IB Economics SL Unit 2: Macroeconomics Mr. R.S. Pyszczek, Jr. City Honors School IB Economics SL:...

IB Economics SLUnit 2: Macroeconomics

Mr. R.S. Pyszczek, Jr.City Honors School

IB Economics SL: City Honors School

Unit 2: Macroeconomics2.1 The Level of Overall Economic Activity

Economic Activity

The Circular Flow of Income Model Pgs 234-236

Describe, using a diagram, the circular flow of income between households and firms in a closed economy with no government.

Identify the four factors of production and their respective payments (rent, wages, interest and profit) and explain that these constitute the income flow in the model.

Outline that the income flow is numerically equivalent to the expenditure flow and the value of output flow.



Economic Activity

The Circular Flow of Income Model

Describe, using a diagram, the circular flow of income in an open economy with government and financial markets, referring to leakages/ withdrawals (savings, taxes and import expenditure) and injections (investment, government expenditure and export revenue).

Explain how the size of the circular flow will change depending on the relative size of injections and leakages.



Economic Activity


Outline that the income flow is numerically equivalent to the expenditure flow and the value of output flow.

Describe, using a diagram, the circular flow of income in an open economy with government and financial markets, referring to leakages/ withdrawals



Economic Activity


The diagram below displays the Circular Flow of resources, goods and services in a nation with a closed economy and no government sector. To fully understand how productive resources, goods and services and money flow from households to firms and from firms to households through voluntary exchanges in a nation’s product and resource markets let’s examine our role(s) in this diagram.


Unit 2: Macroeconomics



Economic Activity

The Circular Flow of Income Model*

One of the main basic economic models is the circular-flow model, which describes the flow of money and products throughout the economy in a very simplified way. The model represents all of the players in an economy as either households or firms (companies), and it divides markets into two categories:

Markets for goods and services (Product Markets)

Markets for factors of production (Factor or Resource Markets)

http://economics.about.com/od/economics-basics/ss/The-Circular-Flow-Model_3.htm#step-heading



Economic Activity


In the Product (goods and services) Markets, households buy finished products from firms that are looking to sell what they make. In this transaction, money flows from households to firms, and this is represented by the direction of the arrows on the lines labeled “$$$$” that are connected to the “Product Market” box



Economic Activity


The term “factors of production” refers to anything that is used by a firm in order to make a final product. Some examples of factors of production are labor (the work done by people), capital (the machines used to makes products), land, and so on. Labor markets are the most commonly discussed form of a Factor Market, but it’s important to remember that factors of production can take many forms.



Economic Activity


When households provide labor to firms, they can be thought of as the sellers of their time or work product. (Technically, employees can more accurately be thought of as being rented rather than being sold, but this is usually an unnecessary distinction.)



Economic Activity


Therefore, the functions of households and firms are reversed in factor markets as compared to in goods and services markets. Households provide labor, capital, and other factors of production to firms, and this is represented by the direction of the arrows on the “Labor, capital, land, etc.” lines on the diagram above.



Economic Activity


In the other side of the exchange, firms provide money to households as compensation for the use of factors of production, and this is represented by the direction of the arrows on the “$$” lines that connect to the “Factor Markets” box.


Unit 2: Macroeconomics



Leakages- Is money leaving that simple circular flow and does not directly go back to the Households. Lets say for instance, that household #1 earns an income of $2,000 a month, they put $200 in savings. The money is going to the bank then the bank writes up a financial claim. The bank is then able to use that money to loan to firms. Leakages lead to a decrease in economic activity. If the sum of all the leakages is more than the injections there tends to be unemployment or deflation.



Examples of Leakages*

Savings: Households saving a portion of their income which than allows the bank to give businesses/firms a loan.

Taxes: The government is deducting a portion of the households income which then goes directly back to the household where eligible. This transaction is called transfer payments, such as subsidies, AISH, Employment Insurance and CPP.

Import spending: Is money leaving a country to pay for imported goods made by other countries. It is simply goods coming into a country and money leaving that country.

Resources:Dr.Power's Class Discussion, Principles of Macreconomics.Sayre Morris- Page 92-94, Google Books



Injections- Is spending that is not dependent on the current level of income. Money that is received by firms that does not come directly from the households. An example of injections is investment spending it results in a physical increase in plant or equipment. Another way to look at investment spending is an increase in the economy’s stock of capital goods. It is money that enters the circular flow. An example is spending from firms and the government and not directly from households. Injections lead to an increase in economic activity. If the sum of all the injections are more than the leakages there tends to be expansion or inflation.



Examples of Injections*

Investment Spending: Is when businesses buy capital goods funded by loans from the bank.

Government Spending: Is when the Government buys goods and services from other businesses using net taxes.

Export Spending: Goods leaving the country and money coming in from the selling of the goods.

Resources: Dr.Power's Class Discussion, Principles of Macreconomics.Sayre Morris- Page 92-94, Google Books



Economic Activity

Measures of Economic Activity: Gross Domestic Product (GDP), and Gross National Product (GNP) or Gross National Income (GNI)

Distinguish between GDP and GNP/GNI as measures of economic activity.

Distinguish between the nominal value of GDP and GNP/GNI and the real value of GDP and GNP/GNI.



Economic Activity


Distinguish between total GDP and GNP/GNI and per capita GDP and GNP/GNI.

Examine the output approach, the income approach and the expenditure approach when measuring national income.



Economic Activity


Evaluate the use of national income statistics, including their use for making comparisons over time, their use for making comparisons between countries and their use for making conclusions about standards of living.

Explain the meaning and significance of “green GDP”, a measure of GDP that accounts for environmental destruction.



Economic Activity

Measures of Economic Activity: Gross Domestic Product (GDP)*Pgs. 237-250

GDP is the monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.



Economic Activity

Measures of Economic Activity: Gross Domestic Product (GDP)

GDP is commonly used as an indicator of the economic health of a country, as well as to gauge a country's standard of living. Critics of using GDP as an economic measure say the statistic does not take into account the underground economy - transactions that, for whatever reason, are not reported to the government. Others say that GDP is not intended to gauge material well-being, but serves as a measure of a nation's productivity, which is unrelated.



Economic Activity


Strengths for using GDP:*

GDP is considered the broadest indicator of economic output and growth.

Real GDP takes inflation into account, allowing for comparisons against other historical time periods.

The Bureau of Economic Analysis issues its own analysis document with each GDP release, which is a great investor tool for analyzing figures and trends, and reading highlights of the very lengthy full release



Economic Activity


Weaknesses of using GDP:*

Data is not very timely - it is only released quarterly.

Revisions can change historical figures measurably (the difference between 3% and 3.5% GDP growth is a big one in terms of monetary policy

The Black-markets or underground markets are not included in the data



Economic Activity

Measures of Economic Activity: Gross Domestic Product (GDP)*

How do we calculate it?

GDP = C + G + I + NX



Economic Activity


How do we calculate it? GDP = C + G + I + NX

"C" is equal to all private consumption, or consumer spending, in a nation's economy. Consumption/Consumer Spending



Economic Activity



"G" is the sum of Government Spending.



Economic Activity



"I" is the sum of all the country's businesses spending on capital. Investment



Economic Activity



"NX" is the nation's total net exports, calculated as total exports minus total imports. (NX = Exports - Imports)



Economic Activity

Measures of Economic Activity: Gross National Product (GNP)*

GNP is an economic statistic that includes GDP, plus any income earned by residents from overseas investments, minus income earned within the domestic economy by overseas residents.



Economic Activity

Measures of Economic Activity: Gross National Product (GNP)*

GNP is a measure of a country's economic performance, or what its citizens produced (i.e. goods and services) and whether they produced these items within its borders.



Economic Activity

Measures of Economic Activity: Gross National Income (GNI)*

The sum of a nation’s gross domestic product (GDP) plus net income received from overseas. Gross national income (GNI) is defined as the sum of value added by all producers who are residents in a nation, plus any product taxes (minus subsidies) not included in output, plus income received from abroad such as employee compensation and property income.



Economic Activity

Measures of Economic Activity: Gross National Income (GNI)

GNI measures income received by a country both domestically and from overseas. In this respect, GNI is quite similar to Gross National Product (GNP), which measures output from the citizens and companies of a particular nation, regardless of whether they are located within its boundaries or overseas.



Economic Activity


To convert a nation’s GDP to GNI, three terms need to be added to the former:

1) net compensation receipts,

2) net property income receivable and

3) net taxes (minus subsidies) receivable on production and imports.



Economic Activity


Let’s use Canada’s 2010 GDP and GNI numbers to understand the reconciliation between these two measures of economic output.

Canada’s GDP in 2010 = $1,624.6 million (~ $1.62 billion)

Net compensation receipts = 0



Economic Activity



Net property income receivable = -$28.2 million (note the negative sign)

Net taxes = 0



Economic Activity



Canada’s 2010 GNI = $1,624.6 + (-28.2) = $1,596.4 million (~$1.60 billion)



The Business Cycle

Short-Term Fluctuations and Long-Term Trend Pgs. 254

Explain, using a business cycle diagram, that economies typically tend to go through a cyclical pattern characterized by the phases of the business cycle.

Explain the long-term growth trend in the business cycle diagram as the potential output of the economy.

Distinguish between a decrease in GDP and a decrease in GDP growth.



The Business Cycle

Economies go through a regular pattern of ups and downs in the value of GDP. This is known as the “business cycle”

(sometimes you also see it referred to as the “economic cycle”).



The Business Cycle*

The business cycle is characterized by four main phases:

Boom: high levels of consumer spending, business confidence, profits and investment. Prices and costs also tend to rise faster. Unemployment tends to be low as growth in the economy creates new jobs



The Business Cycle*


Recession: falling levels of consumer spending and confidence mean lower profits for businesses – which start to cut back on investment. Spare capacity increases + rising unemployment as businesses cut back and reduce stocks



The Business Cycle*


Slump /Depression: a prolonged period of declining GDP - very weak consumer spending and business investment; many business failures; rapidly rising unemployment; prices may start falling (deflation)



The Business Cycle*


Recovery: things start to get better; consumers begin to increase spending; businesses feel a little more confident and start to invest again and build stocks; but it takes time for unemployment to stop growing



The Business Cycle*

Timing and shape of the business cycle is affected by many factors, including:

Changes in the level of business and consumer confidence

Alternating periods of stocking and de-stocking

Changes in the value of consumer spending and business investment

Changes in government policy which can induce a change in the economy



The Business Cycle*

There are, however, some drawbacks for an economy that is growing rapidly:

The risk of demand pull inflation if actual growth exceeds potential growth

Increased inequality if the benefits of growth are not evenly distributed

Increased demand for imports and a trade deficit



The Business Cycle (Click for Video)

Economic growth is the increase in the market value of the goods and services produced by an economy over time. It is conventionally measured as the percent rate of increase in real gross domestic product, or real GDP. Of more importance is the growth of the ratio of GDP to population (GDP per capita), which is also called per capita income. An increase in growth caused by more efficient use of inputs is referred to as intensive growth. GDP growth caused only by increases in inputs such as capital, population or territory is called extensive growth.


https://www.youtube.com/watch?v=TXrOpjG4dUs

https://www.youtube.com/watch?v=TXrOpjG4dUs


Theory of Knowledge: Potential Connections

What is the empirical evidence for the existence of the business cycle? How do we decide whether this evidence is sufficient?


Unit 2: Macroeconomics2.2 Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)

The AD Curve Pgs. 257-271

Distinguish between the microeconomic concept of demand for a product and the macroeconomic concept of aggregate demand.

Construct an aggregate demand curve.

Explain why the AD curve has a negative slope.




The AD Curve*

The total amount of goods and services demanded in the economy at a given overall price level and in a given time period. It is represented by the aggregate-demand curve, which describes the relationship between price levels and the quantity of output that firms are willing to provide. Normally there is a negative relationship between aggregate demand and the price level. Also known as "total spending".




The AD Curve*

Aggregate demand is the demand for the gross domestic product (GDP) of a country, and is represented by this formula:

Aggregate Demand (AD) = C + I + G + (X-M) C = Consumers' expenditures on goods and services. I = Investment spending by companies on capital goods. G = Government expenditures on publicly provided goods and services. X = Exports of goods and services. M = Imports of goods and services.




The AD Curve*




The Components of AD

Describe consumption, investment, government spending and net exports as the components of aggregate demand.





There are four components of Aggregate Demand (AD); Consumption (C), Investment (I), Government Spending (G) and Net Exports (X-M).

AD = C + I + G + (X-M)




The Determinants of AD or Causes of Shifts in the AD Curve

Explain how the AD curve can be shifted by changes in consumption due to factors including changes in consumer confidence, interest rates, wealth, personal income taxes (and hence disposable income) and level of household indebtedness.

Explain how the AD curve can be shifted by changes in investment due to factors including interest rates, business confidence, technology, business taxes and the level of corporate indebtedness.




The Determinants of AD or Causes of Shifts in the AD Curve

Explain how the AD curve can be shifted by changes in government spending due to factors including political and economic priorities.

Explain how the AD curve can be shifted by changes in net exports due to factors including the income of trading partners, exchange rates and changes in the level of protectionism.





Four Components of Aggregate Demand (AD)

1) Consumption*

This is made by households, and sometimes consumption accounts for the larger portion of aggregate demand. An increase in consumption shifts the AD curve to the right. (See next slide)




An increase in consumption shifts the AD curve to the right.




The Components of AD: Factors that affect Consumption*

Consumer Confidence – If consumers are confident about future income, job stability, and the economy is growing and stable, spending is likely to increase. However, job insecurity and uncertainty over income is likely to delay spending. An increase in consumer confidence shifts AD to the right.





Interest Rates – Lower interest rates tend to increase consumption because larger goods are usually purchased on credit and if interest rates are low, then its cheaper to borrow. Consumers mostly borrow to buy houses, which is one of the biggest purchases and lower interest rates means lower mortgage payments, so households can spend more on other goods. Some Economists argue that lower interest rates also make saving less attractive, but there is no real evidence. So, lower interest rates increase Aggregate Demand.





• Consumer Debt – If a consumer has a lot of debt, he is unlikely to buy more since he would have to pay his debt off first. Low consumer debt increases consumption and aggregate demand.

Wealth – Wealth are assets held by a household, such as property or stocks. An increase in property is likely increase to consumption.





2) Investment*

This is spending by firms on capital, not households. Investment is the most volatile component of AD. An increase in investment shifts AD to the right in the short run and helps improve the quality and quantity of Factors of Production in the long run




The Components of AD: Factors that affect Investment*

Interest Rates – Firms borrow from banks to make large capital intensive purchases, and if the interest rate decreases, it becomes cheaper for firms to invest and provides incentive for firms to take risk.




The Components of AD: Factors that affect Investment*

Business Confidence – If firms are confident about the economy and its future growth, they are more likely to invest.

Investment Policy – If governments provide incentives such as tax breaks, subsidies, loans at lower interest rates then investment can increase. However, corruption and bureaucracy deters investment.

National Income – As firms increase output, they would need to invest in new machines. This relationship is known as The Accelerator.




The Components of AD Factors that affect Investment*

3) Government Spending

Government spending forms a large total of aggregate demand, and an increase in government spending shifts aggregate demand to the right. Government spending is categorized into transfer payments and capital spending. Transfer payments include pensions and unemployment benefits and capital spending is on things like roads, schools and hospitals. Governments spend to increase the consumption of health services, education and to re-distribute income. They may also spend to increase aggregate demand.





4) Net Exports

Imports are foreign goods bought by consumers domestically, and exports are domestic goods bought abroad. Net exports is the difference between exports and imports, and this factor can be net imports too, if imports are greater than exports. An increase in net exports shifts aggregate demand to the right. The exchange rate and trade policy affects net exports.




Level of National Income

Consumption*

The percentage of national income that goes towards consumption is determined by the nation’s average propensity to consume (APC). APC is found by dividing the level of consumption (C) by the level of national income (Y). APC = C/Y





Savings*

At lower levels of income, households tend to consume with a greater proportion of their income than at higher income levels. The average propensity to save (APS) is savings (S) divided by national income (Y); this tells us the percentage of a nation’s income that is saved. APS = S/Y





Taxes*

All governments collect taxes. The percentage of the nation’s income collected in taxes tells us the average rate of taxation (ART). The ART is found by dividing the total taxes collected in a country (T) by the national income (Y). ART = T/Y





Imports*

Finally, households may consume goods or services produced abroad, which counts as imports to a nation and is thus not included as part of the nations aggregate demand and is subtracted from GDP. The average propensity to import (APM) is a percentage of national income spent on imports. APM = M/Y





All of a nations income goes towards consumption, savings, paying taxes or buying imports. Therefore:

APC + APS + ART + APM = 1

Consumption increases at a decreasing rate with income. The higher the nations income of households, the lower the average propensity to consume.



Aggregate Supply (AS)

The Meaning of Aggregate Supply Pgs. 274-284

Describe the term aggregate supply.

Explain, using a diagram, why the short-run aggregate supply curve (SRAS curve) is upward sloping.

Explain, using a diagram, how the AS curve in the short run (SRAS) can shift due to factors including changes in resource prices, changes in business taxes and subsidies and supply shocks.




The Meaning of Aggregate Supply*

The total supply of goods and services produced within an economy at a given overall price level in a given time period. It is represented by the aggregate-supply curve, which describes the relationship between price levels and the quantity of output that firms are willing to provide. Normally, there is a positive relationship between aggregate supply and the price level. Rising prices are usually signals for businesses to expand production to meet a higher level of aggregate demand.




The Meaning of Aggregate Supply*

A shift in aggregate supply can be attributed to a number of variables. These include changes in the size and quality of labor, technological innovations, increase in wages, increase in production costs, changes in producer taxes and subsidies, and changes in inflation.




Shifts in the AS curve can be caused by the following factors:*

changes in size & quality of the labor force available for production

changes in size & quality of capital stock through investment

technological progress and the impact of innovation




Shifts in the AS curve can be caused by the following factors:*

changes in factor productivity of both labor and capital

changes in unit wage costs (wage costs per unit of output)

changes in producer taxes and subsidies

changes in inflation expectations - a rise in inflation expectations is likely to boost wage levels and cause AS to shift inwards




In the diagram above - the shift from AS1 to AS2 shows an increase in aggregate supply at each price level might have been caused by improvements in technology and productivity or the effects of an increase in the active labor force.

An inward shift in AS (from AS1 to AS3) causes a fall in supply at each price level. This might have been caused by higher unit wage costs, a fall in capital investment spending (capital scrapping) or a decline in the labor force.




The Meaning of Aggregate Supply (SRAS)*

In the short run, aggregate supply responds to higher demand (and prices) by bringing more inputs into the production process and increasing utilization of current inputs. In the long run, however, aggregate supply is not affected by the price level and is driven only by improvements in productivity and efficiency.


https://www.khanacademy.org/economics-finance-domain/macroeconomics/aggregate-supply-demand-topic/aggregate-supply-demand-tut/v/short-run-aggregate-supply

https://www.khanacademy.org/economics-finance-domain/macroeconomics/aggregate-supply-demand-topic/aggregate-supply-demand-tut/v/short-run-aggregate-supply



Alternative Views of Aggregate Supply

Explain, using a diagram, that the monetarist/new classical model of the long- run aggregate supply curve (LRAS) is vertical at the level of potential output (full employment output) because aggregate supply in the long run is independent of the price level.

Explain, using a diagram, that the Keynesian model of the aggregate supply curve has three sections because of “wage/price” downward inflexibility and different levels of spare capacity in the economy.



Aggregate Supply (AS) *


Long run aggregate supply is determined by the productive resources available to meet demand and by the productivity of factor inputs (labor, land and capital).

In the short run, producers respond to higher demand (and prices) by bringing more inputs into the production process and increasing the utilization of their existing inputs. Supply does respond to change in price in the short run.


https://www.youtube.com/watch?v=HGjtcPssfCs




In the long run we assume that supply is independent of the price level (money is neutral) - the productive potential of an economy (measured by LRAS) is driven by improvements in productivity and by an expansion of the available factor inputs (more firms, a bigger capital stock, an expanding active labor force etc.). As a result we draw the long run aggregate supply curve as vertical.




Improvements in productivity and efficiency cause the long-run aggregate supply curve to shift out over the years.




Shifting the Aggregate Supply Curve over the Long Term

Explain, using the two models above, how factors leading to changes in the quantity and/or quality of factors of production (including improvements in efficiency, new technology, reductions in unemployment, and institutional changes) can shift the aggregate supply curve over the long term.




Short Run and Long Run



Equilibrium

Short-Run Equilibrium

Explain, using a diagram, the determination of short-run equilibrium, using the SRAS curve.

Examine, using diagrams, the impacts of changes in short- run equilibrium.



Equilibrium

Equilibrium in the Monetarist/New Classical Model

Explain, using a diagram, the determination of long-run equilibrium, indicating that long-run equilibrium occurs at the full employment level of output.

Explain why, in the monetarist/new classical approach, while there maybe short-term fluctuations in output, the economy will always return to the full employment level of output in the long run.

Examine, using diagrams, the impacts of changes in the long-run equilibrium.



Equilibrium

Equilibrium in the Keynesian Model

Explain, using the Keynesian AD/AS diagram, that the economy may be in equilibrium at any level of real output where AD intersects AS.

Explain, using a diagram, that if the economy is in equilibrium at a level of real output below the full employment level of output, then there is a deflationary (recessionary) gap.



Equilibrium

Equilibrium in the Keynesian Model

Discuss why, in contrast to the monetarist/new classical model, the economy can remain stuck in a deflationary (recessionary) gap in the Keynesian model.

Explain, using a diagram, that if AD increases in the vertical section of the AS curve, then there is an inflationary gap.

Discuss why, in contrast to the monetarist/new classical model, increases in aggregate demand in the Keynesian AD/AS model need not be inflationary, unless the economy is operating close to, or at, the level of full employment.



Equilibrium


Business confidence is a contributing factor to the level of AD. What knowledge issues arise in attempting to measure business confidence?

The Keynesian and Monetarist positions differ on the shape of the AS curve. What is needed to settle this question: empirical evidence (if so, what should be measured?), strength of theoretical argument, or factors external to economics such as political conviction?


Unit 2: Macroeconomics2.3 Macroeconomic objectives

Low Unemployment

The Meaning of Unemployment Pgs. 285-299

Define the term unemployment.

Explain how the unemployment rate is calculated.

Explain the difficulties in measuring unemployment, including the existence of hidden unemployment, the existence of underemployment, and the fact that it is an average and therefore ignores regional, ethnic, age and gender disparities.



Low Unemployment

The Meaning of Unemployment*

Be out of work and willing to accept suitable job (labor) or start an enterprise (prospective entrepreneur) if the opportunity arises, and actively looking for ways to obtain a job or start and enterprise.

~International Labor Organization



Low Unemployment


Full employment and Underemployment: A society is almost never fully employed, but one of the goals is to reach full employment. Full employment has two conditions: Everyone who wants to work is working, and the rate of inflation is stable. When the economy is at full employment, there is no cyclical unemployment but still frictional and structural unemployment. This is defined as natural unemployment.



Low Unemployment


You are only classified as unemployed if you go and register with the government as available for work.

The labor force is defined as those of 16 years of age or older who are employed plus all those who are unemployed seeking work.



Low Unemployment


UR = Unemployment Rate

UR = Number of Unemployed X 100

Labor Force



Low Unemployment

The Meaning of Underemployment*

As unemployment Americans find part time, temporary, and seasonal work, the official unemployment rate could decline. However, this does not necessarily mean more Americans are working in their desired capacity. It will continue to be important to track underemployment- to shed light on the true state of the U.S. workforce, and the millions of Americans who are searching for full-time employment.



Low Unemployment

Consequences of Unemployment

Discuss possible economic consequences of unemployment, including a loss of GDP, loss of tax revenue, increased cost of unemployment benefits, loss of income for individuals, and greater disparities in the distribution of income.

Discuss possible personal and social consequences of unemployment, including increased crime rates, increased stress levels, increased indebtedness, homelessness and family breakdown.



Low Unemployment


Individual Consequences of Unemployment*

Decreased household income and purchasing power

Decreased quality of life (standard of living)

Increased levels of psychological and physical illness, including stress and depression



Low Unemployment


Social Consequences of Unemployment*

Downward pressure on wages for the unemployed.

Increased poverty and crime

Transformation of traditional societies



Low Unemployment


Economic Consequences of Unemployment*

Lower level of Aggregate Demand (AD)

Under utilization of the nations resources

Brain Drain (see WNY 1990’s-Present)



Low Unemployment



Diminished tax base

A turn towards protectionism and isolationist policies

Increased budget deficits

loss of output



Low Unemployment



Increased transfer payments

Increased taxes, increased burden on workers

Increased difficulty for labor market entrants - employers have more choices, they favor experienced workers

Unemployed workers lose their skills, become irrelevant



Low Unemployment


The individual, social and economic consequences of unemployment are not limited to those outlined previously, but it should be clear that the costs of unemployment are wide ranging, thus making low unemployment a worthy and important goal for macroeconomic policy makers.



Low Unemployment

Types and Causes of Unemployment

Describe, using examples, the meaning of frictional, structural, seasonal and cyclical (demand-deficient) unemployment.

Distinguish between the causes of frictional, structural, seasonal and cyclical (demand-deficient) unemployment.



Low Unemployment

Explain, Using a Diagram, that Cyclical Unemployment is Caused by a Fall in Aggregate Demand.

Explain, using a diagram, that structural unemployment is caused by changes in the demand for particular labour skills, changes in the geographical location of industries, and labour market rigidities.

Evaluate government policies to deal with the different types of unemployment



Low Unemployment

Frictional Unemployment*

Frictional unemployment is another type of unemployment within an economy. It is the time period between jobs when a worker is searching for or transitioning from one job to another. Frictional unemployment is always present to some degree in an economy. It occurs when there is a mismatch between the workers and jobs. The mismatch can be related to skills, payment, work time, location, seasonal industries, attitude, taste, and other factors.



Low Unemployment

Frictional Unemployment

Frictional unemployment is influenced by voluntary decisions to work based on each individual's valuation of their own work and how that compares to current wage rates as well as the time and effort required to find a job.



Low Unemployment

Structural Unemployment*

Structural unemployment is one of the main types of unemployment within an economic system. It focuses on the structural problems within an economy and inefficiencies in labor markets. Structural unemployment occurs when a labor market is not able to provide jobs for everyone who is seeking employment. There is a mismatch between the skills of the unemployed workers and the skills needed for the jobs that are available. It is often impacted by persistent cyclical unemployment.



Low Unemployment

Structural Unemployment

For example, when an economy experiences long-term unemployment individuals become frustrated and their skills become obsolete. As a result, when the economy recovers they may not fit the requirements of new jobs due to their inactivity .



Low Unemployment

The Natural Rate of Unemployment (NRU)*

The natural rate of unemployment, sometimes called the structural unemployment rate, was developed by Friedman and Phelps in the 1960s. It represents the hypothetical unemployment rate that is consistent with aggregate production being at a long-run level.



Low Unemployment

The Natural Rate of Unemployment (NRU)*

The natural rate of unemployment is a combination of structural and frictional unemployment. It is present in an efficient and expanding economy when labor and resource markets are at equilibrium. The natural unemployment rate occurs within an economy when disturbances are not present.



Low Unemployment

Cyclical Unemployment*

Cyclical unemployment is a type of unemployment that occurs when there is not enough Aggregate Demand in the economy to provide jobs for everyone who wants to work. In an economy, demand for most goods falls, less production is needed, and less workers are needed. With cyclical unemployment the number of unemployed workers is greater than the number of job vacancies.



Low and Stable Rate of Inflation

The Meaning of Inflation, Disinflation and Deflation Pgs. 300-327

Distinguish between inflation, disinflation and deflation.

Explain that inflation and deflation are typically measured by calculating a consumer price index (CPI), which measures the change in prices of a basket of goods and services consumed by the average household.

Explain that different income earners may experience a different rate of inflation when their pattern of consumption is not accurately reflected by the CPI.




The Meaning of Inflation*

Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. As inflation rises, every dollar you own buys a smaller percentage of a good or service.




The Meaning of Inflation:

The value of a dollar does not stay constant when there is inflation. The value of a dollar is observed in terms of purchasing power, which is the real, tangible goods that money can buy. When inflation goes up, there is a decline in the purchasing power of money. For example, if the inflation rate is 2% annually, then theoretically a $1 pack of gum will cost $1.02 in a year. After inflation, your dollar can't buy the same goods it could beforehand.




The Meaning of Disinflation:*

A slowing in the rate of price inflation. Disinflation is used to describe instances when the inflation rate has reduced marginally over the short term. Although it is used to describe periods of slowing inflation, disinflation should not be confused with deflation.




The Meaning of Disinflation:

Disinflation is commonly used by the Federal Reserve to describe situations of slowing inflation. Instances of disinflation are not uncommon and are viewed as normal during healthy economic times. Although sometimes confused with deflation, disinflation is not considered to be as problematic because prices do not actually drop and disinflation does not usually signal the onset of a slowing economy.




The Meaning of Deflation*

A general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending.




The Meaning of Deflation

The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression. Central banks attempt to stop severe deflation, along with severe inflation, in an attempt to keep the excessive drop in prices to a minimum.





Declining prices, if they persist, generally create a vicious spiral of negatives such as falling profits, closing factories, shrinking employment and incomes, and increasing defaults on loans by companies and individuals. To counter deflation, the Federal Reserve (the Fed) can use monetary policy to increase the money supply and deliberately induce rising prices, causing inflation. Rising prices provide an essential lubricant for any sustained recovery because businesses increase profits and take some of the depressive pressures off wages and debtors of every kind.





Deflationary periods can be both short or long, relatively speaking. Japan, for example, had a period of deflation lasting decades starting in the early 1990's. The Japanese government lowered interest rates to try and stimulate inflation, to no avail. Zero interest rate policy was ended in July of 2006.




The Meaning of the Consumer Price Index (CPI)* AKA “Headline Inflation”

A measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living.




The Meaning of the Consumer Price Index (CPI)

The U.S. Bureau of Labor Statistics measures two kinds of CPI statistics: CPI for urban wage earners and clerical workers (CPI-W), and the chained CPI for all urban consumers (C-CPI-U). Of the two types of CPI, the C-CPI-U is a better representation of the general public, because it accounts for about 87% of the population.




The Meaning of the Consumer Price Index (CPI)

CPI is one of the most frequently used statistics for identifying periods of inflation or deflation. This is because large rises in CPI during a short period of time typically denote periods of inflation and large drops in CPI during a short period of time usually mark periods of deflation.




The Meaning of Inflation, Disinflation and Deflation

Explain that inflation figures may not accurately reflect changes in consumption patterns and the quality of the products purchased.

Explain that economists measure a core/underlying rate of inflation to eliminate the effect of sudden swings in the prices of food and oil, for example.

Explain that a producer price index measuring changes in the prices of factors of production may be useful in predicting future inflation.




The Meaning of Inflation, Disinflation and Deflation*

The Producer Price Index (PPI) is a weighted index of prices measured at the wholesale, or producer level. A monthly release from the Bureau of Labor Statistics (BLS), the PPI shows trends within the wholesale markets (the PPI was once called the Wholesale Price Index), manufacturing industries and commodities markets. All of the physical goods-producing industries that make up the U.S. economy are included, but imports are not.





The PPI release has three headline index figures, one each for crude, intermediate and finished goods on the national level:

1) PPI Commodity Index (crude): This shows the average price change from the previous month for commodities such as energy, coal, crude oil and the steel scrap.






2) PPI Stage of Processing (SOP) Index (intermediate): Goods here have been manufactured at some level but will be sold to further manufacturers to create the finished good. Some examples of SOP products are lumber, steel, cotton and diesel fuel.






3) PPI Industry Index (finished): Final stage manufacturing, and the source of the core PPI.





The core PPI figure is the main attraction, which is the finished goods index minus the food and energy components, which are removed because of their volatility. The PPI percentage change from the prior period and annual projected rate will be the most printed figure of the release.





The PPI looks to capture only the prices that are being paid during the survey month itself. Many companies that do regular business with large customers have long-term contract rates, which may be known now but not paid until a future date. The PPI excludes future values or contract rates.





PPI Strengths:*

Most accurate indicator of future CPI

Long "operating history" of data series





PPI Strengths:*

Good breakdowns for investors in the companies surveyed (mining, commodity info, some services sectors)

Can move the markets positively

Data is presented with and without seasonal adjustment





PPI Weaknesses:*

Volatile elements, such as energy and food, can skew the data.

Not all industries in the economy are covered.




Consequences of Inflation

Discuss the possible consequences of a high inflation rate, including greater uncertainty, redistributive effects, less saving, and the damage to export competitiveness.

Consequences of Deflation

Discuss the possible consequences of deflation, including high levels of cyclical unemployment and bankruptcies.




Consequences of Inflation: Maintaining a Stable Price Level*

Loss of Purchasing Power

Lower Real Interest Rates for Savers

Higher Nominal Interest Rates for Borrowers

Reduction of International Competiveness




Consequences of Deflation: Supply Side Deflation*

Lower Oil Prices

More Productive Labor Force

Appreciation of the Nation’s Currency




Consequences of Deflation: Supply Side Deflation*

Lower Minimum Wage

Better Infrastructure

Lower Corporate taxes




Types and Causes of Inflation

Explain, using a diagram, that demand-pull inflation is caused by changes in the determinants of AD, resulting in an increase in AD.

Explain, using a diagram, that cost-push inflation is caused by an increase in the costs of factors of production, resulting in a decrease in SRAS.

Evaluate government policies to deal with the different types of inflation.




Types and Causes of Inflation: Demand Pull Inflation*

An increase in any of the components of a nations Aggregate Demand (AD) will lead to an increase in the nation’s price level

Demand Pull Inflation is when too many consumers are chasing too few goods (scarcity), so the average price of goods and services in a nation rises




Types and Causes of Inflation: Demand Pull Inflation*

Demand Pull Inflation is illustrated by an outward shift of AD when a nation is at or near it’s full employment level of output.




Types and Causes of Inflation: Cost-Push Inflation*

An Increase in Oil Prices

An increase in the nominal wage rate

Depreciation of the nation’s currency

Natural Disaster or War

Higher taxes on firms



Economic Growth

The Meaning of Economic Growth

Define economic growth as an increase in real GDP.



Economic Growth

The Meaning of Economic Growth*

Define economic growth as an increase in real GDP.

Economic growth is an increase in the total output of goods and services (GDP) in a nation over time



Economic Growth

Causes of Economic Growth

Describe, using a production possibilities curve (PPC) diagram, economic growth as an increase in actual output caused by factors including a reduction in unemployment and increases in productive efficiency, leading to a movement of a point inside the PPC to a point closer to the PPC.

Describe, using a PPC diagram, economic growth as an increase in production possibilities caused by factors including increases in the quantity and quality of resources, leading to outward PPC shifts.



Economic Growth

Causes of Economic Growth: Production Possibilities Curve

A curve depicting all maximum output possibilities for two or more goods given a set of inputs (resources, labor, etc.). The PPF assumes that all inputs are used efficiently.


http://www.khanacademy.org/economics-finance-domain/microeconomics/choices-opp-cost-tutorial/production-possibilities/v/production-possibilities-frontier

http://www.khanacademy.org/economics-finance-domain/microeconomics/choices-opp-cost-tutorial/production-possibilities/v/production-possibilities-frontier


Economic Growth


As indicated on the chart above, points A, B and C represent the points at which production of Good A and Good B is most efficient. Point X demonstrates the point at which resources are not being used efficiently in the production of both goods; point Y demonstrates an output that is not attainable with the given inputs.



Economic Growth


Among others, factors such as labor, capital and technology will affect where the production possibility frontier lies. The PPF is also known as the production possibility or transformation curve.



Economic Growth


Describe, using an LRAS diagram, economic growth as an increase in potential output caused by factors including increases in the quantity and quality of resources, leading to a rightward shift of the LRAS curve.

Explain the importance of investment for economic growth, referring to investment in physical capital, human capital and natural capital.

Explain the importance of improved productivity for economic growth.



Economic Growth

Causes of Economic Growth: Long Run Aggregate Supply (LRAS)

Long run aggregate supply is determined by the productive resources available to meet demand and also by the productivity of factor inputs (labor, land and capital). Changes in technology also affect the potential level of national output in the long run.


http://www.khanacademy.org/economics-finance-domain/macroeconomics/aggregate-supply-demand-topic/aggregate-supply-demand-tut/v/long-run-aggregate-supply





Economic Growth

Causes of Economic Growth: Long Run Aggregate Supply (LRAS)

In the short run, producers respond to higher demand (and prices) by bringing more inputs into the production process and increasing the utilization of their existing inputs. Supply does respond to change in price in the short run - we move up or down the short run aggregate supply curve.



Economic Growth

Causes of Economic Growth:

Long Run Aggregate Supply

(LRAS)



Economic Growth


Sources of Productivity Growth: Physical Capital* Economies with greater quantities of capital per worker experience a greater level

of output per hour of labor and, therefore, a higher level of economic growth. Increases in capital stock result from high levels of private investment, as firms

replace old capital and expand existing factories to meet AD over time.



Economic Growth

Causes of Economic Growth: Physical Capital

Developing human capital alone is not enough to create economic growth. Economies must also invest in developing physical capital. Physical capital is the tools, factories, and equipment that are used in the production process. As the stock of physical capital increases, the nation experiences capital deepening. Capital deepening refers to the amount of capital available to each worker. Capital deepening provides for a more productive labor force. The average American worker is backed by $130,000 worth of physical capital. This is one of the reasons for America's productivity edge.



Economic Growth


Sources of Productivity Growth: Human Capital Human beings are of economic value. They contribute to economic growth of a

firm and the nation. The better educated or trained a worker is, the more productive they are?



Economic Growth

Consequences of Economic Growth

Discuss the possible consequences of economic growth, including the possible impacts on living standards, unemployment, inflation, the distribution of income, the current account of the balance of payments, and sustainability.



Economic Growth

Consequences of Economic Growth: Economic Consequence*

The economic consequence of growth in per capita GDP is an increase in the average level of income and consumption in a nation



Economic Growth

Consequences of Economic Growth: Non-Economic Consequence*

Externalities (both Positive and Negative)

Inflation

Resource Depletion

Structural Unemployment



Economic Growth

Consequences of Economic Growth: Non-Economic Consequence*

Composition of output (capital vs. consumer goods)

Composition of output (military vs Civilian or Guns vs Butter dilemma)

Unequal income distribution

Effect on Balance of Payments



Equity in the Distribution of Income

The Meaning of Equity in the Distribution of Income

Explain the difference between equity in the distribution of income and equality in the distribution of income.

Explain that due to unequal ownership of factors of production, the market system may not result in an equitable distribution of income.




The Meaning of Equity in the Distribution of Income*

Equality vs. Equity Equity refers to fairness in economics. Equity requires a level playing field on which individuals in society can all have a fair shot at

achieving economic success. Equity ultimately promotes greater equality in income distrbution Equality means minimizing the disparities in income and wealth among a nations

households.




Indicators of Income Equality/Inequality

Analyze data on relative income shares of given percentages of the population, including deciles and quintiles.

Draw a Lorenz curve and explain its significance.

Explain how the Gini coefficient is derived and interpreted.




Indicators of Income Equality/Inequality: Lorenz Curve*

A graphical representation of wealth distribution developed by American economist Max Lorenz in 1905. On the graph, a straight diagonal line represents perfect equality of wealth distribution; the Lorenz curve lies beneath it, showing the reality of wealth distribution.





The difference between the straight line and the curved line is the amount of inequality of wealth distribution, a figure described by the Gini coefficient.





Graphical representation of the Gini coefficient

The graph shows that the Gini coefficient is equal to the area marked A divided by the sum of the areas marked A and B. that is, Gini = A / (A + B). It is also equal to 2*A due to the fact that A + B = 0.5 (since the axes scale from 0 to 1)


https://www.youtube.com/watch?v=yN1alTAMo3w

https://www.youtube.com/watch?v=yN1alTAMo3w




The Lorenz curve can be used to show what percentage of a nation's residents possess what percentage of that nation's wealth. For example, it might show that the country's poorest 10% possess 2% of the country's wealth.




Poverty

Distinguish between absolute poverty and relative poverty.

Explain possible causes of poverty, including low incomes, unemployment and lack of human capital.

Explain possible consequences of poverty, including low living standards, and lack of access to health care and education.




Poverty*

A state or condition in which a person or community lacks the financial resources and essentials to enjoy a minimum standard of life and well-being that's considered acceptable in society. Poverty status in the United States is assigned to people that do not meet a certain threshold level set by the Department of Health and Human Services.




Poverty*

Poverty rates in the United Sates, the percentage of U.S. population with poverty status, are calculated by the U.S. Bureau of Census, and precludes institutionalized people, people living in military quarters, those living in college dormitories and individuals under the age of 15. Poverty rates are an important statistic to follow as a global investor, as a high poverty rate is often indicative of larger scale issues within the country in question.




Poverty*

An international monetary threshold under which an individual is considered to be living in poverty. It is calculated by taking the poverty threshold from each country - given the value of the goods needed to sustain one adult - and converting it to dollars. The international poverty line was originally set to roughly $1 a day. When purchasing power parity and all goods consumed are considered in the calculation of the line, it allows organizations to determine which populations are considered to be in absolute poverty.




Poverty*

Using the international poverty line to determine how well off a population is can be misleading, as the line can be low enough that adding a small amount of additional income will not create an appreciable difference in a person's quality of life. In addition, it can be difficult to quantify other indicators, such as education and health, thus masking the total economic impact on a population.




Causes of Poverty*

Poverty is explained by individual circumstances and/or characteristics of poor people. Some examples are:

Amount of education, skill, experience, intelligence & access

Health, handicaps, age, mental health.


http://www.globalissues.org/issue/2/causes-of-poverty



Causes of Poverty*

Poverty is explained by individual circumstances and/or characteristics of poor people. Some examples are:

Work orientation, time horizon, culture of poverty (generational).

Discrimination, together with race, sex, etc.


http://www.globalissues.org/issue/2/causes-of-poverty



Consequences of Poverty*

The effects of poverty are most often interrelated so that one problem hardly ever occurs alone. For instance, bad sanitation makes it easier to spread around old and new diseases, and hunger and lack of water make people more vulnerable to them.

Impoverished communities often suffer from discrimination and end up caught in cycles of poverty. Let's find out just what this means concretely.


http://www.poverties.org/effects-of-poverty.html



Consequences of Poverty*

Homelessness, poor health, hunger—poverty’s consequences can be severe. Growing up in poverty can harm children’s well-being and development and limit their opportunities and academic success. And poverty imposes huge costs on society through lost productivity and higher spending on health care and incarceration.




The Role of Taxation in Promoting Equity

Distinguish between direct and indirect taxes, providing examples of each, and explain that direct taxes may be used as a mechanism to redistribute income.

Distinguish between progressive, regressive and proportional taxation, providing examples of each.




The Role of Taxation in Promoting Equity: Direct Taxes*

A tax that is paid directly by an individual or organization to the imposing entity. A taxpayer pays a direct tax to a government for different purposes, including real property tax, personal property tax, income tax or taxes on assets. Direct taxes are different from indirect taxes, where the tax is levied on one entity, such as a seller, and paid by another, such a sales tax paid by the buyer in a retail setting.




The Role of Taxation in Promoting Equity: Direct Taxes*

A direct tax cannot be shifted to another individual or entity. The individual or organization upon which the tax is levied is responsible for the fulfillment of the tax payment. Indirect taxes, on the other hand, can be shifted from one taxpayer to another.




The Role of Taxation in Promoting Equity: Indirect Taxes*

A direct tax cannot be shifted to another individual or entity. The individual or organization upon which the tax is levied is responsible for the fulfillment of the tax payment. Indirect taxes, on the other hand, can be shifted from one taxpayer to another.





Indirect taxes can also be defined as fees that are levied equally upon taxpayers, no matter their income. This is a primary reason why they are thought of as taxes that are passed on, as the price of the tax is compensated for by simply increasing the overall price of the good or service. Some economists argue that indirect taxes lead to an inefficient marketplace and alter market prices that don't match their equilibrium price.





A tax that increases the price of a good so that consumers are actually paying the tax by paying more for the products. An indirect tax is most often thought of as a tax that is shifted from one taxpayer to another, by way of an increase in the price of the good. Fuel, liquor and cigarette taxes are all considered examples of indirect taxes, as many argue that the tax is actually paid by the end consumer, by way of a higher retail price.




Other Measures to Promote Equity

Explain that governments undertake expenditures to provide directly, or to subsidize, a variety of socially desirable goods and services (including health care services, education, and infrastructure that includes sanitation and clean water supplies), thereby making them available to those on low incomes.

Explain the term transfer payments, and provide examples, including old age pensions, unemployment benefits and child allowances.




Other Measures to Promote Equity: Transfer Payments*

In the United States, a payment made to individuals by the federal government through various social benefit programs.

In Canada, a payment made to the provinces and territories by the federal government.




Other Measures to Promote Equity: Transfer Payments*

Transfer payments are made by the U.S. Federal Government to individuals through programs such as Social Security, Welfare and Veteran's benefits.

Transfer payments are made by the Canadian Federal Government to the provinces and territories through the Equalization Program, Canada Health Transfer and Canada Social Transfer.




The Relationship Between Equity and Efficiency

Evaluate government policies to promote equity (taxation, government expenditure and transfer payments) in terms of their potential positive or negative effects on efficiency in the allocation of resources.




The Relationship Between Equity and Efficiency: Transfer Payments*

In economics, a transfer payment (or government transfer or simply transfer) is a redistribution of income in the market system. These payments are considered to be non-exhaustive because they do not directly absorb resources or create output. In other words, the transfer is made without any exchange of goods or services. Examples of certain transfer payments include welfare (financial aid), social security, and government making subsidies for certain businesses (firms).




The Relationship Between Equity and Efficiency: Transfer Payments*

Transfer payments are not a part of the national income so they are cut from national income to get n.n.p in order to arrive national income such payments are bad debts incurred by banks, payments of pensions, charity, scholarships etc. In the UK they have several transfer payments such as EMA and a job seeker's allowance.




What criteria can be used to order macroeconomic objectives in terms of priority? Are such criteria external to economics (that is, normative)?

Is economic growth always beneficial? What could be meant by the word “beneficial”?

Is there always a cost to economic growth?




The notion of fairness can be approached from a number of perspectives—equality of opportunity, maximizing the income of the least well-off group, and absolute equality of income. Which of these notions seems to be most attractive? Why? Examine what each of these perspectives suggests is a fair distribution of income.




Equality of opportunity implies correcting for social advantage (for example, government might devote more resources to the education of a child brought up in less prosperous circumstances than one brought up in a comfortable home whose parents are university lecturers). How far should the state go in making such corrections? Should all parents be forced to read to their children so that no child should be at a disadvantage? Should the state attempt to correct for the uneven distribution of natural abilities such as IQ (intelligence quotient) by devoting proportionally more resources to children of less than average IQ.


Unit 2: Macroeconomics2.4 Fiscal policy

The Government Budget

Sources of Government Revenue

Explain that the government earns revenue primarily from taxes (direct and indirect), as well as from the sale of goods and services and the sale of state-owned (government- owned) enterprises.




Sources of Government Revenue*

Government revenue is money received by a government. It is an important tool of the fiscal policy of the government and is the opposite factor of government spending. Revenues earned by the government are received from sources such as taxes levied on the incomes and wealth accumulation of individuals and corporations and on the goods and services produced, exports and imports, non-taxable sources such as government-owned corporations' incomes, central bank revenue and capital receipts in the form of external loans and debts from international financial institutions.




Types of Government Expenditures

Explain that government spending can be classified into current expenditures, capital expenditures and transfer payments, providing examples of each.




Types of Government Expenditures*

Government spending or expenditure includes all government consumption, investment, and transfer payments. In national income accounting the acquisition by governments, of goods and services for current use, to directly satisfy the individual or collective needs of the community, is classed as government final consumption expenditure.





Government acquisition of goods and services intended to create future benefits, such as infrastructure investment or research spending, is classed as government investment (government gross capital formation). These two types of government spending, on final consumption and on gross capital formation, together constitute one of the major components of gross domestic product.





Government spending can be financed by government borrowing or taxes. Changes in government spending are a major component of fiscal policy used to stabilize the macroeconomic business cycle.




The Budget Outcome

Distinguish between a budget deficit, a budget surplus and a balanced budget.

Explain the relationship between budget deficits/ surpluses and the public (government) debt.




The Budget Outcome: Budget Deficit (loss of money)*

A status of financial health in which expenditures exceed revenue. The term "budget deficit" is most commonly used to refer to government spending rather than business or individual spending. When referring to accrued federal government deficits, the term "national debt” is used.





The opposite of a budget deficit is a budget surplus, and when inflows equal outflows, the budget is said to be balanced.




The Budget Outcome: Budget Deficit (loss of money)

In the early 20th century, few industrialized countries had large fiscal deficits. This changed during the First World War, a time in which governments borrowed heavily and depleted financial reserves. Industrialized countries reduced these deficits until the 1960s and 1970s despite years of steady economic growth.





Budget deficits as a percentage of GDP may decrease in times of economic prosperity, as increased tax revenue, lower unemployment and economic growth reduce the need for government programs such as unemployment insurance. If investors expect higher inflation rates, which would reduce the real value of debt, they are likely to require higher interest rates on future loans to governments.




The Budget Outcome: Budget Deficit (loss of money)

Countries can counter budget deficits by promoting economic growth, reducing government spending and increasing taxes. By reducing onerous regulations and simplifying tax regimes, a country can improve business confidence, thereby prompting improved economic conditions while increasing treasury inflows from taxes. Reducing government expenditures, including on social programs and defense, and reforming entitlement programs, such as state pensions, can result in less borrowing.




The Budget Outcome: Budget Surplus (excess of money)*

A situation in which income exceeds expenditures. The term "budget surplus" is most commonly used to refer to the financial situations of governments; individuals speak of "savings" rather than a "budget surplus." A surplus is considered a sign that government is being run efficiently. A budget surplus might be used to pay off debt, save for the future, or to make a desired purchase that has been delayed. A city government that had a surplus might use the money to make improvements to a run-down park, for example.




The Budget Outcome: Budget Surplus (excess of money)

When spending exceeds income, the result is a budget deficit, which must be financed by borrowing money and paying interest on the borrowed funds, much like an individual spending more than he can afford and carrying a balance on a credit card. A balanced budget occurs when spending equals income. The U.S. government has only had a budget surplus in a few years since 1950. The Clinton administration (1993-2001) famously cured a large budget deficit and created a surplus in the late 1990s.




The Budget Outcome: Balanced Budget (equality of money)*

A situation in financial planning or the budgeting process where total revenues are equal to or greater than total expenses. A budget can be considered balanced in hindsight, after a full year's worth of revenues and expenses have been incurred and recorded; a company's operating budget for an upcoming year can also be called balanced based on predictions or estimates.




The Budget Outcome: Balanced Budget (equality of money)

The phrase "balanced budget" is commonly used in reference to official government budgets. For example, governments may issue a press release stating that they have a balanced budget for the upcoming fiscal year, or politicians may campaign on a promise to balance the budget once in office.




The Budget Outcome: Balanced Budget (equality of money)

It is important to understand that the phrase "balanced budget" can refer to either a situation where revenues equal expenses or where revenues exceed expenses, but not where expenses exceed revenues.




The Role of Fiscal Policy

Fiscal Policy and Short-Term Demand Management

Explain how changes in the level of government expenditure and/or taxes can influence the level of aggregate demand in an economy.

Describe the mechanism through which expansionary fiscal policy can help an economy close a deflationary (recessionary) gap.





Fiscal Policy and Short-Term Demand Management*

Government spending policies that influence macroeconomic conditions. Through fiscal policy, regulators attempt to improve unemployment rates, control inflation, stabilize business cycles and influence interest rates in an effort to control the economy






Fiscal policy is largely based on the ideas of British economist John Maynard Keynes (1883–1946), who believed governments could change economic performance by adjusting tax rates and government spending.






To illustrate how the government could try to use fiscal policy to affect the economy, consider an economy that’s experiencing a recession. The government might lower tax rates to try to fuel economic growth. If people are paying less in taxes, they have more money to spend or invest. Increased consumer spending or investment could improve economic growth. Regulators don’t want to see too great of a spending increase though, as this could increase inflation.






Another possibility is that the government might decide to increase its own spending – say, by building more highways. The idea is that the additional government spending creates jobs and lowers the unemployment rate. Some economists, however, dispute the notion that governments can create jobs, because government obtains all of its money from taxation – in other words, from the productive activities of the private sector.






One of the many problems with fiscal policy is that it tends to affect particular groups disproportionately. A tax decrease might not be applied to taxpayers at all income levels, or some groups might see larger decreases than others. Likewise, an increase in government spending will have the biggest influence on the group that is receiving that spending, which in the case of highway spending would be construction workers..






Fiscal policy and monetary policy are two major drivers of a nation’s economic performance. Through monetary policy, a country’s central bank influences the money supply. Regulators use both policies to try to boost a flagging economy, maintain a strong economy or cool off an overheated economy.






Construct a diagram to show the potential effects of expansionary fiscal policy, outlining the importance of the shape of the aggregate supply curve.

Describe the mechanism through which contractionary fiscal policy can help an economy close an inflationary gap.

Construct a diagram to show the potential effects of contractionary fiscal policy, outlining the importance of the shape of the aggregate supply curve.





In Panel (a), the economy faces a recessionary gap (YP − Y1). An expansionary fiscal policy seeks to shift aggregate demand to AD2 to close the gap.

In Panel (b), the economy faces an inflationary gap (Y1 − YP). A contractionary fiscal policy seeks to reduce aggregate demand to AD2 to close the gap.





The Impact of Automatic Stabilizers

Explain how factors including the progressive tax system and unemployment benefits, which are influenced by the level of economic activity and national income, automatically help stabilize short-term fluctuations.





The Impact of Automatic Stabilizers*

Economic policies and programs that are designed to offset fluctuations in a nation's economic activity without intervention by the government or policymakers. The best-known automatic stabilizers are corporate and personal taxes, and transfer systems such as unemployment insurance and welfare. Automatic stabilizers are so called because they act to stabilize economic cycles and are automatically triggered without explicit government intervention.





The Impact of Automatic Stabilizers

Automatic stabilizers act in a manner that is against the prevailing economic trend. For example, in a progressive taxation structure, the share of taxes in national income falls when the economy is booming and rises when the economy is in a slump. This has the effect of cushioning the economy from changes in the business cycle. Similarly, total net transfer payments such as unemployment insurance decline when the economy is in an expansionary phase, and rise when the economy is mired in recession.





Fiscal Policy and its Impact on Potential Output

Explain that fiscal policy can be used to promote long-term economic growth (increases in potential output) indirectly by creating an economic environment that is favorable to private investment, and directly through government spending on physical capital goods and human capital formation, as well as provision of incentives for firms to invest.





Evaluation of Fiscal Policy

Evaluate the effectiveness of fiscal policy through consideration of factors including the ability to target sectors of the economy, the direct impact on aggregate demand, the effectiveness of promoting economic activity in a recession, time lags, political constraints, crowding out, and the inability to deal with supply- side causes of instability.



Theory of knowledge: Potential Connections

In one sense the imposition of taxes by government on individuals amounts to a restriction of individual freedom. How can we know when such government interference in individual freedom is justified?


Unit 2: Macroeconomics2.5 Monetary policy

Interest Rates

Interest Rate Determination and the Role of a Central Bank

Describe the role of central banks as regulators of commercial banks and bankers to governments.

Explain that central banks are usually made responsible for interest rates and exchange rates in order to achieve macroeconomic objectives.

Explain, using a demand and supply of money diagram, how equilibrium interest rates are determined, outlining the role of the central bank in influencing the supply of money.



Interest Rates

Interest Rate Determination and the Role of a Central Bank*

The actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates. Monetary policy is maintained through actions such as increasing the interest rate, or changing the amount of money banks need to keep in the vault (bank reserves).



Interest Rates


In the United States, the Federal Reserve is in charge of monetary policy. Monetary policy is one of the ways that the U.S. government attempts to control the economy. If the money supply grows too fast, the rate of inflation will increase; if the growth of the money supply is slowed too much, then economic growth may also slow. In general, the U.S. sets inflation targets that are meant to maintain a steady inflation of 2% to 3%.



Interest Rates

Interest Rate Determination and the Role of a Central Bank*

Monetary policy operates by steering short-term interest rates, thereby influencing economic developments, in order to maintain price stability for the euro area over the medium term.



Interest Rates


The ECB has adopted a specific strategy to ensure the successful conduct of monetary policy. The ECB has defined price stability as a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area of below 2%. In the pursuit of price stability, the ECB aims at maintaining inflation rates below, but close to, 2% over the medium term.

The strategy also includes an analytical framework for the assessment of all relevant information and analysis needed to take monetary policy decisions. This framework is based on two pillars: economic analysis and monetary analysis



Interest Rates


The primary objective of the ECB’s monetary policy is to maintain price stability. This is the best contribution monetary policy can make to economic growth and job creation.

Monetary policy decisions are taken by the ECB's Governing Council. The Council meets every month to analyse and assess economic and monetary developments and the risks to price stability and to decide on the appropriate level of the key interest rates, based on the ECB's strategy.



The Role of Monetary Policy

Monetary Policy and Short-Term Demand Management

Explain how changes in interest rates can influence the level of aggregate demand in an economy.

Describe the mechanism through which easy (expansionary) monetary policy can help an economy close a deflationary (recessionary) gap.




Monetary Policy and Short-Term Demand Management*

One of several specific aggregate demand determinants assumed constant when the aggregate demand curve is constructed, and that shifts the aggregate demand curve when it changes. An increase in interest rates cause a decrease (leftward shift) of the aggregate curve. A decrease in interest rates an increase (rightward shift) of the aggregate curve. Other notable aggregate demand determinants include the federal deficit, inflationary expectations, and the money supply.





Interest rates are the annual charge for borrowing funds, usually specified as a percent of the amount borrowed. Changes in interest rates affect the overall expense of borrowing and thus expenditures undertaken with the borrowed funds. Higher interest rates tend to decrease expenditures and lower interest rates lead to an increase in expenditures.





Suppose, for example, that the Federal Reserve System decides to implement expansionary monetary policy. Fearing an impending recession on the business-cycle horizon, they decide to expand the money supply with a corresponding decrease in interest rates





A decline in interest rates can entice the business sector to boost investment expenditures. For example, a 1 percentage point interest rate decline (such as from 10 percent to 9 percent) can reduce the total interest cost on a $10 million construction loan by $300,000 over a five-year repayment period. This saving is bound to convince a few firms to undertake extra investment expenditures.





Alternatively, the Federal Reserve System might decide to implement contractionary monetary policy. Fearing the onset of higher inflation, the Fed might decide to reduce the money supply and subsequently increase interest rates. Higher interest rates have the opposite effect on both business investment and household consumption as lower rates. The interest cost of constructing a new factory is higher. So too is the interest expense of buying a new car.





Construct a diagram to show the potential effects of easy (expansionary) monetary policy, outlining the importance of the shape of the aggregate supply curve.

Describe the mechanism through which tight (contractionary) monetary policy can help an economy close an inflationary gap.

Construct a diagram to show the potential effects of tight (contractionary) monetary policy, outlining the importance of the shape of the aggregate supply curve.




Monetary Policy and Short-Term Demand Management: Expansionary




Monetary Policy and Short-Term Demand Management: Expansionary

Lower the discount rate

Buy bonds on the open market

Lower the reserve ratio




Monetary Policy and Short-Term Demand Management:

Expansionary Monetary Policy

Achieves: Increased growth, reduced unemployment

But risks: Inflation Lower exchange rate= expensive imports




Monetary Policy and Short-Term Demand Management: Contractionary




Monetary Policy and Short-Term Demand Management: Contractionary

Raise the discount rate

Sell bonds on the open market

Raise the reserve ratio




Monetary Policy and Short-Term Demand Management:

Contrationary Monetary Policy

Achieves: Reduced Inflation

But risks: Reduced Growth & Increased Unemployment Lower exchange rate= reduced exports




Monetary Policy and Inflation Targeting

Explain that central banks of certain countries, rather than focusing on the maintenance of both full employment and a low rate of inflation, are guided in their monetary policy by the objective to achieve an explicit or implicit inflation rate target.





The central bank responsible for the monetary system of the European Union (EU) and the euro currency. The bank was formed in Germany in June 1998 and works with the other national banks of each of the EU members to formulate monetary policy that helps maintain price stability in the European Union.





The European Central Bank has been responsible for the monetary policy of the European Union since January 1, 1999, when the euro currency was adopted by the EU members. The responsibilities of the ECB are to formulate monetary policy, conduct foreign exchange, hold currency reserves and authorize the issuance of bank notes, among many other things.




Evaluation of Monetary Policy

Evaluate the effectiveness of monetary policy through consideration of factors including the independence of the central bank, the ability to adjust interest rates incrementally, the ability to implement changes in interest rates relatively quickly, time lags, limited effectiveness in increasing aggregate demand if the economy is in deep recession and conflict among government economic objectives.




Evaluation of Monetary Policy: Stimulating Growth During Recession; Strengths

Speed: quick to react to the economy

Control: Have no distractions or long debates on policy

No politics: the economy is bigger than party politics

No Crowding Out: Consumers and Government will have equal access




Evaluation of Monetary Policy: Stimulating Growth During Recession; Weaknesses

Investors are reluctant to borrow: interest rates scare off investors

Time Lags: some time needs to be allowed for implementation

Changes in elasticity of investment: decrease in interest rates may cause delay in investment.


Unit 2: Macroeconomics2.6 Supply-Side Policies

The Role of Supply-Side Policies

Supply-Side Policies and the Economy

Explain that supply-side policies aim at positively affecting the production side of an economy by improving the institutional framework and the capacity to produce (that is, by changing the quantity and/or quality of factors of production).

State that supply-side policies may be market-based or interventionist, and that in either case they aim to shift the LRAS curve to the right, achieving growth in potential output.




Supply-Side Policies and the Economy*

Supply-side economics is better known to some as "Reaganomics," or the "trickle-down" policy espoused by 40th U.S. President Ronald Reagan. He popularized the controversial idea that greater tax cuts for investors and entrepreneurs provide incentives to save and invest, and produce economic benefits that trickle down into the overall economy.




Supply-Side Policies and the Economy*

Like most economic theories, supply-side economics tries to explain both macroeconomic phenomena and - based on these explanations - offer policy prescriptions for stable economic growth. In general, supply-side theory has three pillars: tax policy, regulatory policy and monetary policy.





However, the single idea behind all three pillars is that production (i.e. the "supply" of goods and services) is most important in determining economic growth. The supply-side theory is typically held in stark contrast to Keynesian theory which, among other facets, includes the idea that demand can falter, so if lagging consumer demand drags the economy into recession, the government should intervene with fiscal and monetary stimuli.





This is the single big distinction: a pure Keynesian believes that consumers and their demand for goods and services are key economic drivers, while a supply-sider believes that producers and their willingness to create goods and services set the pace of economic growth





In economics we review the supply and demand curves. The left-hand chart below illustrates a simplified macroeconomic equilibrium: aggregate demand and aggregate supply intersect to determine overall output and price levels. (In this example, output may be gross domestic product and the price level may be the Consumer Price Index.) The right-hand chart illustrates the supply-side premise: an increase in supply (i.e. production of goods and services) will increase output and lower prices.





Supply-side actually goes further and claims that demand is largely irrelevant. It says that over-production and under-production are not sustainable phenomena. Supply-siders argue that when companies temporarily "over-produce," excess inventory will be created, prices will subsequently fall and consumers will increase their purchases to offset the excess supply.



Interventionist Supply-Side Policies

Investment in Human Capital

Explain how investment in education and training will raise the levels of human capital and have a short-term impact on aggregate demand, but more importantly will increase LRAS.




Investment in Human Capital*

A measure of the economic value of an employee's skill set. This measure builds on the basic production input of labor measure where all labor is thought to be equal. The concept of human capital recognizes that not all labor is equal and that the quality of employees can be improved by investing in them. The education, experience and abilities of an employee have an economic value for employers and for the economy as a whole.




Investment in Human Capital

Economist Theodore Schultz invented the term in the 1960s to reflect the value of our human capacities. He believed human capital was like any other type of capital; it could be invested in through education, training and enhanced benefits that will lead to an improvement in the quality and level of production.




Investment in New Technology

Explain how policies that encourage research and development will have a short-term impact on aggregate demand, but more importantly will result in new technologies and will increase LRAS.




Investment in New Technology

Spending on capital goods such as new factories & other buildings machinery & vehicles

Much new investment includes advances in technology

Investment is an important component of AD, and is a factor affecting competitiveness of a country in a globalizing world

In market economies, most investment is done by private sector businesses but a substantial amount of new capital is purchased by the government (state sector)




Investment in Infrastructure

Explain how increased and improved infrastructure will have a short-term impact on aggregate demand, but more importantly will increase LRAS.




Investment in Infrastructure*

The basic physical systems of a business or nation. Transportation, communication, sewage, water and electric systems are all examples of infrastructure. These systems tend to be high-cost investments, however, they are vital to a country's economic development and prosperity. Infrastructure projects may be funded publicly, privately or through public-private partnerships.





Sometimes private companies will choose to invest in a country's infrastructure development as part of a business expansion effort. For example, an energy company might build pipelines and railways in a country where it wants to refine petroleum. This investment can benefit both the company and the country.





Infrastructure is also an asset class that tends to be less volatile than equities over the long term and generally provides a higher yield. As a result, some companies and individuals like to invest in infrastructure for its defensive characteristics. Individuals and institutions can invest in infrastructure through infrastructure funds and can even choose specialized funds, such as those that invest in transportation infrastructure or water infrastructure.




Industrial Policies

Explain that targeting specific industries through policies including tax cuts, tax allowances and subsidized lending promotes growth in key areas of the economy and will have a short-term impact on aggregate demand but, more importantly, will increase LRAS.




Industrial Policies*

The Industrial Policy plan of a country, sometimes shortened IP, is its official strategic effort to encourage the development and growth of the manufacturing sector of the economy. The government takes measures "aimed at improving the competitiveness and capabilities of domestic firms and promoting structural transformation." A country's infrastructure (transportation, telecommunications and energy industry) is a major part of the manufacturing sector that usually has a key role in IP. It is also the case that industries fail dismally to add to such a growing body of manufacturing industries.




Industrial Policies

Industrial policies are sector specific, unlike broader macroeconomic policies. They are often considered to be interventionist as opposed to laissez-faire economics. Examples of horizontal, economy wide policies are tightening credit or taxing capital gain, while examples of vertical, sector-specific policies comprise protecting textiles from imports or subsidizing export industries. Free market advocates consider industrial policies as interventionist measures typical of mixed economy countries.



Market-Based Supply-Side Policies

Policies to Encourage Competition

Explain how factors including deregulation, privatization, trade liberalization and anti- monopoly regulation are used to encourage competition.





Supply-side policies are mainly micro-economic policies designed to make markets and industries operate more efficiently and contribute to a faster underlying-rate of growth of real national output

Successful policies have the effect of shifting the LRAS curve to the right leading to a rise in potential output





Most governments believe that improved supply-side performance is the key to achieving sustained growth without causing a rise in inflation.

Supply-side reform on its own is not enough to achieve this growth. There must also be a high enough level of AD so that the productive capacity of an economy is actually brought into play.





Key concepts to focus on are incentives, enterprise, technology, mobility, flexibility and efficiency.

Improve incentives and invest in people’s skills

Increase labor and capital productivity

Increase the occupational and geographical mobility of labor





Increase capital investment and research and development spending by firms

Promoting more competition and stimulate a faster pace of invention and innovation

Provide a platform for sustained non-inflationary growth of an economy

Encourage the start-up and expansion of new businesses / enterprises




Labor Market Reforms

Explain how factors including reducing the power of labour unions, reducing unemployment benefits and abolishing minimum wages are used to make the labour market more flexible (more responsive to supply and demand).




Labor Market Reforms:

Cutting government spending and taxes and policies to cut government borrowing

Laws to control trade union powers

Reducing red-tape to cut the costs of doing business

Measures to improve the flexibility of the labour market / reforming employment laws





Policies to boost competition such as deregulation and tough anti-monopoly and anti-cartel laws

Privatization of state assets (selling off public sector businesses into the private sector)

Opening up an economy to overseas trade and investment

Opening up an economy to inward labor migration





Many of the traditional legal protections enjoyed by the trade unions have been taken away – including restrictions on their ability to take industrial action. The result has been a decrease in strike action in virtually every industry and a significant improvement in industrial relations in the UK

Improved partnerships between trade unions and employers can make a big contribution to raising productivity and improving the flexibility of workers in their jobs




Incentive-Related Policies

Explain how factors including personal income tax cuts are used to increase the incentive to work, and how cuts in business tax and capital gains tax are used to increase the incentive to invest.





Economists who support supply-side policies believe that lower rates of income tax provide a short-term boost to demand, and they improve incentives for people to work longer hours or take a new job – because they get to keep more of the money they earn.

Cutting tax rates for lower paid workers may help to reduce the extent of the ‘unemployment trap’ – where people calculate that they may be no better off from working than if they stay outside the labor force.





Do lower taxes always help to increase the active labour supply in the economy? It seems obvious that lower taxes should boost the incentive to work because tax cuts increase the reward from a job. But some people may choose to work the same number of hours and simply take a rise in their post-tax income! Millions of other workers have little choice over the hours that they work.



Evaluation of Supply-Side Policies

The Strengths and Weaknesses of Supply- Side Policies

Evaluate the effectiveness of supply-side policies through consideration of factors including time lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on economic growth, the impact on the government budget, the effect on equity, and the effect on the environment.





Recessions are often the result of negative demand-side shocks that hit real incomes of consumers and demand and profits for businesses

The consequences show through in higher unemployment, a fall in capital investment and an increasing rate of business failures





There is a danger that a deep recession and slow recovery will have harmful effects on the supply side leading to a reduction in the growth rate of potential GDP and a loss of productive capacity. This is known as a hysteresis effect

Most macroeconomic policies in a recession center on boosting demand and confidence in a bid to generate a rebound in output, jobs and incomes within the circular flow and prevent hysteresis




How can we know whether government should support pure research, which might contribute to the sum total of human knowledge but which might never have an impact on technology? What other knowledge issues are relevant to investment in pure research?

Investment in education and training is a common supply-side policy. What other reasons could there be for supporting the education of the population? What knowledge issues arise in answering the question as to whether government should shoulder this responsibility or whether it should be left to the market?


IB Economics SL Unit 2: Macroeconomics Mr. R.S. Pyszczek, Jr. City Honors School IB Economics SL:...

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Transcript of IB Economics SL Unit 2: Macroeconomics Mr. R.S. Pyszczek, Jr. City Honors School IB Economics SL:...