macro diagrams and definitions
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MacroEconomics
Diagrams and Definitions
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What is macroeconomics?
• Macroeconomics is the study of a national
economy.
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Macroeconom
ic Goals
Growth
Employment
Price Stability
External Stability
Income Distribution
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Two Sector Circular Flow of Income
4
Wages, Rent and Profits(Y)
Factors of Production
Expenditure on Goods and Services(E)
Good and Services = Output (O)
Households
FirmsE = O = Y
Monetary Flow
Real Flow
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Four Sector Circular Flow of Income
5
Expenditure
Income
Households
Firms
Leakages (L)
Saving (S)
Taxes(T)
Imports (M)
Injections (J)
Exports(X)
Investments(I)
GovernmentSpending (G)
O = E = Y Sum J = Sum L
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Measuring National Income
6
Wages, Rent and Profits
Factors of Production
Expenditure on Goods and Services
Good and Services
Households
Firms
Output Method Income Method
Expenditure Method
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How is national income measured?
Employment income +
Rental income +
Profits +
Interest =
National Income
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How is national output measured?
Value of goods and services =
National Output
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How is national expenditure measured?
Household consumption (C) +
Firms’ investment (I) +
Government spending (G) +
Exports - Imports (X-M) =
National Expenditure
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What is GDP?
National Expenditure =
National Income =
National Output =
Gross Domestic Product
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GDP
• GDP = Gross Domestic Product = Total Value of all Spending in an Economy = The Total Value of all final Goods and Services in an Economy regardless of who owns the productive assets.
• GDP = C + I + G + (X – M)
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GNP
• GNP = Gross National Product = Total Income Earned by a nation’s factors of production regardless of where the assets are located
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Real GDP
Real GDP = Nominal GDP adjusted for inflation
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Calculating Real GDP
Real GDP = Nominal GDP of year measured
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The Uses of National Statistics
Determine a nation’s annual
progress
Develop economic policies Develop models
Predict future economic
developments
Analyze historical changes
Compare economies
Provide a snapshot of a nation’s
standard of living
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Limitations of the Data
Inaccuracies distort data
Unrecorded or under-recorded activity distort
data
Depletion of resources not considered
Composition of Output not considered
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What is economic development?
• Economic Development is a multidimensional concept that includes poverty reduction, provision of education, health care and law and order, civil liberties and civic participation.
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Why GDP fails to accurately measure welfare
GDP
No distinction regarding
composition of output
Does not reflect distribution of
income and output
Does not reflect quality of life e.g.
crime rate, political freedom
etc.
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Why GDP may understate improvements in welfare
GDPNon-Market Output not measured
Informal Markets not measured
Improvement in quality not
measuredIncreased
leisure time not measured
Increasing Life Expectancy
not taken into account
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Why GDP may overstate welfare
GDP
Negative Externalities not
taken into account
Depletion of natural resources
not taken into account
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How can development be measured?
• GDP per capita• Human Development Index
Aims to stress the human dimension of economic growth
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How can development be measured?
Health + Education +
Standard of Living
= Human
Development Index
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How is the HDI determined?
Life Expectancy +
Literacy and
Enrolment
school and colleges +
GDP per Capita
converted to
Purchasing
Power Parity (PPP)
= HDIIndex Value 0-1
Higher Values Higher
Development
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How can development be measured?
Measures of Development
Gender Related
Development Index (GDI)
Gender Empowerment
Measure (GEM)
Human Poverty Index
(HPI)
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Developing and Developed
Low Income
Economics
$905 or less
Lower Middle Income
Economics
$906-$3595
Upper Middle Income
Economies
$3596-$11,115
High Income
Economies
$11116 or more
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How can development be measured?
Important Indicators of development① Infant mortality rate② Maternal mortality ratio③ Enrolment in each level of education④ Literacy ⑤ Internet users per 1000
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Macroeconomic Models
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What is aggregate demand (AD)?
• Aggregate Demand is the aggregate (total) spending on goods and service in a period of time at a given price level.
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What are the components of AD?
C = all household consumption on durables, non-durables and services
I = firm’s replacement investment (spending on capital to maintain
productivity) or induced investment to increase production G = all government spending X-M = spending by foreigners on exports less domestic spending on
imports
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What causes shifts in AD?
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What causes Changes in
Consumption?
Rise in income
Fall in income
Lower Interest Rates
Higher Interest Rates
32
AD AD
ADAD
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What causes Changes in Consumption?
Rise in house and share market values
Fall in house and share market values
Higher confidence
Lower Confidence
33
AD
AD AD
AD
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What causes Changes in Consumption?
Fall in personal taxes
Rise in personal taxes
Lower debt
Higher debt
34
AD
AD AD
AD
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What causes Changes in Investment?
35
Fall in Interest Rates
Rise in Interest Rates
AD
AD
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Demand for investment funds?
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What causes Changes in Investment?
Fall in Business taxes
Rise in Business taxes
Improved Technology
Higher costs of Technology
37
AD
AD AD
AD
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What causes Changes in Investment?
Rise in house and share market values
Fall in house and share market values
Improved expectations about future sales
Worsening expectations about future sales
38
AD
ADAD
AD
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What causes Changes in Investment?
39
Improved governance
Worsening governance
AD
AD
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What causes Changes in Government Spending?
Rise in spending on merit goods public goods etc.
Fall in spending on merit goods public goods etc.
Deliberate Decision to increase AD
Deliberate Decision to decrease AD
40
AD
ADAD
AD
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What causes Changes in Export and
iMport spending?
Trading partners demands more goods
Trading partners demands less goods
41
AD
AD
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What causes Changes in Export and
iMport spending?
Exports more expensive for Trading Partners, buy less
Imports cheaper, buy more
Imports more expensive buy less
Exports less expensive trading partners buy more
42
AD
ADAD
AD
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What is aggregate supply (AS)?
• Aggregate (total) Supply is amount of goods and services that all industries will produce at a given price level.
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What is aggregate supply in the short run (SRAS)?
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What are the components of AS?
Wages Domestic resources
Imported raw
materials
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What causes shifts in SRAS?
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What causes shifts in SRAS?
Wages increase
Wages decrease
Fall in prices of resources
Rise in prices of resources
47
AS
AS AS
AS
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What causes shifts in SRAS?
Higher Business Taxes
Lower Business Taxes
Rise in subsidies
Fall in subsidies
48
ASAS
ASAS
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What causes supply shocks?
Sudden beneficial events e.g., oil discovery, good weather and harvest, technological breakthrough
Sudden negative event e.g. war, natural disaster, oil price increase
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AS
AS
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Macroeconomic Equilibrium
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Shifts in AD
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Shifts in SRAS
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The Business Cycle
• Fluctuations in the growth of real output, consisting of periods of expansion and contraction called business cycles or trade cycles.
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Business Cycle
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Business Cycle: Expansion
Near Full Employ-ment
Most resources employed
Some Rise in Prices
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Business Cycle: Peak
Full Employ-ment
All resources employed
Inflation
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Business Cycle: Contraction
Growing Unemploy-ment
Some resources
not employed
Slowing Inflation
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Business Cycle: Trough
Widespread Unemployment
Resources not fully
employed
Deflation
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Relationship between real GDP and Employment
GDP Falls
Unemployment Increases
59
Unemployment Falls
GDP Increases
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Using Diagrams to Illustrate Macroeconomic Goals
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Using Diagrams to Illustrate Macroeconomic Goals
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Changes in SR Equilibrium
Changes in AD
Shift to RightPrices and Output
increases
Shift to LeftPrices and Output
fall
Changes in SRAS
Shift to RightPrices Fall but
Output Increases
Shift to LeftPrices Increase but Output falls
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Changes in AD
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Changes in SRAS
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Economic Scenarios
An economy with a deflationary (recessionary) gap
An economy with a inflationary gap
An economy at a full level of output
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Deflationary (recessionary) gap
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Recession
• A recession is when the economy experiences two consecutive quarters of falling GDP.
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Inflationary gap
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Full employment level of output
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Causes of Business Cycle
Changes in AD
Shift to RightInflationary Gap
Shift to LeftRecessionary
Gap
Changes in SRAS
Shift to Right Higher GDP and
Lower Prices
Shift to LeftStagflation
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Changes in AD
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Changes in AS
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What is the neoclassical perspective?
Neoclassical Perspective
Price mechanism
regulates markets
Full employment
achieved without
intervention
Economy is an
harmonious system
Perfect competitive
equilibrium is the
benchmark
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The Neoclassical LRAS
In the Long Run all resources
including wages change to match changes in the
price level
LRAS is vertical (perfectly
inelastic) at potential GDP or full employment
level of GDP
Potential GDP is independent of the price level
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Neoclassical (Free Market) LRAS
LRAS perfectly inelastic at Full Employment Level of Output (Ymax)Potential Output = Quantity and Quality of FOPs not Price
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Why is the LRAS vertical?
Prices increase 5% in the SR but inputs have
not yet changed in
price.
Firms make a quick 5% profit and increase output
But in the LR prices of
inputs rise by 5%
Therefore Firms have
no incentive to increase
output
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Implications of the neoclassical LRAS?
In time any inflationary or recessionary
gap will disappear and the economy
will move to full employment
Governments do not need to intervene in the
market
In the LR increases in AD will not impact real GDP but
only bring about inflation
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Long-run equilibrium
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Long-run equilibrium and Decline in AD
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Return to Long-run equilibrium
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Long-run equilibrium
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Long-run equilibrium and Increase in AD
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Return to Long-run equilibrium
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What is the Keynesian perspective?
Keynesian Perspective
Price Mechanism fails as wages are
“downward sticky”
Reaching full employment
requires intervention
The economy is inherently unstable
The economy can get stuck in
the SR
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The Keynesian SR/LRAS?
Wages and prices are unlikely to fall during periods of
recession. Wages and prices are “downward
sticky”.
Sticky prices are explained
through the actions of
oligopolies who fear a price rises and unions who
resist wage cuts.
Potential GDP is dependent of the
price level because
inflexibility of wages and prices
stops the economy moving
into the LP.
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Keynesian SR/LRAS
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Keynesian SR/LRAS
• Keynes argued that as there is nothing inherent in the economy to move the SR into the LR, then SRAS = LRAS
NB In diagrams taking a Keynesian you may see the AS curve labeled Keynesian AS or simply LRAS as long as the diagram’s title makes clear which perspective is being adopted
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Inflationary Gap in the Keynesian Perspective
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Full Employment Equilibrium in the Keynesian Perspective
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Economic Growth: Improved Quantity & Quality of FOPs
Improve efficiency
Reduce unemployment
Increase quantity of resources
Develop higher quality FOPs
Use better Technology
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Economic Growth: Neoclassical Perspective
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Economic Growth: Keynesian Perspective
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Policy Alternatives to Manage the Economy
Discretionary Policies aim to
Stabilize the Economy
Fiscal
Demand-side Policies
Supply-side Policies
Monetary
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Expansionary Policies (in recession)
Fiscal Policy
Increase government
spending
Decrease personal and/or business taxes
Combination of both policies
Monetary Policy
Increase money supply
Lower interest rates (easy
money)
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Contractionary Policies (in inflation)
Fiscal Policy
Decrease government
spending
Increase personal and/or business taxes
Combination of both policies
Monetary Policy
Decrease money supply
Raise interest rates (tight
money)
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Strengths of Fiscal Policy
Combats rapid and escalating inflation
Opportunity to use spending to redistribute
income
Opportunity to use spending to
provide public goods and services
Combats a deep recession
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Weaknesses of Fiscal Policy
Time lags in recognizing the
problem, determining and implementing
policies
Inadequate information Political constraints
Crowding-out i.e. Government
borrowing raises interest rates
Tax cuts may be ineffective
Unable to fine tune economy
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Strengths of Monetary Policy
Quick implementation No political constraints
Combats rapid and escalating inflation
No political constraints as Central Banks are independent bodies
No crowding-out Better able to fine tune the economy
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Weaknesses of Monetary Policy
Time lags Inadequate information
Possible ineffectiveness in the face of a deep
recession
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The Neoclassical/Monetarist Challenge
• Argument that discretionary fiscal polices that try to stabilize the economy are so flawed that they actually cause instability
Alternative policies1. Ensure steady supply of money2. Ensure price and wage flexibility3. Focus on supply-side policies to achieve
economic growth
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Supply-side Policies
Discretionary Fiscal Policies that aim to increase potential
output
Market-orientated Policies
Interventionist-orientated Policies
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Market-orientated Policies
Economic Growth through
supply-side policies
Price Stability Full Employment
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Market-orientated Supply-side Policies: Objectives
Reduce Government
Sector
Improve incentives for private initiative
Ensure the Labor market responds
to supply and demand
Free Trade (Discussed in
Section 4)
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Reduce Government
Sector
Privatization to increase
incentives and reduce costs
Deregulation to encourage competition
and efficiency
Private Financing of
Public Services
Outsourcing to Private Sector
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Reduce Government Sector: Pros and Cons
More competitionGreater efficiencyLower costsImproved services
Higher costs of private financing Job lossesDeregulation undermines fairness
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Improve incentives for private initiative
Reduce personal taxes to
encourage more work
Lower taxes on interest income
to stimulate saving and investment
Lower business taxes to increase investment, R&D and innovation
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Make labor more responsive to supply and demand : Pros and Cons
Labor markets more competitiveWages respond to supply and demandLower costs and higher profits Increased employment
Increase income inequalityUnemployment benefits help to maintain consumption
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Support industr
y
Provide education and health to
improve quality of labor
Fund and provide incentives for R&D
Support SMEs (small to medium
sized firms) Support infant industries through grants, subsidies tax exemptions &
tariffs
Invest in infrastructure
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Government policies to improve industry: Pros and Cons
Provide an underpinning for economic growth
Inefficiencies and resource misallocationOpportunity costsIncreased taxes
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Shifting the SRAS and the LRAS in the AS-AD Model
SR• Focus on the price of
labor, inputs and taxation and legislation
LR• Focus on new technology,
new production methods, quality and/or quantity of FOPs
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The Multiplier Effect
• Any change in Consumption, Investment, Government Spending and Net Exports
Change components of AD
• Produces induced expenditures, a chain reaction of further expenditures
Change in real GDP
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Marginal Propensity
•Marginal Propensity to Consume
MPC
•Marginal Propensity to Save
MPS•Marginal Propensity to Tax
MPT
•Marginal Propensity to Import
MPI
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Example of the Multiplier in Effect
Initial Spending by government $100m
2nd Round of Spending $60m
3rd Round of Spending $36m
4th Round of Spending $21.6m
5th Round of Spending $12.96m
And So On
Last Round $0.01m
Total Spending, including initial spending by government
$249.99m
Assumption 60% of additional income spent on Consumption (MPC = 0.6)
The Multiplier = 1/1-MPC
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The Multiplier Effect
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The Accelerator Theory & the Combined multiplier/accelerator effect
• Argues that small changes in GDP produces larger changes in investment spending.
• These fluctuations interact with the Multiplier effect to increase the momentum of business cycle.
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Crowding-out Effect
Governments borrow to
finance fiscal polity
Interest rates rise
Private investment falls
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Crowding-out Effect
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Crowding-out Effect
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Unemployment and Inflation
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Unem
ployment
Unemployment
• Number of adults who are not working but actively look for a job
Underemployment
• Number of adults who are working part-time but looking for full time work or people who are not fully using their skills.
Unemployment Rate
• Number of unemployed as a percentage of the labor force
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Economic Costs of unemployment
Loss of real output (GDP)
Loss of income
Loss of tax revenue
Cost of unemployment
benefits
Unemployment unequally
distributed
Long-term unemployed may
become unemployable
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Social Costs of unemploymentStress Social Problems
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Structural Unemployment
Technological Changes
Changes in consumer demand
Labor markets rigidity e.g. minimum wage
laws
Changes in geographical location
of employment
Frictional Unemployment
Workers between jobs
Seasonal Unemployment
Seasonal demand for labor changes
Economy at Potential
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Types of Unemployment
Economy at Potential
StructuralUnemployment
FrictionalUnemployment
SeasonalUnemployment
Economy below Potential
Real Wage Unemployment
Cyclical Unemployment
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Keynesian Remedy for Unemployment During a Recession
Cyclical Unemployment Insufficient AD
Expansionary Fiscal and
Monetary Polices
Increase in ADReturn to Real GDP at potential
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Neoclassical Remedy for Unemployment During a Recession
Real Wage Unemployment
Recessionary gap produces labor surplus
as wage levels stay above equilibrium
Market rigidity caused by minimum wage
legislation, collective bargaining & firms paying high wages
Eliminate minimum wage legislation and
collective bargaining by unions
SRAS shifts to rightReturn to long term equilibrium
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Real Wage Unemployment
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Eliminating Cyclical (Demand-deficient) Unemployment
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Inflation and Deflation
Inflation• A continuing increase in the
general price level of goods and service within the economy
Deflation• A continuing decrease in the
general price level of goods and service within the economy
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Inflation & D
eflation
Demand-pull Inflation
• Increase in AD• Reduction in AD
solution to this from of inflation
Cost-push Inflation
• Increase in the costs of production (supply-side shocks) produces fall in AS
• Solutions tied to cause of the fall in AS and attempt to reduce the FOPs
Excessive Money Supply Induced
Inflation
• Increase of money supply
Deflation
• Decease in AD• Increase in AS
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Demand-pull Inflation
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Cost-push Inflation
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Economic Costs of Inflation
Loss of international competitiveness
Money illusion
Menu CostsUncertainty
Redistribution of income
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Stakeholders and InflationWinners Fixed income earnersCash holdersSavers Borrowers at interest rates lower than inflation
LosersBorrowers at interest rates higher than inflationPayers of fixed incomes and wages
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Economic Costs of
Deflation
Financial crisis
Deflationary Spiral
Menu costsUncertainty
Redistribution of income
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“Good” Deflation
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Measuring Inflation
The consumer price index (CPI) compares the value of a basket of goods and services in one year with a same basket in the base year.
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Problems Measuring Inflation
Static Basket of Goods and Services
• Belongs to a fictitious “average” person
• Fixed weighting may not reflect substitutions people make in their spending (substitution effect leads to overestimation of inflation)
New Retail Outlets
• Purchases at discount stores, megastores and online stores may not be counted (new retail outlet bias leads to overestimation of inflation
New Products
• New products may not be immediately counted (new product bias leads to overestimation of inflation
• Improved quality may not be measured (quality bias leads to overestimation of inflation)
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The Phillips Curve
Inflation and Unemployment inversely related
Government must deal with a trade-off
between price stability and full employment
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NRU = NAIRU
Structural Frictional Seasonal Natural Rate of Unemployment
If governments avoid demand-side expansionary policies Non-accelerating inflation rate of unemployment is achieved (NAIRU)
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Long-run Phillips Curve
Neo-classical perspective
• No trade-off between unemployment and inflation in LR
NRU
• At long-run equilibrium there will be a natural rate of unemployment (NRU)
Lowering NRU
• Only Supply-side polices can sift the LRPC to the right
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Phillips Curve
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Phillips Curve
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Neo-classical challenge to the Phillips Curve
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LR Phillips Curve
If expansionary policies adopted, inflation would increase to 4% or more. Real wages have fallen and firms hire additional labor.
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LR Phillips CurveUnemployment is now below NRU at 4%. (b)Workers have fallen for the “money illusion” and slow to realize that real wages have fallen because inflation is actually over 4%.
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LR Phillips CurveUnemployment is now below NRU at 4%. (b)Workers have fallen for the “money illusion” and slow to realize that real wages have fallen because inflation is actually over 4%.
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LR Phillips CurveOnce workers realize real wages have fallen they will demand at least a 4% pay rise. Real wages will return to previous levels and firm will fire workers.Unemployment has returned to (c)
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LR Phillips CurveAny attempt to to increase AD will only result in temporary changes to unemployment but increasingly high rates of inflation
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LR Phillips CurveFriedman argued that no trade off exists if governments do not use demand side policies.