3. Macroeconomic

How to measure economic activity

Gross Domestic Product (GDP)

: the value of all final goods and services produced within an economy over a period of time, usually a year or a quarter.

Output approach	Expenditure approach	Income approach
adds up the value of all the final goods and services produced by each economic sector	adds up the total amount spent on domestically produced final goods and services	adds up all the income generated in the production process and by the factors of production in the economy
GDP = sector 1 + sector 2 + sector 3 + … + sector n	GDP = C + I + G + (X-M) • C = consumption spending • I = investment spending • G = government spending • X-M = net export	GDP = rent + wage + interest + profit

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Gross National Income (GNI): 

G D P+\text { factor income from abroad }- \text { factor income sent abroad. }

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GDP or GNI per capita:  GDP or GNI  population of the country \frac{\text { GDP or GNI }}{\text { population of the country }} population of the country  GDP or GNI ​

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Measures standard of living of a country.

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Real GDP or GNI per capita at purchasing power parity (PPP): converts each country’s per capita income figure to a common currency.

Real vs Nominal:

Real GDP	Nominal GDP
Nominal GDP adjusted for inflation	Measures economic activity in monetary terms, at current prices.

GDP deflator: comprehensive price index that measures the average level of prices of all goods and services included in the GDP of a country.

\text { GDP deflator }=\frac{\text { nominal GDP }}{\text { real GDP }} \times 100

\text { Real GDP }=\frac{\text { nominal GDP }}{\text { GDP deflator }} \times 100

3.1. Measuring economic activity and illustrating its variations

Aggregate demand

Aggregate demand(AD): total spending on domestic goods and services at average price levels per period of time.

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

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C = consumption expenditures

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I = investment expenditures

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G = government expenditures

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X-M = net export (export - import)

Figure 3.2.1 The aggregate demand curve

Why is the AD curve downward sloping?

Wealth effect	Trade effect	Interest rate effect
average price level(APL) ↑ → real value of money people possess ↓ (i.e. people feel ‘poorer’) → consumer expenditure (C) ↓ → C is a component of AD → upward movement along AD	APL ↑ → exports become less competitive abroad // imports seem more attractive at home country → value of net export (X-M) ↓ → X-M is component of AD → upward movement along AD .	APL ↑ → demand for holding money ↑ → C and investment expenditure (I) ↓ (i.e. people and firms will borrow less from banks to buy durables and capital equipment) → C & I are components of AD → upward movement along AD .

Shifts of the AD curve

3.2 Variations in economic activity: aggregate demand and aggregate supply

Economic growth

Economic growth: increase of real GDP over time.

\text { Growth } 2_{2019 \rightarrow 2020}=\frac{r G D P_{20}-r G D P_{19}}{r C D P_{19}} \times 100

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Growth rate = % change of real GDP between two periods.

Assume that real GDP in 2019 = $19,220 billion & real GDP in 2018 = $18,783 billion.

\text { Growth in } 2019=\frac{19220-18783}{18783} \times 100=2.33 \%

Growth over the short term

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AD increase → real GDP increase.

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Any factor that increases any component of AD will shift it to the right and increase real output.

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

A. Improved consumer & business confidence → C & I ↑ → C & I are components of AD → AD ↑ → real GDP ↑ → economic growth ↑ in short term.

B. Interest rates ↓→ ↓cost of borrowing for households and firms → C & I ↑ → C & I are components of AD → AD ↑→ real GDP ↑ → economic growth ↑ in short term.

Interest rates ↓→ exchange rate depreciation → exports cheaper & more competitive // imports more expensive & less attractive → X-M ↑ → X-M is component of AD → AD ↑ → real GDP ↑ → economic growth ↑ in short term.

C. G ↑ → G is component of AD → AD ↑.

D. Tax ↓ → disposable income ↑ → C ↑.

E. Exchange rate depreciation → X-M ↑.

Figure 3.3.1 Short term growth on the Keynesian model

3.3 Macroeconomic objectives

Measuring economic inequality

Economic inequality:

unequal distribution of income and wealth.

Figure 3.4.1 Lorenz curve

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The poorest 20% of people receives only 7% of national income.

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Diagonal line: line of perfect income equality (i.e. poorest 20% earns 20% of income and the poorest 40% earns 40% of income).

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As we move further to the right of the diagonal, the distribution of income becomes more and more unequal.

Gini coefficient: ratio of the area between the Lorenz curve and the diagonal over the area of the half-square.

3.4 Economics of inequality and poverty

Functions of money

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Medium of exchange

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Acceptable as a means of payment in all market transactions.

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Unit of account

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Express prices → measure and compare values of goods and services.

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Store of value

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Hold purchasing power and wealth over time.

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Standard of deferred payment

3.5 Demand management (demand-side policies): monetary policy

Fiscal policy: changes in the level of government expenditures (G) and taxes (T) to affect AD.

Government expenditures

Capital expenditures	Current expenditures	Transfer payments
Public investments: spending on infrastructure (roads, airports).	Salaries of public sector employees Expenditures on public school, hospital.	Pensions, unemployment benefits.

Government revenues

Where government gets its revenue from:

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Direct tax.

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Indirect tax.

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Sale of state owned enterprises (by privatisation).

Goals of fiscal policy

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Lift an economy from recession: close a large recessionary or inflationary gap.

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Decrease cyclical unemployment.

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Lift an economy from recession → higher demand for employers → lower unemployment.

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Decrease inflation.

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Long-term economic growth.

3.6 Demand management (demand-side policies): fiscal policy Fiscal policy

Supply-side policies: attempt to shift LRAS to the right and achieve long-run economic growth.

Goals of supply-side policies

Goal	Explanation
Increase the productive capacity.	Increase potential output by rightward shift of the LRAS curve.
Improve competition and efficiency.	Make the economy more responsive to the forces of demand and supply so as to increase efficiency in production.
Reduce labour costs and unemployment through labour market flexibility.	Make labour market more responsive to the forces of demand and supply so as to reduce unemployment as well as labour costs.
Increase incentive of firms to invest in innovation.	Lower cost of production provide firms with incentives to engage in research and development (R&D) which increases the productive capacity of the economy.
Reduce inflation to improve international competitiveness.	Reduce inflationary pressure in the economy, which makes exports more competitive in global markets.

Market-based policies

Product market related policies

Anti-monopoly regulation	Deregulation	Privatisation	Trade liberalisation
Establish competition commissions, pass antitrust laws.	Relax inappropriate rules, restrictions, and laws in the operation of firms / markets. • Airline, banking, and electricity industries.	Transfer of state-owned assets to the private sector. • Utilities: water, electricity. • Privately owned firms pursue profit maximisation → operate more efficiently.	Elimination of policies that protect domestic firms from foreign competition. • Tariff • Quotas • Subsidies • Health & safety barriers

Labour market related policies

Reduce power of labour unions	Decrease or abolish minimum wage	Reduce non-wage labour costs
Decrease money wages and production costs. • Firms reduce prices and increase output.	Decrease production costs → lower prices → increase output → increase investment.	Employer contributions to national insurance, pension schemes.

Incentive-related policies

Cut personal income tax	Cut business tax and capital gains tax
Increase labour supply: more individuals join the labour force → shift LRAS curve to the right.	Increase profitability of investments → increase potential output → shift LRAS curve to the right.

Interventionist supply-side policies

Increase public investments in education, training, healthcare	Public investment in infrastructure	Public investment in research and development (R&D)
Increase stock and quality of human capital: education, training, skills, experience	Infrastructure: physical capital that decreases the overall cost of economic activity. • Better transportation network. • Electrification → access to information.	Spillover benefits • Invest R&D in the form of subsidies, tax allowances, and patents.

Industrial policies

3.7 Supply-side policies

Economic growth

Fiscal policy

Strengths	Weaknesses
Increase in government expenditures (G), decrease in taxes (T) → increase AD: expansionary fiscal policy → promote economic growth.	Long time lags • Not effective during a recession.

Monetary policy

Strengths	Weaknesses
Decrease in interest rates → increase AD → increase real GDP: promote economic growth.	Limited ability to stimulate growth • If interest rates are close to 0, then there’s limited scope to decrease interest rates.
Flexible, incremental, reversible, short time lags: better than monetary policy as a short-run stabilisation tool.	Not effective during deep recession • Very low consumer and business confidence.

Supply-side policy

Strengths	Weaknesses
Public investments in infrastructure, education, healthcare → accelerate economic growth.	Huge opportunity cost.

Low and stable rate of inflation

Fiscal policy

Strengths	Weaknesses
Contractionary fiscal policy: Decrease G, increase T → AD ↓ → inflation ↓	After excessive government expenditures: Tighter monetary policy → inflationary pressures.

Monetary policy

Strengths	Weaknesses
Increase interest rates → price stability.	Ineffective to deal with deflation • Interest rates are already low (close to 0).

Supply-side policy

Strengths	Weaknesses
More flexible labour markets • Increase productive capacity → reduce inflation.	Long time lags • Further increase inflationary pressures Takes long time for policies to come into effect.

3.8 Macroeconomic policies - strengths, limitations and conflicts