Economics 2003-04: Macroeconomics Page 1
SECTION 3: MACROECONOMICS
3.1 MEASURING NATIONAL INCOME
Methods of Calculating National Income
There are three methods of calculating national income:
The expenditure method:
o This adds up all the spending in the economy: C + I + G + X - M.
o It is called Gross Domestic Product (GDP) at market prices and includes:
I: Investment which includes: Planned investment in capital, Unplanned
increases in stocks or inventories
G: Govt. spending on goods and services. Because they are often provided
free of charge (no market value), they are valued at cost.
X: Exports: the domestic economy receives the money
M: Imports: these must be subtracted because it is spending on goods and
services from outside the domestic economy.
The income method: adds up all the sources of income in the domestic economy.
o Transfer payments (pensions, unemployment and welfare benefits) are
excluded: no good or service is produced for the income.
o Income includes:
Wages and salaries
Profits: divided into dividends given to shareholders and undistributed or
earnings retained by the firm
Rent which includes the cost of raw materials and intermediate inputs and
imputed rent on any owner occupied housing
The output method:
o Adds up the value added by a firm’s production:
The value of the firm’s output minus the value of inputs
o Alternatively this method adds up the output of final goods and services.
If $100 worth of goods and services has been produced (output method) this must
have generated $100 worth of income (income method) for the various factors of
production and will lead to $100 worth of spending (expenditure method).
If people do not buy some, firms end up with stocks of unsold goods which are
included in investment and assumes the firms ‘bought’ the goods for themselves.
For this reason GDP = National Income = National Output.
If spending by households is added up this will show the spending at market prices.
But this does not truly reflect income earned by factors because of indirect (sales)
taxes paid by firms to govt. and subsidies received by firms from govt. Therefore:
Market price - indirect taxes + subsidies = factor cost.
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Adjustments to National Income Accounts
Gross Domestic Product (GDP): the value of final goods and services produced by
factors within the domestic economy. It must be adjusted to exclude:
o Goods made in previous years and sold this year
o Capital gains which are just a redistribution of benefits.
Intermediate goods or semi-finished goods:
o Final goods already include the value of the intermediate good, and it would be
double counting to include intermediate as well as final goods
o Circulating capital or inventories or stocks of raw materials, intermediate goods
and final goods.
o Capital equipment, machinery and buildings, and residential housing
o Gross investment consists of:
Net investment (new physical capital and stocks or inventories)
Depreciation or capital consumption: repair and maintenance to existing
stocks of capital or replacement of worn out capital.
Net Domestic Product (NDP) = GDP - depreciation. Because depreciation is an
estimate, most economists prefer to work with GDP.
Gross National Product (GNP) includes the value of final goods and services produced
by factors owned by domestic households all over the world:
GNP = GDP + Foreign investment income – investment income paid to foreigners
o For developing countries, GDP tends to exceed GNP: factor payments made to
foreigners exceed factor payments received from foreigners
o For industrialized countries, GDP is smaller than GNP: factor payments received
from foreign countries are larger than what is paid to foreigners.
Personal Disposable Income is obtained by:
GNP = GDP at market prices + net property income from foreign economies
GNP at factor cost = GNP at market prices - indirect taxes + subsidies
Net National Product (NNP) = GNP at factor cost - depreciation
where: NNP is sometimes referred to as Net National Income (NNI)
Personal Income = NNP - retained earnings - business taxes + transfers
where: retained earnings = undistributed profits
Personal Disposable Income = Personal Income – personal income taxes.
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Standard of Living
Comparisons over Time
If national income rises is this an indication of a rise in the standard of living?
Inflation: can cause GDP to rise even if there is no extra production.
To eliminate this problem GDP is adjusted for inflation:
Real GDP = Nominal or current GDP/Price deflator
Does the price deflator take into account the increase in quality of goods and
services and the fall in the prices of goods such as videos and computers?
Population increases: cause GDP to rise but not necessarily per person:
To adjust for this problem we divide by the population:
Real Per Capita GDP = Real GDP/Population
Per capita income still ignores the distribution of income: there could be a few rich
people and large numbers of poor.
Non-market sector: goods and services traded in a barter or parallel economy which
are not reported as output or income. Should we include them?
Future growth through capital goods: national income accounting does not
distinguish between the production of consumption and capital goods:
Producing consumption goods leads to more today but less tomorrow.
Production of capital goods involves less consumption today but higher future
growth and greater consumption in the future.
Externalities: pollution and the cleanup of pollution or increased traffic congestion
and the resulting increase in gas consumption can actually lead to a rise in GDP even
though the quality of life may have been reduced.
Quality of life: pollution regulations or more vacation time can lead to a fall in GDP
but lead to an increase in the quality of life; how should we adjust?
Govt. services: how do we value national defense or govt. medical services? We
count them at cost which may be too high or too low an estimate.
Comparing Across Countries
Purchasing power parity: rather than use a single currency to compare we convert to
PPPs which measure the actual purchasing power of domestic income in terms of
what it can buy within the country.
Accounting systems are different amongst countries. Many LDCs cannot afford
comprehensive systems and use a lot of guesswork or estimation to fill the gaps.
Climate differences: some countries spend more on energy to heat or cool houses
There may be considerable differences in the distribution of income, the size of the
non-market sector, the balance between consumption and capital goods production
and between production of consumer goods and weapons for war.
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Direct vs. Indirect Taxes
Indirect (Expenditure) Taxes
Indirect taxes are taxes based on expenditure (consumption), and account for 20%
of all taxes collected in OECD countries.
Value added taxes are assessed throughout the production process: each
intermediary is able to claim back the tax paid on intermediate goods.
o It is more efficient because it is self policing: each link in the chain will be
claiming tax back on the input costs.
o In Europe VAT has now been raised to 20% with little fear of cheating.
An excise tax is levied on a particular commodity such as cigarettes
A sales tax is levied on all or most goods which are sold through retail outlets.
Excise and sales taxes are charged only at the time of sale to the consumer.
o The burden of collecting the tax falls entirely on the seller.
o It can lead to tax cascading: some commodities effectively get taxed more than
once; this is related to the double counting problem.
o It is estimated that widespread cheating will occur once the tax exceeds 10%.
Indirect taxes are less likely to distort behaviour than income taxes:
o High income taxes may lead some to choose leisure over work..
o With indirect taxes some rich people may choose to save and invest.
Direct (Income) Taxes
Direct taxes are taken from income before there is any expenditure.
The Laffer curve suggests that as the marginal tax rate increases, total tax revenue
first increases and then falls when the marginal rate becomes excessive:
o People lose interest in working hard and earning money if the marginal rate gets
o People start to work in the parallel economy where they do not declare their
income and the government does not collect revenue
o People move to another country where taxes are lower.
By getting rid of excessively high marginal tax rates through using a flat tax system,
more tax revenues could be collected.
With personal allowances and higher rates for higher incomes, income taxes can be
progressive. On the other hand consumption (indirect or expenditure) taxes are
generally levied at a constant rate and can therefore be regressive:
o Poor people pay relatively more tax as a proportion of their income on basic
necessities than rich people do.
o Several countries have exemptions or lower rates of sales or consumption taxes
on things such as food and medicine in order to reduce the regressive nature of
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3.2 INTRODUCTION TO DEVELOPMENT
Microeconomics vs. Macroeconomics
Microeconomics deals with individual markets and with the actions of households
and firms in those markets.
Macroeconomics deals with the major groups of players in the economy,
consumers, producers and govts.
o Prices: instead of looking at individual prices we look at the price level.
o Income: instead of looking at household income we look at National Income.
National Income & the Standard of Living
The total of all the goods and services made in any one year in a single country
which go through a market place is referred to as the National Product.
As someone must have earned money to produce those goods and services, it is also
referred to as National Income.
Inflation may have increased values being added and we would like to distinguish
between changes due to inflation and actual changes in the physical outputs.
o To do that we use a price index to deflate the production back to some base
year period of prices, and we call it real national income, Y.
One of the most common measures of national income is Gross Domestic Product
(GDP). If real GDP increases then it indicates that the economy is producing more
output each year.
Standard of living: if the population has grown faster than real GDP, then output per
person has actually fallen. To measure real per capita GDP we deflate GDP to put it
into real terms, and then we divide it by the population.
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Growth vs. Economic Cycles
In Macroeconomics we deal with cycles and policies to counteract cycles. During
any ten year period there is a cycle in the economy which appears to be related to
the replacement cycle for capital equipment.
In Economic Development we will examine how growth can be increased through
various policies designed to increase productivity:
o The economy as a whole moves in an upward direction called the long term
trend or growth pattern which results from:
Increases in productivity or output per person which come from: investment
in capital, human capital, and R & D leading to technological breakthroughs.
Seasonal cycles are related to the primary sector: agriculture, forestry, fishing.
With industrialization, a new manufacturing or industrial cycle appeared:
o The two most powerful cycles appear to be a 3 year cycle and a 10 year cycle.
Because they are not matched, it means that the combination of the two leads
to different patterns each decade.
Typically at the end of a decade, industrialized countries tend to enter a serious
recession which ends in a trough in the first year or two of the new decade,
followed by an economic recovery.
o Recovery proceeds to roughly the middle of the decade at which point there is
typically a mini-recession with a small peak and a trough.
o A new recovery period begins and those countries enter a boom toward the end
of the decade.
o Once the economy peaks, a new recession follows.
The cycles are not exact, and sometimes the mini-recession in the middle of the
decade is stronger than the recession at the end of the decade.
During a boom the economy is operating at or beyond full capacity. There is a
shortage of skilled people and raw materials. It is a period of excess demand.
o Prices rise faster than costs, profits are rising and investors are optimistic.
The boom can turn into a slump if people decide they do not need to replace capital
equipment because this leads to a fall in spending.
During a downturn, the job creation rate is typically slower than the number of
people entering the job market looking for work:
o If there are people looking for work who cannot find it, they are defined as
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o As the economy starts to recover, the job creation rate speeds up and the
unemployment rate falls particularly for skilled people. For the hard core
unemployed, there may be very little change.
Capital Utilization Rate
Rather than calling capital unemployed, we reverse the definition and look at the
capacity utilization rate.
o Typically 15% of capital is being repaired or replaced and the average utilization
rate is around 85%.
o During boom times the capacity utilization rate rises to as high as 92%.
The rate of replacement of capital is slower than the demand for services
from capital equipment.
But there is a price for running capital so hard: maintenance schedules are
not maintained and the capital wears out at a faster rate.
A trough is associated with high unemployment of labour and unused productive
capacity (unemployed capital).
o Unemployment rises not because people are laid off, but because the job
creation rate is slower than the number of people entering the job market.
o Capacity utilization rates for capital may drop as low as 70%, this means that
machines do not need to be replaced: when a machine wears out, you simply
replace it with an existing machine which has been shut down.
o Business profits are low, and investors are pessimistic.
A trough cannot last long because capital equipment wears out and both
households and businesses start to replace it.
o Spending picks up and we enter a recovery.
o As sales and profits pick up, investors become more optimistic.
If the recession is particularly deep and long lasting, it is called a depression.
o Typically a depression results when there is a financial panic during a recession.
o Better knowledge about the economy, stronger economic policies and the steady
growth resulting from industrialization and technological breakthroughs appear
to have prevented serious depressions in most western economies since 1930.
The output gap: a measure of the difference between actual and potential GDP.
o If the gap is positive: (Yfe –Y) > 0, we refer to it as a recessionary gap.
o If the gap is negative: (Yfe –Y) < 0, it means that we have gone beyond full
employment and we are in an inflationary gap.
It is possible to go beyond full employment by running more shifts in
factories, using machines beyond their normal capacity utilization rate, and
by paying overtime to worker to work more hours.
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INDICATORS OF ECONOMIC DEVELOPMENT
Growth & the Standard of Living
A proper measure of the standard of living must include GNP per capita, some index
of human development and some measure for valuing losses in natural resources
and the damage occurring from pollution.
GDP is referred to as nominal or current income. To make it comparable with other
years we must convert it into real or constant dollar income:
We divide the current measure of income by a price deflator
The price index used to deflate the income relates back to some base period: if
we use a deflator equal to 100 in 1986, the real income is converted into
constant 1986 dollars.
Rather than using the consumer price index, we use the implicit deflator: an
index using the whole basket of goods made in the economy and not just those
used by consumers, it is calculated as follows:
GDP at currentprices
Implicit deflator *100%
GDP at base period prices
Per capita real income: real GDP divided by the population.
Standard of Living
To compare standards of living we need an index or measure of the flow of goods and
services produced in each country:
Adjusted for purchasing power parity to reflect the true costs of living in different
Adjusted to account for the large proportion of non-market activities in LDCs
Adjusted to include unreported activities:
High income taxes and labour laws have encouraged underground workshops
Illegal activities which may be reported for income tax purposes, but are generally
not included in GDP accounting.
The loving care and attention paid by mothers to bearing and raising children.
LDCs experience problems with developing such a measure:
Poor statistical services: data from certain sectors of poor countries, such as
agriculture and handicrafts are the worst of all.
Estimates are based on fairly reliable statistics on modern industrial and mining
enterprises combined with estimates of rural sector performance based on small
samples or outright guesses.
When housework or child care are performed by paid servants or day care
employees, they are included in GDP. When performed by unpaid members of
the household they do not enter GDP.
A large number of activities do not enter the market, thus the non-traded
services sector is large relative to GDP.
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A large part of rural output is for subsistence: families consume a great deal of their
These activities include: growing and preparing food, carrying water, collecting
firewood, building accommodation, and child care.
Non-market transactions include: bicycle repair, hair cutting, retailing, and illegal
Comparing GDPs: Valuation Problems
Exchange rates particularly those of developing countries, are frequently highly
Trade restrictions make it possible for an official exchange rate to be
substantially different from a rate determined by free trade.
There is a reasonably systematic relation between the degree to which the
exchange rate conversion method understates GDP and the level of
development of the country.
Purchasing power parity: takes account of the local buying power of the income
earned in a country.
Even though Japan has a high income per capita, the cost of living is also very
high in Japan. When adjusted for PPP, the per capita income in Japan is not as
high as expected.
Adjusting for PPP has raised the per capita purchasing power dramatically for
countries such as China and India.
Even in absolute terms the results are startling: in descending order of rank for
total GDP: US, China, Japan, Germany, India, France, Italy, Britain, Brazil and
Per capita GDP does seem to correlate reasonably well with wider definitions of the
standard of living in terms of ranking.
Countries with low per capita GDP also have low adult literacy, low life
expectancy and high infant mortality.
It appears that the gap between the GNP per capita for rich and poor countries
is rising. Over 80% of the world output is produced by less than 25% of the
Comparisons are made more difficult if a high proportion of market income goes to
the military rather than into investment or consumption for the poor.
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Human Development & the Standard of Living
Human Development includes such factors as infant mortality, life expectancy,
protein and calories per day, number of doctors and hospital beds per 100,000
people, and education levels.
Infant mortality is measured as the number of live born babies who do not
survive to their first birthday out of each thousand babies: for LDCs it is 75 and
for MDCs it is 18.
Life expectancy is the number of years a new born baby can expect to live: for
LDCs it is 61 and for MDCs it is 71.
Poor quality drinking water, poor sanitation, inadequate nutrition and poor
health care provision account for the higher death rates.
Calories per day in the US have risen from 3,292 to 3,682 between 1965 and
1986. For Bangladesh they have fallen from 1,964 to 1,804 during the same
period. The UN estimates that 2400 calories a day is the minimum required.
Adult literacy is defined either:
As the proportion of the population over the age of 15 who can read and
write a simple statement about their daily life.
Or those who have had 9 or more years of schooling.
Illiteracy rates are less than 5% for MDCs and range from 58% for females
and 44% for males in low income LDCs.
Human Development Index
The HDI is a composite of three basic components:
Longevity is measured by life expectancy. The minimum for life expectancy is 25
years and the maximum is 85, so the longevity component for a country where life
expectancy is 55 would be 0.5.
Knowledge is measured by a combination of adult literacy (2/3s) and mean years of
schooling (1/3). The minimum adult literacy is 0% and the maximum is 100%, the
literacy component for a country where literacy is 75% would be 0.75
Standard of living is measured by purchasing power based on GDP per capita
adjusted for the local cost of living (PPP)
Comparisons of Human Development over time indicate that some countries have
been able to transform economic growth into human progress. Other countries
have failed to do this despite high rates of economic growth.
The HDI does not take into account disparities in the various indicators between
rich and poor, or rural and urban, or between men and women, nor investments in
human capital in areas such as health and education.
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Sustainable Development & the Standard of Living
LDCs tend to be even more dependent on natural resources than MDCs, and proper
national accounting must take this critical asset into account.
In many LDCs some of the greatest losses which are not recorded in GDP figures are
damage from pollution and the over use of existing resources.
In GDP accounting there should be:
The using up of resources
Additions for replanting of trees, the restocking of lakes and the ocean with fish,
the restoration of mine sites, and the setting aside of wildlife reserves and parks
Case study: Indonesia
Primary production accounts for 40% of GDP, 50% of employment and 80% of
Using market values for standing trees, proven oil reserves and productive land it is
possible to see how oil, timber and soil resources have been depleted.
GDP growth without accounting for environmental impacts averaged 7% per year
from 1971 to 1984. This dropped to 4% per year when loss of primary resource
values was calculated.
It is easier to measure the quantity of natural resources being used and to attempt
to put a market value on them, than it is to measure the fall in the quality of such
things as water and air.
A second problem is the valuation procedure when there are no market prices.
If people are asked how much they are willing to pay to have improvements
made, the valuation is relatively low.
If people are asked how much they wish to be compensated for the loss in
quality of environmental assets, the valuation is relatively high.
There are some environmental assets which are priceless, there are no
opportunity costs as there are no substitutes, how does one value these?
Sustainable Development: Growth and the Environment
Soil erosion is a serious problem in many countries:
It occurs partly because of poor farming practices
Forest cover is lost due to cutting for fuel: removal of trees can lead to severe
flooding and water erosion of soil.
Overgrazing by animals leads to desertification
The green revolution requires large amounts of chemicals which destroy the
micro-organisms in the soil and large amounts of irrigation which can lead to
salinization because water brings up salts from deep in the soil.
Poor cultivation practices can lead to wind erosion.
80% of all hydrocarbons are burnt by 20% of the world. This has serious impact on
the ozone layer.
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Policies to Link Environmental Costs to Economic Benefits
Subsidies should be removed that encourage excessive use of fuels, irrigation water,
chemicals and forest removal.
Rights to own land, forest and fisheries must be clarified to encourage better
Human development including sanitation, clean water, education, agricultural
extension, credit for small investments can all help powerless individuals to gain
control over their environment and protect it rather than exploit it.
Pollution standards and policies need to be realistic and consistent with the
monitoring, enforcement and administrative traditions of a country.
Market forces should be harnessed to provide incentives to use environmentally
friendly means of production.
The redistribution of power can increase local participation in setting and
implementing sound environmental policies. Institutions need to be held
accountable, and there must be increased willingness to pay for environmental
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3.3 MACROECONOMIC MODELS: KEYNESIAN
The Consumption Function
The Influence of Income on Consumption
Consumption is the largest single category of domestic expenditure, accounting for
over 50% of GDP, and including consumption of foreign goods (imports).
Changes in consumption can be predicted by analysing changes in:
o Income and wealth
o Credit availability:
Goods are divided into perishable (food), semi-durable (clothes) and durable
The availability of credit will allow people to buy more expensive durable
goods which means they are able to spend more than their current income.
However, repayment of past debt will limit current consumption.
Expectations: optimism leads to greater spending, this is why we measure
The age profile of the population: younger households spend to build up a
household, middle age households start to save toward retirement.
Price levels: rising prices reduce the value of money and may lead people to save
more to rebuild real money balances.
After tax income is divided between savings and consumption:
o If income taxes are 30%, then after tax income is 70% of national income
o If consumption is 80% of after tax income, it is 0.8 times 0.7 , or 56% of
The equation for the consumption function is:
C = Ca + bYd
Ca = autonomous consumption and includes all of the non-income
determinants: wealth, credit, expectations, age and price levels.
b = marginal propensity to consume (MPC = C/Y)
The equation for the import function is:
M = Ma + mYd
m = marginal propensity to import (MPM = M/Y)
The Influence of Wealth on Consumption
Savings depend on wealth and the position in the life cycle for the family.
People want to smooth their consumption pattern over their lifetime:
o Only with a permanent change in income will people adjust their consumption.
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o With a temporary decline in income, people maintain consumption levels
according to their expected income by running down their savings
People have a goal for their wealth and will keep adding assets to their portfolio:
o People keep adding to wealth until the income flow from that wealth will allow
them to retire:
o If there is a temporary increase in income
People save it and add it to wealth.
Consumption increases only out of the income earned from that wealth.
For example: if you receive an extra $10,000 worth of income, and you normally
consume 80% of your income:
o We would expect you to consume $8,000 out of that extra income.
o Instead, you add the extra $10,000 to your wealth, and let us assume that those
assets earn $1,000 at 10% interest
o You would consume only $800 or 80% of the income earned on your assets.
If the level of wealth is below the target, households will save toward the goal. If
the level of wealth is at the target, households no longer need to save.
An unexpected rise in wealth will lead people to save less, and vice versa.
If prices rise in the economy, the purchasing power of wealth declines:
o Households will attempt to save more to add back the wealth that has been lost,
this means that consumption will fall.
Consumption Function Consumption Function
The consumption function illustrates the relationship
between income and consumption. Note it is real
after tax income earned in one year (Personal
disposable income) recorded on the bottom axis.
pti on F
The 45 degree line indicates the transfers of exactly Con
the same amount from one axis to another.
$ 4 0 ,0 0 0
The consumption function cuts the 45 degree line at P ersonal Disposable Income
the point where consumption equals income of
o Below that income, the household consumes more than its income, and savings
o Above that income, consumption falls below income and households are saving.
The slope of the consumption function (MPC) is the the marginal propensity to
The slope of the savings function (MPS) is the marginal propensity to save.
MPC plus MPS equal one to indicate that any increase in income is divided
proportionately between savings and consumption (slope of 45 degree line = 1).
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Aggregate Expenditure (AE) consists of C + I + G + X - M
Internal expenditure or what is sometimes referred to as domestic absorption:
o C = Consumption is a function of income, and the slope of the consumption
function is the MPC.
o I = Investment is a function of interest rates (usually referred to as the Marginal
Efficiency of Investment or MEI) and income as shown by the accelerator.
However, for now we assume it is not a function of income.
o G = Government expenditures change slowly as such a high proportion of
expenditures are legislated that govt. has very little discretion over budgets.
o X = Exports are a function of foreign and not domestic income.
o M = Imports are subtracted from AE and are very similar to consumption: they
are a function of domestic income.
(X - M) = Net Exports:
o As domestic income rises, people import more and net exports (X-M) fall.
o If world income rises, net exports (X-M) rise: X is a function of foreign income.
o If domestic prices rise, exports fall and imports rise so net exports fall.
If domestic prices rise relative to foreign prices, net exports tend to decline:
o Exports decline because foreigners find domestic goods more expensive.
o Domestic households find foreign goods relatively cheaper and will tend to
Depreciation of the domestic currency means that it will buy less of foreign goods,
net exports tend to rise:
o Foreigners will find domestic goods cheaper
o Households will find foreign goods more expensive.
A ggregate E xpenditure
The new components (I, G, X, M) are added ne
If tax = 0.3
If P DI = 0.7* GNP
on to C to give the AE line.
If MP C = 0.8
Then Cons = 0.8* 0.7
Only C is a function of income, therefore the
slope of the AE line is the same as the slope Expen
of the consumption function. rega
Real National Income
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Equilibrium National Income
Equilibrium income: determined by the balance between expenditure and output:
o Planned expenditures can differ from actual expenditures leading to changes in
o If expenditure is greater than output,
inventories will be falling, firms will hire Aggregate Expenditure
labour to increase production to meet 45 deg line
the new level of expenditures. 120
o If expenditure is less than output,
inventories rise, firms will cut production
by laying off workers, output falls until
inventories settle at the desired level.. A
o Only when inventories are exactly equal
to the desired level, neither rising nor 0 20 40 60 80 100 120 140 160 180
falling, will national income be in Real National Income
If income at point A is less than full employment, the govt. may decide to use policy
to shift the AE curve upward to AE2:
o Fiscal policy could be used to increase G or lower T (which would stimulate C
o Monetary policy could be used to lower interest rates which would induce an
increase in investment and consumption of durable goods.
o Trade policy could be used either to increase exports or reduce imports: in
either or both cases, net exports would rise and so would AE.
Whichever policy is used to shift AE up:
o We reach point B: expenditures are greater than income, so inventories must be
o Firms hire workers and increase production, the workers earn and spend more
income, and output increases as we move from B to C.
o At point C, we are in equilibrium as expenditures are equal to output once again.
Downward shifts in AE can result from different policies:
o Fiscal: a drop in govt. expenditures and a rise in tax rates
o Monetary: an increase in interest rates and resulting drop in investment
o Trade: a reduction in tariff barriers which stimulates imports.
Leakages and Injections
There are three leakages from the system: savings, taxes and imports.
There are three injections: investment, government expenditures and exports:
o There does not have to be equality between each pair (I = S, G = T, X = M).
o But there does have to be equality between all three injections and all three
leakages: (I + G + X) = (S + T + M) in equilibrium.
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If AE rises as a result of an increase in I, G or X, it has been found that income
often increases proportionately more. This is referred to as the multiplier effect and
results from the respending chain:
o People receiving the payment from the increase in AE will have to pay taxes on
it, will save some, and will then consume domestic and foreign goods with what
o The leakage into savings, taxes and imports means there will be less money to
be respent at the next link in the respending chain: the higher the leakages, the
shorter the respending chain will be.
The simple multiplier in a closed economy (no trade) and no government taxation is
Y 1 1
AE 1 MPC MPS
MPC = marginal propensity to consume;
MPS = marginal propensity to save.
o As MPC + MPS = 1, then (1 - MPC) is equivalent to MPS.
o This is the simple multiplier assuming no other leakages than savings.
The multiplier in a closed economy (no trade), and with a government sector which
both spends and taxes is given by:
AE 1 (1 t ) MPC
t = the marginal tax rate
The multiplier in an open economy (with trade) and with a government sector
which both spends and taxes is given by:
AE 1 (1 t )( MPC MPM)
MPM = marginal propensity to import
AE 1 (1 t )( MPCdomestic )
MPCdomestic = MPC - MPM
Page 18 Economics 2003-04: Macroeconomics
When sales are increasing and inventories are running down, firms hire labour in
the short run. If the change appears permanent they add to capital.
Future profit expectations of firms are determined by past output growth:
o Future sales and thus their present demand for capital goods to meet those
future sales, depends on changes in past sales.
Investment is sensitive to the rates charged for borrowing money, often called the
Opportunity Cost Rate of Return (OCRR). When interest rates rise, it costs more to
borrow money for investment and investment falls.
Investment is also sensitive to Return on Investment (ROI). If ROI rises above the
OCRR, it pays to borrow at the OCRR and invest at the higher ROI:
o As the economy heads into recession, ROI falls below OCRR and people stop
o As the economy recovers from recession, ROI may rise above OCRR and people
start to invest.
The capital output ratio indicates the amount that must be invested in K in order to
get a flow of value output, the average ratio for most firms is 5:
o To increase production of a particular good so that an extra $10 is added to net
revenue, it is necessary to invest in $50 worth of capital.
Sales $ 1,000 $ 1,100 $ 1,200 $ 1,200 $ 1,100
Capital 10 11 12 12 11
Depreciation 1 1 1 1 0
Net Investment 0 1 1 0 0
Gross Investment 1 2 2 1 0
A company has 10 machines each worth $500 which produce $100 worth of output
each year: 10 machines, total sales of $1,000:
o Depreciation is one machine a year
o Gross investment = depreciation plus net investment: 1 machine per year.
If sales increase by 10% ($1,100), an extra machine is needed to produce more:
o Gross investment for one year will go up by 100% to 2 machines: one for
depreciation and one for the new investment required for production.
o Note that even though sales only increase by 10%, investment increases by
100%, hence the name accelerator.
If sales increase by another 10% to $1,200:
o Gross investment for one year will stay the same: 2 machines: one for
depreciation and one for the new investment required for production.
Economics 2003-04: Macroeconomics Page 19
o Note that even though sales have increased, investment does not increase: for
the accelerator to cut in, we need the rate of growth of sales to be increasing as
If sales stay at the new higher level of $1,200:
o Gross investment falls back to 1 machine: there is no new investment, simply
replacement of a worn out machine.
If sales fall 10% back to the previous level of $1,100:
o Only 11 machines are required:
As we had 12 machines the previous year and one of them has worn out, we
are left with 11 machines
We do not even need to spend money to replace a worn out machine
o When gross investment falls to zero, this may trigger a movement into a
recessionary gap as aggregate expenditure falls.
Many economists believe that this is where the business cycle comes from: from
changes in gross investment which depend on the multiplier and the accelerator:
o Sales have to be rising in order to prompt a higher level of investment.
o Even though sales settle down at a new higher level, investment falls back.
o If sales actually fall, as they do in a recession:
Net investment will go to zero
Gross investment may also fall to zero: one of the new machines which is no
longer needed because of the fall in sales will replace the old machine.
The accelerator and multiplier working together can lead to business cycles:
o Coming out of a recession, when aggregate expenditure rises, the multiplier
o If business people feel the change is permanent they buy capital at the rate of 5
times as much as the increase in sales because of the capital output ratio.
o The rise in investment leads to another increase in aggregate expenditure and
the multiplier boosts income yet again.
Eventually the rounds of spending will be finished and aggregate expenditure stays
constant at a new higher level. Or the economy reaches the full capacity point and
cannot grow any more:
o Net investment falls to zero, inventories rise in the capital goods industry,
workers are laid off, aggregate expenditure falls via the multiplier, and a
recession may start.
As aggregate expenditure starts to fall, spending on replacement of capital may also
fall to zero worsening the conditions in the capital goods industry.
At the bottom of the cycle, aggregate expenditure may start to rise:
o Consumption may increase because durable goods need to be replaced.
o Investment may increase because capital needs to be replaced.
Page 20 Economics 2003-04: Macroeconomics
Aggregate Demand and Short Run Aggregate Supply
Income effect: the AD curve is downward sloping because as prices rise, real
income falls and people have less to spend.
Substitution effect: when the price level rises in the economy there are no
substitutes to switch to as in microeconomics. There are three possibilities:
o Real balance effect: as prices rise, the real value of wealth declines, people tend
to build the wealth back again by saving more and consuming less.
o Net export effect: as domestic prices rise relative to foreign prices, exports
become expensive and imports cheaper: thus exports fall and imports rise.
o Interest rate effect: people may try to borrow to maintain their spending,
interest rates rise which discourages durables consumption and investment.
The aggregate demand curve has the same components as aggregate expenditure:
o Whenever C, I, G, X and M change, the aggregate demand curve shifts in and
out, just as the AE line shifted up and down.
o However, price induced changes in any of these components leads to
movements along the AD curve.
Aggregate supply slopes upward as the full employment point is reached:
o Not because factor prices are rising: along the SRAS curve it is assumed that
factor prices stay the same.
o Diminishing returns: near full employment some factors, particularly capital, are
fixed in supply, and costs rise because more of a variable factor is added to a
o Resource Bottlenecks: as full employment is approached even some variable
inputs are in short supply and this slows the production process raising costs.
o Declining productivity: as firms hire more labour and capital, the people and
machines left to hire are less skilled or less efficient as we approach full
employment: productivity falls, unit costs rise and firms raise prices to cover
increased costs of production.
The components of aggregate supply include:
o The labour force, the amount of capital goods and the available natural
o The prices of the factors of production: as they rise, the SRAS curve slowly shifts
o The productivity of the factors of production: as they become more productive,
the SRAS curve shifts out.
o Technology: as technological progress occurs, the SRAS curve shifts out.
Economics 2003-04: Macroeconomics Page 21
AD & SRAS: Short Run Equilibrium
Suppose the AD curve shifted out to the Aggregate Demand Shocks
right because one or more of the
components either increased (C, I, G, X) or 140 SRAS
decreased (M). 120
In the figure we move from equilibrium at
60 E1 A
E1 to point A: 40
o AD > SRAS: inventories must be falling 20 AD1
and businesses hire labour. 0
o Increased production leads to an 20 40 60 80 100 120 140
increase in Y: we move along the SRAS
Real National Income
curve from E1 to E2..
o However, as businesses hire more labour, they find that they are less skilled,
productivity falls, unit costs rise, and firms are forced to raise prices.
o The increased price level leads to price induced changes in AD: consumption
falls, exports fall and imports rise: we move back along AD from point A to point
E2, a point of short run equilibrium:
AD = SRAS: Inventories are neither rising nor falling.
Effect on the multiplier:
Zone 1: on the left portion of the SRAS curve which tends to be flat and is usually
associated with a recession, income is well below full employment:
o The full multiplier operates: there is enough skilled labour and efficient capital
that unit costs and prices do not rise.
o There are no priced induced leakages into savings and imports.
Zone 2: in the upward sloping area of SRAS the multiplier has been reduced so
income does not increase to A but to point E2: there have been price induced
leakages into savings and imports.
Zone 3: on the right hand vertical section of the SRAS curve, typically associated
with a boom in the economy, income is at or above the full employment point:
o The multiplier is reduced in effect: there are virtually no skilled people left to
hire, and no un-utilized efficient capital
o Unit costs rise, prices rise, and there are price induced leakages into savings and
Page 22 Economics 2003-04: Macroeconomics
Long Run Equilibrium
Potential (full employment) income is Ouput Gaps
constant and is shown by a vertical line, LRAS
often called the Long Run Aggregate
Supply curve (LRAS). E2 SRAS3
At Eo we are in short run equilibrium with E1
ADo = SRAS1, equilibrium income is below Eo
potential income and we get a E3
recessionary gap (positive output gap). ADo
At E1, equilibrium is above potential or full Yo Y* Y1
employment income and we get an
Real National Income
inflationary gap (negative output gap).
Shifts in SRAS
For most countries, there is a slow but steady increase in productivity each year:
o Part of it comes from new investment in capital equipment, and part from
education and training of the work force.
o This increase in productivity causes the SRAS curve to shift steadily outward,
although at a slow rate.
At Y1 where AD1 = SRAS1
At Y1, income is above the full employment point, this can only occur if labour
o The average workweek expands from 40 hours per week to as high as 55 hours
o Labour shortages will emerge in some industries and among skilled workers.
o High profits for firms and unusually large demand for labour exerts upward
pressure on wages.
o Capital is operated beyond the safe capacity:
Most firms experience a 15% depreciation rate each year, which means that
only 85% of the machines are running to allow repairs and replacement of
Capital can be kept going without regular maintenance, but it damages the
machinery and raises the costs of capital, this causes SRAS to shift up.
o As factor costs rise, the upward pressure on wages means there is pressure for
wages to rise faster than productivity is rising.
o The SRAS will shift left because of upward pressure from the labour market.
Short run equilibrium is associated with the following criteria:
o AD = SRAS; leakages = injections; and inventories are unchanging.
Long run equilibrium requires all the above plus:
o %∆wages = %∆productivity; or real wages are unchanging.
Economics 2003-04: Macroeconomics Page 23
This is the full employment level of income, we are in long run equilibrium:
o Factor costs are neither rising nor falling: wages are rising at the same rate as
productivity is growing.
This is why the vertical line above Yfe is referred to as the long run aggregate
supply curve (LRAS).
Income is less than full employment income:
o Unemployment means there should be downward pressure on wages, however,
unions and workers resist any attempt to lower wages.
There is unusually low demand for labour:
o There will be labour surpluses and firms will resist upward pressure on wages.
o Wages will increase more slowly than productivity: unit labour costs will be
o The SRAS will be shifting to the right: %∆Q/L > %∆wages.
o Eventually we will reach long run equilibrium at point E3.
Wages are Sticky Downward
Unit labour costs fall much more slowly in a recession than they rise in a boom:
o There is great resistance to wages being cut.
o Even in quite severe recessions when prices are stable, wages may continue to
rise, although the rate of increase tends to be lower than the increase in
Page 24 Economics 2003-04: Macroeconomics
The Phillips Curve
The Phillips curve attempts to answer the question: why do wages rise more quickly
than productivity during boom times and yet do not fall very fast when there is
unemployment during a recession?
The Phillips curve has the rate of wage inflation on the vertical axis (this contrasts
with the price level for the SRAS curve).
The Phillips curve indicates the direction in which SRAS shifts and how fast the
SRAS curve is shifting when actual income does not equal potential or full
employment income (when we are not in long run equilibrium).
At The Full Employment Point
When equilibrium Y is equal to potential or full employment income (Yfe):
o Demand for labour equals supply (only frictional or structural unemploy.).
o There is neither upward or downward pressure on wages.
o The Phillips curve cuts the axis at potential income, Yfe, at the corresponding
level of unemployment Unat (the natural rate of unemployment).
The Phillips Curve
Above the Full Employment Point Rate of Change in Wages
If the level of income determined by AD and 15
SRAS is Y1, converting this into the 10
unemployment equivalent gives us U1.
The Phillips curve indicates that at this level of 0
unemployment wages are rising at 10%. U1 Unat
For now we assume no increase in -10 Unem ploym ent Rate
productivity in the figure
With wages rising, SRAS is shifting left by the annual increase in labour costs.
As the SRAS shifts to the left, eventually it will be equal to AD at the potential or full
employment level of income, Yfe:
o This level of Y corresponds to Unat, the natural rate of unemployment.
o Wages are neither rising nor falling.
Below the Full Employment Point
If the level of income is below the full employment level, U will be to the right of
Unat in the Phillips curve. People are very reluctant to accept a wage cut, and the
Phillips curve flattens below the axis (wages falling less than 2% per year).
If we re-introduce productivity increases, the SRAS will slowly shift outward, and
income will eventually rise to the full employment level, and unemployment fall to
Economics 2003-04: Macroeconomics Page 25
3.4 DEMAND-SIDE POLICIES
Fiscal Policy is a tool of stabilization or demand management policy, and is used to
remove recessionary and inflationary gaps by altering G and T.
The budget balance, G – T, is the difference between expenditures and revenue:
o If they are equal, the govt. has a balanced budget.
o If revenue or receipts are greater than expenditures we have a budget surplus
and if expenditures exceed receipts we have a budget deficit.
FISCAL POLICY: RECESSIONARY
GAP LRAS SRAS
If expenditures (G) are increased without a matching increase in T, it must be
deficit financed meaning the govt. must borrow money.
A recessionary gap can be removed by cutting T or increasing G which causes the
AD to shift right.
Alternatively the govt. could do nothing:
o Phillips curve: wages will fall, although very slowly, leading to a rightward shift
o Cyclical recovery: there may be cyclical forces in the economy that increase AD.
o Q/L: there is a tendency for productivity to increase steadily over time leading to
a rightward shift of the SRAS.
FISCAL POLICY: INFLATIONARY GAP
Inflationary Gap LRAS SRASo
An inflationary gap can be removed by
increasing T or cutting G which causes AD
to shift left.
Alternatively the govt. could do nothing: E1
o Phillips curve: wages will rise, leading
to a leftward shift in SRAS. ADo
o Cyclical downturn: there may be AD1
cyclical forces in the economy that Yfe Yo
reduce AD. Real National Income
Page 26 Economics 2003-04: Macroeconomics
Problems with Fiscal Policy
Discretionary policy often runs into problems with lags:
o Recognition lag: it takes some time before a gap is recognized.
o Legislative lag: it takes time to decide what to do and if it requires a change in
taxes or borrowing, it takes time to get approval from parliament.
o Implementation lag: it takes more time to put the policy into effect.
The result is that stabilization policy or demand management policy has often done
more to encourage fluctuations than to remove them.
Another problem is that policies put into effect may be very difficult to reverse:
o If there were a recessionary gap, the govt. may decide to cut corporate taxes:
o After the usual lag, businesses start to increase investment.
o By the time the investment shifts out the AD curve, the economy may already
have recovered and the shift in AD may open an inflationary gap.
o The problem then becomes one of trying to reverse the policy. It is extremely
unpopular to raise taxes when businesses have become used to lower taxes.
To overcome this problem it has been suggested that policies be made short run:
o The govt. announces that the tax cuts will only last for two years.
o This may help with investment, but many consumers will simply absorb the
increased income into savings as a result of the wealth effect.
Financing Government Expenditures
When govts. attempt to increase G, they must finance it somehow:
o They can raise taxes by the same amount as G, but this would lead to a fall in
consumption and investment.
o They can borrow the money, but this leads to a rise in interest rates and a fall in
The demand for money shifts out, but the supply of loanable funds does not
change so interest rates rise.
This is called the crowding out effect because private businesses wanting to
borrow money now find they have to pay more to borrow and cut
o They can expand the money supply and use the money to finance the increase
in G, but this leads to inflation.
The attempt to use fiscal policy to fine tune the economy is no longer accepted as a
valid stabilization tool. Only where there are large persistent gaps, particularly gaps
associated with recessions or depressions, is it generally agreed that fiscal policy
does have role to play in restoring the economy to full employment.
Economics 2003-04: Macroeconomics Page 27
Beneficial Effects of Fiscal Policy
AD is constantly changing as a result of shifts in I, C, X and M. As recessionary and
inflationary gaps appear they lead to changes in wage rates and shifts in the SRAS.
This makes it difficult to identify when there is a recessionary or inflationary gap.
In most western economies, there are built in stabilizers which tend to offset the
fluctuations in AD:
o G tends to be very stable, the tax rate tends to be very stable, and govt.
transfer payments for such things as pensions tend to be stable.
o However, transfer payments for welfare or to the unemployed tend to increase
in recessions, thus automatically increasing G.
o Tax revenues equal the tax rate times income: (T = t*Y)
If income rises as it does during inflationary gaps, tax revenues rise because
both Y is rising and t is rising as people are pushed into higher tax brackets.
As income falls during recessionary gaps, tax revenues fall.
Taxes reduce the marginal propensity to consume:
o Even if the MPC is 80%, if taxes take away 50% of income, then effectively the
MPC is only 40% out of national income.
Short term fluctuations are dampened by the automatic stabilizers even when it is
difficult to recognize when gaps appear and apply policy.
Automatic stabilizers impose fiscal drag during recoveries:
o Fiscal drag: as the economy recovers G falls and T rises which slows recovery.
Balanced Budget Multiplier
If the govt. decides to raise T as much as G, we expect AD to shift out by the
amount of G and to shift in by the amount C & I fall because of the increase in T.
Instead, we get a balanced budget change:
o If the marginal propensity to consume is 0.8, 80% of the tax increase will be
matched by a drop in consumption, the rest will be paid out of savings.
o A balanced budget change leads to a small increase in GDP equal to 100% of
the increase in G minus only 80% of the increase in T.
o The end result: a total effect of 20% of the initial increase in G multiplied by the
multiplier, 5, equal to 100%.
The balanced budget multiplier is often equal to one.
Offsetting the Paradox of Thrift
If all households in the economy simultaneously try to increase the amount that
they save, the combined increase in thrift will shift the AD curve to the left and lead
to a reduction in equilibrium income.
In a depression we can reduce unemployment if we encourage all actors in the
economy to spend more. It is not only possible but it is recommended to spend
one's way out of a depression: fiscal policy can be very beneficial.
Page 28 Economics 2003-04: Macroeconomics
Problems with Demand Management
Demand side policies are used to reduce excess demand:
o If caused by excess money, then monetary policy is used to reduce demand.
Deflationary fiscal policy aims to reduce demand directly rather than indirectly by
changing money supply or interest rates.
Lags: there are lags in monetary and fiscal policy which may lead to effects which
make the cycles worse rather than better.
Small multiplier: near the full employment level, the simple multiplier is
considerably reduced because of the effects of rising prices.
Financing deficits: in order to shift aggregate demand the govt. has to pay for the
increase in G somehow which may lead to problems:
o If taxes are raised, then C and I will fall and AD will fall,
o If govt. borrows money, there is crowding out of private investment.
o If govt. borrows from the central bank (equivalent to printing money) then there
will be inflation in 18 months.
Liquidity trap: in a depression or serious recession, monetary policy can be
ineffective because of the liquidity trap where people hold money rather than bonds
and thus it is impossible to get interest rates down.
Steep MEI curve: in a depression even if interest rates do fall, the marginal
efficiency of investment curve (project evaluation array line) may be so steep and
shifted in so far that investment hardly increases.
Problems with Keynesian Policies
Keynesian policies attempted to reduce the suffering encountered in a market
system by providing assistance to the less fortunate. The benefits are the counter-
cyclical effects of automatic stabilizers, but the costs include:
o Disincentive to work: welfare and unemployment assistance has encouraged
people supported by the govt. not to be productive by imposing a "tax" in the
form of a loss of social assistance for those who go and work. This reduces the
motivation to look for a job, and shifts the LRAS to the left.
o Increased taxes: the steady increase in taxes for social security have increased
business costs, this has shifted the LRAS to the left.
o More regulation: greater regulation of industry protects firms from competition
and leads to inefficiency which shifts the LRAS to the left.
o Substitution of capital for labour: there has been greater social regulation such
as labour protection laws which have substantially increased the costs of hiring
employees leading to the substitution of capital for labour which increases the
natural rate of unemployment (shifting the LRAS to the left).
o Underground economy: higher tax rates have led to disincentive problems and
to a significant proportion of economic activity going underground.
Economics 2003-04: Macroeconomics Page 29
3.3 MACROECONOMIC MODELS: MONETARIST
The allocation of resources takes place in the real sector of the economy through
supply and demand as determined by the relative price ratio.
The level of prices in the economy is determined by the amount of money.
o Doubling the amount of money will simply double prices, but is unlikely to
change the relative price ratios amongst the goods in the long run.
o Those ratios are determined by the real costs to produce those goods in terms
of the resources required.
o During the initial period while the money is being doubled, there may be some
short run influences which lead to alterations on the real side of the economy.
Inflation can be traced back to 1250, from 1250 to 1525 prices were stable in the
sense that inflations would be offset by deflations.
o When gold was discovered in the Americas and sent back to Europe, prices rose
steadily until 1650.
o Prices were then reasonably stable until 1933. At that time, most nations went
off the gold standard and prices rose steadily until 1979 -1985.
Medium of exchange function of money:
o The difficulty with barter is the double coincidence of wants: the need to find
someone who has what you want and who is prepared to trade it for what you
have to offer. A great deal of time can be wasted finding a trading partner.
o With money people can trade their goods for money and quickly locate and pay
money for what they need.
o To act as a medium of exchange, money must have a high value for its weight,
it must be divisible, and not counterfeitable.
Store of value function: money provides a convenient way to store purchasing
power as long as its value is stable.
o Not everyone can be trying to save money at the same time, if they did, there
would not be anyone to make the goods and services.
Unit of account function: money acts as a unit of deferred payment.
o The added dimension of time enters because the account is not closed until
The most popular types of money which have fulfilled all three functions have
usually involved gold and silver.
Page 30 Economics 2003-04: Macroeconomics
From Metal Money to Paper Money
To avoid having to weigh the metal every time a transaction was made, coins were
invented and stamped with an official seal guaranteeing the metal content of the
coin. There was an enormous saving of time.
Debasement of the currency: occasionally rulers would recall the currency and issue
a new coin, debasing the metal by using more copper.
The modern day equivalent of debasement, is the printing of money. As more and
more money is printed, it becomes worth less and less.
Because of the dangers of carrying gold and being robbed, people learnt to store
their gold with the goldsmith:
o The goldsmith would issue receipts for the stored gold.
o People found they could trade receipts instead of going back to the goldsmith to
cash in the receipts for gold.
o Goldsmiths noticed that people did not return for their gold, so they started
lending out the gold or issued more receipt than there was gold.
o If there was a scare, and people rushed to the bank to cash in their receipts, the
bank would not be able to pay back the gold as there were more receipts than
Fractionally Backed Paper Money
Known as a fractionally backed paper money banking system, banks joined together
to form a central bank.
o If any one of the member banks experienced a run, they would get shipments of
gold from the central bank until all the depositors were certain it was safe and
they would re-deposit their money.
o In time the central banks took over the issuing of the paper currency, and
eventually governments took over the central banks.
o By 1935 most governments had gone off the gold standard, and almost all
currency today is fiat currency: it is backed by the govt. and not by gold.
o Fiat money has value because it is accepted for transactions by law.
Paper and coins were largely replaced with bank deposits:
o People wrote cheques on those deposits rather than pay cash.
o In most industrialized countries, paper and coinage money only represent 10%
of the money supply, around 90% is deposit money held in banks and is
transferred through the use of a cheque.
o Banks are able to create money by issuing more deposits than they have cash
reserves available to cover them: often called the relending chain or multiple
expansion of the money supply.
Economics 2003-04: Macroeconomics Page 31
The Banking System & The Central Bank
In most countries the Central Bank (CB) is govt. owned and operated.
Govts use the central bank to carry out monetary policy.
o The central bank is the lender of last resort: it stands ready to back any of the
chartered banks if there are emergencies such as a run on the bank.
o It looks after govt. accounts and often buys govt. bonds, particularly if the bond
market needs to be supported.
Central banks are also usually responsible for the money supply.
If the Central Bank (CB) buys a bond from the public, the public receives the cash
in the form of a cheque from the CB and the CB receives the bond.
Money is created through deposit creation rather than printing currency.
Central banks are often responsible for bond and money markets.
Bond markets refer to markets where debt instruments which mature in one year or
more are traded.
Money markets: where debt instruments maturing within one year are traded.
o In most countries the most common form of money market instrument is the
treasury bill issued by a govt.
Commercial banks tend to borrow short term from their depositors and lend long
term to people and businesses that need loans, and can suffer if interest rates
increase sharply in the short term.
o Part of the job of the CB is to ensure that interest rates move smoothly and
slowly and the range over which rates fluctuate is fairly narrow.
Demand for Money
Households hold wealth in many forms: cash, bonds, stocks, real estate or in
businesses. For this course, we assume that people hold only money or bonds.
Wealth held in the form of money is called the demand for money.
Once we know the demand for money, we also know the demand for bonds.
The opportunity cost of holding money is the interest foregone on the bond that
could have been purchased instead.
As GDP rises in the economy, people will spend more because consumption rises,
therefore the transactions balances will also rise.
The demand for money depends on the value of transactions
MD PY (or as used by the IB: PT)
Page 32 Economics 2003-04: Macroeconomics
Commercial or chartered banks hold deposits for their customers and permit certain
deposits to be transferred by cheque from one account to another.
o They make loans to households and firms and buy govt. securities.
With credit granting systems like Visa, banks form a group to spread the risk.
Bank deposits are a medium of exchange only because they can be transferred
through the use of a cheque.
The commercial bank system makes use of clearing houses:
o Cheques to bank A from customers in bank B, are posted against cheques from
bank B, only the difference is settled.
Banks offer a safe place to store money and to earn a guaranteed return,
commercial bank liabilities are the deposits owed to the depositors.
Banks attract deposits by offering a rate of interest and by providing services for a
small fee such as clearing cheques and providing regular monthly statements.
Commercial bank assets are the securities it buys which pay interest and dividends
and the loans it makes to its customers.
o Banks expect that the loan will be repaid, and that they will make enough
money on the interest to pay for the paperwork and the risk of non-payment.
Regulation of Commercial Banks
Commercial banks which are usually privately owned, have been required by the CB
to hold a certain minimum amount of cash as backing for their deposits.
Excess reserves: cash balances in excess of what is legally required.
o Recession: banks may not lend money for fear of failure on the part of the
o Boom times: the opportunity cost for not lending money is the interest foregone,
and excess reserves are low during boom times.
Over the years the fraction of required reserves has fallen steadily as banks have
found they only need a 4% - 5% reserve to meet the day to day demands of clients
o Bank credit multiplier or monetary expansion: if $100 is deposited in a bank
account, the banking system is only required to hold 5% which means the
money supply can be expanded by $2,000 (5% of $2000 is $100)
The CB is the lender of last resort, and can support money and bond markets so
that banks experiencing difficulty can easily sell their securities.
In many countries govt. now provides deposit insurance so that if the bank fails,
depositors will not lose their money.
Economics 2003-04: Macroeconomics Page 33
3.4 DEMAND-SIDE POLICIES
Open Market Operations
The most important tool for controlling the money supply and interest rates is the
purchase and sale of bonds by the central bank (CB), referred to as open market
When the CB buys a bond from the public, the person selling the bond receives a
cheque from the CB which is then deposited in a commercial bank.
o The bank sends the cheque to the CB which then increases the deposits of the
commercial bank. Thus new money is injected into the system leading to a
multiple expansion of deposits through the relending chain.
When the CB sells a bond to the public, it receives a cheque from the person and
sends it to the commercial bank for payment.
o The commercial bank sends the money to the CB and there is a contraction of
the money supply through the relending chain operating backwards.
o Rather than calling in loans which can lead to bankruptcy, the commercial bank
typically does not make any new loans until its reserves are back up to the legal
When the CB sells bonds in the market, there are two effects:
o The reserve effect is that money now leaves the system and is put in the CB
leading to a contraction of the money supply.
o At the same time, when the CB sells bonds, the price of bonds falls and interest
rates rise leading to a contraction of investment and the AD curve.
In reverse, when the CB buys bonds:
o The money enters the system leading to expansion through the relending
o At the same time the price of bonds rise, interest rates fall and investment
increases leading to an expansion of the AD curve.
Closing an Inflationary Gap
Wages start to rise, shifting the SRAS in to the left leading to inflation.
The value of money transactions rises, people sell bonds to obtain more money.
Bond prices fall, interest rates rise, there is a price induced fall in investment.
The fall in real expenditure leads to a movement back along the AD curve.
Thus inflationary gaps are self correcting as long as the money supply is not
increased, but the process is frustrated if the money supply is increased.
o With inflation of 15%, if the money supply increases 15%, people do not sell
bonds to obtain cash, interest rates do not rise to choke off real expenditure.
Monetary policy could close the gap more quickly by decreasing the money supply,
leading to a rise in interest rates, a fall in investment: AD shifts left.
Page 34 Economics 2003-04: Macroeconomics
If the central bank wants to raise interest rates:
o They will sell bonds, the money supply will ALTERING INTEREST RATES BY
CHANGING THE M ONEY SUPPLY
contract from Ms1 to Ms2.
o There will be an excess demand for money: Ms3 Ms2 Ms1
at r1 in the diagram it is measured as MS1-
Rate of Interest
o Households will sell bonds, and the price of r3
bonds will fall.
o This leads to an increase in interest rates in
the market. r2
o Eventually interest rates will rise high Demand for
enough to convince people to stop trying to
hold so much cash, and the excess demand
for money will disappear at r2.
Supply of Money
Closing a Recessionary Gap
If wages fall, SRAS would shift out, prices would fall and income rise.
o The value of money transactions falls, people buy bonds with the excess money.
o Bond prices rise, interest rates fall: there is a price induced rise in investment.
o The rise in real expenditure leads to a movement along the AD curve.
As wages are sticky down, however, the SRAS shifts slowly to the right, and the fall
in prices and the monetary adjustment mechanism operates very slowly.
Monetary policy could close the gap more quickly by increasing the money supply,
interest rates fall, investment rises and AD shifts out.
If the central bank wants to reduce interest rates:
o They will buy bonds, the money supply increases
o At r3, excess supply is measured as M2-M3.
o People will buy bonds with the excess and the price of bonds will rise
o Interest rates will fall, and there is less incentive to hold bonds and eventually
there will no longer be an excess demand for bonds.
Shifting Govt. Deposits
Rather than changing interest rates the CB which acts as the bank for the govt. may
close a recessionary gap by moving cash from a govt. account in the CB to a govt.
account in a commercial bank, which leadsto an expansion of the money supply.
To close and inflationary gap, the CB transfers govt. deposits back to the CB leads
which leads to a contraction of the money supply.
Economics 2003-04: Macroeconomics Page 35
Problems With Monetary Policy
The Transmission Mechanism
Fiscal policy operates directly on AD through changes in G and T.
Monetary policy operates through adjustments in the money supply which then lead
to changes in interest rates and investment before impacting on AD. Problems with
this transmission mechanism during depressions can make monetary policy useless:
o Monetary expansion fails because Banks hold excess reserves rather than lend
o Interest rates may not fall because people may hold money rather than invest in
bonds:: the liqiuidity preference curve is flat.
o Firms may be afraid to invest: the MEI curve is vertical, large changes in interest
rates lead to only small changes in investment.
Lags in Implementing Monetary Policy
The monetary transmission mechanism takes varying lengths of time from 18
months to 3 years. While there is still a recognition lag, there is no need for a
legislative lag as the govt. does not have to go to parliament to get permission to
change the money supply.
There is still an implementation lag.
o Open market operations lead only slowly to changes in the money supply and
o It takes time in companies to adjust investment plans in response to changes in
o It then takes time for investment to be put in place and for the multiplier
respending chain to lead to changes in national income: Economists estimate it
takes 18 months on average for half the effects to be felt in the economy.
Lags are long and unpredictable increasing the risk that using monetary policy could
lead to destabilizing effects.
The poor record of monetary policy as a short term stabilizer has led to the
introduction of a monetary rule approach where the money supply would only be
increased by a set amount.
o Some countries chose the rate as equal to the population growth rate plus the
growth rate in productivity.
o Experience since then shows that there have been quite sudden shifts in the
liquidity preference function, also known as the demand for money, which has
made the monetary rule approach less stable than had been hoped.
Most economists now believe that fiscal policy must be used to restore the economy
to full employment during a serious recession or depression:
o The labour market experiences sticky wages which means wages fall too slowly
o Weaknesses in the monetary transmission mechanism plus lags mean that
monetary policy is unpredictable.
The monetary adjustment mechanism is most powerful in boom times.
Page 36 Economics 2003-04: Macroeconomics
Problems with Aggregate Demand & Supply
Slope of the SRAS curve
The effects of monetary policy will be divided between the price level and real
output effects depending on the slope of the SRAS.
o Zone 3: in boom times, the SRAS curve is very steep. This means that shifts in
the AD curve translate into large changes in the price level and little change in
In the long run, because the LRAS is vertical above the full employment income
level, the major impact of monetary policy will be on the price level.
While the CB can affect both price and income in the short run, it only influences
prices in the long run.
Rational expectations: people do not form expectations of future inflation based on
the past; they tend to look ahead and make an estimate based on information they
have available at that moment.
Expectations can alter the speed at which adjustment takes place. A change in the
expected rate of inflation will change aggregate demand:
o If inflation is expected to rise, consumers will increase current buying,
o If inflation is expected to fall, expenditures may be delayed.
If the money supply is increased, and the AD curve shifts out to the right, workers
anticipate that increasing the money supply will lead to higher prices and they will
demand higher wages right away:
o The general expectation of an x percent inflation creates pressures for wages to
rise by x percent and hence for unit costs and the SRAS curve to shift by x
o As AD shifts to the right, the SRAS shifts to the left.
Rational expectations means that workers cannot be fooled, there is no money
o Workers know that real wages remain unchanged, and real income stays the
o Govt. will be unable to reduce unemployment below the natural rate even in the
short run (see the long run Phillips curve).
While it is unlikely that the effects are completely offset, expectations are yet
another reason why monetary policy may not be very effective.
Economics 2003-04: Macroeconomics Page 37
3.4 SUPPLY SIDE POLICIES
Because of dissatisfaction with demand management policies, policy makers have
turned to permanently reducing structural unemployment so when cycles occur, the
impacts are less severe:
o If unemployment at the peak of the cycles is 7%, and if it rises to 12% to 13%
at the bottom of the cycle, many people will suffer during downturns.
o If the natural rate of unemployment could be reduced to 2% at the peak of the
cycle, then unemployment may not rise to more than 4% at the bottom.
Supply side policies attempt to shift the LRAS to the right far enough to reduce
o By focussing on incentives:
Taxes and subsidies are reduced to encourage work, risk taking and I.
Unemployment benefits are reduced, raising the opportunity cost of not
o By increasing productivity of labour (Q/L rises):
Education and training will increase productivity.
Investment in capital will increase the K/L ratio.
o By increasing the productivity of capital (Q/K rises): through tax deductions for
R&D: firms are motivated to find ways to increase capital productivity.
o By reducing the costs of inputs:
Eliminating or reducing the minimum wage and the strength of unions.
Lowering interest rates and thus lowering the rental price of capital.
Providing incentives to find cheaper sources of raw materials.
o By reducing the power of big companies through anti-monopoly regulation.
European - Japanese approach:
By assisting labour to move from sunset to sunrise industries, structural
unemployment can be eliminated.
In Sweden, when workers lose jobs in sunset industries:
o They have a choice of training for jobs in sunrise industries,
o The govt. pays for the full wages of the worker during the retraining, which
usually lasts from 6 months to 2 years,
o The firm guarantees to hire the worker for a minimum of five years.
In Japan, when firms close down a sunset division:
o The firm approaches the govt. and asks for training assistance for redundant
workers in a new or existing sunrise division.
o The govt. pays the full wages during the training period, and the firm
guarantees lifetime employment.
Page 38 Economics 2003-04: Macroeconomics
In Germany students in high school try out careers in sunrise industries to reduce
the numbers of students graduating in a redundant career,
o About 60% of high school students in Germany participate in a work coop
program where they work from 1 to 5 afternoons a week in a firm or occupation
they are interested in entering. Wages are not paid.
o Students are allowed to change once a year, and employers are permitted to ask
students to leave if they have problems.
o Because students are exposed only to jobs and careers where there are
openings, training for sunset industries is avoided.
o Because both students and firms have a chance to assess each other, by the
end of high school firms are happy to hire students and students are happy to
go to work in familiar firms.
The US govt. is reluctant to become involved in directing people into training and
careers and has depended on tax cuts to bring about supply side changes.
Reducing taxes will increase supplies of labour and capital:
o Lower taxes would increase the ROI and provide an incentive to invest in
capital, thus increasing K/L.
o Lower taxes would also increase the return on R&D, leading to investment in
even more productive capital.
o People who were already employed would work harder if they could keep more
income after taxes, and those who were unemployed would be brought into the
work force by the boost in income.
Tax revenue would remain constant, even though tax rates had been cut:
o The increases in productive capacity (capital) and in productivity (labour) would
shift LRAS to the right increasing the taxes collected.
However, cuts in taxes can lead to an increase in C, causing a rightward shift in AD.
o In the short run, AD shifted to the right, opening up an inflationary gap.
o The supply side shifts of LRAS were not large enough and quick enough to
counteract the aggregate demand effects.
o Incomes rose, but not by enough to restore tax revenues back to what they
were: the result was bad deficits for the US govt.
The supply side effects have been harder to find:
o They were dissipated throughout the economy.
o They did take place but over a longer period of perhaps 10 years or more.
o However, the reforms had a major effect on improving the functioning of the US
economy, and reducing the natural rate of unemployment.
O They also appear to have led to disinflation: a slowing down in the rate of
inflation. (Deflation is where prices actually fall).
Economics 2003-04: Macroeconomics Page 39
3.5 UNEMPLOYMENT & INFLATION
Policy Goals: Price Stability
The price level refers to the average level of prices in the economy while the rate of
inflation is the rate at which the price level is rising.
A price index measures the average of a group of prices from some initial time
called the base period.
The most common is the Consumer Price Index (CPI) which measures the cost of
living for a typical household.
o A survey is done to determine which items are the most important in most
household budgets, and a weighting scheme is devised.
o The prices for those goods are weighted (in percent terms) by their importance
in the budget.
o The summation of all the weighted prices is then set equal to 100 in the base
year. If the following year the sum adds up to 104, then we know there has
been 4% inflation since the base year.
One problem that arises is that consumption patterns change over time, and the
weights on various items change steadily as people's tastes switch to different
products. In many countries the central statistics bureau does a new survey every
5 to 10 years to recalculate the weights.
The inflation rate between any two periods of time is measured by the percent
change in the price index from the first period to the second where we use the GDP
Implicit Price Deflator for the whole GDP rather than just the CPI:
* 100 Inflation rate
o If prices fall we have deflation, if prices rise we have inflation.
o If the rate of inflation falls, we have disinflation: prices are still rising but at a
The History of Inflation
From 1200 to 1525 prices were very stable, periods of inflation were followed by
periods of deflation.
The first period of sustained inflation ran from 1525 to 1650 and is associated with
the gold from the New World being brought back to Spain. It is estimated that the
amount of gold increased 5 times, and prices did likewise.
From 1650 to 1935 prices moved up and down but there were no periods of
sustained inflation or deflation. The inflation in the 1920's was matched by a
deflation in the 1930's.
Page 40 Economics 2003-04: Macroeconomics
By 1935 most developed countries made the decision to go off the gold standard:
there was no check on the money supply and many govts. started printing money.
Prices in most countries have risen at least 20 times those in 1935.
Between 1976 and 1979, most industrialized countries decided not to print money
in excess, and prices have been increasing only slowly ever since.
The purchasing power of money measures the real value of money in terms of the
goods and services that can be purchased with a given amount of money.
Inflation reduces the real value of anything with a price fixed in money terms. If
people do not anticipate inflation, there will be winners and losers:
o The winners include people who owe money to others: the real value of the
amount owed will decline.
o Employers will gain as the real value of the wages they have contracted to pay
o The losers include people on fixed incomes, wage earners who fall behind in real
wage terms, and people who lend money.
o Inflation makes export prices more expensive and imports look cheaper so net
exports fall and importers will gain while exporters lose.
To protect against inflation potential losers can anticipate inflation:
o Wages can have an expectational element built in to contracts to protect
o Banks and other people lending money can charge an interest rate high enough
to include the anticipated inflation.
o However, people on fixed incomes, particularly the retired are unable to alter
their pensions, and this group has been very badly hurt by inflation.
It is unlikely that inflation will be anticipated properly and different adjustment rates
mean that some will gain and some will lose from inflation. One problem area is
o If there is a capital gain (the value of something purchased has gone up before
being sold) some of that gain will be due to inflation and should not be taxed.
However, most govts. do not make an allowance for inflation in the tax system.
The Interest Rate
The interest rate is the price paid to borrow money.
The prime rate of interest is what the banks charge their best business customers
and may be thought of as the market interest rate or opportunity cost rate of
Economics 2003-04: Macroeconomics Page 41
The real interest rate gives us the return on the investment in terms of purchasing
power and is equal to the nominal interest rate minus inflation:
Real interest rate = nominal interest rate – inflation
Page 42 Economics 2003-04: Macroeconomics
Inflationary shock: any event that tends to drive the price level upward. Supply
shocks arise from:
o Raw materials: increases in price such as the oil shock. Increases in the price of
imported raw materials such as oil are usually isolated and not persistent.
o Labour: continued wage cost push is an example of repeated supply shocks.
The SRAS shifts inward, to the left:
o The price level rises and income falls below the full employment point. This is
referred to as stagflation.
o A recessionary gap opens, and pressure mounts for wages and other factor
prices to fall.
o SRAS shifts out to the right and there is a return to full employment
accompanied by a fall in prices.
Temporary shocks lead to inflation followed by deflation.
Supply shock: the SRAS shifts in to the left
If the CB responds by increasing the money supply, we say the price shock has
o The increase in the money supply leads to an outward shift of the AD curve.
o This eliminates the recessionary gap, but leads to further inflation.
Keynesians believe that waiting for cost deflation to restore full employment forces
the economy to suffer through an extended slump because wages are sticky down
and productivity grows very slowly in a recession.
Monetarists are opposed as they believe that the long run Phillips curve is vertical
over the NAIRU or Unat and inflation will continue to accelerate.
Wage-cost push inflation:
Powerful unions may administer repeated shocks by pushing for higher wages:
o Firms pass the wage increases on in the form of higher prices.
o If the CB does not accommodate, the SRAS shifts inward creating a recession.
o Unions would eventually cease pushing wages up in order to maintain jobs.
Persistent unemployment will erode the power of unions.
Non-accommodated wage push inflation tends to be self limiting.
If the CB accommodates, both money wages and prices will have risen.
o Workers are no better off so unions try again.
If the CB accommodates the new supply shock, costs and prices will rise.
A wage price spiral: this can only be halted if the CB stops accommodating the
o The longer the CB waits to do so, the more entrenched will be the expectations.
Economics 2003-04: Macroeconomics Page 43
Employers expect prices to rise and grant wage increases.
Workers push for higher wages as they see prices rising.
o Once accommodation stops, stagflation sets in: rising prices combined with
Demand Pull Inflation
A rightward shift in AD can only come about either because of an increase in an
autonomous element or an increase in the money supply:
o An inflationary gap opens up and wages and other costs rise leading to a
leftward shift of the SRAS.
o The rise in the price level induces changes leading to a movement back along
the AD curve to the full employment point. This leads to even more inflation.
If the CB reacts to the demand shock by increasing the supply of money, it is
validating the shock.
Govt. may not want output to fall, particularly if they face an election.
o Wage increases cause SRAS to shift left, but money supply increases again and
AD shifts to the right.
o The price level rises, but output does not fall.
There is a tendency for employers to smooth out the income of employees by
paying steady wages and letting profits and layoffs do the adjusting to the shocks in
Productivity rises as a worker gains experience but falls off as the worker gets
With wages rising with seniority and layoffs done by seniority, workers and
employers are bound to each other.
Employers know that self policing is the best policy. If workers feel they are
unfairly treated they will cut productivity, which is one reason why employers are so
reluctant to lower wages.
It is also a reason why employers tend to pay more than the market wage. They
know that working is better than being laid off, and workers will work hard without
the need for monitoring if they are paid slightly more than the market wage.
Page 44 Economics 2003-04: Macroeconomics
Definitions of Inflation
If inflation is to continue it must be accompanied by continuing increases in the
Inflation affects both price levels and output in the short run.
In the long run, shifts in SRAS and AD do not effect employment and output, they
affect only the price level.
o Thus inflation is a purely monetary phenomenon from the point of view of long
Random Shock Inflation
These are the supply and demand shocks which often trigger bursts of inflation
which must come to an end unless monetary expansion occurs.
The cost of labour must be related to growth in productivity. If wage increases lead
to a rise in unit costs, it must be because wages are rising faster than productivity.
Inflationary gap inflation (Phillips Curve adjustment)
The excess demand for labour associated with an inflationary gap puts upward
pressure on wages and the SRAS curve shifts in to the left.
The excess supply of labour associated with a recessionary gap puts downward
pressure on wages.
The general expectation of an x percent inflation creates pressures for wages to
rise by x percent and hence for SRAS to shift by x percent.
If income is held above potential income, the price level will be rising. This can
only happen if the CB is accommodating the increase in wages.
When the SRAS and the AD curves are shifting up at the same speed, the
inflationary gap remains unchanged. Eventually people will believe that monetary
validation (accommodation) and hence inflation will continue:
o The SRAS will begin to shift up even faster:
If the CB is told to accommodate in order to hold the level of output
constant, it must increase the rate at which the money supply is increased.
The rate of inflation will start to increase which fuels expectations of
increased inflation leading to accelerating or entrenched inflation.
Economics 2003-04: Macroeconomics Page 45
Breaking Entrenched Inflation
If employers expect 5% inflation, they will agree to wage increases of 5% and raise
If the CB accommodates, then AD will be rising by 5% per year as well.
Even if the CB does not accommodate completely, the negative demand effect of a
recessionary gap may be rather weak. The demand effect may be swamped by the
expectational and random shock effects.
Eliminating Entrenched Inflation: Step 1
To break entrenched inflation, the expectation SRAS2
of inflation must be broken: Price
o Step 1: remove the inflationary gap, if E1
there is one.
Stop accommodating: the rate of
monetary expansion has to be slowed AD1
to lower the rate at which AD is shifting
up. The SRAS will keep shifting left at
the old rate and will soon eliminate the Yfe Y1
inflationary gap (from Eo to E1). Real National Income
Disinflation results: prices are still rising
but at a slower and slower rate.
Eliminating Entrenched Inflation: Step 2
o Step 2: because wages depend not only on
excess demand, which has now gone, but SRAS2
also on inflationary expectations, the SRAS E2
will continue to shift left leading to E1
Rising unemployment will dampen
expectations of inflation and the inflation Y2 Yfe
will halt leaving a large recessionary gap. Real National Income
o Step 3: return to full employment either: Eliminating Entrenched Inflation: Step 3
By allowing the SRAS curve to shift to the Price
right (moving to E3a), lowering prices and Level
By using fiscal or monetary policy to shift SRAS2
the AD curve (moving to E3b). The great E3b
fear is that this may rekindle inflationary E3a
Economists who worry about waiting for wages Y2 Yfe
and prices to fall, fear that the process will take a Real National Income
long time and create a great deal of misery for
Page 46 Economics 2003-04: Macroeconomics
Policy Goals: Full Employment
We assume that output and employment are closely related because output can
only increase if employment increases. In a recessionary gap (positive output gap),
there is a loss of production as a result of the unemployment: we can never retrieve
The labour force is often defined as those people between the ages of 15 and 65
who are either working or actively seeking work if they are not employed. Only
unemployed people who are registered as unemployed will appear in national
statistics. In MDCs there is a strong incentive to register because of unemployment
benefits. This is not true in LDCs which means their unemployment statistics are
The unemployment rate is defined as: U
Full employment: there is no output gap, we are at potential income. There are no
people unemployed for cyclical reasons, but unemployment occurs:
o Search (or frictional): those who are in transition, they have finished studying
and are entering the work force for the first time, or moving between jobs.
o Structural: those who have the wrong skills or are in the wrong location.
There may be job openings but there is a mismatch between the skills
required and the skills of the people looking for work
People are not prepared to move communities to take the jobs for which
they have the skills but which are located in other communities.
o Discouraged workers are usually young people who have had to wait too long
between graduating and finding a career related job.
In most industrialized countries, unemployment rises when the rate of new job
creation slows down during a recession:
o Even in a recession there are thousands of new jobs being created, but the rate
of new job creation is not as fast as the rate of people looking for work.
o Skilled people may have lost a job but will soon find one as soon as the rate of
job creation picks up.
o The structurally unemployed will never get another job even if the rate of job
creation picks up, they do not have the skills or are in the wrong place.
The natural rate of unemployment means the amount of frictional and structural
unemployment associated with the full employment income level.
o For Sweden and Japan it was 2% for many years, in the US it has been at the
4% level since 1985, and in Canada and Australia it has been around 7.5%.
Involuntary unemployment: in depressed regions unemployment is higher than the
official figures because people have given up looking for work.
Underemployment or disguised unemployment occurs if people accept a part time
job because full time work is not available, or if firms are overstaffed.
Economics 2003-04: Macroeconomics Page 47
Except in depressions or serious recessions, unemployment increases when the
creation of new jobs falls below the net increase in the size of the labour force.
o Short term unemployed: Except during deep recessions or depressions, most
workers who are laid off only experience a short period of unemployment.
o Long term unemployed: people who lack skills or are in the wrong locations.
o Marginal unemployed: workers moving in and out of jobs several times a year.
o Youth unemployment: young workers have a higher unemployment rate:
They have been denied a working experience early in their careers.
They may remain as marginal workers who take temporary jobs at low pay
and with little future job security.
With minimum wage laws employers are discouraged from hiring young people
while providing on the job training.
Female participation: the rapid increase in female participation has made it very
difficult for markets to respond adequately.
The inflow of women in the labour force exceeded the speed of new job creation
for women, creating a higher unemployment rate for women.
o As this rate has slowed down, the female unemployment rate has fallen.
The discrepancy between men and women has narrowed considerably as women
have received training in areas formerly dominated by men.
At full employment income, there is only search (or frictional) and structural
During recessions there is cyclical unemployment which can be corrected with
fiscal, monetary or trade policy.
The Natural Rate of Unemployment
NAIRU: the non-accelerating inflation rate of unemployment, also referred to as the
natural rate of unemployment, is that level of unemployment which does not lead to
an increase in inflation.
NAIRU rose steadily until 1979, the year when most developed nations agreed to
stop accommodating inflation in an attempt to control inflation.
During recessions the natural rate of unemployment falls (search). During the
recovery from recessions, the natural rate of unemployment starts to rise again:
o During recessions, people will take a job more quickly, and less time is spent in
searching for the perfect job (search or frictional unemployment falls).
o During boom times, workers are willing to take longer to find a job.
The natural rate of unemployment is assumed to consist of structural and search
(frictional) unemployment rather than cyclical unemployment.
Page 48 Economics 2003-04: Macroeconomics
Structural, Search & Real Wage Unemployment
There is a mismatch between the structure of the labour force in terms of skills,
industries and location, and the types or places where jobs are available.
Sectoral structural unemployment:
o The only sector in which employment has not increased and in many countries
has decreased is in the primary, natural resource sectors.
o In many industrialized countries there has also been a decline in manufacturing
and construction accompanied by tremendous growth in the service sector.
o Market services: provide inputs to the goods producing industries, the value of
services is included in the goods they help to produce, and include:
Transport, communication, utilities, wholesale and retail trade
Finance, insurance, real estate, business and personal services
o Non-Market services: are paid for out of taxes, they contribute to human capital
and economic infrastructure, and include:
Health, education and public administration.
Industrial structural unemployment: unemployment develops in sunset
industries where international competition forces change:
o The goods industries operate in an environment of international
competitiveness. Productivity and the ability to compete are fundamental to
their success and to the demand for services: goods and services are starting to
merge into each other.
Regional structural unemployment: in regions where natural resources have
run out or where industries cannot compete internationally or domestically, severe
unemployment can develop.
Minimum wage structural unemployment: minimum wage laws cause
structural unemployment by pricing the unskilled out of the market.
o While this increases the wages for the workers who are lucky enough to get
jobs, it makes it difficult for elderly people looking to supplement their pension
or for young people who have no working experience.
o Lower wages are needed to pay for on the job training for young people or for
the lower productivity of older workers.
o Retraining and relocation: workers can retrain and develop new skill sets and
move to where there are jobs available. This is unlikely to occur except in the
case of young workers.
The UK pursued policies of trying to move jobs to the people, but industries
would not move and structural unemployment increased.
In Sweden, a policy to promote mobility and to assist with retraining kept
unemployment rates low for many decades.
Economics 2003-04: Macroeconomics Page 49
Unskilled service jobs: the growth in this sector has more than compensated for the
loss of unskilled jobs in the manufacturing and construction industries.
Jobs do not pay well, are often part time, and do not provide job security.
They provide work for those who cannot find jobs elsewhere, they offer part time
employment for those looking for such work, and they often provide the first job
experience for young people who are completing their education and looking to
enter the work force.
Search (Frictional) Unemployment
The normal turnover as young people enter the labour force, and other people
leave and search for a better job.
Involuntary unemployment occurs when a person is willing to accept a job at the
market wage, but no job is available.
Voluntary unemployment occurs when a job is available but the person is not willing
to accept it.
o The person is looking for a better job.
o They do not have knowledge of all available jobs and the wage rates.
The costs of searching are lowered if the household has another source of income
or if there is unemployment insurance available: this makes it easier for the
unemployed to spend longer searching for a better job.
Real Wage Unemployment
Real Product wage: when analysing firms and industries we normally consider unit
costs, the costs to produce a unit of output.
A closely related concept is the cost of hiring a worker for one hour divided by the
output produced in that hour: defined as the real product wage.
The cost to the employer includes wages and fringe benefits plus the social taxes
for unemployment or other types of insurance.
If labour unions or minimum wages hold the real wage above equilibrium, or if
there is an economy wide rise in real product wages, some firms will not be able to
cover their labour costs and will shut down, leading to unemployment.
This is most likely to occur when breaking entrenched inflation. Despite the drop in
the inflation rate, unions will push for higher wages and real wages will rise.
If high real wages persist because there is resistance to wages falling, the firms
that survive will adapt new technology that replaces expensive labour with capital,
and this also leads to unemployment.
Unemployment may eventually force real wages down or new technologies may be
invented which will hire the unemployed despite the high real wages.
Page 50 Economics 2003-04: Macroeconomics
Cyclical unemployment can be reduced with appropriate fiscal, monetary and trade
Real wage unemployment can be reduced by not allowing inflation to break out
leading to the need to break entrenched inflation which can create the problem in
the first place.
Search (frictional) unemployment can be reduced by:
o Reducing unemployment benefits.
o Creating employment agencies to reduce the search time.
o Introducing study-work programs such as the German one which allows half the
students in high school to learn by working in a job several afternoons per
Structural unemployment can be reduced through retraining and relocation:
o Older workers resist changes and are reluctant to admit that innovations have
destroyed the value of the knowledge and experience that they already have.
This is why employers tend to hire younger workers who will learn the new skill
In many industrialized countries, sunset industries and regions are supported with
subsidies. But agreements with industry to hire un-needed (usually older) workers
increases costs and makes the industry even less viable and puts an even greater
burden on taxpayers.
In Sweden the state approaches firms in the sunrise area and arranges for
unemployed people from sunset industries to enter into a training program which
eventually leads to a full time position. The govt. pays all the labour costs during
the training period.
In Japan, the govt. approaches companies with sunset divisions and assists them in
investing in new sunrise divisions by paying for retraining of workers.
Large, sick, declining industries appear like a national disgrace.
o However, at any point in time there are a number of new firms in sunrise
o The attempt by govt. to pick winners and losers has proven to be a waste of
money, and often inhibits the real winners.
o A policy is needed that encourages private initiatives and risk taking.
o Retraining and relocation grants make movement easier and reduce structural
unemployment without inhibiting economic change and growth.
Economics 2003-04: Macroeconomics Page 51
Reducing Unemployment in the Future
The Japanese govt. has found that a certain percentage of the workforce does not
adapt well to industrial manufacturing and it has encouraged the continuation of
quasi-traditional industries like agriculture, fishing, forestry, ceramics etc.
o By buying the output at subsidized prices and reselling it at market prices people
are able to earn a living without it costing the government a great deal of
o This is not welfare, people are only paid if they produce.
o And the industries must remain labour intensive rather than substituting capital
Knowledge driven methods of production force countries to adjust to structural
changes more rapidly in the future.
How can countries succeed in global markets while maintaining a humane social
welfare system which encourages workers to cooperate with change?
Countries which have experienced the most success have streamlined their capital
markets to make investment more attractive and less tied up with red tape.
o These countries have tended to foster technology extension systems to help
small firms adapt to the new technology.
o They do not shield large, inefficient firms from market discipline but they do
provide training support for change.
Promotion of small business in Japan:
o A loan guarantee system for small firms is run with no cost to the govt.
o A small debt policing system prevents large firms from preying on small supplier
firms by refusing to pay for goods or services delivered unless the small firm
lowers the price.
Page 52 Economics 2003-04: Macroeconomics
The Long Run Phillips Curve
We have assumed that it is rational for The Phillips Curve
everyone to incorporate expectations of
Rate of Change in Wages
inflation into their behaviour. PS2
This will lead to shifts in the Phillips
o There is a difference between the 10%
long run and the short run Phillips 5%
o If expectations are fully rational, U1 U*
Unem ploym ent Rate
then the long run Phillips curve will
be vertical, there will be no tradeoff.
o If the govt. attempts to reduce
unemployment below the natural level, it will just lead to an increase in the
The short run Phillips curve when expectations are fixed is given by PS1.
o If the govt. attempts to lower the unemployment rate to U1, below the natural
rate Unat, wage rates will increase.
o Through the shifting in of the SRAS, the inflation rate will also increase to 5%.
o If this is sustained through monetary accommodation, workers come to expect
inflation and the Phillips curve shifts up to PS2.
If the govt. attempts to maintain unemployment at U1, it will lead to a higher rate
of wage increase, and a subsequently higher rate of inflation (10%).
o Inflation will increase and expectations will lead to a new upward shift of the
short run Phillips curve to PS3, with inflation of 15%.
In order to reduce inflation it will require a severe recessionary gap to be opened to
get the Phillips curve to shift back down again and reduce the upward pressure on
Inflationary expectations are stuck:
o Even if the govt. decides to abandon its policy of trying to force unemployment
below the natural rate:
As the SRAS shifts left it will continue past the full employment point
because unions want to catch up for all the years they feel they have been
Wage demands drive the SRAS curve even further to the left opening up a
recessionary gap which leads to stagflation.
There may be a tradeoff between inflation and unemployment in the short run, but
in the long run the Phillips curve is vertical, and there is no tradeoff.
NAIRU: is defined as the non-accelerating rate inflation rate of unemployment. This
means that we do not have to be where %∆wages = 0. As long as the %∆wages
stays the same, we are at the NAIRU point.
Economics 2003-04: Macroeconomics Page 53
3.6 DISTRIBUTION OF INCOME
The Laffer Curve
US supply side policies attempted to shift the
Supply Side: Laffer Curve
LRAS curve to the right by reducing taxes: 80
o Inflation would be reduced, real output 60
increased, and unemployment reduced. Tax
o Eventually, the boost in productivity and Revenue
(T = t*Y)
numbers employed would lead to higher tax
revenues to compensate the tax cuts. 0
In the Laffer curve:
o As tax rates rise, so does tax revenue
o After a certain point the disincentive effects of the tax rate are so great that the
tax base is eroded and tax revenues start to fall.
US supply side theorists believed that the US was to the right of t*, and that
reductions in taxes would lead back to t*:
o Lower taxes would stimulate incentives to work, save, invest, innovate and
accept entrepreneurial risk.
o This would shift the LRAS to the right, permanently reduce unemployment and
lead to an increased tax base leading to greater tax revenues.
Problems with Demand-Side Policies
Decreases in taxes may induce some to choose more leisure rather than work.
There are demand side effects which may result in inflation before supply side
effects can counteract this. Large budget deficits and soaring inflation will result.
However, the economy's position on the Laffer curve is undocumented.
Anti-inflationary monetary policy were instituted in North America, Europe and
Japan in 1981.
o The inflation rate fell much more quickly than was expected, and has settled
around 2% for a number of years with no inflationary gap.
Full employment and a low, stable inflation rate appear to be compatible in the long
run: as long as the SRAS shifts only because of random shock effects, Phillips curve
adjustments and expectational influences.
Cost-push inflation can return once the fear of unemployment has disappeared.
This is the problem with governments being committed to a full employment policy,
much of the discipline of the market tends to be removed from wage bargaining.
If the goal were a stable price level rather than full employment, the govt. might
make the maintenance of something close to full employment much more likely.
This is why the goal of price stability comes before the goal of full employment.