It explain the intoruduction to Macroeconomic variables

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Week 8
Introduction to macroeconomics

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Macroeconomics is ...
• the study of the economy as a whole
• it deals with broad aggregates
• but uses the same style of thinking
about economic issues as in
microeconomics.

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Some key issues in macroeconomics
• Inflation
– the rate of increase of the general price level
• Unemployment
– a measure of the number of people looking for
work, but who are without jobs
• Output
– real gross national product (GNP) measures total
income of an economy
• it is closely related to the economy's total output

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More key issues in macroeconomics
• Economic growth
– increases in real GNP, an indication of the
expansion of the economy’s total output
• Macroeconomic policy
– a variety of policy measures used by the
government to affect the overall
performance of the economy

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Inflation in UK, USA and Germany
1960 - 2001
0
2
4
6
8
10
12
14
16
Annual %
1960-73 1973-81 1981-90 1990-01
UK
USA
Germany

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Unemployment
in UK, USA and Germany
0
2
4
6
8
10
%
p.a.
1960-73 1973-81 1981-90 1990-01
UK USA Germany

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Economic growth
in UK, USA and Germany
0
1
2
3
4
5
%
p.a.
1960-73 1973-81 1981-90 1990-01
UK USA Germany

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The circular flow of income,
expenditure and output
Y
Households Firms
C + I
I
C
S

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Government in the circular flow
Y
C + I + G
I
C
S
Households Firms
Government
C + I + G - Te
Te
G
B - Td
Y + B - Td

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Adding the foreign sector
• To incorporate the foreign sector into
the circular flow
• we must recognize that residents of a
country will buy imports from abroad
• and that domestic firms will sell
(export) goods and services abroad.

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GDP and GNP
• Gross domestic product (GDP)
– measures the output produced by factors
of production located in the domestic
economy
• Gross national product (GNP)
– measures the total income earned by
domestic citizens
• GNP = GDP + net income from abroad

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Three measures of national
output
• Expenditure
– the sum of expenditures in the economy
– Y = C + I + G + X - Z
• Income
– the sum of incomes paid for factor services
– wages, profits, etc.
• Output
– the sum of output (value added) produced
in the economy

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What GNP does and does not
measure
• Some care is needed:
– to distinguish between real and nominal
measurements
– to take account of population changes
– to remember that GNP is not a
comprehensive measure of everything that
contributes to economic welfare

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Output and aggregate demand

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Aggregate output in the short run
• Potential output
– the output the economy would produce if
all factors of production were fully
employed
• Actual output
– what is actually produced in a period
– which may diverge from the potential level

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Some simplifying assumptions
• Prices and wages are fixed
• The actual quantity of total output is
demand-determined
– this will be a “Keynesian” model
• For now, also assume:
– no government
– no foreign trade
• Later chapters relax these assumptions

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Aggregate demand
• Given no government and no international
trade, aggregate demand has two
components:
– Investment
• firms’ desired or planned additions to physical capital &
inventories
• for now, assume this is autonomous
– Consumption
• households’ demand for goods and services
• so, AD = C + I

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Consumption demand
• Households allocate their income
between CONSUMPTION and SAVING
• Personal Disposable Income
– income that households have for spending
or saving
– income from their supply of factor services
(plus transfers less taxes)

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The consumption function
Income
C = 8 + 0.7 Y
The consumption function shows desired aggregate
consumption at each level of aggregate income
0
The marginal propensity
to consume (the slope of
the function) is 0.7 – i.e.
for each additional £1 of
income, 70p is consumed.
With zero income,
desired consumption
is 8 (“autonomous
consumption”).
8

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The saving function
S = -8 + 0.3 Y
Income
0
The saving function shows
desired saving at each
income level.
Since all income is either
saved or spent on
consumption, the saving
function can be derived
from the consumption
function or vice versa.

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The aggregate demand schedule
Income
C
Aggregate demand is
what households plan
to spend on consumption
and what firms plan to
spend on investment.
AD = C + I
I
The AD function is
the vertical addition
of C and I.
(For now I is assumed
autonomous.)

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Equilibrium output
Output, Income
45o line The 45o line shows the
points at which desired
spending equals output
or income.
AD
Given the AD schedule,
This the point at which
planned spending equals
actual output and income.
equilibrium is thus at E.
E

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Effects of a fall in aggregate demand
Output, Income
45o line
AD0
Y0
Suppose the economy
starts in equilibrium
at Y0.
a fall in aggregate
demand to AD1
AD1
Leads the economy
to a new equilibrium
at Y1.
Y1
Notice that the change in equilibrium output is
larger than the original change in AD.

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The multiplier
• The multiplier is the ratio of the change
in equilibrium output to the change in
autonomous spending that causes the
change in output.
• The larger the marginal propensity to
consume, the larger is the multiplier.
– The higher is the marginal propensity to
save, the more of each extra unit of
income “leaks” out of the circular flow.

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Fiscal policy and foreign
trade

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Some key terms
• Fiscal policy
– the government’s decisions about spending and
taxes
• Stabilization policy
– government actions to try to keep output close to
its potential level
• Budget deficit
– the excess of government outlays over
government receipts
• National debt
– the stock of outstanding government debt

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Government
in the income-expenditure
model
• Y=C+I+G (assumption: no foreign
trade)
• Direct taxes
– affect the slope of the consumption
function
– and hence the slope of the AD schedule.
• Government expenditure affects the
position of the AD schedule

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Fiscal policy?
Income,
output
45o line
AD0
Y0
But this ignores some
important issues –
prices, interest rates,
and the need to fund
the government
spending.
AD1
This seems to suggest
that the government
could influence aggregate
output in the economy
by raising AD from AD0
to AD1,
Y1
thus raising equilibrium
output from Y0 to Y1.

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but in surplus at high levels
then the budget will be in
deficit at low levels of
income
The government budget
The budget deficit equals total government spending
minus total tax revenue.
If government spending is
independent of income
G
Income, output
The balanced budget multiplier states that an increase in
government spending plus an equal increase in taxes leads
to higher equilibrium output.
Balanced
budget
but net taxes depend on
income,
NT
Y
0

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Foreign trade
and income determination
• Introducing exports (X) & imports (Z)
• TRADE BALANCE
– the value of net exports (X - Z)
• TRADE DEFICIT
– when imports exceed exports
• TRADE SURPLUS
– when exports exceed imports
• Equilibrium is now where
– Y = C + I + G + X - Z

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At higher income levels, there is a trade deficit.
At relatively low income,
exports exceed imports
– there is a trade surplus.
Exports, imports and the trade balance
Income
but that imports increase
with income
Imports
Assume that exports
are independent of
income,
Exports
There is trade balance at income Y*, but there is no
guarantee that this corresponds to full employment.
Y*

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Foreign trade and the multiplier
• The marginal propensity to import
– is the fraction of additional income that
domestic residents wish to spend on
additional imports.
• The effect of foreign trade is to reduce
the size of the multiplier
– the higher the value of the marginal
propensity to import, the lower the value of
the multiplier.