IB Economics Section 3: Macroeconomics
Terms in this set (131)
Formula for GDP
GDP = C+I+G+∆R+S+(X-M)
Certain flows will increase the circular flow. Any increase in these will increase the circular flow and the amount of GDP.
Certain flows will decrease the circular flow. Any increase in these will decrease the circular flow and the amount of GDP. Withdrawals are S (savings if the bank does not lend the money out), T (taxes), M (imports).
For injections and withdrawals what has to happen for GDP to increase
For injections and withdrawals what has to happen for GDP to decrease
For injections and withdrawals what has to happen for GDP to stay the same
Methods of calculating GDP
Expenditure approach: GDP = C+I+G+∆R+S+(X-M) -IT + S (IT=indirect taxes, S=subsidies)
Factor incomes approach: GDP = Y + R + P + Int - Stock + S (Y=income, R=rental income, P=profits, Int=interest, S=statistical discrepancy)
Output Approach: Calculating using the method by adding together the value added at each stage of production by each producer.
Definition of GDP
Is the total value of goods and services produced within a country within a given time period (usually 1 year). It can also be seen as the country's national income over the time period.
Definition of GNP
Is the total value of goods and services produced within a country within a given time period. It includes income earnt from national companies abroad, minus income earnt by foreign companies within their income earnt by foreigners within their country. GNP is GDP + Net income from foreign investments.
Net National Product
NNP=GNP - depreciation that has been allowed for in the given time period. Depreciation is an allowance for the reduction in the value of capital.
A nominal value is the actual amount in that year's dollars terms.
A real value is purchasing power of the item being calculated. It eliminates changes in prices between years - allowing comparisons to be made between years.
Shows the changes in prices (inflation) between the years. The most common index use is the consumer price index (CPI).
Calculating Real Values
(nominal) ÷ (CPI) x1000.
Nominal National Income
The actual dollar amount of total income is that years dollar terms.
Real National Income
The purchasing power of the total income - it eliminates the change in prices between the years.
Inflation vs Deflation
Increases in prices are known as inflation . Decreases in prices are known as deflation .
Real National Income (GDP or GNP) calculations
Used as a comparison between years to see if national income is actually increasing or decreasing .
Calculating Index Number
The most common index number (CPI - Consumer Price Index) is used to calculate the change in consumer goods over a period time. This index number is calculated in the following manner:
Add up the value of the same goods at two different time periods.
Calculate using .... Index = (Time Period 1 ÷ Time Period 0) x 100 (or 1000)
GDP/GNP per Capita
The average income of the country per capita (per person). Calculation: GDP÷population. It used to show whether growth in the country can be explained due to just the population increasing or if economic growth has actually occurred. GDP/Capita would stay the same if the GDP increase rate was the same as the population increase.
Use GNP when...
A country has a net income from overseas and this income from overseas is used for re-investment within the country. Also the increase in investment results in additional consumption in the country. The increase in investment and consumption results in an increase in revenue for the government who then spends it on public goods.
Use GDP when...
GDP measures domestic aspects of growth so will reflect changes in labour employment rate. There is a greater link between unemployment and GDP than there is between unemployment and GNP. Standards of living are more influenced by domestic factors, thus GDP will provide a more accurate link of standards of living.
Problems with using GDP to measure Growth within a country:
Within a country:
Inflation and population growth may result in GDP figures increasing, but in reality the country may be worse off.
People over time tend to purchase superior, more expensive goods which may overstate inflation. GDP does not also reflect improvements in the quality of goods over time.
There may be errors or changes in accounting methods to calculate GDP.
Problems with using GDP to measure Growth between countries:
- GDP does not show what is being produced within a country and whether these goods help in raising the standard of living of citizens.
GDP does show a bit the externalities and environmental damage which affects the standard of living of citizens.
The citizens of different countries spend a different proportion of their incomes on certain goods.
GDP does not show the distribution of income within a country,so while GDP figures may be similar between countries, one country may have a greater gap between the rich and poor.
Many countries have a large parallel (black) market which is not counted in GDP figures, but which may enhance the standard of living of is citizens.
Difference between exchange rates can distort GDP figures.
Purchasing Power Parity
Purchasing Power parity shows the number of units (eg dollars) of a country's currency is required to buy the same amount of goods. It allows the actual purchasing power between countries to be compared. PPP says that goods and services should cost the same in all countries when measured in a common currency.
Indication of development
GDP per capita is still the best method to indicate development as there is a strong. NB: correlation between most standard of living indicators and economic growth. HOWEVER - what comes first ..... development or growth.
Calculating over/under valuation of the exchange rate
(PPP-Exchange Rate) ÷ (Exchange Rate) x100
What three variables make up the Human Development Index (HDI)?
Life expectancy at birth
Enrollment in Education and Adult literacy
GDP/GNP per capita
What problems are there with using this index?
Births and deaths are not always officially recorded. Enrollment in school does not always mean high attendance. GDP may be underestimated (parallel markets) or over estimated due to inflated output figures due to political reasons.
Human Poverty Index (HPI)
Measures the percentage of the population which does not meet target levels of economic and standard of living indicators.
What makes up the HPI?
% of people not expected to reach 40 years old.
% of illiterate adults.
% of people who do not gain decent living standards.
Aggregate Demand Curve
Shows the quantity of real total output (Real GNP/GDP) produced in the country demanded at each price level.
Formula for Aggregate Demand
AD = C + I + G + (X-M)
Shape of the AD curve
AD curve is downward sloping because of a number of reasons...
Real Income Effect
The amount a consumer spends is based on their real income.
Real Balance Effect
A fall in the price level increase the purchasing power of money - resulting in a real increase in the money supply (increase in quantity of AD). This enables firms and households to increase their consumption and investment expenditure now, rather than wait until later.
International Substitution Effect
If the price level falls, domestic goods may become more competitive compared to imported goods. This may increase purchases of domestic goods resulting in an increase in quantity of AD demanded.
Interest Rate Effect
Interest rate is positively correlated with the price level. If the price level rises then banks will increase the interest rate to maintain the real interest revenue coming into the bank. The higher the interest rate, the higher the opportunity cost of firms and households spending, the higher the cost of borrowing to spend, resulting in less spending and more saving. Ultimately, resulting in a decrease of the quantity of aggregate demand.
Aggregate Supply Curve
Shows the quantity of goods that firms are willing to supply at each price level. It is assumed that the price of factors of production will remain constant in the short run.
Shape of the Short Run AS Curve
The mainstream shape of the SRAS curve that is followed today is based on Keynesian theory.
Distinct areas of the SRAS curve
A horizontal section: When the economy is in severe recession or depression.
An upward sloping section: Slopes upwards because higher prices are an incentive to produce more . As production increases, bottle-necks in production will occur leading to diminishing returns as fixed factors of production do not change in the short run. Variable factors of production become more scarce which add to costs so there must be an incentive of higher prices to produce more.
A vertical section: Workers are unwilling to work overtime, there is no additional labour available, and firms are unwilling to work 'machines into the ground'.
Keynesian Theory believes that
Markets do not always clear for example while some labour market may clear, others will not, so lowering wages will not increase the demand for labour.
Wages are downward sticky which leads to wages above the equilibrium clearing level.
Not intervening in the market will not solve unemployment.
New Classical/Monetarist View:
- People understand the effective that a higher price level will lead to a fall of real wages.
Wages are market based and so inflation expectations will result in workers bidding up wages in order to maintain their real wages.
The SRAS curve will shift to the left when wages are increased - there will be a separate SRAS curve for each wage rate.
The long run aggregate supply curve (LRAS) is independent of the price level. The LRAS shows potential real output.
National Income Equilibrium
Occurs when planned expenditure (quantity of real GDP demanded) equals planned output (quantity of real GDP supplied).
Full employment (new Classical View)
The The LRAS curve shows the potential output in the economy in the long run. The potential output is theoretical. When all markets are clear (including labour) this must be the full employment level. The full employment level includes people in between jobs since there are always level people seeking jobs. This is call the natural rate of unemployment.
Inflationary Gap (Short term)
An inflationary gap occurs when the short run equilibrium is above the long run equilibrium ie above the full employment level. This means that actual GDP is greater than potential GDP. This will create inflationary pressures. The inflationary gap is the between YFE and YE .
Deflationary Gap (Recessionary Gap)
A deflationary gap occurs when the short run equilibrium is below the long run equilibrium ie below the full employment level. This means that actual GDP is less than potential GDP. This will create deflationary pressures. The deflationary gap is the between YE and YFE .
Business Cycle - AD/AS
Horizontal Long Run potential GDP curve. With wide 'W' shape (Actual Real GDP) starting at LR curve and going above and below LR curve. Above is known as 'inflationary gap', below as 'deflationary gap'. The distance between the two bottom parts of the 'W' is one business cycle.
Explanation of the Business cycle
Above the horizontal Long Run potential GDP curve the economy is operating above its long run potential. There will be an inflationary gap. The points of the 'W' on the Long Run potential GDP curve are when the economy is operating at the long run full employment. Below the horizontal Long Run potential GDP curve actual GDP is less than potential GDP. There is a deflationary gap.
Low economic activity, high unemployment due to low output, low consumption expenditure, low inflation, low government tax revenue, high unemployment payments, government budget deficit.
Output increases due to increase demand or supply, unemployment falls, consumption & investment & imports increase, inflation increases, interest rates will begin to increase to keep inflation under control.
The economy is at its production capacity, tight labour markets as very low unemployment, high wage rate demands - increase inflation, high C+I+M, high government tax revenue, asset speculation from people.
A recession is when the economy experiences two consecutive quarters (6 months) of falling GDP (negative economic growth). Less investment and output, resulting in less labour required. Increased unemployment and decrease C + M, government tax revenue falls, inflation falls.
There is no agreed definition but in general if real GDP decreases by more than 10%.
How is potential GDP measured?
It is measured based on an estimate of the long-run output trend of the economy.
A trend line is used to remove cyclical variations in GDP over time.
Why is it important to study/understand business cycles?
- Business cycles help the government implement economic policy. - Understanding business cycles allow the government to implement policies which reduce the
extreme fluctuations in the economy. Fluctuations lead to uncertainty for firms and households, especially for forward planning.
- Business cycles help firms not over capitalising (purchasing assets) in the short run and then have to dump them when they are not required.
Provide the government with more certainty of expected tax revenue, which is then used for spending in the economy.
Increase in AD
Results in an increase in the price level and increase in real GDP/employment.
Decrease in AD
Results in a decrease in the price level and a decrease in real GDP/employment.
AD curve will shift if....
Changes to : Expectations, International Issues, Fiscal policy, Monetary policy.
Expectations, International Issues, Fiscal policy, Monetary policy.
The government policy for revenue and expenditure. Most revenue comes from taxes e.g. income tax, GST.
The government's policy to control inflation through adjusting influencing interest rates.
When actual output is greater than long run potential output.
When actual output is less than long run potential output.
When government spending exceeds revenue.
When government revenue exceeds spending.
Amount of money owed to foreign banks and governments.
Automatic stabilising if the economy is in a boom period then
Unemployment spending will fall and a larger proportion of a consumers income goes towards paying income tax as most countries have a progressive tax system.This means that AD will NOT increase as much as it potentially could have if there was not a progressive tax system and consumers could keep and spend a constant proportion of their income. This means the economy will progress but at a slower rate.
Automatic stabilising if the economy is in a recessionary period then
Unemployment spending increases and consumers get to keep a larger proportion of their income assuming the country has a progressive tax system. This means the fall in AD will NOT be as much as it potentially could have been if there was not a progressive tax system and as people's income falls they get to keep a larger proportion of their income. This means the economy will slow down but at a slower rate.
Helps the economy avoid large fluctuations in its economic activity.
Discretionary policy, if the economy is in a boom period then
the government can decrease government spending and increase taxes. If the economy is in a recessionary period then the government can increase government spending and decrease taxes.
Real interest rate
The nominal interest rate minus the inflation rate.
Interest rates are adjusted by who?
The country's central bank NOT the government.
If you want to slow the economy down what policy can be used and why?
Tight monetary policy. This would be done by increasing the official cash rate, causing interest rates to rise, encouraging less consumption and investment expenditure, causing AD to decrease.
What is a loose monetary policy?
Decreasing the official cash rate will cause interest rates to fall. This would encourage more consumption and investment expenditure, causing AD to increase.
What is an issue with interest rate policies?
Interest rates take time to actually start affecting the economy - the business cycle is used to help predict ahead of time when interest rate need to be increased or lowered.
Exchange rate policies
The Reserve Bank will watch the exchange rate as this has an impact on the value of net exports = X - M.
Shifts of the SRAS curve will happen if...
The price of labour changes
The price of inputs (e.g. raw materials) to production changes
Taxes and legislation changes (e.g. minimum wages), environmental regulations affecting production.
Shifts of LRAS curve will happen if...
Increased labour and capital productivity
Improved production process
Other general general efficiency gains
When LRAS increases over time....
this allows changes in AD to have only a small impact on the price level (inflation).
Marginal Propensity to consume
This is the proportion of any increase in injections that goes towards domestic consumption.
MPC formula =
∆C ÷ ∆Y.
Marginal Propensity to leak
This is the proportion of any increase in injections that does not go towards domestic consumption; instead towards savings, taxes and imports.
MPL formula =
1 - MPC
The multiplier (k)
The amount that national income will increase by as a result of the initial injection. The higher the increase will be in national income as a result of the injection. Vice versa.
Formula for the multiplier
k = 1 ÷ (MPL) or k = 1 ÷ (1-MPC)
The accelerator (Keynesian Theory)
The accelerator model states that investment is assumed to be primarily linked with changes in the demand for output rather than changes in interest rates.
Government spending by borrowing from the public will crowd out (stop) any private sector investment spending from happening. The assumption is that extra government spending occurs by the government borrowing money from the public. The increase in demand for money will increase interest rates. At high interest rate, investment falls. The amount of the fall in investment depends on the relative view of how much investment is affected by interest rates.
Partial crowding out
The increase in government borrowing and spending results in only partial crowding out. There is a reduction in investment but overall the economy moves forward.
Full crowding out
When extra government spending completely eliminates Investment expenditure. The economy moves from AD to AD' and then back to AD.
When All the people who are willing and able to work and have jobs at the equilibrium wage rate i.e. when the hours demanded by firms for labour equals the hours supplied by workers.
Underemployment is when
People offering themselves for full time work cannot find it.
Labour force is
The total of unemployed people plus employed people. Unemployed people have to be registered as being unemployed.
The unemployment rate is
The percentage of the labour force that are unemployed.
The demand for labour slopes downwards because
At a high wage rate, there is little incentive to employ people but as the wage rate falls, the incentive to employ people increases.
The supply for labour slopes upwards because
At a low wage rate, there is little incentive to work (low opportunity cost) but as the wage rate increases, the opportunity cost of not working increases so the incentive to supply yourself as labour increases.
There is a mismatch between the skills of labour and the demands (jobs) in the economy.
Structural unemployment can be divided into
1) Regional unemployment - a main employing industry in a region shuts down. 2) Sectoral Unemployment - a specific sector slowly declines over time e.g. typewriter manufacturers. 3) Technological unemployment - where technology has reduced the need for labour to produce goods and services (Charlie and the Chocolate factory - toothpaste lids).
Unemployment created due to people being in-between jobs. This tends to be short term but could be long term due to minimum wage rates reduce the demand for workers or a lack of skills that workers have to offer.
Unemployment that is season based e.g. ski instructors in sumner, fruit pickers in winter.
Any country will always have structural, frictional and seasonal unemployment. These make up the natural rate of unemployment. This is the same as the full employment level.
Definition of full employment
When everyone who wants a job, has a job.
Definition of Equilibrium labour market
When ADL = ASL
Definition of Voluntary Unemployment
is Structural + Frictional + Seasonal unemployed people who are NOT willing to accept the equilibrium wage rate. At the equilibrium wage rate, voluntary unemployment is the same as the natural rate of unemployment.
Unemployment that is related to the phases of the business cycle. It occurs because of downward-sticky wages - i.e. they do not fall so an excess supply of labour is created.
Real wage unemployment is
When the labour market does not clear at the real wage rate (i.e. the actual wage rate is above equilibrium) and unemployment is more than it should be.
Definition of Inflation
A consistent increase in the general (average) price level. Inflation tends to be calculated using the CPI (consumer price index).
Definition of Deflation
When the price level (determined by the CPI) falls during a given time period.
A fall in AD results in consumers and firms to reduce their consumption and investment expenditure. This will pro-long the recessionary period as they may continue to reduce their expenditure in the expectation that prices will be cheaper in the future.
Falling prices result in people expecting prices to fall more, therefore AD reduces even more. The results in a further decrease in AD - the economy ends up in a deflationary spiral.
Cost push inflation
A sudden increase in costs of factor prices for firms (i.e. costs of production). It will result in SRAS shifting to the left.
Demand pull inflation
A sudden increase in AD due to an event affecting C+I+G+(X-M). If it increase suddenly it is called a demand side shock. It will result in AD increasing due to people anticipating higher in the future, thus demanding now. Workers will bid higher wages which shifts SRAS to the left. However a demand-pull spiral may occur because if AD continues to increase, the price level will continue to increase and workers will demand higher wages therefore SRAS shift to the left etc.
Money supply growth
An increase in the money supply will decrease interest rates. At lower interest rates there will be an increase in investment expenditure which results in AD increase. Lower interest rates will also result in consumption expenditure increasing as well. This causes inflation. However, in the long term, output will not increase as inflation results in GDP increasing beyond the LRAW curve, resulting in real wages falling, causing workers to demand higher wages, making SRAS shift to the left...
Issues with measuring inflation
The inflation rate in most country's is measured by the consumer price index (CPI). However these may not reflect the relative important of items in the basket - therefore a weighted price index is more accurate which is used by most countries.
The Phillips curve shows the relationship between wage inflation and unemployment. The relationship between both factors is a negative one. If the government wants to reduce unemployment, the opportunity cost will be higher inflation. Vice versa.
Short run Phillips curve
Assumes that labour does not react to higher inflation in terms of demanding higher wages.
Long run Phillips curve
The short-run Phillips curve will only operate in the short run as in the long run, factors such as a supply-side shock or cost-push inflation will cause inflation to increase due to ... workers bidding up wage levels to maintain their real incomes. This is an increase in costs of production for the producer which causes SRAS to shift to the left. Will also cause unemployment to increase as ..... a shift of the SRAS curve to the left will result in employment levels falling.
Everyone has the same income.
Fairness in incomes (the distribution of them within a country).
The idea that people on the same incomes should be treated the same e.g. taxed at the same rate.
The idea that people on different incomes should be treated differently e.g. those on low incomes should be taxed at a lower rate compared to those on higher incomes.
Taxes that are directly levied (charged) on an individual or business e.g. PAYE (income tax), company tax (tax on profits). These taxes can then be used to redistribute income.
A tax that is paid by a third party on behalf of another person e.g. GST, VAT (the shop pays it on your behalf).
Taxes that increase as incomes increase e.g. income tax. At each income level, the tax rate increases and income above that rate is taxed at the new rate.
A tax rate that is set at a proportion of income. E.G. in New Zealand, company tax rate is 30%. As profits rise, the tax rate stays the same but the amount paid will increase.
A tax that as incomes rise, the % of income that goes towards tax falls. This tends to affect low income groups harder as most of their income is spent on goods and services which are taxed e.g. GST.
Welfare payments funded out of taxes. Transfer payments include payments for unemployed, retirement, single payments.
People willing to give up free time for income.
People withdraw themselves from working for free time.
Used to show the extent of inequality of income in the country.
Used to show the amount of inequality of income in a country. Formula : (A) ÷ (A+B). A high Gini Coefficient number would have result in area A being very large compared to area B. If income is perfectly distributed ie complete equality, the the Gini coefficient would equal 0. If there is complete inequality then the Gini coefficient would equal 1.