Busactivity

9The Economy and

Business Activity

9The Economy and

Business Activity

Macroeconomic ObjectivesMacroeconomic 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.

• 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 IncomeThe Circular Flow of Income

• The inner flow• The inner flow

Factorpayments

Factorpayments

Consumption ofdomestically

produced goodsand services (Cd)



The circular flow of incomeThe circular flow of income

Firms

Households


• Withdrawals

– net saving (S)

– net taxes (T)

– import expenditure (M)

• Injections

– investment (I)

– government expenditure (G)

– export expenditure (X)

• Withdrawals

– net saving (S)

– net taxes (T)

– import expenditure (M)

• Injections

– investment (I)

– government expenditure (G)

– export expenditure (X)

Factorpayments

Factorpayments





Investment (I)Investment (I)

Governmentexpenditure (G)


Exportexpenditure (X)


BANKS, etc

Netsaving (S)

Netsaving (S)

GOV.

Nettaxes (T)

Nettaxes (T)

ABROAD

Importexpenditure (M)



WITHDRAWALS

INJECTIONS


• 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




• effect of J > W

• effect of W > J


Factorpayments

Factorpayments





Investment (I)Investment (I)





BANKS, etc

Netsaving (S)

Netsaving (S)

GOV.

Nettaxes (T)

Nettaxes (T)

ABROAD




WITHDRAWALS

INJECTIONS





• effect of J > W

• effect of W > J


• The circular flow and the four macroeconomic objectives




• effect of J > W

• effect of W > J


• The circular flow and the four macroeconomic objectives

The Determination of Business ActivityThe 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 GDPEquilibrium GDP







– the GDP and E lines







45°

O GDP (£bn)

GDP = Cd + W

E = Cd + J

Cd, E, W, J (£bn)

Cd

JJ









• 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











– finding the equilibrium point









– 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



• The multiplier

– the multiplier process

– definition of the multiplierGDP / J

– the marginal propensity to consume domestic goods and services

• mpcd = Cd / GDP

• The multiplier




• 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 expenditureThe multiplier: a rise in aggregate expenditure

Cd

J

Cd = 40

GDP = 60

GDP


• The multiplier




• mpcd = Cd / GDP

– formula for the multiplier

• 1 / (1–mpcd)

• The multiplier




• 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 expenditureThe multiplier: a rise in aggregate expenditure

The Business CycleThe 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


• Economic growth & the business cycle

– fluctuations in actual growth

– the phases of the business cycle

• the upturn

• the expansion

• the peaking out


O

Nat

iona

l out

put

Time

Potential output

1

2

3

4

1

2

34Actualoutput

The business cycleThe business cycle



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

– the phases of the business cycle• the upturn

• the expansion

• the peaking out


– long-term output trend


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

– the phases of the business cycle• the upturn

• the expansion

• the peaking out


– long-term output trend

O

Nat

iona

l out

put

Time

Potential output

Actualoutput

Trendoutput

The business cycleThe 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 length of the phases






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





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

Ann

ual g

row

th r

ate

(%)

UK

Growth rates in selected industrial countriesGrowth 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

Ann

ual g

row

th r

ate

(%)

UK


-3

-2

-1

0

1

2

3

4

5

6

7

8

9

10

1970 1975 1980 1985 1990 1995 2000 2005

Ann

ual g

row

th r

ate

(%)


-3

-2

-1

0

1

2

3

4

5

6

7

8

9

10

1970 1975 1980 1985 1990 1995 2000 2005

UK

EU15

Ann

ual g

row

th r

ate

(%)


-3

-2

-1

0

1

2

3

4

5

6

7

8

9

10

1970 1975 1980 1985 1990 1995 2000 2005

UK

EU15

Ann

ual g

row

th r

ate

(%)


-3

-2

-1

0

1

2

3

4

5

6

7

8

9

10

1970 1975 1980 1985 1990 1995 2000 2005

UK

EU15

USA

Ann

ual g

row

th r

ate

(%)


-3

-2

-1

0

1

2

3

4

5

6

7

8

9

10

1970 1975 1980 1985 1990 1995 2000 2005

UK

EU15

USA

Ann

ual g

row

th r

ate

(%)


-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

Ann

ual g

row

th r

ate

(%)


-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


• 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

• 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 ActivityMoney, 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 sheetCredit creation: Banks' original balance sheet

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

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






• the deposits multiplier












– creation of credit: the real world






– creation of credit: the real world







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














• banks respond to the demand for money







• 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

• 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


• 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

• 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


• Equilibrium rate of interest

– where demand for money equals supply




OMoney

Ra

te o

f in

tere

st

Md

re

Equilibrium in the money marketEquilibrium in the money market

MS



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



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


OMoney

Ra

te o

f in

tere

st

Md

re

Equilibrium in the money marketEquilibrium 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

• 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


UnemploymentUnemployment

• 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

• 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 and the labour market

– the aggregate demand and supply of labour



Aggregate demand and supply of labourAggregate demand and supply of labour

O

Ave

rag

e (r

ea

l) w

ag

e ra

te

No. of workers

ASL

ADL




• equilibrium in the model




QeO

Ave

rag

e (r

ea

l) w

ag

e ra

te

No. of workers

ASL

ADL

We

Aggregate demand and supply of labourAggregate demand and supply of labour





– disequilibrium unemployment





O

Ave

rag

e (r

ea

l) w

ag

e ra

te

No. of workers

ASL

ADL

We

W2

Disequilibrium unemploymentDisequilibrium unemployment

Q2 Q1

B A






– equilibrium unemployment






Equilibrium unemploymentEquilibrium unemployment

O

Ave

rag

e (r

ea

l) w

ag

e ra

te

No. of workers

ADL

We

ASL

e

Qe

Q2QeO

Ave

rag

e (r

ea

l) w

ag

e ra

te

No. of workers

ASL

ADL

We

N

e d

Equilibrium unemploymentEquilibrium unemployment

Equilibrium and disequilibrium unemploymentEquilibrium and disequilibrium unemployment

O

Ave

rag

e (r

ea

l) w

ag

e ra

te

No. of workers

ADL

We

e

Qe

ASL

O

Ave

rag

e (r

ea

l) w

ag

e ra

te

No. of workers

ASL

ADL

We

W2

b a

e

Disequilibriumunemployment


O

Ave

rag

e (r

ea

l) w

ag

e ra

te

No. of workers

ASL

ADL

We

W2

b a

e

N

c

Equilibriumunemployment

Disequilibriumunemployment








• Disequilibrium unemployment














– real-wage unemployment
















– demand-deficient (cyclical) unemployment








– demand-deficient (cyclical) unemployment

Ann

ual g

row

th r

ate

(%)

UK

Unemployment rates in selected industrial countriesUnemployment rates in selected industrial countries

0

2

4

6

8

10

12

14

1970 1975 1980 1985 1990 1995 2000 2005

Ann

ual g

row

th r

ate

(%)

UK

0

2

4

6

8

10

12

14

1970 1975 1980 1985 1990 1995 2000 2005


0

2

4

6

8

10

12

14

1970 1975 1980 1985 1990 1995 2000 2005

Ann

ual g

row

th r

ate

(%)

UK

EU15


0

2

4

6

8

10

12

14

1970 1975 1980 1985 1990 1995 2000 2005

Ann

ual g

row

th r

ate

(%)

UK

EU15


0

2

4

6

8

10

12

14

1970 1975 1980 1985 1990 1995 2000 2005

Ann

ual g

row

th r

ate

(%)

UK

EU15

USA


0

2

4

6

8

10

12

14

1970 1975 1980 1985 1990 1995 2000 2005

Ann

ual g

row

th r

ate

(%)

UK

EU15

USA


0

2

4

6

8

10

12

14

1970 1975 1980 1985 1990 1995 2000 2005

Ann

ual g

row

th r

ate

(%)

UK

EU15 Japan

USA


0

2

4

6

8

10

12

14

1970 1975 1980 1985 1990 1995 2000 2005

Ann

ual g

row

th r

ate

(%)

UK

EU15 Japan

USA



• Equilibrium unemployment

– frictional (search) unemployment

– structural unemployment

• changing pattern of demand

• technological unemployment

• regional unemployment

– seasonal unemployment

• Equilibrium unemployment

– frictional (search) unemployment

– structural unemployment

• changing pattern of demand

• technological unemployment

• regional unemployment

– seasonal unemployment

InflationInflation

• 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

• 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

Ann

ual g

row

th r

ate

(%)

UK

Inflation rates in selected industrial countriesInflation 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

Ann

ual g

row

th r

ate

(%)

UK

-2

0

2

4

6

8

10

12

14

16

18

20

22

24

26

1965 1970 1975 1980 1985 1990 1995 2000 2005


-2

0

2

4

6

8

10

12

14

16

18

20

22

24

26

1965 1970 1975 1980 1985 1990 1995 2000 2005

Ann

ual g

row

th r

ate

(%)

UK

EU15


-2

0

2

4

6

8

10

12

14

16

18

20

22

24

26

1965 1970 1975 1980 1985 1990 1995 2000 2005

Ann

ual g

row

th r

ate

(%)

UK

EU15


-2

0

2

4

6

8

10

12

14

16

18

20

22

24

26

1965 1970 1975 1980 1985 1990 1995 2000 2005

Ann

ual g

row

th r

ate

(%)

UK

EU15

USA


-2

0

2

4

6

8

10

12

14

16

18

20

22

24

26

1965 1970 1975 1980 1985 1990 1995 2000 2005

Ann

ual g

row

th r

ate

(%)

UK

EU15

USA


-2

0

2

4

6

8

10

12

14

16

18

20

22

24

26

1965 1970 1975 1980 1985 1990 1995 2000 2005

Ann

ual g

row

th r

ate

(%)

UK

EU15 Japan

USA


-2

0

2

4

6

8

10

12

14

16

18

20

22

24

26

1965 1970 1975 1980 1985 1990 1995 2000 2005

Ann

ual g

row

th r

ate

(%)

UK

EU15 Japan

USA


InflationInflation

• Aggregate demand & supply and prices

– aggregate demand curve



O

Pri

ce le

vel

National output

AD

Aggregate demand and aggregate supplyAggregate demand and aggregate supply

InflationInflation



• why AD curves slope downwards



• why AD curves slope downwards

InflationInflation



• 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






InflationInflation






– aggregate supply curve







O

Pri

ce le

vel

National output

AS

AD


InflationInflation







• why AS curves generally slope upwards








InflationInflation








– equilibrium








– equilibrium

O

Pri

ce le

vel

National output

AS

AD

Pe


O

Pri

ce le

vel

National output

AS

AD

Pe

P2

ab


InflationInflation








– equilibrium

– shifts in AD and AS curves








– equilibrium

– shifts in AD and AS curves

InflationInflation

• Causes of inflation– demand pull


Demand-pull inflationDemand-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


O

Pri

ce le

vel

National output

AS

AD1

P1

Q1

AD2

P2

Q2


InflationInflation


– cost push• wage push

• profit push

• import-price push



• profit push


Cost-push inflationCost-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


O

Pri

ce le

vel

National output

AS1

AD

P1

Q1

AS2

P2

Q2


InflationInflation



• profit push


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



• profit push


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

The interaction of demand-pull and cost-push inflationThe 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


O

Pri

ce le

vel

National output

AS1

AD1

P1

AD2

P2

AS3

AD3

P3

AS2


InflationInflation



• profit push


– expectations and inflation



• profit push



InflationInflation



• profit push



• Policies to tackle inflation



• profit push



• Policies to tackle inflation

InflationInflation



• profit push



• Policies to tackle inflation– demand-side policies



• profit push




InflationInflation



• profit push




– supply-side policies



• profit push




– supply-side policies