Section 9-The Macroeconomy

Economic growth
Economic growth- in the short-run is an increase in a country's output and in the long

run an increase in a country’s productive potential

Actual economic growth on PPC and AD/AS diagram

The actual growth on PPC is

inside the curve. the points on the curve show the use of all the resources but in reality
 not all the resources are used especially labour so the diagrams show how there is

actual growth.

Potential growth shown on PPC and AD/AS diagram

The potential growth how much

the GDP or how much more the resources the country could actually allocate.

• Economic development- an increase in welfare and the quality of life

• Sustainable development - development that ensures that the needs of the present

generations can be met without compromising the well being of future generations.

• Output gap- a gap between actual and potential output

• Negative output gap- a situation where actual output is below potential output

• positive output gap- a situation where actual output is above potential output.

Economic growth factors:

• Increased mobility & flexibility

• More efficient allocation

• New export markets

• Corporate tax reduction

• Upturn in business cycle

• Increase in labour force

• Labour quality improvement

• More research & development

• Technological advances

• Net investment in capital stock

• Capital-intensive production \n

Trade cycles
Trade cycle- fluctuations in the economic activity over a period of years

factors contributing to economic growth -increase in quantity and quality of resources

• costs of economic growth- opportunity cost, depletion of resources, stress and anxiety

• Benefits of economic growth- increased goods & services, rise in employment,

increases investment.

GDP
ways of measuring GDP

• output measure- measures the value of output produced by industries.

• income method - Using income of people

• expenditure method - the amount people spend

Money GDP = total output measured in current prices

Real GDP - total output measured in constant prices.

• Real GDP = (Money GDP x price index in base year) / price index in current year.

• Shadow economy- the output of goods and services not included in official national

figures

• Purchasing power parity- a way of comparing international living Standards by using an

exchange rate based on the amount of each currency needed to purchase the same

basket goods and services.

 Avoid confusing national debt with budget deficit. The former is built up over time while

the latter occurs over the course of 1 year

• Kuznets curve- a curve that shows the relationship between economic growth and

income inequality. The Kuznets curve suggests that as an economy develops, income

becomes more unevenly distributed and then after a certain income level is reached,

income becomes more evenly distributed. The thinking behind this initial rise in income

inequality is that as an economy develops there will be a movement of labour from low-

paid and low-skilled agricultural jobs to higher paid and more skilled manufacturing jobs.

Poverty cycles and development traps

poverty cycle- the links between, for example, low income, low savings, low investment

and low productivity.

 Development traps -

restrictions on the growth of developing economies that arise from low levels of savings

and investment

• Developed economies- high income countries, Mature markets, high standard of living,

high levels of productivity, economy with high GDP per head.

• Developing economies - economy with high GDP per head.

• Emerging economies - economies with a rapid growth rate and that provide good

investment opportunities

Differences between different types of economies:

• The differences that exist between them are related to the geographical area in which

the countries are located. This also means that developing countries located in the

same region are usually affected by the same types of problems. The problems of

developing countries in sub-Saharan Africa, may, for example, be quite distinct from

those of developing countries in Asia. A number of developing economies in Africa, Asia

and Latin America do, however, suffer from poverty cycles, which are also sometimes

referred to as development traps.The term ‘emerging economies’ describes those

developing economies that have high rates of economic growth and are expected to

give high rates of return on investment while carrying a greater risk than investment in

developed economies.
• Developing economies have low income or middle income. Emerging economies tend

to have middle or high income and developed economies have high income. It can,

however, be misleading as some countries’ economies may be growing while others

may be contracting. It also does not capture all the influences on development.

• If either the proportion of debt service exceeds 80% of GNI or the value of debt service

to exports is 220% of exports, then the country is considered to be severely indebted. If

either of the two rates exceeds 60% of the critical level, then the country is said to be

moderately indebted. The presence of debt on such a scale diverts resources to debt

repayment and away from spending on health and education, infrastructure and poverty

relief.

• Developing economies typically have a high dependence on the primary sector. As an

economy develops, the contribution to GDP of the primary sector tends to decline. The

secondary sector becomes the major contributor and as the economy develops further,

the tertiary sector usually makes the largest contribution to output.

• Developing economies tend to have high rates of population growth. This is due largely

to natural increases in population size with the birth rate exceeding the death rate.

Theories:

• Malthusian theory - the view that population grows in progression whereas the quantity

of food grows in arithmetic geometric progression. However, there are many

technological changes made in.

• Prebish - Singer hypothesis: a theory that suggests that tend to move against

developing economies so that the developing economies have to export more to gain

the terms a trade a given quantity of imports.

 Unemployment
The size of a country’s labour force depends upon a wide range of demographic,

economic social and cultural factors, such as:

• the total size of the population of working age

• the number of people who remain in full-time education

above the school leaving age

• the retirement age

• the proportion of women who join the labour force.

Labour productivity: output per worker hour.

• Unemployment: the state of being willing and able to work but without a job.

• Full employment: the level of employment corresponding to where all who wish to work

have found jobs, excluding frictional unemployment.

• The natural rate of unemployment: the rate of unemployment that exists when the

aggregate demand for labour equals the aggregate supply of labour at the current wage

rate and price level.

• Frictional unemployment - unemployment that is temporary and arises when people are

in between jobs

• Structural unemployment - unemployment caused as a result of the changing structure

of economic activity.

• Cyclical unemployment - unemployment that results from a lack of aggregate demand

• Seasonal unemployment- unemployment that results from change in seasons,

therefore, changing demand for the product.

Unemployment on AD/AS diagram

 Difficulty in calculating

unemployment:

• The Claimant count - a measure of unemployment based on those claiming

unemployment benefits Labour force survey. a measure of unemployment based on a

survey identifying people actively seeking a job.

Ways to correct unemployment:

Deflationary monetary and fiscal policy

The inflationary fiscal measures it may use are:

• a reduction in indirect or direct taxation to increase consumer expenditure

• a cut in corporate taxes to stimulate investment

• an increase in government spending.

The possible monetary measures include:

• reducing the rate of interest to increase consumer expenditure and investment

• expanding the money supply to, again, increase consumer expenditure and investment
• lowering the exchange rate, either through a formal devaluation or through intervention

in the foreign exchange market in the case of a managed float, to increase net exports.

Circular flow of income

- Injections: additions to the

circular flow of income.

• Withdrawals: leakages from the circular flow of income.

• An open economy is an economy that engages in international trade. In contrast, a

closed economy is one that does not export or import goods and services.

• Open economy: S + T + M = I + G + X

• Closed economy: S +T = I + G

Circular flow in a closed economy:

 Circular flow in an open

economy:

Multiplier
Multiplier = a numerical estimate of a change in spending in relation to the final change

in spending.

• 1/1-mpc or 1/mps
• 1/ mps+mrt- for closed or 3 sector economy

• 1/ mps+mrt+mpm- for open or 4 sector economy

• Marginal propensity to save (mps)- the proportion of extra income which is saved

• Marginal rate of taxation (mrt)- the proportion of extra income spent as taxes

• Marginal propensity to import (mpm)- proportion of extra income spent on imports

• Marginal propensity to consume (mpc)- proportion of income that is spent

• Average Propensity to Consume (APC) is the ratio between total consumption and total

income. Marginal Propensity to Consume (MPC) is the ratio between additional

consumption and additional income.

Inflationary and deflationary gap

The consumption function, or Keynesian consumption function, is an economic formula

that represents the functional relationship between total consumption and gross national

income.

Inflationary gap- the excess of aggregate expenditure ever potential output (equivalent

to a positive output gap).

Deflationary gap- a shortage of aggregate expenditure so that potential output is not

reached (equivalent to a negative output gap).

In the diagram below, ab is the inflationary gap and vu is the deflationary gap.
Impact of a cut in government spending - a)

Impact of an increase in government spending- b)

 Investment, money and market failure
• Induced investment investment made in response to change in income

• Autonomous investment: investment that is made independent of income.

• Accelerator theory: a model that suggests investment depends on the rate of change in

income.

• Narrow money: money that can be spent directly.

• Broad money: money used for spending and saving.

• Fisher equation :MV = PY

M = money supply V = velocity P= price level y = output of economy

• The Fisher Effect states that the real interest rate equals the nominal interest rate minus

the expected inflation rate.

• For example, the money supply may initially be US$80 billion, the velocity of circulation

5, price level 100 and output is 4 billion. If V and Y are unchanged, an increase in the

money supply by 50% to 120 would cause the price level to also rise by 50% to 150.

The monetarist view is that inflation is a monetary phenomenon. Keynesians, however,

argue that the equation cannot be turned into a theory since V and Y can change with a

change in the money supply and so no predictions can be made about what effect a

change in M will have on P.

Types of market failure

• Public good

• Inequality

• Monopoly

• Merit good

• Factor immobility

• Externalities

• demerit good

minimizing unemployment

• increasing productivity

• controlling inflation.
 Quantitative easing: a central bank buying government bonds from the private sector to

increase the money supply.

Total currency flow: the current plus capital plus financial balances of the balance of

payments

Keynesian and Monetarists+ liquidity trap and

virtuous cycle
• Keynesians: economists who think that government intervention is needed to achieve

full employment.

Keynesian 45 degree diagram

• Monetarists: economists who argue that control of the money supply is essential to

avoid inflation

• Precautionary motive: a reason for holding money for unexpected or unforeseen events.

• Active balances: the amount of money held by households or firms for possible future

use.
• Speculative motive: a reason for holding money with a view to make future gains from

buying financial assets.

• Idle balances: the amount of money held temporarily as the returns from holding

financial assets are too low

• Liquidity trap: a situation where interest rates cannot be reduced anymore in order to

stimulate an upturn in economic activity

Virtuous cycle: the links between, for example, an increase in investment, increase in

productivity, increase in income and increase in saving.

 Living standard comparison
• Measurable Economic Welfare(MEW): a composite measure of living standards that

adjusts GDP for factors that reduce living standards and factors that improve living

standards.

• Human Development Index(HDI): a composite measure of living standards that includes

GNI per head, education and life expectancy.

• Multidimensional Poverty Index (MPI): a composite measure of deprivation in terms of

the proportion of households that lack the requirements for a reasonable standard of

living.

• NAIRU: i.e. non-accelerating inflation rate of unemployment is unemployment rate at

macroeconomic equilibrium which prevents rate of inflation from rising.

• Note: NAIRU is shown on expectations augmented Philips curve/long-run Philips

curve/very long-run aggregate supply curve of new-classical economists.

• optimum population: The optimum population is a concept where the human population

is able to balance maintaining a maximum population size with optimal standards of

living for all people