6The Economy and

Business Activity

Macroeconomic Objectives

• Microeconomics and macroeconomics

• The major macroeconomic issues– economic growth

– unemployment

– inflation

– balance of payments and exchange rates

• Government macroeconomic policy– controlling various intermediate variables

• interest rates, money supply, taxes, government expenditure, etc.

The Circular Flow of Income

• The inner flow

Factorpayments

Consumption ofdomestically

produced goodsand services (Cd)

The circular flow of income

Firms

Households

The Circular Flow of Income

• Withdrawals

– net saving (S)

– net taxes (T)

– import expenditure (M)

• Injections

– investment (I)

– government expenditure (G)

– export expenditure (X)

Factorpayments

Consumption ofdomestically

produced goodsand services (Cd)

Investment (I)

Governmentexpenditure (G)

Exportexpenditure (X)

BANKS, etc

Netsaving (S)

GOV.

Nettaxes (T)

ABROAD

Importexpenditure (M)

The circular flow of income

WITHDRAWALS

INJECTIONS

The Circular Flow of Income

• The relationship between withdrawals and injections

– the links between them

– planned injections may not equal planned withdrawals

• effect of J > W

• effect of W > J

– equilibrium in the circular flow

Factorpayments

Consumption ofdomestically

produced goodsand services (Cd)

Investment (I)

Governmentexpenditure (G)

Exportexpenditure (X)

BANKS, etc

Netsaving (S)

GOV.

Nettaxes (T)

ABROAD

Importexpenditure (M)

The circular flow of income

WITHDRAWALS

INJECTIONS

The Circular Flow of Income

• The relationship between withdrawals and injections

– the links between them

– planned injections may not equal planned withdrawals

• effect of J > W

• effect of W > J

– equilibrium in the circular flow

• The circular flow and the four macroeconomic objectives

The Determination of Business Activity

• The importance of aggregate demand

– effects of J > W

– effects of W > J

• Identifying the equilibrium level of GDP

– the 45o line diagram

45°

O GDP (£bn)

GDP = Cd + W

Cd, E, W, J (£bn)

Equilibrium GDP

The Determination of Business Activity

• The importance of aggregate demand

– effects of J > W

– effects of W > J

• Identifying the equilibrium level of GDP

– the 45o line diagram

– the GDP and E lines

45°

O GDP (£bn)

GDP = Cd + W

E = Cd + J

Cd, E, W, J (£bn)

Cd

JJ

Equilibrium GDP

The Determination of Business Activity

• The importance of aggregate demand

– effects of J > W

– effects of W > J

• Identifying the equilibrium level of GDP

– the 45o line diagram

– the GDP and E lines

• effects of E > GDP

• effects of GDP > E

45°

O GDP (£bn)

GDP = Cd + W

E = Cd + J

Cd, E, W, J (£bn)

Cd

GDP1 GDP2

a

b

c

d

Equilibrium GDP

The Determination of Business Activity

• The importance of aggregate demand

– effects of J > W

– effects of W > J

• Identifying the equilibrium level of GDP

– the 45o line diagram

– the GDP and E lines

• effects of GDP > E

• effects of E > GDP

– finding the equilibrium point

45°

O GDP (£bn)

GDP = Cd + W

E = Cd + J

Cd, E, W, J (£bn)

Cd

GDP1 GDP2GDPe

a

b

c

de

Equilibrium GDP

The Determination of Business Activity

• The multiplier

– the multiplier process

– definition of the multiplier∀∆GDP / ∆J

– the marginal propensity to consume domestic goods and services

• mpcd = ∆Cd / ∆GDP

GDP

E1

O GDP (£bn)100

E2

160

Multiplier = ∆GDP / ∆ J= 60/20 = 3

100

120

160

Cd, E, W, J (£bn)

The multiplier: a rise in aggregate expenditure

Cd

∆ J

∆Cd = 40

∆GDP = 60

∆GDP

The Determination of Business Activity

• The multiplier

– the multiplier process

– definition of the multiplier∀∆GDP / ∆J

– the marginal propensity to consume domestic goods and services

• mpcd = ∆Cd / ∆GDP

– formula for the multiplier• 1 / (1–mpcd)

GDP

E1

O GDP (£bn)100

E2

160

Multiplier = ∆GDP / ∆ E= 60/20 = 3

100

120

160

Cd, E, W, J (£bn)

Cd

∆ J

∆Cd = 40

∆GDP = 60

∆GDP

The multiplier: a rise in aggregate expenditure

The Business Cycle

• Growth in actual and potential output

• Economic growth & the business cycle

– fluctuations in actual growth

– the phases of the business cycle

• the upturn

• the expansion

• the peaking out

• the slowdown or recession

O

Nat

iona

l out

put

Time

Potential output

1

2

3

4

1

2

34Actualoutput

The business cycle

The Business Cycle

• Growth in actual and potential output

• Economic growth & the business cycle– fluctuations in actual growth

– the phases of the business cycle• the upturn

• the expansion

• the peaking out

• the slowdown or recession

– long-term output trend

O

Nat

iona

l out

put

Time

Potential output

Actualoutput

Trendoutput

The business cycle

The Business Cycle

• Growth in actual and potential output• Economic growth & the business cycle

– fluctuations in actual growth– the phases of the business cycle

• the upturn• the expansion• the peaking out• the slowdown or recession

– long-term output trend– the business cycle in practice

The Business Cycle

• Growth in actual and potential output• Economic growth & the business cycle

– fluctuations in actual growth– the phases of the business cycle

• the upturn• the expansion• the peaking out• the slowdown or recession

– long-term output trend– the business cycle in practice

• the length of the phases

The Business Cycle

• Growth in actual and potential output• Economic growth & the business cycle

– fluctuations in actual growth– the phases of the business cycle

• the upturn• the expansion• the peaking out• the slowdown or recession

– long-term output trend– the business cycle in practice

• the length of the phases• the magnitude of the phases

An

nual

gro

wth

rat

e (

%)

UK

Growth rates in selected industrial countries

-3

-2

-1

0

1

2

3

4

5

6

7

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1970 1975 1980 1985 1990 1995 2000 2005

An

nual

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%)

UK

Growth rates in selected industrial countries

-3

-2

-1

0

1

2

3

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1970 1975 1980 1985 1990 1995 2000 2005

An

nual

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%)

Growth rates in selected industrial countries

-3

-2

-1

0

1

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1970 1975 1980 1985 1990 1995 2000 2005

UK

EU15

An

nual

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%)

Growth rates in selected industrial countries

-3

-2

-1

0

1

2

3

4

5

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7

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10

1970 1975 1980 1985 1990 1995 2000 2005

UK

EU15

An

nual

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%)

Growth rates in selected industrial countries

-3

-2

-1

0

1

2

3

4

5

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7

8

9

10

1970 1975 1980 1985 1990 1995 2000 2005

UK

EU15

USA

An

nual

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Growth rates in selected industrial countries

-3

-2

-1

0

1

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4

5

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9

10

1970 1975 1980 1985 1990 1995 2000 2005

UK

EU15

USA

An

nual

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wth

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Growth rates in selected industrial countries

-3

-2

-1

0

1

2

3

4

5

6

7

8

9

10

1970 1975 1980 1985 1990 1995 2000 2005

UK

EU15 Japan

USA

An

nual

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%)

Growth rates in selected industrial countries

-3

-2

-1

0

1

2

3

4

5

6

7

8

9

10

1970 1975 1980 1985 1990 1995 2000 2005

UK

EU15 Japan

USA

The Business Cycle

• Causes of cyclical fluctuations– Why does AD change in the first place?– Why do booms and recessions persist?

• time lags• bandwagon effects

– the accelerator

– Why do booms and recessions end?• ceilings and floors• echo effects• the accelerator• random shocks• changes in government policy

Money, Interest Rates and Business Activity

• The meaning of money– narrow definitions of money (M0 in the UK)

– broad definitions of money (M4 in the UK)

• The supply of money– banks and the creation of credit

• simple illustration

Credit creation: Banks' original balance sheet

Credit creation: Effect of a new deposit of £10bn

Credit creation: Full effect of a new deposit of £10bn

Money, Interest Rates and Business Activity

• The meaning of money– narrow definitions of money (M0 in the UK)

– broad definitions of money (M4 in the UK)

• The supply of money– banks and the creation of credit

• simple illustration

• the deposits multiplier

Money, Interest Rates and Business Activity

• The meaning of money– narrow definitions of money (M0 in the UK)

– broad definitions of money (M4 in the UK)

• The supply of money– banks and the creation of credit

• simple illustration

• the deposits multiplier

– creation of credit: the real world

Money, Interest Rates and Business Activity

• The meaning of money– narrow definitions of money (M0 in the UK)

– broad definitions of money (M4 in the UK)

• The supply of money– banks and the creation of credit

• simple illustration

• the deposits multiplier

– creation of credit: the real world• banks' liquidity ratio may vary

Money, Interest Rates and Business Activity

• The meaning of money– narrow definitions of money (M0 in the UK)

– broad definitions of money (M4 in the UK)

• The supply of money– banks and the creation of credit

• simple illustration

• the deposits multiplier

– creation of credit: the real world• banks' liquidity ratio may vary

• banks respond to the demand for money

• Causes of increases in money supply

– increased demand for money

• banks reduce liquidity ratio

– inflow of funds from abroad

– a public-sector deficit (PSNCR)

• depends on how it is financed

– from banking sector: money supply expands

– from outside the banking sector: money supply does not expand

Money, Interest Rates and Business Activity

• The demand for money

– reasons for holding money

• transactions and precautionary motive

• assets or speculative motive

– determinants of demand for money

• money national income

• speculation about future return on assets

• rate of interest

Money, Interest Rates and Business Activity

• Equilibrium rate of interest

– where demand for money equals supply

Money, Interest Rates and Business Activity

OMoney

Ra

te o

f in

tere

st

Md

re

Equilibrium in the money market

MS

• Equilibrium rate of interest

– where demand for money equals supply

– if supply of money rises or demand for money falls, the rate of interest will fall

Money, Interest Rates and Business Activity

OMoney

Ra

te o

f in

tere

st

Md

re

Equilibrium in the money market

MS

• Effects of changes in money supply on national income

– rise in money supply causes interest rate to fall

– fall in interest rate causes investment to rise

– rise in investment causes GDP to rise

• Determinants of the size of these effects

Money, Interest Rates and Business Activity

Unemployment

• Measuring unemployment

– defining the unemployment rate

– claimant unemployment

• do claimant statistics give a true picture of unemployment?

– standardised unemployment (ILO/OECD)

• use of labour force surveys

Unemployment

• Unemployment and the labour market

– the aggregate demand and supply of labour

Aggregate demand and supply of labour

O

Ave

rage

(re

al)

wa

ge r

ate

No. of workers

ASL

ADL

Unemployment

• Unemployment and the labour market

– the aggregate demand and supply of labour

• equilibrium in the model

QeO

Ave

rage

(re

al)

wa

ge r

ate

No. of workers

ASL

ADL

We

Aggregate demand and supply of labour

Unemployment

• Unemployment and the labour market

– the aggregate demand and supply of labour

• equilibrium in the model

– disequilibrium unemployment

O

Ave

rage

(re

al)

wa

ge r

ate

No. of workers

ASL

ADL

We

W2

Disequilibrium unemployment

Q2 Q1

B A

Unemployment

• Unemployment and the labour market

– the aggregate demand and supply of labour

• equilibrium in the model

– disequilibrium unemployment

– equilibrium unemployment

Equilibrium unemployment

O

Ave

rage

(re

al)

wa

ge r

ate

No. of workers

ADL

We

ASL

e

Qe

Q2QeO

Ave

rage

(re

al)

wa

ge r

ate

No. of workers

ASL

ADL

We

N

e d

Equilibrium unemployment

Equilibrium and disequilibrium unemployment

O

Ave

rage

(re

al)

wa

ge r

ate

No. of workers

ADL

We

e

Qe

ASL

O

Ave

rage

(re

al)

wa

ge r

ate

No. of workers

ASL

ADL

We

W2

b a

e

Disequilibriumunemployment

Equilibrium and disequilibrium unemployment

O

Ave

rage

(re

al)

wa

ge r

ate

No. of workers

ASL

ADL

We

W2

b a

e

N

c

Equilibriumunemployment

Disequilibriumunemployment

Equilibrium and disequilibrium unemployment

Unemployment

• Unemployment and the labour market

– the aggregate demand and supply of labour

• equilibrium in the model

– disequilibrium unemployment

– equilibrium unemployment

• Disequilibrium unemployment

Unemployment

• Unemployment and the labour market

– the aggregate demand and supply of labour

• equilibrium in the model

– disequilibrium unemployment

– equilibrium unemployment

• Disequilibrium unemployment

– real-wage unemployment

Unemployment

• Unemployment and the labour market

– the aggregate demand and supply of labour

• equilibrium in the model

– disequilibrium unemployment

– equilibrium unemployment

• Disequilibrium unemployment

– real-wage unemployment

– demand-deficient (cyclical) unemployment

An

nual

gro

wth

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%)

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Unemployment rates in selected industrial countries

0

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1970 1975 1980 1985 1990 1995 2000 2005

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1970 1975 1980 1985 1990 1995 2000 2005

Unemployment rates in selected industrial countries

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2

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1970 1975 1980 1985 1990 1995 2000 2005

An

nual

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EU15

Unemployment rates in selected industrial countries

0

2

4

6

8

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1970 1975 1980 1985 1990 1995 2000 2005

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nual

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EU15

Unemployment rates in selected industrial countries

0

2

4

6

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1970 1975 1980 1985 1990 1995 2000 2005

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nual

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EU15

USA

Unemployment rates in selected industrial countries

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2

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1970 1975 1980 1985 1990 1995 2000 2005

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USA

Unemployment rates in selected industrial countries

0

2

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1970 1975 1980 1985 1990 1995 2000 2005

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Unemployment rates in selected industrial countries

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1970 1975 1980 1985 1990 1995 2000 2005

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Unemployment rates in selected industrial countries

Unemployment

• Equilibrium unemployment

– frictional (search) unemployment

– structural unemployment

• changing pattern of demand

• technological unemployment

• regional unemployment

– seasonal unemployment

Inflation

• Defining inflation

– consumer price inflation

– other categories of inflation

• Inflation in historical perspective

– low inflation in 1950s and 60s

– high inflation in 1970s and 80s

– low inflation since mid 1990s• most developed countries gear monetary policy

to achieving a low target rate of inflation

An

nual

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UK

Inflation rates in selected industrial countries

-2

0

2

4

6

8

10

12

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16

18

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26

1965 1970 1975 1980 1985 1990 1995 2000 2005

An

nual

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-2

0

2

4

6

8

10

12

14

16

18

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26

1965 1970 1975 1980 1985 1990 1995 2000 2005

Inflation rates in selected industrial countries

-2

0

2

4

6

8

10

12

14

16

18

20

22

24

26

1965 1970 1975 1980 1985 1990 1995 2000 2005

An

nual

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%)

UK

EU15

Inflation rates in selected industrial countries

-2

0

2

4

6

8

10

12

14

16

18

20

22

24

26

1965 1970 1975 1980 1985 1990 1995 2000 2005

An

nual

gro

wth

rat

e (

%)

UK

EU15

Inflation rates in selected industrial countries

-2

0

2

4

6

8

10

12

14

16

18

20

22

24

26

1965 1970 1975 1980 1985 1990 1995 2000 2005

An

nual

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wth

rat

e (

%)

UK

EU15

USA

Inflation rates in selected industrial countries

-2

0

2

4

6

8

10

12

14

16

18

20

22

24

26

1965 1970 1975 1980 1985 1990 1995 2000 2005

An

nual

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wth

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%)

UK

EU15

USA

Inflation rates in selected industrial countries

-2

0

2

4

6

8

10

12

14

16

18

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24

26

1965 1970 1975 1980 1985 1990 1995 2000 2005

An

nual

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UK

EU15 Japan

USA

Inflation rates in selected industrial countries

-2

0

2

4

6

8

10

12

14

16

18

20

22

24

26

1965 1970 1975 1980 1985 1990 1995 2000 2005

An

nual

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EU15 Japan

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Inflation rates in selected industrial countries

Inflation

• Aggregate demand & supply and prices

– aggregate demand curve

O

Pri

ce le

vel

National output

AD

Aggregate demand and aggregate supply

Inflation

• Aggregate demand & supply and prices

– aggregate demand curve• why AD curves slope downwards

Inflation

• Aggregate demand & supply and prices

– aggregate demand curve• why AD curves slope downwards

– lower price level leads to fewer imports

– lower price level tends to cause interest rates to fall

– lower price level increases value of people's savings

Inflation

• Aggregate demand & supply and prices

– aggregate demand curve• why AD curves slope downwards

– lower price level leads to fewer imports

– lower price level tends to cause interest rates to fall

– lower price level increases value of people's savings

– aggregate supply curve

O

Pri

ce le

vel

National output

AS

AD

Aggregate demand and aggregate supply

Inflation

• Aggregate demand & supply and prices

– aggregate demand curve• why AD curves slope downwards

– lower price level leads to fewer imports

– lower price level tends to cause interest rates to fall

– lower price level increases value of people's savings

– aggregate supply curve• why AS curves generally slope upwards

Inflation

• Aggregate demand & supply and prices

– aggregate demand curve• why AD curves slope downwards

– lower price level leads to fewer imports

– lower price level tends to cause interest rates to fall

– lower price level increases value of people's savings

– aggregate supply curve• why AS curves generally slope upwards

– equilibrium

O

Pri

ce le

vel

National output

AS

AD

Pe

Aggregate demand and aggregate supply

O

Pri

ce le

vel

National output

AS

AD

Pe

P2

ab

Aggregate demand and aggregate supply

Inflation

• Aggregate demand & supply and prices

– aggregate demand curve• why AD curves slope downwards

– lower price level leads to fewer imports

– lower price level tends to cause interest rates to fall

– lower price level increases value of people's savings

– aggregate supply curve• why AS curves generally slope upwards

– equilibrium

– shifts in AD and AS curves

Inflation

• Causes of inflation– demand pull

Demand-pull inflation

O

Pri

ce le

vel

National output

AS

AD1

P1

Q1

O

Pri

ce le

vel

National output

AS

AD1

P1

Q1

AD2

Demand-pull inflation

O

Pri

ce le

vel

National output

AS

AD1

P1

Q1

AD2

P2

Q2

Demand-pull inflation

Inflation

• Causes of inflation– demand pull

– cost push• wage push

• profit push

• import-price push

Cost-push inflation

O

Pri

ce le

vel

National output

AS1

AD

P1

Q1

O

Pri

ce le

vel

National output

AS1

AD

P1

Q1

AS2

Cost-push inflation

O

Pri

ce le

vel

National output

AS1

AD

P1

Q1

AS2

P2

Q2

Cost-push inflation

Inflation

• Causes of inflation– demand pull

– cost push• wage push

• profit push

• import-price push

– the interaction of demand-pull and cost-push inflation

The interaction of demand-pull and cost-push inflation

O

Pri

ce le

vel

National output

AS1

AD1

P1

O

Pri

ce le

vel

National output

AS1

AD1

P1

AS2

AD2

P2

The interaction of demand-pull and cost-push inflation

O

Pri

ce le

vel

National output

AS1

AD1

P1

AD2

P2

AS3

AD3

P3

AS2

The interaction of demand-pull and cost-push inflation

Inflation

• Causes of inflation– demand pull

– cost push• wage push

• profit push

• import-price push

– expectations and inflation

Inflation

• Causes of inflation– demand pull

– cost push• wage push

• profit push

• import-price push

– expectations and inflation

• Policies to tackle inflation

Inflation

• Causes of inflation– demand pull

– cost push• wage push

• profit push

• import-price push

– expectations and inflation

• Policies to tackle inflation– demand-side policies

Inflation

• Causes of inflation– demand pull

– cost push• wage push

• profit push

• import-price push

– expectations and inflation

• Policies to tackle inflation– demand-side policies

– supply-side policies