IB Economics The Level of Overall Economic Activity Chapter 13

What do you know?  In groups write down what you know about macroeconomics  Think about these things (but don’t limit your thoughts to these)  What is the difference/link between micro and macro  Who are the main players in the macro economy?  What does a good economy look like?  What is happening in the world economy at the moment?  Even if you know words but don’t know their meaning write them down!

Learning Objectives  Understand the five main macroeconomic objectives (goals)  Understand, describe and illustrate the circular flow of income  Understand the different measures of national income  Calculate national income  Explain the meaning and significance of ‘green GDP’  Evaluate the uses of national statistics  Explain and illustrate the business cycle

What is Macro economics?  Before we looked at micro economics  We looked at what happened within the firm and within the market  Now add all of those markets together and we get the macro economy  We looked at allocation of resources in a market  Macroeconomics is concerned with the allocation of a nation’s resources  There are five main variables  Economic growth  Employment  Price stability  External stability  Income distribution

Macro objectives  There are five objectives that most economies have  A steady increase of national output (growth)  A low level of unemployment  A low and stable rate of inflation  A favourable balance of payments (Trade - Exports minus Imports)  An equitable (fair) distribution of income

The circular flow game  To understand how an economy works we need to understand the flows  To do this we will use a really simple model  There are four households (families) who have been shipwrecked on a desert island  Divide into 4 groups  The supply of money in the economy is £5 and we assume that all the money will be used to buy good and services  Household A spends £5 and received from household B goods and services in exchange.  Household B then spends £5 on goods sold by household C and the process is repeated until all households have participated.  Keep count of how much your household spends  Keep count of how much you earn

The circular flow game  If these 4 families are the entire economy  What is the value of national output = ?  £20  What is national income = ?  £20  What is national expenditure = ?  £20

The circular flow game - summary  In a simplified model GDP = National Output = National Income = National Expenditure  Not only is this true in a simplified model it is also true (with a few statistical adjustments) for any economy  In a more sophisticated economy households do not trade with each other and we need to add firms GDP = National Output = national income = national expenditure

Check your understanding  National Income, National Output and National Expenditure should always be equal. Why is this?  If a newspaper headline says ‘UK National Income increased last year by 2%’, what does this mean in terms of  output and expenditure?  Changes in flow?  Same amount of growth in national output and national expenditure  Flow has increased  More flowing in than out

What circular flows do we have in this 2 sector model?

Leakages and Injections  This model is very simplified  What is it not taking into consideration?  Do people spend all of their income?  No, they save some in the bank or other financial institutions  This is known as a leakage from the circular flow  If households don’t buy all the output that is produced by the firms will have unsold stock  They will reduce their output  They will use less factors of production and pay less income  The amount of income in the economy will fall Saving: foregoing current consumption to allow for consumption in the future

Leakages and Injections  The good thing about savings is that firms will have access to them by borrowing money from banks  They can use the money to increase their stock of capital and expand their output  This is known as investment  It is an injection into the circular flow of income  Investment allows the amount of income circulating in the economy to rise

Leakages and Injections  Why is this model still too simple?  An economy is not closed  Households can buy goods and services from other countries  Would this be an injection or a leakage?  Imports are a leakage – this is income that is being spent and not being returned to firms  People buy the countries exports of goods and services  Are exports leakages or injections  Exports are an Injection because they represent a source of income not coming directly from the households

Leakages and Injections  Why is this model still too simple?  There are more than two sectors  We now need to introduce the government sector  What injection and leakage can be added to this diagram due to the introduction of the government sector?

Leakages and Injections  Some of the income earned by the households must be paid to the government in the form of taxes  Taxes are a leakage  Governments spend money in the economy on schools, roads, campaigns, hospitals etc  Government spending is an injection  Don’t assume that government spending = revenue from taxes

Leakages and Injections  You will see later that governments can spend more than they earn to deliberately influence the level of leakages and injections to affect the level of national income

How is national income measured?  There are three ways (which we saw before when we played the desert island game) of measuring income  Can you remember?  Output – the value of goods and services produced (less the costs of inputs)  Income – the value of all incomes earned in the economy  Expenditure – the value of all spending in the economy  Spending by households known as consumption (C)  Spending by firms known as investment (I)  Spending by government (G)  Spending by foreigners on exports minus spending on imports or net exports (X-M)  There is an identity that you will need to learn GDP = C + I + G + (X-M)

How is national income measured?  In practice, the data collected to calculate GDP comes from many different and varied sources  There are often inaccuracies  This can be due to timing  Often figures have to be revised at later date when full information is collected

Different measures of income GDP – the total of all economic activity in a country regardless of who owns the productive assets Gross National Product (GNP) or Gross National Income (GNI) – the total income that is earned by a country’s factors of production regardless of where the assets are located GNIGDPincome earned from assets abroad income paid to foreign assets operating domestically = + - Over time capital gets used up – it’s value depreciates GDP does not take this into consideration. NNI does. NNI = GNI minus depreciation Green GDP – GDP minus environmental costs

Real GDP or nominal GDP  To make a comparison of GDP year on year you need to take into consideration the rise in prices  You are measuring by the total value of goods and services  The goods and services may not have changed  Inflation may mean that the prices of the same goods and services have gone up  We use a GDP deflator to do this  GDP x 100/(100 + inflation rate) = real GDP  If the inflation rate was 4%  Real GDP = GDP x 100/104 Real GDP – GDP which has been adjusted for inflation Nominal GDP – GDP which has not been adjusted for inflation

GDP per capita  To make a judgement about the progress of a country in comparison with other countries in terms of raising living standards the GDP per capita figure is much more appropriate GDP per capita – GDP divided by the size of the population

Limitations of the data  Inaccuracies – figures tend to become more accurate after time as they are revised  Unrecorded or under-recorded economic activity (informal markets)  DIY in developed countries  Care for elderly or children  Subsistence farming in developing countries  Illegal activities (alien workers, drug trafficking etc)  Work done for cash (and no tax is paid)  Countries with higher tax burdens tend to have a larger hidden economy  External costs  GDP does not take into account resource depletion or negative externalities  Quality of life concerns  GDP may grow because people are working longer hours  Composition of output  Output could be defence that does not benefit consumers

The Business Cycle  The business cycle fluctuations in economic activity measured by changes in real GDP  Fluctuations in practice are highly irregular Recovery: economic expansion largely driven by increase in aggregate demand as households and consumers are encouraged to spend more. Firms increase their output in response to the increase in demand. Newly employed workers spend their income on goods and services

The Business Cycle Boom: increased demand for goods and services pushes up average prices (inflation). The rate of growth of GDP will fall as the economy nears its potential output. Policy makers may try to slow growth (to reduce inflation) causing a fall in total demand and recession could begin. Recession: defined as two consecutive quarters of negative GDP growth. Falling aggregate demand will lead firms to lay off workers so unemployment rises. This means less spending leading to lower rates of inflation or deflation Trough: at some point the contraction will come to an end. Aggregate demand will pick up and enter the recovery phase

Negative output gap (A): the economy is producing below its trend and unemployment is likely to be a problem Long term trend and output gaps Positive output gap (B): the economy is producing above its trend and inflation is likely to be a problem Economies fluctuate but tend to have positive long term growth trends