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EC111 MACROECONOMICS Spring Term 2012

Lecturer: Jonathan Halket: Room 3.202; Tel: 872394; Email: jhalket@essex.ac.uk
Term-time Office Hours: Wednesday 2-4 pm.
Reminder: Assignment Due Monday, March 5
th
; Test Friday, March 15
th

Week 16
Topic 1: Macroeconomics and the National Economy.
In macroeconomics we consider the economy as a whole rather than the individual
decision-making unit. Instead we consider the behaviour at the aggregate level; firms,
households, the government, banks; the world economy. We consider how different
groups or sectors interact to generate relationships between key economic variables
such as national income, consumption, investment and imports as well as a variety of
economy-wide prices: the overall price index, wages, exchange rates, interest rates etc.
Macroeconomic analysis is closely linked to policy. The key macroeconomic outcomes
that concern us here are also goals for macroeconomic policy:
Sustained long-term growth in national income per capita.
Keeping the level of economic activity relatively stable from year to year.
Keeping the rate of unemployment as low as is feasible.
Keeping price inflation low and stable.
There may be some trade-offs between these objectives (something we shall look at).
Other variables are of interest too, but they are intermediate variables rather than ends
in themselves. But Wait: What do you think should be the ultimate end?
National income and growth.
National income represents the amount of marketed goods and services that is produced
in the economy in a year. It is a flow rather than a stock (such as the capital stock or the
stock of financial assets). Every time something is bought it must also be produced and
sold, so national income and national product are essentially the same thing. Measuring
this in real terms, and dividing by population, gives measures like (real) Gross National
Product (GNP) per capita, which are the focus of most studies of economic growth.
Economic growth is measured over decades rather than months or years. Faster growth
makes a huge difference to average living standards in the long run because of
compounding. If per capita income grows at 2 percent per year then income doubles in
36 years (not 50); if the growth rate is 4 percent, income doubles in 18 years (rule of
thumb: 72/growth rate). In the UK (one of the slower growers) real per capita GNP has
increased by a factor of 3.3 since 1950 (two generations and by 7.2 since 1870 (five
generations).
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In the long-run standards of living are determined by the capacity of the economy to
produce. In other words it is determined by the position of the production possibility
frontier (PPF), which in per-capita terms depends on the size of the capital stock and on
technology. Thus growth in per capita income depends on capital formation and
technical progress (and perhaps a few other things).
But note:
GNP is a measure of marketed goods and services (so we can measure it in
monetary terms). So goods and services that are produced outside the market
dont enter into the national statistics. Household production of meals, cleaning
DIY, gardening, childcare etc., are not counted as part of GNP. This poses
problems, especially when comparing poor and rich countries; less so for
changes over time.
Per capita GNP is not synonymous with economic welfare, which we might think
of as consumption plus leisure. There are other aspects of well-being that should
also be recognised; health (especially life expectancy); education; broader things
such as political rights and civil liberties. Also externalities are not counted.
Per capita GDP Multiples (Maddison data)
1950/1870 2006/1950 2006/1870
Austria 2.0 6.1 12.2
Belgium 2.0 4.2 8.4
Denmark 3.5 3.6 12.4
Finland 3.7 5.5 20.4
France 2.8 4.5 12.6
Germany 2.1 5.2 10.9
Italy 2.3 5.7 13.2
Netherlands 2.2 3.9 8.5
Norway 4.0 5.1 20.5
Sweden 4.1 3.6 14.6
Switzerland 4.3 2.6 11.4
United Kingdom 2.2 3.3 7.2
Ireland 1.9 8.1 15.7
Greece 2.2 8.2 17.9
Portugal 2.1 6.8 14.6
Spain 1.8 8.6 15.6
Australia 2.3 3.3 7.5
New Zealand 2.7 2.2 5.9
Canada 4.3 3.4 14.5
United States 3.9 3.2 12.7
Source: http://www.ggdc.net/maddison/
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Economic Fluctuations
Productive capacity (potential real GNP) typically increases gradually over time, but
actual GNP is more volatile.

We can think of full capacity output what GNP would be if we were on the PPF. But
there is always some unused capacity in the economy (unemployment is never zero). But
sometimes we are close to the PPF; sometimes further away. Do we always want to be
on the PPF?
Economists attempt to estimate trend output: the underlying trend of actual output,
once we account for the ups and downs. This is quite tricky as the growth of full
capacity (and trend) output may change (eg the slowdown from the 1970s and the speed
up from the mid-1990)s. One aim of economic policy is to smooth out the ups and downs
and stay close to trend.
Deviations from trend are called output gaps; measured as the percentage difference
between actual and trend output. For the UK this shows the big recession in the early
1980s followed by a boom and then a milder recession in the mid-1990s. Note also the
big recession in 2009-10.
Confusingly, we will use a concept called Potential Output which is not Full-capacity
Output and definitely not Actual Output and closely related but technically not Trend
Output. Potential Output is output when the economy is in long-run equilibrium (a
notion we have yet to define): every worker that wants to work at the equilibrium wage
can find work, every machine that can profitably be operated at the equilibrium rental
rate is in use. Potential output allows for equilibrium unemployment a concept we will
return to too.
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But note that:
It is very difficult to forecast and hence to set policy for next year or future
years.

This is sometimes called the business cycle because there are recurrent booms
and slumps. But it is not a regular cycle as the name implies. Leading indicators
are often used but are not very reliable. The global financial crisis is an
exception.

It is difficult to frame policy unless we know something about the sources of the
shocks (meaning that they are not anticipated) to GNP that come along from
time to time. Do they just reflect shifts in demand for goods and services or are
there forces on the supply side (more on this later)?

Question: does the correlation between different countries/regions provide a
clue?

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Unemployment
Unemployment has been seen as a key target variable for macroeconomic policy. That
may seem odd because work is a bad in the standard utility maximising context. But it
is interpreted as unused capacity; worse still some people would like to work but there
are not enough jobs, so there is an obvious welfare loss.
Unemployment moves in a way that is broadly consistent with the output gap (the
relation between them is known as Okuns law). This is not surprising as labour is a
key variable input to production.

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There are different definitions of unemployment, e.g the claimant count for the UK. But
OECD data is based on surveys (like the UK Labour Force Survey) that count as
unemployed people who are not employed but who are available and looking for work.
This is expressed as a percentage of the labor force:
Number of people in Labor Force = # of employed + # of unemployed
Unemployment rate = # of unemployed / Labor Force
Unemployment was fairly low up to the mid-1970s; then it rose steeply to over 10
percent in the mid 1980s. That has led to a long debate:
What were the causes of sustained high unemployment; should the government have
done more (or less) on the demand side? Was there a widening of the gap between
potential output and trend output? And if so why? And why did UK performance
improve relative to the rest of the EU from the mid-1990s (perhaps not any more)?
Unemployment is of particular concern because it falls on a minority; those who keep
their jobs dont suffer. There is a constant flow into and out of unemployment, but if
those who become unemployed stay there for a long time then the costs are more
concentrated.
A key question is to what extent (or how quickly) competition for jobs pushes down
wage rates, creating more employment as firms shift down their (downward sloping)
labour demand curves. Are their institutional barriers to wage adjustment? And does
that explain the persistence of unemployment, sometimes called Eurosclerosis?
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I nflation
Inflation is defined the rate of increase of the aggregate price index: ___________,
where P is the price level (an index number, set to 100 in a base year). We shall
sometimes denote this as
As we shall see, wages and prices tend to rise faster when the economys resources are
more fully employed. One of the signals that the economy is overheating is that
inflation is relatively high. In some cases prices have accelerated out of control and most
central banks set monetary policy to keep inflation within a target range.
This is largely the result of the experience of the 1970s; in the UK retail price inflation
reached 24 percent in 1975. Now the Bank of England targets the Harmonised Index of
Consumer Prices (HICP) with a central target of 2 percent and a range of 1-3 percent.


One curious feature is that inflation was highest just at a time when the output gap was
increasingly negative and unemployment was rising. This led to a major re-think of
macroeconomic policy, to which we shall return.



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National I ncome Accounting
The circular flow of income between four groups of actors or agents:
Households: receive income from the supply of labour services to firms they also
own assets from which they receive income. Income is either consumed or saved
(to buy more assets) or is taken by the government in tax. Households may also
receive transfers from the government.

Firms: Use factors of production to produce goods. They pay households for the
use of factors of production, in the form of wages or interest or dividends. They
sell goods to households or the government or overseas. They pay tax and
receive income from the government.

Government: receives tax and makes transfers to households or firms. It spends
on goods and services, which may be consumed or invested.

The rest of the world: Foreign households, firms and governments buy domestic
goods and assets or sell foreign goods and assets to domestic residents. They pay
or receive income from assets.


Households spend their income on goods and services and firms pay households for
factor services. Remember that since firms are owned directly or indirectly by
households, all firms income must be received by households. Goods and services flow
in one direction; factors services in the other. The counterpart to these flows is
payments in money.
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Note that, here spending on domestically produced goods other than for consumption is
described as an injection into the circular flow. Withdrawals occur when some of
household income is not directly paid to firms for consumption goods.

Definitions and identities
We can measure national income in three different ways. This is because there are two
sides to every transaction; whenever something is bought it must also be sold. National
Income is the money value of all these transactions. It represents the flow of income, the
spending of that income, and the production of goods on which income is spent.
Gross National I ncome(Y): Since firms have no separate identity, all factor payments
flow to households. National income is total wage payments plus profits, rents etc.
Gross National Product (Q): The value of the production of all firms. Production is not
quite the same as sales because:
Firms buy goods from other firms as inputs, e.g. raw materials. To count both
the value of raw materials or intermediate goods and the final goods would be
double counting, so we used value added, i.e. the extra value each firms adds to
the good.
Firms may accumulate inventories if some goods remain unsold. We treat this as
if the firms bought the goods from themselves. So, value added for one firm is
sales and inventory accumulation minus intermediate inputs.
Gross National Expenditure (Z): This is total expenditure on goods and services.
Expenditure may be for consumption (C) by households or spending by firms on
investment in capital goods (I).
Question: Can households also invest?
Consider now a closed economy with no government. The value of goods and services
produced must equal the value sold so: Q = Z, or GNP = GNE. Since Z = C + I we have
Q = C + I. Income received by households must be either spent or saved, hence Y = C +
S, where S is saving. But income is simply the factor payments of firms, which is equal
to firms value added or total national output. Hence Y = Q = Z, and therefore:
Y = C + S = Z = C + I
In this closed economy we have S = I. Note that these relationships are true by
definition. They are called national income accounting identities (often denoted by a
three bar equals sign: ).


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Gross versus Net: GNP or GNE are so called because they do not include any allowance
for depreciation of the capital stock. Every year some of the existing stock is used up.
To calculate national income or expenditure and account for replacement we must
deduct depreciation, D, to give net investment I D. Net National Product (NNP) is
therefore C + I - D = Z D and Net National Income is Y D.
Adding the Government: Government spending, G, is defined to exclude transfer
payments since these are not payments for goods or factor services. If the government
spends on providing health services or education it is part of G. The government buys
or provides them on behalf of households. So now:
GNE = C + I + G = Y
The government levies two types of taxes. Direct tax, Td, is taxes on incomes (and e.g.
National Insurance). We take this net of benefit transfers. Indirect tax, Te is taxes on all
expenditures, like VAT. Indirect taxes raise the price of goods and so we need to adjust
for this. We define GNE at factor cost = GNE at market price minus Te
GNE at factor cost = C + I + G Te
Household disposable income is income net of direct tax, Yd = Y Td. Disposable
income may be either spent or saved so that Yd = C + S. So now:
Y = Yd + Td = C + S +Td
This still equals Gross National Expenditure (at factor cost) so that:
Y = C + S + Td = C + I + G Te
Rearranging we have: I + G = S + Td + Te (total injections equals total withdrawals)
Or, alternatively: G Td Te = S I (the governments budget deficit equals private
sector net saving).
If the government runs a deficit, then it must borrow from the private sector
(households and firms), which must therefore save more than it invests.
The foreign sector: Exports of goods and services, X, are defined as expenditure by
people abroad on domestically produced goods. Imports, Z, are our expenditures on
goods and services produced abroad. This is expenditure that appears as part of C and I
(and possibly G) but which has no counterpart in domestic production. We now write:
GNE = C + I + G Te + X Z = C + S + Td
Hence:
G Td Te = S I + Z X
Now if the government runs a deficit it must be finances either by borrowing from the
domestic private sector or from abroad.
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NX=X Z is the balance of trade. If the value of imports exceeds the value of exports
then the country has a balance of trade deficit. It must be borrowing foreign currency to
make up the difference. It could be borrowed either by the private sector or the public
sector (more on this later).
Finally note that if firms or households invested abroad they would receive a flow of
interest and dividends. This is part of domestic income but not part of domestic
production. So Gross Domestic Product (GDP) is GNP minus net (asset) income from
abroad.
Here are some numbers for the UK Economy in 2007