in many
macroeconomic variables. When GDP growth declines, consumption growth falls
(typically by a smaller amount), investment growth falls (typically by a larger amount)
and unemployment rises. Although economists look at various leading indicators to
forecast movements in the economy, these short run fluctuations are largely
unpredictable.

Economic fluctuations are used to describe a variation of periods during which the
economy is growing and then decreasing, facing what we also call a recession. To
measure these growth and recession, we would watch the evolution of the GDP of a
country for example. The GDP represents the sum of every revenues earned through
different industries, the difference between the volume of exports and import and the
investments.

In this unit you will see how the economy makes the decisions that how much goods and
services should be produced and at which price level. All the fluctuations which whether
it’s about short run or long run are part of economic activities. So in this unit you will
know in detail how the economist play their role and how economic theories practically
implies and how does model work.

The crucial differences between how the economy works in the long run and how it
works in the short run are that prices are flexible in the long run but sticky in the short
run. This unit will introduce the model of aggregate demand and aggregate supply,
which helps explain economic fluctuations. The model of aggregate supply and aggregate
demand provides framework to analyze economic fluctuations and see how the impact of
policies and events varies over different time horizons. Keep in mind these fluctuations
are deviations from the long-run trends explained by the models we learned in previous
unit. In the next unit, we will learn how policymakers can affect aggregate demand
with fiscal and monetary policy.

7.2 Learning Outcomes

By the end of this unit, and having completed the Essential readings and activities, you
should be able to:
 understand the key facts about economic fluctuations
 analyze short-run economic fluctuations
 drive the aggregate Demand Curve
 drive the aggregate Supply Curve
 provide framework to analyze economic fluctuations
 see how the impact of policies and events varies over different time horizons.
 discuss the causes of economic fluctuations

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7.3 Main Topics to Discuss
7.3.1 Three key Facts about Economic Fluctuations
Before discussing the model, however, let’s look at some of the key facts that describe
the ups and downs of the economy.

What are Fluctuations?

Fluctuation Definition: Continual changes from one point or condition to another,
economic fluctuations are simply fluctuations in the level of the national income of a
country representing growth or contraction. A market economy is not static. It's dynamic.
A rise in national income means an economy is growing, while a decline in national
income means that an economy is contracting. The current economic model describing
economic fluctuations in a market economy is the business cycle.

To measure these growth and recession, we would watch the evolution of the GDP of a
country for example. The GDP represents the sum of every revenues earned through
different industries, the difference between the volume of exports and import and the
investments. Each year, the GDP is measured according to the previous year record to
evaluate its growth. Let’s say the GDP equal 100 in year N. The following year, N+1, the
GDP equal 110. We just recorded an increase of 10% from one year to another. And if it
goes on and, on each year,, we would consider the economy is facing a prosperity phase.
Over the course of 10 years, this annual increase of 10% will lead to a GDP record of 259
(100x1.1x1.1…=100= 100x1.110=259). Now let’s say the GDP continue to grow but this
growth is slower each year, from 10% to 1% for the course of 10 years. Again, we’ll still
record a growth but less important and that’s what we call a recession. The GDP should
then decrease down to 89 =259x0.9x0.9… =259x0.910 =89).

After these two cycles, if the economy recovers - meaning the recorded growth is higher
than the one observed the previous year - another cycle starts again.

Fact 1: Irregular and Unpredictable

Also known as the “business cycle”. Economic fluctuations are impossible to predict
accurately. Sometimes recessions are close together and sometimes the economy goes
many years without recess.

Fact 2: Most Macroeconomic Quantities Fluctuate Together

Real GDP measures short term changes in the economy. Most variables fluctuate
together, but they fluctuate in different amounts. When real GDP falls, then other
variables fall as well, from personal income, consumer spending, to investment spending,
the change in real GDP reflects changes in the economy. Because recessions are economy
wide phenomena, they show up in many sources of macroeconomic data.

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Fact 3: As unemployment rises, output falls.
The GDP and the unemployment rate have an inverse relationship. During times of
economic contraction, unemployment rises. For example, during the Great Depression
and the Great Recession, unemployment rates were exceedingly high.

7.3.2 Explaining Short- run Economic Fluctuations

In the short run, the aggregate supply curve is upward sloping. In the short run, an
increase in the overall level of prices in the economy tends to raise the quantity of goods
and services supplied. Short-run fluctuations in output and price level should be viewed
as deviations from the continuing long-run trends. In the short run, output is determined
by both the aggregate supply and aggregate demand within an economy. Anything that
causes labor, capital or efficiency to go up or down results in fluctuations in economic
output. To understand how the economy works in the short run, we need first to know the
concept of aggregate demand curve and aggregate supply curve.

7.3.3 The Aggregate Demand Curve

 What is Aggregate Demand?
Aggregate demand is an economic measurement of the sum of all final goods and
services produced in an economy, expressed as the total amount of money exchanged for
those goods and services. Since aggregate demand is measured by market values, it only
represents total output at a given price level and does not necessarily represent quality or
standard of living. It is the combination of consumer spending, investments, government
spending, and net exports within a given economic system (often written out as AD = C +
I + G + NX).

As a result of this, increases in overall capital within an economy impacts the aggregate
spending and/or investment. This creates a relationship between monetary policy and
aggregate demand. This brings us to the aggregate demand curve. It specifies the amounts
of goods and services that will be purchased at all possible price levels. This is the
demand for the gross domestic product of a country. It is also referred to as the effective
demand. The aggregate demand curve illustrates the relationship between two factors the
quantity of output that is demanded and the aggregated price level.

 Calculating Aggregate Demand

The Keynesian equation for aggregate demand is: AD = C + I + G + Nx
Where:
C = Consumer spending on goods and services
I = Private investment and corporate spending on non-final capital goods (factories,
equipment, etc.)
G = Government spending on public goods and social services (infrastructure, Medicare,
etc.)
Nx = Net exports (exports minus imports)
This is the same formula used by the Bureau of Economic Analysis to measure GDP.

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Downward sloping aggregate demand curve

DD is the demand curve, the most noticeable feature of the aggregate demand curve is
that it is downward sloping, as seen in Figure: 7.1. There are several reasons for this
relationship. Remember that a downward sloping aggregate demand curve means that as
the price level drops, the quantity of output demand increases. Similarly, as the price
level drops, the national income increases.

Reasons for Downward Sloping:

There are three basic reasons for the downward sloping aggregate demand curve
 Pigou's Wealth Effect,
 Keynes's Interest-rate Effect,
 Mundell-Fleming's Exchange-Rate Effect.

These three reasons for the downward sloping aggregate demand curve are distinct, yet
they work together.
1) The Price Level and Consumption: The Wealth Effect
 A decrease in the price level makes consumers feel wealthier, which in turn
encourages them to spend more.
 This increase in consumer spending means larger quantities of goods and
services demanded
2) The Price Level and Investment: The Interest Rate Effect
 A lower price level reduces the interest rate, which encourages greater
spending on investment goods.
 This increase in investment spending means a larger quantity of goods and
services demanded.
3) The Price Level and Net Exports: The Exchange Rate Effect
 When a fall in the Euro land price level causes Euro land interest rates to fall,
the real exchange rate depreciates, which stimulates Euro land net exports.

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  The increase in net export spending means a larger quantity of goods and
services demanded.

Why the Aggregate Demand Curve Might Shift?

The downward slope of the aggregate demand curve shows that a fall in the price level
raises the overall quantity of goods and services demanded. Many other factors, however,
affect the quantity of goods and services demanded at any given price level. When one of
these other factors changes, the aggregate demand curve shifts: Factors are Consumption,
Investment, Government Purchases and Net Exports.

What is Aggregate Supply Curve?

Aggregate supply, also known as total output, is the total supply of goods and services
produced within an economy at a given overall price level in a given period. It is
represented by the aggregate supply curve, which describes the relationship between
price levels and the quantity of output that firms are willing to provide. Normally, there is
a positive relationship between aggregate supply and the price level.

Shape of Aggregate Supply Curve

The aggregate supply curve depicts the quantity of real GDP that is supplied by the
economy at different price levels. The reasoning used to construct the aggregate supply
curve differs from the reasoning used to construct the supply curves for individual goods
and services. The aggregate supply curve, however, is defined in terms of the price level.
Increases in the price level will increase the price that producers can get for their products
and thus induce more output. But an increase in the price will also have a second effect; it
will eventually lead to increases in input prices as well, which ceteris paribus, will cause
producers to cut back. So, there is some uncertainty as to whether the economy will
supply more real GDP as the price level rises. In order to address this issue, it has become
customary to distinguish between two types of aggregate supply curves, the short run
aggregate supply curve and the long run aggregate supply curve.

Causes of Aggregate Supply Shifts

A shift in aggregate supply can be attributed to several variables. These include changes
in the size and quality of labor, technological innovations, an increase in wages, an
increase in production costs, changes in producer taxes and subsidies and changes in
inflation. Some of these factors lead to positive changes in aggregate supply while others
cause aggregate supply to decline. For example, increased labor efficiency, perhaps
through outsourcing or automation, raises supply output by decreasing the labor cost per
unit of supply.

 Short Run Aggregate Supply Curve

The short run aggregate supply (SAS) curve is considered a valid description of the
supply schedule of the economy only in the short run. The short run is the period
that begins immediately after an increase in the price level and that ends when
input prices have increased in the same proportion to the increase in the price level.
During the short run, sellers of final goods are receiving higher prices for their

85
 products, without a proportional increase in the cost of their inputs. The higher the
price level, the more these sellers will be willing to supply. The SAS curve showed
in Figure: 7.2 (a) is therefore upward sloping, reflecting the positive relationship
that exists between the price level and the quantity of goods supplied in the short
run.
 Long run Aggregate Supply Curve.
The long run aggregate supply (LAS) curve describes the economy's supply
schedule in the long run. The long run is defined as the period when input prices
have completely adjusted to changes in the price level of final goods. In the long
run, the increase in prices that sellers receive for their final goods is completely
offset by the proportional increase in the prices that sellers pay for inputs. The
result is that the quantity of real GDP supplied by all sellers in the economy is
independent of changes in the price level. The LAS curve showed in Figure: 7.2
(b)is a vertical line, reflecting the fact that long run aggregate supply is not affected
by changes in the price level. Note that the LAS curve is vertical at the point
labeled as the natural level of real GDP. The natural level of real GDP is defined as
the level of real GDP that arises when the economy is fully employing all its
available input resources.

7.3.5 Causes of Economic Fluctuations or Fluctuation in Economic Activities

Fluctuations in the economy are caused by many different factors. One factor would be
climate. A dry hot year comes along, and crops are hurt. This causes prices of food to
rise. This causes people to quit buying other things then food and people who produce
those things can't sell their products. Economies are also if affected by politics, banking,
lack of raw materials for industrial production, lack of labor availability, lack of job
knowledge by workers and other problems even to worker revolts. Now we will discuss
the causes of booms and dips in economic growth.

 Causes of Economic Growth

Booms/ depressions in economic growth can occur due to several reasons:

86
1. Increase in aggregate demand caused by:
 An increase in consumption: this may be caused by a rise in income levels, a
decrease in interest rates, house price inflation
 A rise in the level of government spending
 A balance of payments surplus
2. Labor shortages
If there are shortages of workers in specific areas it means that the economy will
not be able to utilize its resources efficiently and therefore economic growth will
slow.
3. Increase in demand for imports
This will worsen the balance of payments deficit.

Demand & Supply Side Shocks

Supply side and demand side shocks can lead to instability in the economy. Shocks are
unexpected events that influence the demand / supply in an economy. As the UK operates
in a global market their economy is open to shocks from across the world.

Demand Side Shocks

These can include:
 A significant rise or fall in exchange rates in short term
 Changes in the rate of economic growth for countries that you trade a lot with
 Changes in aggregate demand
 A boom in capital expenditure e.g. in construction or ICT

Supply Side Shocks

These affect the costs and prices of supply like:
 Technology
 Natural disasters which impact the supply of goods e.g. crops
 Political situations that influence the supply of products e.g. oil
 Trend rates in Economic Growth

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7.4 Self-Assessment Questions
7.4.1 Multiple choice questions (AD/AS - self-test questions)
i) Which of the following would NOT cause a shift in AD?
a. A reduction in income tax
b. A reduction in interest rates
c. An increase in government spending
d. A fall in the cost of production
ii) Which of the following would NOT cause a shift in AS?
a. The level of government spending
b. The costs of the factors of production
c. Incentives
d. The structure of the economy
iii) If the price of imports rose, caused by a change in the value of the pound then the
AS would shift to the:
a. Right
b. Left
c. Vertically
d. Not at all
iv) Which of the following might have caused the shift in aggregate supply shown in
the diagram

a. An improvement in technology
b. A depreciation of the exchange rate
c. An increase in costs
d. A reduction in government expenditure
e. A cut in income tax
f. An increase in wage levels
v) A key determinant of exports is:
a. The industrial base of the economy
b. The number of people in work
c. The political beliefs of the government
d. The role of the central bank

88
vi) Which of the following would cause the shift shown in the diagram below? Tick all
the answers that apply.

a. The government increase interest rates

b. The Chancellor increases tax-free allowances in his budget
c. The rate of value-added tax is increased
d. Controls on the level of bank lending are relaxed
e. The government allows tax relief on R&D spending
f. The rate if income tax is reduced
vii) When using AD/AS analysis to illustrate changes within an economy, which of the
following would NOT need to be considered when looking at changes to economic
growth?
a. Increased labor productivity
b. More efficient use of the capital stock
c. Increased availability of social capital
d. Developing a more efficient capital and finance sector
viii) Which of the following is a major influence on AS?
a. Consumption
b. Government spending
c. The quality of the factors available
d. The advice of government
ix) An increase in aggregate demand (given no change in aggregate supply) will cause
higher inflation.
 True
 False
x) An increase in costs will make the aggregate supply curve more inelastic.
 True
 False
xi) The less responsive is AS to a rise in AD, the more prices will rise for a given
increase in AD
 True
 False

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xii) An increase in expenditure tax will shift both the aggregate demand and supply
curves to the left.
 True
 False
xiii) An improvement in productivity will shift both the aggregate demand and supply
curves to the right.
 True
 False
xiv) Which of the following is likely to result from a rapid rise in aggregate demand?
a. Increased unemployment
b. Static living standards
c. Rising prices
d. Surplus on the balance of payments

7.4.2 Essay Questions

1. List and discuss three key facts about economic fluctuations
2. What is the economic reason that the aggregate supply curve, or short run
aggregate supply curve slope upward?
3. What are the components of the aggregate demand curve?
4. What are the economic reasons that the aggregate demand curve slopes down?
5. Briefly explain the reason for the near-horizontal shape of the aggregate supply
curve, or short run aggregate supply curve, on its far left.
6. Briefly explain the reason for the near-vertical shape of the aggregate supply curve,
short run aggregate supply curve, on its far right.
7. What is potential GDP?

7.5 Key Terms

Aggregate Supply: This is the total quantity of output firms will produce and sell—in
other words, the real GDP.
Upward-Sloping Aggregate Supply Curve: Also known as the short run aggregate
supply curve—shows the positive relationship between price level and real GDP in the
short run.
Recession: A period of declining real incomes and rising unemployment
Depression: A severe recession
Model of Aggregate Demand and Aggregate Supply: The model that most economists
use to explain short-run fluctuations in economic activity around its long-run trend
Aggregate Demand Curve: A curve that shows the quantity of goods and services that
households, firms, the government, and customers abroad want to buy at each price level
Aggregate Supply Curve: A curve that shows the quantity of goods and services that
firms choose to produce and sell at each price level
Natural Rate of Output: The production of goods and services that an economy
achieves in the long run when unemployment is at its normal rate
Stagflation: A period of falling output and rising prices

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Key Facts about Economic Fluctuation
i. Economic Fluctuations Are Irregular and Unpredictable
ii. Most Macroeconomic Quantities Fluctuate Together
iii. As Output Falls, Unemployment Rises

7.6 Recommended Books

1. Mankive, N. Gregory. Principles of Macroeconomics (Chapter 20)
2. Able, Andrew, B., Bernanke, Ben S. & Croushore, D. Macroeconomics (Chapter 9)

Additional Books:
1. Parkin, Michael - Macroeconomics, Latest Edition
2. Miller, R.L.– Economics Today – Latest Edition

7.7 Links/Bibliography
For further information on topics in this unit, additional problems, applications,
examples, online quizzes, and more, please visit the following websites.

Note: These websites were viewed, when the study guide has been developed.

 Viewed on 22/9/2019 at: www cengage.com/economics/mankiw.

 Viewed on 22/9/2019 at: academic.udayton.edu/PMAC/Chapters/chap8-5.htm
 Viewed on 22/9/2019 at: https://www.tutor2u.net/economics/reference/aggregate-
demand-ad
 Viewed on 23/9/2019 at:
 https://www.sparknotes.com/economics/macro/aggregatedemand/section2/
 Viewed on 23/9/2019 at:
 https://www.tutor2u.net/economics/.../macroeconomy/economic_activity_fluctuati
ons...
 Viewed on 25/9/2019 at:
https://www.quora.com/What-are-economic-fluctuations

91
92
UNIT-8

THE INFLUENCE OF MONETARY

AND FISCAL POLICY ON
AGGREGATE DEMAND

Written by: Mr. Sharafat Afzal

Reviewed by: Dr. Fouzia Jamshaid
93
 CONTENTS

8.1 Introduction ................................................................................................95

8.2 Learning Outcomes ....................................................................................95

8.3 Main Topics to Discuss ..............................................................................95

8.4 Self Assessment Questions ......................................................................102

8.5 Key Terms ................................................................................................102

8.6 Recommended Books ..............................................................................103

8.7 Links/Bibliography ..................................................................................103

94
8.1 Introduction
In the former unit, we used the model of aggregate demand and aggregate supply to
explain short-run economic fluctuations. As you have observed in the previous unit, that
monetary and fiscal policy can influence aggregate demand. Thus, a change in one of
these policies can lead to short-run fluctuations in output and prices. In this unit, you will
examine in more detail how the government’s policy tools influence the position of the
aggregate-demand curve. These tools include monetary policy (the supply of money set
by the central bank) and fiscal policy (the levels of government spending and taxation)
Now you will see in this unit how fiscal and monetary policies tools can shift the
aggregate demand curve and, in doing so, affect macroeconomic variables in the short
run. Many others factor also influence aggregate demand besides monetary and fiscal
policy. Especially, desired spending by households’ changes, aggregate demand. If
policymakers do not act, shifts in aggregate demand cause short-run fluctuations in
output and employment. Accordingly, monetary and fiscal policymakers sometimes
use the policy tools at their disposal to attempt to equalize these shifts in aggregate
demand and so stabilize the economy. Here we will discuss the theory behind these
policies in detail.

8.2 Learning Outcomes

By the end of this unit, and having completed the essential readings and activities, you
should be able to:
 find the how the Fiscal Policy Influence on Aggregate Demand
 determine that monetary policy Effects on Aggregate Demand
 use Policy to Stabilize the Economy

8.3 Main Topics to Discuss

8.3.1 Influence of Fiscal Policy on Aggregate Demand
What is Fiscal Policy?
Fiscal policy is the use of government spending and taxation to influence the economy.
Fiscal policy is the use of government revenue collection (mainly taxes) and expenditure
(spending) to influence the economy. According to Keynesian economics, when the
government changes the levels of taxation and government spending, it influences
aggregate demand and the level of economic activity. Fiscal policy is often used to
stabilize the economy over the course of the business cycle.

Changes in the level and composition of taxation and government spending can affect the
following macroeconomic variables, amongst others:
 Aggregate demand and the level of economic activity;
 Saving and investment;
 Income distribution.

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Fiscal policy can be distinguished from monetary policy, in that fiscal policy deals with
taxation and government spending and is often administered by an executive under laws
of a legislature, whereas monetary policy deals with the money supply and interest rates
and is often administered by a central bank. Governments use fiscal policy to influence
the level of aggregate demand in the economy to achieve the economic objectives of
price stability, full employment and economic growth.

The government has two policies when setting fiscal policy:

 Change the level and composition of taxation, and/or
 Change the level of spending in various sectors of the economy.

Main Types of Fiscal Policy:

i) Neutral: This type of policy is usually undertaken when an economy is in
equilibrium. In this instance, government spending is fully funded by tax revenue,
which has a neutral effect on the level of economic activity.
ii) Expansionary: This type of policy is usually undertaken during recessions to
increase the level of economic activity. In this instance, the government spends
more money than it collects in taxes.
iii) Contractionary: This type of policy is undertaken to pay down government debt
and to cap inflation. In this case, government spending is lower than tax revenue.

In times of recession, Keynesian economics suggests that increasing government spending

and decreasing tax rates is the best way to stimulate aggregate demand. Keynesians argue that
this approach should be used in times of recession or low economic activity as an essential
tool for building the foundation for strong economic growth and working towards full
employment. In theory, the resulting deficit would be paid for by an expanded economy
during the boom that would follow. In times of recession, the government uses expansionary
fiscal policy to increase the level of economic activity and increase employment. In times of
economic boom, Keynesian theory postulate that removing spending from the economy will
reduce levels of aggregate demand and contract the economy, thus stabilizing prices when
inflation is too high.

Expansionary policy shifts the aggregate demand curve to the right, while contractionary
policy shifts it to the left.

Impacts of Fiscal Policy on Aggregate Demand

Under the fiscal policy government attempts to influence the direction of the economy
through changes in government spending or taxes. These actions lead to an increase or
decrease in aggregate demand, which is reflected in the shift of the aggregate demand
(AD) curve to the right or left respectively. As the aggregate demand is made up of
consumption, investment, government spending, and net exports. The aggregate demand
curve will shift as a result of changes in any of these components.

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 Expansionary policy involves an increase in government spending, a reduction in
taxes or a combination of the two. It leads to a right-ward shift in the aggregate
demand curve.
 Contractionary policy involves a decrease in government spending, an increase in
taxes or a combination of the two. It leads to a left-ward shift in the aggregate
demand curve

Expansionary and Contractionary Fiscal Policy:

Expansionary policy shifts the AD curve to the right, while contractionary policy shifts it
to the left, you can see in Figure: 8.1-part a & b.

Part: a Part :b

Expansionary fiscal policy is used to kick-start the economy during a recession. It boosts
aggregate demand, which in turn increases output and employment in the economy. In
pursuing expansionary policy, the government increases spending, reduces taxes, or does
a combination of the two. Since government spending is one of the components of
aggregate demand, an increase in government spending will shift the demand curve to the
right. A reduction in taxes will leave more disposable income and cause consumption and
savings to increase, also shifting the aggregate demand curve to the right. An increase in
government spending combined with a reduction in taxes will, unsurprisingly, also shift
the AD curve to the right, we can observe in Figure 8.1-part a (AD1 right AD2). The
extent of the shift in the AD curve due to government spending depends on the size of the
spending multiplier, while the shift in the AD curve in response to tax cuts depends on
the size of the tax multiplier. If government spending exceeds tax revenues, expansionary
policy will lead to a budget deficit.

A contractionary fiscal policy is implemented when there is demand-pull inflation. It can

also be used to pay off unwanted debt. In pursuing contractionary fiscal policy, the
government can decrease its spending, raise taxes, or pursue a combination of the two.
Contractionary fiscal policy shifts the AD curve to the left, we can also observe in Figure

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8.1-part b (AD1 left AD2). If tax revenues exceed government spending, this type of
policy will lead to a budget surplus.

Counter-cyclical Fiscal Policies: Keynesian economists advocate counter-cyclical fiscal

policies. This means increased spending and lower taxes during recessions and lower
spending and higher taxes during economic boom times.

In instances of recession, government spending does not have to make up for the entire
output gap. There is a multiplier effect that boosts the impact of government spending.
The government could stimulate a great deal of new production with a modest
expenditure increase if the people who receive this money consume most of it. This extra
spending allows businesses to hire more people and pay them, which in turn allows a
further increase in spending, and so on in a virtuous circle. In addition to changes in
spending, the government can also close recessionary gaps by decreasing income taxes,
which increases aggregate demand and real GDP, which in turn increases prices.
Conversely, to close an expansionary gap, the government would increase income taxes,
which decreases aggregate demand, the real GDP, and then prices. The effects of fiscal
policy can be limited by crowding out. Crowding out occurs when government spending
simply replaces private sector output instead of adding additional output to the economy.
Crowding out also occurs when government spending raises interest rates, which limits
investment.

8.3.2 The Impact of Monetary Policy on Aggregate Demand

What is Monetary Policy?
Monetary policy is the process by which the monetary authority of a country, typically
the central bank or currency board, controls either the cost of very short-term borrowing
or the monetary base, often targeting an inflation rate or interest rate to ensure price
stability and general trust in the currency. Further goals of a monetary policy are usually
to contribute to the stability of gross domestic product, to achieve and maintain low
unemployment and to maintain predictable exchange rates with other currencies.
Monetary economics provides insight into how to craft an optimal monetary policy. In
developed countries, monetary policy has generally been formed separately from fiscal
policy, which refers to taxation, government spending, and associated borrowing.

Impacts of Monetary Policy on Aggregate Demand:

Changes in a country’s money supply shift the country’s aggregate demand curve.
 Aggregate demand (AD) is the sum of consumer spending, government spending,
investment and net exports.
 The AD curve assumes that money supply is fixed.
 The decrease in the money supply is mirrored by an equal decrease in the nominal
output, otherwise known as Gross Domestic Product (GDP).
 The decrease in the money supply will lead to a decrease in consumer spending.
This decrease will shift the AD curve to the left.
 The increase in the money supply is mirrored by an equal increase in nominal
output, or Gross Domestic Product (GDP).

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 The increase in the money supply will lead to an increase in consumer spending.
This increase will shift the AD curve to the right.
 Increased money supply causes reduction in interest rates and further spending and
therefore an increase in AD.

A. Contractionary Monetary Policy

Contractionary monetary policy decreases the money supply in an economy. The
decrease in the money supply is mirrored by an equal decrease in the nominal
output, otherwise known as Gross Domestic Product (GDP). In addition, the
decrease in the money supply will lead to a decrease in consumer spending. This
decrease will shift the aggregate demand curve to the left. This reduction in money
supply reduces price levels and real output, as there is less capital available in the
economic system.

A. Expansionary Monetary Policy

Expansionary monetary policy increases the money supply in an economy. The
increase in the money supply is mirrored by an equal increase in nominal output, or
Gross Domestic Product (GDP). In addition, the increase in the money supply will
lead to an increase in consumer spending. This increase will shift the aggregate
demand curve to the right .In addition; the increase in money supply would lead to
movement up along the aggregate supply curve. This would lead to a higher prices
and more potential real output. Figure: 8.2 depicted the aggregate demand graph
which shows the effect of expansionary monetary policy, which shifts the
aggregate demand (AD) to the right.

The Basic Mechanics of Expansionary Monetary Policy

A central bank can enact a contractionary monetary policy several ways. The primary
means a central bank uses to implement an expansionary monetary policy is through open
market operations. The central bank can issue debt in exchange for cash. This results in
less cash being in the economy. Because the banks and institutions that purchased the

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debt from the central bank have less cash, it is harder for them to make loans to its
customers. As a result, the interest rate for loans increase. Businesses then, presumably,
have less money to use to expand its operations or even maintain its current levels. This
could lead to an increase in unemployment. The higher interest rates can also slow
inflation. Consumption and investment are discouraged, and market actors will choose to
save instead of circulating their money in the economy. Effectively, the money supply is
smaller, and there is reduced upward pressure on prices since demand for consumption
goods and services have dropped.

Other Methods of Enacting Restrictive Monetary Policy

Another way to enact a contractionary monetary policy is to decrease the amount of
discount window lending. The discount window allows eligible institutions to borrow
money from the central bank, usually on a short-term basis, to meet temporary shortages
of liquidity caused by internal or external disruptions

A final method of enacting a contractionary monetary policy is by increasing the reserve

requirement. All banks are required to have a certain amount of cash on hand to cover
withdrawals and other liquidity demands. By increasing the reserve requirement, less
money is made available to the economy at large.

8.3.3 Using the Policy to Stabilize the Economy

Economic stabilisation is one of the main remedies to effectively control or eliminate the
periodic trade cycles which plague capitalist economy. Economic stabilisation, it should
be noted, is not merely confined to a single individual sector of an economy but embraces
all its facts. In order to ensure economic stability, several economic measures have to be
devised and implemented.

In modern times, a programme of economic stabilisation is usually directed towards the

attainment of three objectives: (i) controlling or moderating cyclical fluctuations; (ii)
encouraging and sustaining economic growth at full employment level; and (iii)
maintaining the value of money through price stabilisation. Thus, the goal of economic
stability can be easily resolved into the twin objectives of sustained full employment and
the achievement of a degree of price stability.

The following instruments are used to attain the objectives of economic stabilisation,
particularly control of trade cycles, relative price stability and attainment of economic
growth:
 Monetary policy
 Fiscal policy; and
 Direct controls.

1. Monetary Policy:
The most commonly advocated policy of solving the problem of fluctuations is monetary
policy. Monetary policy pertains to banking and credit, availability of loans to firms and
households, interest rates, public debt and its management and monetary management.

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However, the fundamental problem of monetary policy in relation to trade cycles is to
control and regulate the volume of credit in such a way as to attain economic stability.
During a depression, credit must be expanded and during an inflationary boom, its flow
must be checked.

Monetary management is the function of the commercial banking system, and through it,
its effects are primarily exerted the economy. Monetary management directly affects the
volume of cash reserves of banks, regulates the supply of money and credit in the
economy, thereby influencing the structure of interest rates and availability of credit.

Both these factors affect the components of aggregate demand (consumption plus
investment) and the flow of expenditures in the economy. It is obvious that an expansion
in bank credit causes an increasing flow of expenditure (in terms of money) and
contraction in bank credit reduces it.

In the armoury of the central bank, there are quantitative as well as qualitative weapons to
control the credit- creating activity of the banking system. They are bank rate, open
market operations and reserve ratios. These are interrelated to tools which operate on the
reserves of member banks which influence the ability and willingness of the banks to
expand credit. Selective credit controls are applied to regulate the extension of credit for
purposes.

2. Fiscal Policy
Today, foremost among the techniques of stabilisation is fiscal policy. Fiscal policy as a
tool of economic stability, however, has received its due importance under the influence
of Keynesian economies only since the depression years of the 1930s.The term ‘‘fiscal
policy” embraces the tax and expenditure policies of the government. Thus, fiscal policy
operates through the control of government expenditures and tax receipts. It encompasses
two separate but related decisions: public expenditures and level and structure of taxes.
The amount of public outlay, the inducement and effects of taxation and the relation
between expenditure and revenue exert a significant impact upon the free enterprise
economy. Broadly speaking, the taxation policy of the government relates to the
programme of curbing private spending. The expenditure policy, on the other hand, deals
with the channels by which government spending on new goods and services directly add
to aggregate demand and indirectly income through the secondary spending which takes
place on account of the multiplier effect.

Taxation, on the other hand, operates to reduce the level of private spending (on both
consumption and investment) by reducing the disposable income and the resulting
savings in the community. Hence, under the budgetary phenomenon, public expenditure
and revenue can be combined in various ways to achieve the desired stimulating or
deflationary effect on aggregate demand.

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3. Direct Controls:
Broadly speaking, direct controls are imposed by government which expressly forbid or
restricts certain kinds of investment or economic activity. Sometimes, direct government
controls over prices and wages as a measure against inflation have been advocated and
implemented. During World War II, price-wage controls were employed in conjunction
with consumer rationing and materials allocation to curb generalised total excess demand
and to direct productive resources into channels desired by the government. Monetary-
fiscal controls may be used to curb excess demand in general but direct controls can be
more useful when they are applied to specific scarcity area

8.4 Self-Assessment Questions

1. Which two variables are related to the aggregate demand (AD) curve? Give two
examples of changes in the economy that shifts the AD curve to the right and
explain why the shifts occur?
2. Describe the short-run aggregate supply curve and long-run aggregate supply
curve. Why is one of these curves horizontal and the other vertical?
3. Give an example of a government policy that acts as an automatic stabilizer.
Explain why the policy has this effect.
4. Consider two policies—a tax cut that will last for only one year and a tax cut that is
expected to be permanent. Which policy will stimulate greater spending by
consumers? Which policy will have the greater impact on aggregate demand?
Explain.
5. Suppose government spending increases, would the effect on aggregate demand be
larger if the Federal Reserve held the money supply constant in response or if the
Fed were committed to maintaining a fixed interest rate? Explain.
6. In which of the following circumstances is expansionary fiscal policy more likely
to lead to a short-run increase in investment? Explain.
 When the investment accelerator is large or when it is small?
 When the interest sensitivity of investment is large or when it is small?

5.5 Key Terms

Fiscal Policy: The setting of the level of government spending and taxation by
government policymakers
Monetary Policy: Monetary policy is the macroeconomic policy laid down by the central
bank. It involves management of money supply and interest rate and is the demand side
economic policy used by the government of a country to achieve macroeconomic
objectives like inflation, consumption, growth and liquidity.
Multiplier Effect: The additional shifts in aggregate demand that result when
expansionary fiscal policy increases income and thereby increases consumer spending
Crowding-Out Effect: The offset in aggregate demand that results when expansionary
fiscal policy raises the interest rate and thereby reduces investment spending

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8.6 Recommended Books
1. Mankive, N. Gregory. Principles of Macroeconomics (Chapter 21)
2. Able, Andrew, B., Bernanke, Ben S. & Croushore, D. Macroeconomics
(Chapter10)

Additional Books
1. Rudiger Dornbusch & Stanley Fischer, 6th Edition,
2. Fayranet, al. Macroeconomics Controversies 5th Edition

8.7 Links/Bibliography
For further information on topics in this unit, additional problems, applications,
examples, online quizzes, and more, please visit the following websites.

Note: These websites were viewed, when the study guide has been developed.

 Viewed on 27/9/2019 at: www.cengage.com/economics/mankiw.

 Viewed on 27/9/2019 at:
www.economicsdiscussion.net/microeconomics/macroeconomic-policy
 Viewed on 27/9/2019 at:
 https://science.blurtit.com/107177/what-are-the-tools-of-macroeconomic-policy
 Viewed on28/9/2019 at:
www.economicsdiscussion.net/macroeconomics/development...macro-economics..
 Viewed on 28/9/2019 at: https://www.quora.com/Why-do-people-study-
macroeconomics
 Viewed on 28/9/2019 at: https://courses.lumenlearning.com/boundless-
economics/chapter/equilibrium
 Viewed on 15/9/2019 at: https://courses.lumenlearning.com/boundless/
 Viewed on 29/9/2019 at: www.sbp.edu.pk
 Viewed on 29/9/2019 at: www.esp.edu.pk
 Viewed on 29/9/2019 at: www.pbs.edu.pk

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104
UNIT-9

UNEMPLOYMENT AND
TRADE-OFF BETWEEN INFLATION
AND UNEMPLOYMENT

Written by: Mr. Sharafat Afzal

Reviewed by: Dr. Fouzia Jamshaid
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 CONTENTS

9.1 Introduction ..............................................................................................107

9.2 Learning Outcomes ..................................................................................107

9.3 Main Topics to Discuss ............................................................................108

9.4 Self Assessment Questions ......................................................................115

9.5 Key Terms ................................................................................................116

9.6 Recommended Books ..............................................................................116

9.7 Links/Bibliography ..................................................................................117

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9.1 Introduction
Unemployment is the macroeconomic problem that affects people most directly and
severely. For most people, the loss of a job means a reduced living standard and
psychological distress. It is no surprise that unemployment is a frequent topic of political
debate and that politicians often claim that their proposed policies would help create jobs.
In this Unit, we begin our study of unemployment by discussing why there is always
some unemployment and what determines its level. We start this unit by identifying
unemployment and discuss types of unemployment. We look at some of the relevant facts
that describe unemployment. We also discuss some explanations for the economy’s
natural rate of unemployment: job search, minimum-wage laws, unions and efficiency
wages theory.

To measure the economic performance of any country there are two important indicators
inflation and unemployment. We will discuss in this unit also that how are these two
measures of economic performance related to each other. By contrast, the inflation rate
depends primarily on growth in the money supply, which a nation’s central bank controls.
In the long run, therefore, inflation and unemployment are largely unrelated problems. In
the short run, just the opposite is true. One of the Ten Principles of Economics discussed
in Unit: 1 is that society faces a short-run trade-off between inflation and unemployment.
If monetary and fiscal policymakers expand aggregate demand and move the economy up
along the short-run aggregate-supply curve, they can expand output and lower
unemployment for a while, but only at the cost of a more rapidly rising price level. If
policymakers’ contract aggregate demand and move the economy down the short-run
aggregate-supply curve, they can lower inflation, but only at the cost of temporarily
lower output and higher unemployment.

Moreover, in this unit, we will examine the inflation–unemployment trade-off more

closely. The relationship between inflation and unemployment has attracted the attention
of some of the most important economists of the last half century. The best way to
understand this relationship is to see how thinking about it has evolved. As we will see,
the history of thought regarding inflation and unemployment since the 1950s is
inextricably connected to the history of the U.S. economy. These two histories will show
why the trade-off between inflation and unemployment holds in the short run, why it does
not hold in the long run and what issues the trade-off raises for economic policymakers.

9.2 Learning Outcomes

By the end of this unit, and having completed the essential readings and activities, you
should be able to:
 familiarize with the concept and types of unemployment.
 understand the concept Job Search and Minimum Wage Laws
 highlight the role of union and collective bargaining
 use the Theory of Efficiency Wages

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 explain the concept the Philips Curve
 discuss the role of expectation to shifts in Philips Curve
 describe the role of supply shocks to shifts in Philips Curve
 understand the concept of the cost of reduction inflation

9.3 Main Topics to Discuss

9.3.1 Identifying Unemployment
What is Unemployment?
Unemployment occurs when a person who is actively searching for employment is unable
to find work. Unemployment is often used as a measure of the health of the economy.
The most frequent measure of unemployment is the unemployment rate, which is the
number of unemployed people divided by the number of people in the labor force.
Unemployment or joblessness is the situation of actively looking for employment, but not
being currently employed. The unemployment rate is a measure of the prevalence of
unemployment and it is calculated as a percentage by dividing the number of unemployed
individuals by all individuals currently in the labor force.

Types of Unemployment
While the definition of unemployment is clear, economists divide unemployment into
many different categories. The two broadest categories of unemployment are voluntary
and involuntary unemployment. When unemployment is voluntary, it means that a person
has left his job willingly in search of other employment. When it is involuntary, it means
that a person has been fired or laid off and must now look for another job. Digging
deeper, unemployment both voluntary and involuntary is broken down into three types.
i) Frictional Unemployment
Frictional unemployment arises when a person is in between jobs. After a person
leaves a company, it naturally takes time to find another job, making this type of
unemployment short-lived. It is also the least problematic from an economic
standpoint. Arizona, (A state in USA) for example, has faced rising frictional
unemployment in May 2016, since unemployment has been historically low for the
state. Arizona citizens feel confident leaving their jobs with no safety net in search
of better employment.
ii) Cyclical Unemployment
Cyclical unemployment comes around due to the business cycle itself. Cyclical
unemployment rises during recessionary periods and declines during periods of
economic growth. For example, the number of weekly jobless claims in the United
States has slowed in the month of June, as oil prices begin to rise and the economy
starts to stabilize, adding jobs to the market.
iii) Structural Unemployment
Structural unemployment comes about through technological advances when
people lose their jobs because their skills are outdated. Arizona, for example, after
seeing increased unemployment rates in May 2016, sought to implement "structural
reforms" that will give people new skills and therefore more job opportunities.

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9.3.2 Job Search and Minimum Wage Laws
One reason for unemployment is that it takes time to match workers and jobs. In fact,
workers have different preferences and abilities, and jobs have different attributes.
Furthermore, the flow of information about job candidates and job vacancies is imperfect,
and the geographic mobility of workers is not instantaneous. For all these reasons,
searching for an appropriate job takes time and effort, and this tends to reduce the rate of
job finding. Indeed, because different jobs require different skills and pay different
wages, unemployed workers may not accept the first job offer they receive. The
unemployment caused by the time it takes workers to search for a job is called frictional
unemployment.

Causes of Frictional Unemployment

1. A mismatch between the workers and available jobs
If there is a mismatch between jobseekers and available jobs in the market, that is
considered frictional unemployment.
2. Workers dissatisfaction with work conditions

Workers’ anxiety towards salaries, benefits, work location, job responsibilities, etc. may
force them to quit their current job, and look for something that better meets their updated
expectations.

Effects of Frictional Unemployment

Economists believe that frictional unemployment has positive and negative effects in the
economy such as:

Positive Effects
 It provides businesses within the economy with a larger selection of human capital.
 Companies may gain access to more qualified employees.

Negative Effects
 If job seekers take a long time to find new job, there will be an increasing
frustration among jobseekers that can lead to a decrease in productivity.
 Moreover, a longer frictional unemployment may result in a production decline in
the economy because companies will not be able to satisfy their employee’s
demands.

How to Control Frictional Unemployment?

As frictional unemployment may negatively affect the economy. The following actions
can be taken to control the frictional unemployment at acceptable lower levels:
 Increase the information communication between jobseekers and employers
 Faster information exchange will reduce the matching time between the jobseekers
and employers and consequently lower the unemployment.
 Refuse to accept discrimination against workers, jobs, or locations
 Improve the Jobs’ Flexibility

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Real Wage Rigidity and Structural Unemployment
A second reason for unemployment is wage rigidity, the failure of wages to adjust to a
level at which labor supply equals labor demand. The unemployment resulting from wage
rigidity and job rationing is sometimes called structural unemployment. To understand
wage rigidity and structural unemployment, we must examine why the labor market does
not clear. When the real wage exceeds the equilibrium level and the supply of workers
exceeds the demand, we might expect firms to lower the wages they pay. Structural
unemployment arises because firms fail to reduce wages despite an excess supply of
labor. We now discuss the three causes of this wage rigidity: minimum-wage laws, the
monopoly power of unions and efficiency wages.

Minimum-Wage Laws
The government causes wage rigidity when it prevents wages from falling to equilibrium
levels. Minimum-wage laws set a legal minimum on the wages that firms pay their
employees. For most workers, then, this minimum wage is not binding, because they earn
well above the minimum. Yet for some workers, especially the unskilled and
inexperienced, the minimum wage raises their wage above its equilibrium level and,
therefore, reduces the quantity of their labor that firms demand. Economists believe that
the minimum wage has its greatest impact on teenage unemployment.

9.3.3 Union and Collective Bargaining

A union is a worker association that bargains with employers over wages, benefits, and
working conditions. Moreover, for a variety of historical reasons, unions continue to play
a large role in many European countries. In Belgium, Norway, and Sweden, for instance,
more than half of workers belong to unions. In France and Germany, most workers have
wages set by collective bargaining by law, even though only some of these workers are
themselves union members. In these cases, wages are not determined by the equilibrium
of supply and demand in competitive labor markets.

The Economics of Unions

A union is a type of cartel. Like any cartel, a union is a group of sellers acting together in
the hope of exerting their joint market power. Most workers in the U.S. economy discuss
their wages, benefits, and working conditions with their employers as individuals. By
contrast, workers in a union do so as a group.

Collective Bargaining
The process by which unions and firms agree on the terms of employment is called
collective bargaining. When a union bargains with a firm, it asks for higher wages, better
benefits, and better working conditions than the firm would offer in the absence of a
union strike

If the union and the firm do not reach agreement, the union can organize a withdrawal of
labor from the firm, called a strike. Because a strike reduces production, sales, and profit,
a firm facing: a strike threat is likely to agree to pay higher wages than it otherwise
would. Economists who study the effects of unions typically find that union workers earn

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about 10 to 20 percent more than similar workers who do not belong to unions.
Economists disagree about whether unions are good or bad for the economy. There is no
consensus among economists about whether unions are good or bad for the economy.
Like many institutions, their influence is probably beneficial in some circumstances and
adverse in others.

9.3.4 The Theory of Efficiency Wages

Definition of Efficiency Wage Theory/Hypothesis
The idea of the efficiency wage theory is that increasing wages can lead to increase labor
productivity. Therefore, if firms increase wages, some or all the higher wage costs will be
recouped through increased staff retention and higher labor productivity. You can
observe in Figure: 9.1.

Quantity of Labour

In theory, higher wages could cause increased labor productivity (MRP). In this case, the
wage increases can pay for themselves.

Reasons for Efficiency Wage Theory

i) Fear of losing jobs “Shirking model”: The argument is that if workers are paid a
higher wage, they have more to lose from being made redundant. Therefore, if they
have a job with a wage significantly higher than benefits or alternative jobs, they
will have greater motivation to impress their boss and keep it. Shapiro and Stiglitz
posited “that workers with a higher wage will work at an effort level which
involves no shirking”. This wage is above market clearing levels.

ii) Loyalty. Secondly, if workers receive a higher pay, they may just feel more loyalty
towards the company and be willing to work harder and with more determination.
By contrast, if they feel they are being exploited by a monopsonist employer, and

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 then they will do the minimum amount of work to get by but try to take more
breaks and not work as hard.

iii) Labor market “Gift Exchange” According to G. Akerlof (1982) that the labor
market has a ‘gift exchange’ where good labor relations depended on goodwill.
Firms could pay wages above market clearing levels, and in return, workers would
take on more responsibility and initiative.

iv) Lower costs of supervision. Rebitzer (1995) noted that lower wages were
associated with higher levels of supervision. Workers receiving higher wages were
more motivated and therefore needed less managerial supervision.

v) Attract higher quality labor. If a firm pays above the market clearing level, it will
attract a better-quality worker who will feel they can get the relatively better-paid
job.

vi) Nutritional theories. In developing economies at very low rates of pay, increasing
wages can enable a reduction in absolute poverty better health, and nutrition lead to
better quality labor.

Limitations of Efficiency Wage Theory

i) In practice, many factors determine worker morale and productivity; wages are just
one of them. Often other factors are more important such as work conditions,
management, etc. If non-wage factors are negative, then higher wages may be
insufficient to boost productivity.

ii) It depends on the reaction of other firms. If other firms also start paying above
market clearing levels, then the gain from attracting best quality workers will be
lost.

iii) Firms with monopsony power may not need to pay higher wages to create the
threat of workers losing their jobs.

9.3.5 Phillips Curve

What is the Phillips Curve?
The Phillips curve is an economic concept developed by A. W. Phillips stating that
inflation and unemployment have a stable and inverse relationship. Phillips curves a
curve that shows the short-run trade-off between inflation and unemployment. The theory
claims that with economic growth comes inflation, which in turn should lead to more jobs
and less unemployment. However, the original concept has been somewhat disproven
empirically due to the occurrence of stagflation in the 1970s, when there were high levels
of both inflation and unemployment.

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Understanding the Phillips Curve
Figure: 9.2 present the Phillips curve which shows the relationship between inflation rate
and unemployment rate. The concept behind the Phillips curve states the change in
unemployment within an economy has a predictable effect on price inflation. The inverse
relationship between unemployment and inflation is depicted as a downward sloping,
concave curve, with inflation on the Y-axis and unemployment on the X-axis. Increasing
inflation decreases unemployment, and vice versa. Alternatively, a focus on decreasing
unemployment also increases inflation, and vice versa.

The Phillips curve illustrates a negative association between the inflation rate and the
unemployment rate. At point A, inflation is low and unemployment is high. At point B,
inflation is high and unemployment is low

The Phillips Curve and Stagflation

Stagflation occurs when an economy experiences stagnant economic growth, high
unemployment and high price inflation. This scenario, of course, directly contradicts the
theory behind the Philips curve. The United States never experienced stagflation until the
1970s, when rising unemployment did not coincide with declining inflation. Between
1973 and 1975, the U.S. economy posted six consecutive quarters of declining GDP and
at the same time tripled its inflation.

9.3.6 Shifts in Philips Curve: The Role of Expectations

The phenomenon of stagflation and the break down in the Phillips curve led economists
to look more intensely at the role of expectations in the association between
unemployment and inflation. Because workers and consumers can adjust their
expectations about future inflation rates based on current rates of inflation and

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unemployment, the inverse relationship between inflation and unemployment could only
hold over the short run.

When the central bank increases inflation in order to push unemployment lower, it may
cause an initial shift along the short run Phillips curve, but as worker and consumer
expectations about inflation adapt to the new environment, in the long run the Phillips
curve itself can shift outward. This is especially thought to be the case around the natural
rate of unemployment or NAIRU (Non-Accelerating Inflation Rate of Unemployment),
which essentially represents the normal rate of frictional and institutional unemployment
in the economy. So, in the long run, if expectations can adapt to changes in inflation rates
then the long run Phillips curve resembles and vertical line at the NAIRU; monetary
policy simply raises or lowers the inflation rate after market expectations have worked
themselves out.

In the period of stagflation, workers and consumers may even begin to rationally expect
inflation rates to increase as soon as they become aware that the monetary authority plans
to embark on expansionary monetary policy. This can cause an outward shift in the short
run Phillips curve even before the expansionary monetary policy has been carried out, so
that even in the short run the policy has little effect on lowering unemployment, and in
effect the short run Phillips curve also becomes a vertical line at the NAIRU.

9.3.7 Shifts in Philips Curve: The Role of Supply Shocks

Friedman and Phelps had suggested in 1968 that changes in expected inflation shift the
short-run Phillips curve: shocks to aggregate supply. In 1974, the Organization of
Petroleum Exporting Countries (OPEC) began to exert its market power as a cartel in the
world oil market to increase its members’ profits. Within a few years, this reduction in
supply caused the world price of oil to almost double. A large increase in the world price
of oil is an example of a supply shock. A supply shock is an event that directly affects
firms’ costs of production and thus the prices they charge; it shifts the economy’s
aggregate-supply curve and, as a result, the Phillips curve. For example, when an oil price
increase raises the cost of producing gasoline, heating oil, tires, and many other products,
it reduces the quantity of goods and services supplied at any given price level.

Policymakers face a difficult choice between fighting inflation and fighting

unemployment due to an adverse shift in aggregate supply. If they contract aggregate
demand to fight inflation, they will raise unemployment further. If they expand aggregate
demand to fight unemployment, they will raise inflation further. They must live with a
higher rate of inflation for a given rate of unemployment, a higher rate of unemployment
for a given rate of inflation, or some combination of higher unemployment and higher
inflation. Faced with such an adverse shift in the Phillips curve, policymakers will ask
whether the shift is temporary or permanent. The answer depends on how people adjust
their expectations of inflation. If people view the rise in inflation due to the supply shock
as a temporary aberration, expected inflation will not change and the Phillips curve will
soon revert to its former position. But if people believe the shock will lead to a new era of

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higher inflation, then expected inflation will rise and the Phillips curve will remain at its
new, less desirable position.

So, we can conclude that the short-run Phillips curve also shifts because of shocks to
aggregate supply. An adverse supply shock, such as an increase in world oil prices, gives
policymakers a less favourable trade-off between inflation and unemployment. That is,
after an adverse supply shock, policymakers have to accept a higher rate of inflation for
any given rate of unemployment or a higher rate of unemployment for any given rate of
inflation.

9.3.9 The Cost of Reduction Inflation

When the Government contracts growth in the money supply to reduce inflation, it moves
the economy along the short-run Phillips curve, which results in temporarily high
unemployment. The cost of disinflation depends on how quickly expectations of inflation
fall. Some economists argue that a credible commitment to low inflation can reduce the
cost of disinflation by inducing a quick adjustment of expectations.

9.4 Self-Assessment Questions

1. How is the unemployment rate measured?
2. How might the unemployment rate overstate the amount of joblessness? How
might it understate the amount of joblessness?
3. How would an increase in the world price of oil affect the amount of frictional
unemployment? Is this unemployment undesirable? What public policies might
affect the amount of unemployment caused by this price change?
4. Draw the supply curve and the demand curve for a labor market in which the wage
is fixed above the equilibrium level. Show the quantity of labor supplied, the
quantity demanded, and the amount of unemployment.
5. How do unions affect the natural rate of unemployment?
6. How does a union in the auto industry affect wages and employment at General
Motors and Ford? How does it affect wages and employment in other industries?
7. Draw the long-run trade-off between inflation and unemployment. Explain how the
short-run and long-run trade-offs are related.
8. The Government decides to reduce inflation. Use the Phillips curve to show the
short-run and long-run effects of this policy. How might the short-run costs be
reduced?
9. Illustrate the effects of the following developments on both the short-run and long-
run Phillips curves. Give the economic reasoning underlying your answers.
 A rise in the natural rate of unemployment
 A decline in the price of imported oil
 A rise in government spending
 A decline in expected inflation

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9.5 Key Terms
Labor Force: The total number of workers, including both the employed and the
unemployed
Unemployment Rate: The percentage of the labor force that is unemployed
Labor-Force Participation Rate: The percentage of the adult population that is in the
labor force
Natural Rate of Unemployment: the normal rate of unemployment around which the
unemployment rate fluctuates
Cyclical Unemployment: The deviation of unemployment from its natural rate
Frictional Unemployment: Unemployment that results because it takes time for workers
to search for the jobs that best suit their tastes and skills
Structural Unemployment: Unemployment that results because the number of jobs
available in some labor markets is insufficient to provide a job for everyone who wants
one
Job Search: The process by which workers find appropriate jobs given their tastes and
skills
Union: A worker association that bargains with employers over wages, benefits, and
working conditions
Collective Bargaining: The process by which unions and firms agree on the terms of
employment
Strike: The organized withdrawal of labor from a firm by a union
Efficiency Wages: Above-equilibrium wages paid by firms to increase worker
productivity
Phillips Curve: A curve that shows the short-run trade-off between inflation and
unemployment
Supply Shock: An event that directly alters firms’ costs and prices, shifting the
economy’s aggregate supply curve and thus the Phillips curve
Rational Expectations: The theory that people optimally use all the information they
have, including information about government policies, when forecasting the future

9.6 Recommended Books

1. Mankive, N. Gregory.Principles of Macroeconomics (Chapters15&22)
2. Able, Andrew, B., Bernanke, Ben S. & Croushore, D. Macroeconomics (Chapter
13)
3. Richard T. Froyen. Macroeconomics (Chapter 10)

Additional Books:
1. Parkin, Michael - Macroeconomics, Latest Edition
2. Miller, R.L.– Economics Today – Latest Edition

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9.7 Links/Bibliography
For further information on topics in this unit, additional problems, applications,
examples, online quizzes, and more, please visit the following websites.

Note: These websites were viewed, when the study guide has been developed.

 Viewed on 15/10/2019 at: www.cengage.com/economics/mankiw.

academic.udayton.edu/PMAC/Chapters/chap8-5.htm
 Viewed on 15/10/2019 at: https://www.tutor2u.net/economics/reference/aggregate-
demand-ad
 Viewed on 15/10/2019 at:
https://www.tutor2u.net/economics/.../macroeconomy/economic_activity_fluctuati
ons
 Viewed on 15/10/2019 at: https://www.quora.com/What-are-economic-fluctuations
 Viewed on 16/10/2019 at: www.sbp.edu.pk
 Viewed on 16/10/2019 at: www.esp.edu.pk
 Viewed on 16/10/2019 at: www.pbs.edu.pk

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