© The McGraw-Hill Companies, 2002 Week 8 Introduction to macroeconomics

© The McGraw-Hill Companies, Macroeconomics is... the study of the economy as a whole it deals with broad aggregates but uses the same style of thinking about economic issues as in microeconomics.

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

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

© The McGraw-Hill Companies,

5 Inflation in UK, USA and Germany

© The McGraw-Hill Companies, Unemployment in UK, USA and Germany

© The McGraw-Hill Companies, Economic growth in UK, USA and Germany

© The McGraw-Hill Companies, The circular flow of income, expenditure and output Y HouseholdsFirms C + I IC S

© The McGraw-Hill Companies, Government in the circular flow Y C + I + G I C S HouseholdsFirmsGovernment C + I + G - T e TeTe G B - T d Y + B - T d

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

© The McGraw-Hill Companies, GDP and GNP Gross domestic product (GDP) –measures the output produced by factors of production located in the domestic economy Gross national product (GNP) –measures the total income earned by domestic citizens GNP = GDP + net income from abroad

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

© The McGraw-Hill Companies, What GNP does and does not measure Some care is needed: –to distinguish between real and nominal measurements –to take account of population changes –to remember that GNP is not a comprehensive measure of everything that contributes to economic welfare

© The McGraw-Hill Companies, 2002 Output and aggregate demand

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

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

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

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

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

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

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

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

© The McGraw-Hill Companies, Effects of a fall in aggregate demand Output, Income Desired spending 45 o line AD 0 Y0Y0Y0Y0 Suppose the economy starts in equilibrium at Y 0. a fall in aggregate demand to AD 1 AD 1 Leads the economy to a new equilibrium at Y 1. Y1Y1Y1Y1 Notice that the change in equilibrium output is larger than the original change in AD.

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

© The McGraw-Hill Companies, 2002 Fiscal policy and foreign trade

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

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

© The McGraw-Hill Companies, Fiscal policy? Income, output Aggregate demand 45 o line AD 0 Y0Y0 But this ignores some important issues – prices, interest rates, and the need to fund the government spending. AD 1 This seems to suggest that the government could influence aggregate output in the economy by raising AD from AD 0 to AD 1, Y1Y1 thus raising equilibrium output from Y 0 to Y 1.

© The McGraw-Hill Companies, but in surplus at high levels then the budget will be in deficit at low levels of income The government budget The budget deficit equals total government spending minus total tax revenue. If government spending is independent of income G G, NT Income, output The balanced budget multiplier states that an increase in government spending plus an equal increase in taxes leads to higher equilibrium output. Balanced budget but net taxes depend on income, NT Y0Y0

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

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

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