The Circular Flow of Income
1) Closed, ungoverned, spendthrift 2 sector model
(Refer to diagram 1)
Therefore in equilibrium for this to go on forever, Y must equal C. An economy is in equilibrium when
there are no forces at work trying to change output, incomes, employment and prices.
2) Closed, ungoverned, frugal 2 sector model
(Refer to diagram 2)
3) Three sector closed economy
(Refer to diagram 3)
4) The Open Governed Economy
(Refer to diagram 4)
The Objectives of Macroeconomics
There are four main areas of concern:
1) The level of output
4) The foreign sector
The Level of Output
There is a need to maintain a high level of output and also to maintain a steady growth of this output. This
output has to be measured in terms of the value of all the goods and services that are produced, this is called
gross domestic product (GDP). The value of GDP fluctuates over time due to the business cycle. (Refer to
The Concept of Potential OutpuO (P )
This represents the possible combinations of goods and services which can be produced when all the
factors of production in the economy are fully employed. It can be measured as a certain level of real
GDP or recognized as a point on the country’s production possibility frontier (PPF). (Refer to diagram 6) If the actual GDP is less than O then the economy experiences unemployment but if the actual GDP
(Nominal) is greater than POthen the country experiences inflation.
The aim must be to maintain a high level of employment and a low level on involuntary unemployment. The
more people there are at work, the higher the level of output (Real GDP) and therefore the higher the
standard of living.
The level of employment is the number of people at work. The working populations or labor force consists of
those people generally between 16 and 65 who are at work or who wish to work. Excluded from the working
population are those who choose not to work (voluntary unemployed), those of independent means (the rich),
and the home makers (housewives).
Recently the proportion of 16 to 65 year olds in the working population (sometimes called the activity ratio)
has been increasing due to the number of women wishing to work. Unemployment is the proportion of the
working population which is out of work and seeking work. This proportion varies greatly over time.
The aim is to maintain stable price levels which will maintain the value of the money system inside the
country. Prices are measured by the consumer price index (CPI) and inflation is measured by changes in the
CPI. A fall in prices is called deflation. Disinflation is a fall in the rate of inflation.
But in some circumstances rising prices can be an incentive.
E.G. Rising Prices Higher money profitsEncourages a higher outputMore employment
Thus it is not necessary for prices to remain constant and it may be quite good to have gently increasing price
levels and therefore some rates of inflation are acceptable.
The Foreign Sector
During the last 9 years the value of the U.S. dollar has fallen by over 30 percent against the Euro. Changing
exchange rates can create problems E.G. if the U.S. dollar depreciates then U.S. exports become cheaper and
U.S. imports more expensive which is bad for Americans but good for America’s balance of payments.
Currency values can change for many reasons not just trade related reasons E.G. if there are concerns about
the strength of a country’s economy or the willingness of a government to intervene in order to keep the
currency strong. The Instruments of Macroeconomic Policy
These instruments are anything which achieves an economic objective which has been set by the government
E.G. reducing the level of unemployment. There are four main types of policies:
1) Fiscal policies
2) Monetary policies
3) Foreign policies
4) Income policies
This refers to the levels of taxation, how taxation is distributed, and the level of government spending (which
determines how mixed the economy is). The level of taxation and/or government spending helps to determine
the level of national income or GDP and taxes reduce a household’s disposable income which in turn reduces
consumption which reduces GDP.
These include managing the money supply, the banking system, and the level of credit available. Changes in
the money supply affect the price of money which is the rate of interest which affects the level of investment
and therefore the level of GDP. Thus higher rates of interest will cause a fall in GDP via the monetary
mechanism and this will reduce inflation. Lower rates of interest will increase GDP and therefore reduce
This concerns trading policies E.G. the level of tariffs (import taxes/duties) and the level of quotas and also
exchange rate management which is used to affect the price of a country’s currency.
In reality these are wages and prices policies which are designed to reduce the increase in cost of production
and therefore to influence the rate of inflation which in turn affects the price of a country’s exports and
therefore the level of unemployment.
In the short run these policies have demonstrated that there is a tradeoff between unemployment and
inflation E.G. policies to reduce inflation have increased the level of unemployment. In addition to these
policies, governments have affected the economy by passing laws to do with minimum wages, government
deficits, and trade embargos. Aggregate Supply and Demand
There are two main forces at work in the economy. Aggregate supply (AS) which is the total amount of goods
and services domestic firms are willing to produce and sell in a given time period and aggregate demand (AD)
which is the total quantity of goods and services demanded from domestic firms in a given time period.
(Refer to diagram 7)
The Equilibrium of AS and AD
(Refer to diagram 8)
The Shape of the AD Curve
Ad can be expected to be normal I.E sloping downwards from the left to the right reflecting the fact that as the
prices of goods and services fall then with all other factors held constant the quantity demanded will increase.
The Shape of the AS Curve
This presents a problem because the shape of the AS curve will differ between the short run and the long run
and in addition economists disagree about the short run shape.
AS in the Short Run
There is a disagreement between the Keynesians and the Classicists.
The Keynesians believe that the short run AS curve is ‘flat-ish’ because short run output will respond to
changes in prices and therefore the short run Keynesian curve is elastic. (Refer to diagram 9)
Why do the Keynesians believe this? Because they believe that in the short run many costs of productions are
fixed meaning that they are contractual and cannot be altered E.G. rents, raw material prices and even wages
may be fixed for two or three years in advance. Therefore with these fixed costs if a firm can raise its prices in
the short run they will find it very profitable to produce more and firms will respond to changes in demand by
increasing their output in the short run. (refer to diagram 10)
Thus Keynesians believe in the elastic short run AS curve because of what they call stickiness in the factor
However, the classicists do not believe in this stickiness and they believe that output levels are not responsive
to price changes and therefore the short run classical AS curve is highly inelastic. (Refer to diagram 11)
However some extreme classicists believe that even in the short run AS could be perfectly inelastic. (Refer to
diagram 12) AS in the Long Run
In the long run everybody agrees that all production costs (wages, rents, etc.) will respond to changes in the
economy’s price level (the rate of inflation) E.G. workers will demand wage increases in line with or even
above the rate of inflation and rents will also increase by the rate of inflation. Therefore if input prices and
output prices are rising by the same amount then firms will not be able in the long run to benefit by increasing
output and they will stay at their original profit maximizing output. (Refer to diagram 13)
In the long run the increase in demand because of increased wages increases productions costs and prices and
although there may be short run increases in output in the long run the AS curve is vertical because given
enough time all costs will adjust and therefore the long run AS in vertical.
A Conclusion on the Short Run and Long Run AS Curves
In the long run a conclusion can be drawn that changes in aggregate demand will only affect the price level
and will have no effect on output or employment. (Refer to diagram 14)
However similar ideas may or may not be applied to the short run (Refer to diagram 15)
The concept of P andOAS and AD
Remember that P reOresents the long run sustainable level of output for the economy with a given amount of
resources. For the moment we can consider that P is the full employment level of output. The AS curve for
the short run can now be fitted around P O.
Output below P
In this area there is spare capacity (unemployed resources and therefore firms can respond to
increases in demand by raising the price and output. (Refer to diagram 16)
Outputs Above P O
Above P all the nation’s resources are already fully employed and therefore increases in extra
production caused by increases in demand will be accompanied by small increasing in output and large
increases in prices. (Refer to diagram 17
The short run AS curve can now be fitted around potential output with both a Keynesian and a Classical
section. (Refer to diagram 18)
Sometimes the short run AS curve is divided into 5 sections (Refer to diagram 19) Aggregate Supply and Demand in Practice
1. The Vietnam War Boom (Refer to diagram 20)
2. The Supply Shocks of 1973/4 – A supply shock occurs when there are sharp increases in the costs of
production which shift the AS curve upward and to the left. In 1973/4 there were a series of supply
shocks which caused aggregate supply to sharply decrease as a result of OPEC quadrupling the price of
oil, El Nino causing the failure of the South American fishing and Guano industry, significant crop
failures around the world and a significant reduction in the amount of world trade because of the
problems associated with the changeover from fixed exchange rates to floating exchange rates. (Refer
to diagram 21)
3. The Tight Money Policies of the Early 1980s – By the early 19080s the problem was an overheated
economy with a high rate of inflation (both actual and inertial) which had been caused by increasing
aggregate demand. The solution chosen was a monetarist one where the Federal Reserve used a tight
money policy of high interest rates which caused aggregate demand to rapidly fall. The results of this
tight money policy were the control of inflation but massive unemployment. (Refer to diagram 22)
A Policy Decision – To Accommodate or Not to Accommodate Inflation
Some policy decisions are easy E.G. if aggregate demand falls because one part of aggregate demand declines
then the government can encourage increases in other parts of AD. However problems concerning supply are
much more difficult. Imagine there has been a supply shock, AS has moved to AS and2then the government
can choose from two policies.
In the first policy approach the government increases AD so that output and employment are maintained at
the expense of inflation and the supply shock is accommodated. (Refer to diagram 23)
But in the second policy approach the supply shock is not accommodated because the government decreases
AD meaning that there is no inflation but there are losses in output and employment. (Refer to diagram 24) Economic Measurement
This is the measurement of the major trends in an economy. The most important measurement is of GDP
which is the total dollar value of all the goods and services produced in a country in a yeay.
GDP = C+I+G+X N
XN= Net exports
Nominal GDP is the current dollar value of GDP but it is not a useful concept when comparing one year with
another because of inflation. However inflation can be removed with the use of a price index. The index is
called a GDP deflator (this is not the CPI) and when nominal GDP is deflated we get real GDP.
Real GDP = Nominal GDP
Inside an economy there are three main flows:
1) The Product Flow
(Refer to diagram 25)
There are four main problems in measuring the flow of product:
Only final goods must be counted, it is important not to count intermediate goods such as the steel in a
car in order to avoid double counting. Therefore in the product flow we only include goods which are
sold to their final destination
The services of the domestic engineer (housewife) are not counted
Self-supplied services e.g. painting your own house are included in GDP figures and given an estimated
or imputed value
Services like national defense and the judicial systems are not sold through a market (they have no
price) but they must be included and are given a value equal to their cost of production
2) The Earnings or Incomes Approach (Incomes Flow)
This is the sum total of all factor incomes from the production of goods and services (Refer to diagram
26) There is one problem in measuring this flow. Only the value added at each stage of production
must be included.
3) The Expenditure Flow
This is the total flow of spending on currently produced goods and services, all payments for second-
hand goods are therefore excluded.
However, when valuing GDP it is important to understand how to treat investment, government
expenditure and income, and net exports. The Treatment of Investment
Gross investment is all the machinery, equipment, buildings etc. which are produced or formed
in a year but during that year some capital equipment wears out and this is called depreciation.
Therefore the new investment in the year is the amount over and above depreciation and this
is called net investment.
Net investment = Gross investment – Depreciation
The Treatment of Government
The production of public goods and services e.g. roads must be included in GDP but transfer
payments such as pensions and welfare are excluded because no goods or services are
produced in exchange. Government national debt payments are also excluded. Finally, the
product approach is measured at current market prices which include taxation. Therefore
taxation needs to be added to the total incomes or earnings in order for the two approaches to
The Treatment of Net Exports
Net exports are the difference between the dollar value of goods and services exported and
imported. Thus the profits of Japanese companies operating in the United States must be
considered a debit or import because the money leaves the United States. Net exports are
sometimes called net foreign investment.
Onwards from GDP to PI and DI
Personal income (PI) represents all the income received by a household e.g. the factor earnings plus all
transfer payments (pensions, welfare etc.)
Disposable income (DI) is personal income minus all personal taxes (especially income taxes and social
Households can then decide to consume or save their disposable income.
Beyond GDP to Friendlier Measures Such As Net Economic Welfare
GDP measures quantity not quality. Concepts such as net economic welfare try to take into account the quality
of life. Some things should be added to GDP figures such as the amount of leisure time and the value of leisure
time activities. Also the underground economy needs to be addressed. Some legal underground activities
should be added E.G. mowing the neighbor’s yard in exchange for your house being painted but illegal
underground activities such as drugs and prostitution need to be taken away. In addition there are other
negatives such as environmental damage, acid rain, oil spills, noise pollution and road rage. Thus a high GDP
per capita does not mean a happy society. Keynesian Economics
The following ideas about consumption and investment form the basis of Keynesian thought.
This is the proportion of (disposable) income which is spent on the consumption of goods and services. What
is not spent is saved (called non-consumption). How is current consumption related to current income? We
know as income rises, consumption rises, but so does savings. In addition we know that some people do not
save. In the United States there is a remarkably constant relationship between consumption and current
income. (Refer to diagram 27)
The average propensity to consume (apc) shows us the proportion of current income which is spent on
consumption, when all current income is consumed the apc is equal to 1, if people save the apc is less than 1
and if the household dissaves the apc is greater than 1. On any straight line consumption function which does
not pass through the origin, the apc falls continuously as the income rises.
The marginal propensity to consume (mpc) tells us how much of any increase in income we will spend on
consumption. With a straight line consumption function the mpc is always constant. (Refer to diagram 28)
However on a curved consumption function the apc and the mpc will fall as the income rises. (Refer to
Real World Evidence on People’s Consumption
The natural assumption is that as current income rises people’s consumption rises, however perhaps we
should consider the following:
The Permanent Income Hypothesis
This idea suggests that our current level of consumption is not related to our current income,
but our idea of our lifetime income. (Refer to diagram 30)
Does the rate of interest affect the level of saving?
There is absolutely no real world evidence to suggest that changes in interest rates affect
peoples’ savings plans
Different groups within the economy
Some groups have higher propensities to spend than others. You may think that poor people
have a higher propensity to consume but poor people need to save more because they are
more worried about the future and therefore people on lower incomes have a higher
propensity to save. (Refer to diagram 31) Farmers have a high propensity to save because they
know eventually a harvest will fail. Young people with expectations (college graduates) save less
than other groups. As people near retirement they tend to save more. Investment
This is the formation of capital (machinery, tools, buildings etc.) which will increase future production.
Investment is important because it affects short run output via aggregate demand and long run growth
because of the capital stock. In the GDP accounts there are 3 types of investment.
1) Private fixed residential investment (new houses and additions to existing houses)
2) Business investment (plant equipment, tools and machinery)
3) Inventories (stocks of unsold goods)
Business investment accounts for over 70% of all investment.
What affects the level of investment?
The level of investment is probably a function of the profitability. We need to know the cost of the capital
investment, the flow of revenue from it, the rate of interest, and what is going to happen in the future
The Flow of Revenue from an Investment
This flow is determined by the general level of business activity in the economy (the business
cycle). It might be thought that during recessions there is little need to invest and during booms
a large need to invest. (Refer to diagram 32) However it is much more likely that the actual level
of investment is determined by the rate of change in GDP. This means that investment is the
highest when income is growing at its fastest (business men are optimistic) and investment will
be at its lowest when the economy is declining fastest. This is known as the Accelerator Theory
The Costs Involved in an Investment
(Refer to diagram 33) Investment goods (capital) last many years and firms pay for these goods
by borrowing money. The costs of borrowing is the rate of interest and as the rate of interest
rises investment becomes less attractive (the choking off effect). Another cost of investment is
the level of taxation upon business profits and/or any government support of investment which
may come in the form of tax rebates (e.g. duty-free items for business)
Business men often have to make intelligent guesses about the future. If the outlook is
pessimistic then current investment will be low. Also some people are pessimist e.g. the
Latvians whilst others are optimists e.g. the Kuwaiti’s.
Policies to Affect the Levels of Investments
Monetary policies use the rate of interest to encourage or choke off the investment. Fiscal policies include
taxation on business profits which may be raised or lowered. The diagram below shows the ‘Investment
Demand Curve’ and the causes of a shift in this curve. (Refer to diagram 34) The Multiplier Approach to the Determination of
National Income and Output
Just as a product market can reach equilibrium so can an economy. The purpose of the following work is to
find the equilibrium in the economy if we are given the value of consumption function, value of injections
(I+G+X) and the value of the withdrawals (S+T+M).
Both consumption and savings are determined by the level of income but investment is determined by so
many different factors that it is considered an exogenous variable. Therefore if the consumption and savings
are determined by income the country’s equilibrium income will be determined by the level of investment.
Example 1: In the simple example below of a closed ungoverned economy, investment is the only injection
and savings the only withdrawal. Therefore in equilibrium saving must be equal to investment. In this example
households consume ¾ of their current income plus a further $2000m at all levels of income. Investment is
currently $1000m. (Refer to diagram 35)
In this example the equilibrium value for national income is 12000. What would happen in this economy if the
actual income fell below the equilibrium value? At any income below the equilibrium value the amount of
savings is less than the level of investment therefore the actual level of income will begin to rise. (Refer to
Thus this economy will return to equilibrium when the level of savings has increased to equal the level of
However, if the economy overheats and the current income (nominal GDP) is greater than the equilibrium
value then once again withdrawal and injections will cause the economy to return to equilibrium. (Refer to
We show how changes in investment will affect the level of national income and output. The relationship
between the change in the investment and the resulting change in national income is called the investment
multiplier. (Refer to diagram 38)
The value of the investment multiplier is determined by the proportion of the increased investment which is
eventually passed on to the domestic firms in the form of consumption expenditure. In this example mpc is ¾
therefore in the beginning ¾ of the extra 1000 is passed on to the firm and then ¾ of the ¾ is passed on and so
on. The 1000 increase in investment has caused national income to increase by 4000. (Refer to diagram 39)
The value of the multiplier can be determined using the following formula:
Multiplier 1 = 1 = 4
1-mpc 1 – /
4 Using Fiscal Policy: In a certain economy consumers spend 5/6 of their current income plus $3000 at all
levels of income. Investment is currently $2000.
We now introduce fiscal policy. That is taxation (a withdrawal) and government spending (an injection).
The main problem in calculating the equilibrium level of income is disposable income (Y ) because our d
functions must only contain income and not disposable income therefore disposable income must be
substituted out of the functions.
Example: Consumers spend ¾ of their disposable income plus a further $2000 at all levels of income. All
incomes are taxed at a rate of 20%.
Y d Y – T
C = ¾ Y d 2000
T = / 5
Yd= Y - / 5 = / Y 5
Investment is currently $2000m and government spending $1000m. Therefore to find the equilibrium
value of income in this economy we must first find the value of the savings function.
(Refer to diagram 40)
To find the savings function:
S = ¼ Y d 2000
Y d Y – T
Yd= / Y5
S = ¼ ( /5Y) – 2000
S = / 5 – 2000
In equilibrium I + G = S + T
2000 + 1000 = ( / Y5– 2000) + / Y 5
2/5Y = 5000
Y = 12500
How has taxation affected the multiplier?
In our original example without taxation C= ¾Y = 2000, with an mpc of ¾ the multiplier was 4. By
introducing a 20% tax, C= ¾Y +20d0 which means the consumption function is now / Y + 2000 and t5e
mpc is reduced to / an5 the multiplier is reduced to 2.5. Taxation reduces the value of the multiplier,
increases in tax rates reduce the multiplier and decreases in tax rates increase the multiplier. The effect of changing the tax rate
In the original example the rate was 20%. The government now reduces the tax rate to 10%. The
consumption and saving functions remain the same as do the exogenous variables (I and G).
(Refer to diagram 41)
S = ¼Y d 2000
Yd= Y – T = / Y10
S = ¼ ( / 10 – 2000
S= / 40– 2000
In equilibrium I + G = S + T
2000+ 1000 = / Y –40000 + / Y 10
S + T = / Y40 2000
Working for Y:
5000 = / Y 402000 + / Y 10
S + T = / Y40 2000
Y = 5000 ÷ / = 4000 x / 13
Y = 20000 ÷ 13
I + G = 3000
C + I + G = / Y40 2000 + 3000 Now tax is increased to 40%
(Refer to diagram 42)
S = ¼Y d 2000
Y d Y – T = / Y5
S = / Y (¼) – 2000
S = /20 - 2000
In equilibrium I + G = S + T
2000 + 1000 = / Y – 2000 + / Y 2
S + I = / 20– 2000
I + G = 3000
C + I + G = / 20+ 5000
Increase government spending to 40000 ÷ 11
I + G = S + T
2000 + 40000 ÷ 11 = / Y – 2000
(4000 + [40000 ÷ 11]) ÷ / = Y 20
([44000 ÷ 11] + [40000 ÷ 11]) x / 11
= (84000 ÷ 11) x / = 1180000 ÷ 121
A Summary of the Effect of Changing Tax Rates
(Refer to diagram 43)
The effect on the multiplier
Original 20% Yd= / 5
C = ¾ ( / Y) + 2000
C = / 5 + 2000 mpc = / 3 5
Multiplier = 1 = 1 = /2 = 2.5
1- / 2/
5 5 Reduce 10% tax Y = / Y
C = ¾ ( /10) + 2000
C = / Y40 2000 mpc = / 40
Multiplier = 1 = 1 = 4/13 3.077
1- / 40 /40
Increase tax 40% Yd= / 5
C = ¾ ( /5Y) + 2000
C = / 20+ 2000 mpc = /9 20
Multiplier = 1 = 1 = /11 1.8181
1- /20 11/20
Increasing taxes reduces the multiplier
Decreasing Taxes increases the multiplier
The Theory of Fiscal Policy
At one time governments always balanced their budgets meaning that their spending had to be equal to the
level of tax receipts therefore it was thought that the government was neutral and had no impact on
determining output, income, and employment in the economy. But today it is accepted that the size of the
government’s budget does affect GDP.
The Effects of Government Expenditure Upon AD
If the government increases its expenditure while keeping tax rates the same then this will have a significant
impact upon GDP. But if the government’s extra spending is financed by extra taxation then the government
will now be spending money that the households would have spent and therefore in this case the extra
government spending would have little effect on GDP. This is known as the ‘Crowding Out Effect’. (In the work
that follows we assume that there is no crowding out effect)
Recessionary and Inflationary Gaps
(Refer to diagram 44)
Now imagine that an economy has settled into equilibrium below P and cOrrently the government is running
a small budget deficit. In order to close this recessionary gap and reduce the amount of unemployment there
are two possible fiscal methods:
1) Decreasing the tax rates – Remember tax rates are a withdrawal and by reducing withdrawals GDP will
increase and the C+I+G function will swing upwards, eventually closing the gap. (Refer to diagram 45) 2) Increasing government expenditure – By increasing an injection GDP will increase. This raises the C+I+G
function vertically by the increased government spending and the gap will be closed via the multiplier
process. (Refer to diagram 46)
Note that either a decrease in taxation or an increase in government spending will cause an increase in the
government deficit but which of these two methods will cause the smallest increase in the government
To simplify this idea imagine a government currently has a balanced budget but also has a recessionary
gap. The government knows that it can close this gap by increasing its expenditure by $100 billion thus
causing a budget deficit of $100 billion.
Or the same budget deficit of $100 billion could be created by $100 billion worth of tax cuts. However this
tax cut would not be enough to close the gap because some of the consumers’ extra disposable income
will be saved. Therefore to close the gap would mean a decrease in taxation of more than $100 billion thus
creating a budget deficit of more than $100 billion.
Therefore changes in government expenditure are more cost effective than changes in taxation.
The Initial and Final Size of the Budget Deficit
The budget deficit has been created by the fiscal policy which the government used to close the
recessionary gap. We also know that if tax rates are held constant then an increase in the nation’s GDP will
reduce a budget deficit or increase a budget surplus. (Refer to diagram 47)
Thus if a government intends to close a recessionary gap by increasing its expenditure then at first the
budget deficit increases by the amount of this extra expenditure, but as the gap closes GDP rises and tax
receipts also rise and therefore the final size of the budget deficit will be smaller than the government’s
original extra spending.
The Balanced Budget Multiplier
Suppose an economy is in equilibrium with a balanced budget (G=T) and then the government increases
the size of the budget but keeps it balanced. The effect of this will be to increase the level of GDP because
the government’s propensity to consume is 1 which is greater than the household’s propensity to consume
because households save and buy imports.
The balanced budget multiplier measures the relationship between the change in government expenditure
and taxation and the resulting change in GDP. E.G. if the government increase its balanced budget by $200
billion and as a result GDP increases by $60 billion then the balanced budget multiplier equals 0.3 ($60
billion ÷ $200 billion) More on AD and AS
The Foundation of AD
What factors affect the position of AD?
There are many factors which affect the position of AD. Its exact position is affected by:
1) Monetary policy because an increase in the money supply will reduce interest rates which
increases the amount of credit available producing higher levels of consumption and
2) Fiscal policy because tax reductions increase disposable income and therefore consumption
whilst increases in government spending directly increase total demand
3) Foreign output because a boom in a foreign country may increase a country’s net exports
e.g. when the USA booms, Bermuda’s tourism increases
4) Business conditions and expectations become greater business confidence may lead to
5) Changing asset values because when house and stock prices decreases then the wealth of
consumers decreases and this may cause a decrease in consumption
6) Population changes because an increase in population causes greater consumption and
more investment in housing
Which of the above factors is most important?
The monetarists suggest that the money supply is by far the most important factor and that
there is a direct relationship between the money supply and nominal GDP. Neo-Keynesians
suggest that consumption, investment, government spending and exports are the most
important influences .But most modern economists believe that at different times each has
been more important. Sometimes the monetarists have been right and sometimes the
Keynesians have been right.
In the short run the position of AS is important because it interacts with AD to determine the
level of output, employment and/or inflation. In the long run the position of AS determines
The actual position of the AS curve depends upon 2 things. Firstly, the position of P and as P
changes over time the short run AS curve shifts to the right. Secondly, wage price behavior
causes inflation. And this causes the AS curve to move upwards and therefore over time the
following happens. (Refer to diagram 48) The Classical and Keynesian Compared
Remember to the classicists the AS curve is vertical or near vertical because the economy operates smoothly
via the price mechanism (wages and prices can increase or decrease) and therefore they suggest that changes
in aggregate demand will only affect the price level and not output and employment. (Refer to diagram 49)
If this is true then economies will never be wasteful because if there is insufficient demand then all the
workers will still be able to find jobs at the new wage rates that will have fallen quickly. Finally, the classicists
say that monetary and fiscal policies will not affect output and employment through changes in AD but will
only affect price levels.
Keynesians believe in stickiness and that changes in AD have a large effect on output and employment. (Refer
to diagram 50) Keynesians therefore believe that monetary and fiscal policies can affect output and
employment via the multiplier.
The great divide is now clear, the difference between classical and Keynesian economists is about how quickly
and smoothly the price mechanism operates in the economy.
The Open Economy
Foreign Trade and Economic Activity
Net Exports and Output in the Open Economy
Open economy macroeconomics is the study of how economies behave when the trade and
financial linkages among nations are considered.
Foreign trade involves imports and exports. Although the United States produces most of what
it consumes, it still has the largest number of imports, which are goods and services produced
abroad and consumed domestically. Exports are goods and services produced domestically and
consumed abroad. Net exports are defined as exports minus imports. The counterpart of net
exports in net foreign investment and it is approximately equal to net exports.
In an open economy, a nation’s expenditures may differ from its production. Total domestic
expenditures are equal to consumption plus domestic investment plus government purchases.
The difference between national output and domestic expenditures is exports minus imports.
Determinants of Trade and Net Exports
The demand for imports depends upon the relative price of foreign and domestic goods. If the
price of domestic cares rises relative to the price of Japanese cars, Americans will buy more
Japanese cars and fewer domestic cars. Therefore the volume and value of imports will be
affected by domestic output and the relative prices of domestic goods and foreign goods. American exports depend primarily upon foreign output as well as upon the prices of U.S.
exports relative to the prices of foreign goods. As foreign output rises, or as the exchange rate
of the dollar depreciates, the volume and value of American exports tend to grow.
Short Run Impact of Trade on GDP
There are two major new macroeconomic elements in the presence of international trade. First, we have a
fourth component of spending, net exports, which adds to aggregate demand. Second, an open economy has
different multipliers for private investment and government domestic spending because some spending leaks
out to the rest of the world.
The Marginal Propensity to Import and the Spending Line
The marginal propensity to import (MPm)s the increase in the dollar value of imports for each $1 increase in
GDP. The MP is closely relate4d to the marginal propensity to save (MPS). MPS tells us what fraction of an
additional dollar of income is not spent but leaks into saving. Tme MP tells us how much of additional output
and income leaks into imports.
The Open Economy Multiplier
Opening up an economy lowers the expenditure multiplier. One way of understanding the expenditure
multiplier in an open economy is to calculate the rounds of spending and respending generated by an
additional dollar of government spending, investment, or imports.
Because a fraction of any income increase leaks into imports in an open economy, the open economy
multiplier is smaller than the multiplier for a closed economy.
Open economy multiplier = 1
MPS + MP m
E.G. Suppose that Germany needs to buy American computers to modernize antiquated facilities in what used
to be East Germany. Each extra dollar of U.S. computers will generate $1 of income in the United States, of
which $2/3=$0.667 will be spent by Americans on consumption. Business Cycles
Over the last 200 years there have been marked fluctuations in output, prices, interest rates and employment.
Until 2007 these cycles had the following features. They were global affecting all countries and all industries
because with greater integration and interdependence between countries these cycles spread rapidly
throughout the world. These cycles have a distinct pattern and they pass through certain phases and last
between 5 and 12 years however not all the cycles are identical. (Refer to diagram 51)
Business Cycle Theory
There are many different theories as to the cause of business cycles, some point to under-consumption whilst
others to changes in the money supply. But other ideas concern the political business cycle e.g. politicians
need to get re-elected therefore it is convenient to have a recession in midterm followed by a pre-election
boom. Weirder ideas involve sun spots and the innovation cycle.
But most realistic theories are about investment, too much or too little investment can harm the economy.
Remember it is thought that the level of investment is related to the rate of change in the business cycle (the
accelerator theory) (Refer to diagram 52)
Therefore if business cycles are caused by changes in investment then how can the flow of investment
become a smooth flow? The answer is to divide investment into private investment and government/public
Thus when private investment is low, public investment in projects such as roads, airports, incinerators, sports
stadia etc. should be high and when private investment is high, public investment should be low. (Refer to
But the importance of time lags needs to be realized. In the USA when private investment starts to slow down
the government needs to recognize this then the government needs to decide upon a course of action and
finally the investment projects need to be completed. But both the decision-making phase and the
implementation phase are subject to time lags and very often by the time the public investment takes place
it’s too late and the overall situation may become twice as bad with total investment fluctuating even more.
(Refer to diagram 54) Economic Indicators
Forecasting changes in business activity is important because of changes in the level of business profits and
changes in peoples’ income and well-being. If businesses know a downturn is coming they reduce inventories
and reduce production and employment. But if governments see a boom and inflation coming they will use
monetary or fiscal policy to slow the economy down. Economic forecasts are not very good but a trained
economic forecaster is about twice as good as people who guess.
There are 3 different types of economic indicators:
1) Leading indicators
2) Coincidental indicators
3) Lagging indicators
These indicators peak and trough before GDP peaks and troughs. (Refer to diagram 55) These are things like
the average length of the working week, the number of new unemployment claims, the number of new orders
for durable consumer goods, and the number of new housing starts. In total there are 11 leading indicators
which are added together into a single composite index which is quite good at giving 3 month forecasts but is
only fairly good for forecasts of six months or longer. This index predicts troughs more accurately than peaks.
These peak and trough at the same time as GDP. (Refer to diagram 56) Examples include total unemployment,
industrial production, and personal incomes.
These peak and trough after GDP peaks and troughs. (Refer to diagram 57) Examples include the prime rate of
interest charged by banks, levels of consumer borrowing, and other investment costs. Unemployment
Unemployment is important because when it is high resources are wasted, output it lost, peoples’ incomes are
depressed and the economic effects spill over into peoples’ lives.
The Measure of Unemployment
Each month in the US, 60,000 households are surveyed and the survey divides the people into three groups:
1) Employed people – These are people who do any paid work including part-time work
2) Unemployed people – There are people who are actively seeking work plus those people waiting to
report to a new job within the next month
3) Not in the labor force – This group is over 35% of the adult population in the US and includes those
going to school or college, early retirees, housewives, those too ill to work, and those not looking for
Employed + Unemployed = The Labor Force
The unemployment rate is calculated as the number of unemployed divided by the labor force.
Criticisms of the Unemployment Rate
1) These figures do not include the discouraged worker. These are people who have been unemployed for
so long that they have given up looking for work
2) The figures underestimate the impact of unemployment. The current unemployment rate should be
multiplied by 3 to give the number of American workers who will experience unemployment during the
3) The figures totally ignore workers who were full-time but are now part-time
4) The figures make no effort to look for levels of underemployment e.g. workers who are working below
their capability and those who are over-qualified for the job that they do and who then may become
The Seasonal Adjustment of the Unemployment Rate
These are adjustments made by statisticians to the crude rate of unemployment for seasonal factors such as
winter employment and construction and all the school leavers in June. Types of Unemployment
These are people inbetween jobs, moving from one job to another. This type of unemployment
is increasing because people are changing jobs more often and taking off more time between
jobs. In some sense this is a type of voluntary unemployment.
This occurs when there is a change in the pattern of demand e.g. the fall in demand for coal.
But this is not too bad because as one industry declines a new industry is usually growing.
This is related to the business cycle and occurs when the demand for labor is low in all
industries and all locations. It is the type of unemployment governments can do the least
Technological unemployment occurs when people are replaced by machines and seasonal
unemployment occurs in the travel and tourism industry and the construction industry in North
Why does unemployment occur?
Unemployment can be seen as a form of market breakdown. Labor is a commodity, there is a demand for it
and a supply of it and therefore there is a market mechanism and a market price. If there is a shortage of labor
then the price (wage) would begin to rise. However if there is too much labor then the price will fall. Thus
there should never be any involuntary unemployment if the labor market operates smoothly and efficiently.
(Refer to diagram 58)
However, the labor market clearly does not work efficiently. In diagram 58 wags are flexible (both upwards
and downwards) then wages will respond to changes in supply and demand there will not be involuntary
unemployment but if wages are inflexible then this will cause involuntary unemployment which is a problem
for the economy.
Keynes and Involuntary Unemployment
Keynes suggested that wages do not adjust smoothly and quickly towards the equilibrium wage
because of stickiness or inflexibility in the labor market.
Now imagine that the current wage is above the equilibrium wage. This would cause
involuntary unemployment which will remain as long as the wage does not fall. (Refer to
diagram 59) On the other hand it is possible that wages may be held below the market equilibrium and
when this happens there is an excess demand for labor and the newspaper will be full of job
adverts (Refer to diagram 60)
Sources of Inflexibility in the Labor Market (Keynes’ Stickiness)
Labor is not sold in competitive markets but in administrated markets. Wages are often set by
firms a year or more in advance and will not be changed even if the market conditions change.
When wages in the real world are adjusted then all the workers in all industries receive a very
similar wage rise regardless of the supply and demand conditions for each type of labor. When
shortages of a certain type of labor occur it is often difficult to adjust that group’s wages and
more frequently the qualifications are adjusted to get more labor. Finally the trade unions allow
even less flexibility by allowing no wage cuts and negotiating long t