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Macro-economics

The national economy pages introduce macro-economic

concepts, models, and theories, and explains how macro-

economic problems are analysed, and policies evaluated.

Macro-economic theory

Macro-economics is traditionally broken down into macro-

economic theory and macro-economic policy. Macro-economic

theory involves the construction and use of models of the

whole, macro, economy. Economists build such models so that they can explain the structure of an economy, and the role

and significance of the parts that make up this

structure. Macro-economic models also help the economist

understand how the separate components of the macro-

economy are related.

Macro-economic models are also used to help economists and

policy makers make predictions, or forecasts, about the

economy, and about the effect of changes in one economic

variable, such as exchange rates, on other variables, such as

prices and output.

Macro-economic policy objectives

Macro-economic policy refers to how governments and other

policy makers compensate for market failures in order to

improve economic performance and well-being. Improvements

in performance begin with the setting of policy objectives,

which include the achievement of sustainable economic growth

and development, stable prices and full employment. Some of

the objectives set are potentially in conflict with each other,

which means that, in attempting to achieve one objective,

another one is sacrificed. For example, in attempting to achieve full employment in the short-term price inflation may

occur in the longer term.

Policy targets

In order to achieve policy objectives, policy makers will set

targets to aim for. Targets are often fixed, and widely known,

such as the current UK inflation target of 2%, but they may

also be flexible and less widely known, such as exchange rate

and employment targets.

Policy instruments

Once policy objectives and targets are established, policy

makers need to choose between alternative policy tools, or

instruments. These instruments are the levers of control of the

macro-economy and include monetary instruments such as

interest rates, and fiscal instruments such as tax rates and

government spending.

Policy disagreements

Policy disagreements occur for a number of reasons. Macro-

economic policy is often shaped by long held normative beliefs

about what is essential, and this influences the choice of model,

objective, target, and instrument. For example, some

economists put the eradication of poverty above the

maximisation of corporate profits, and this will strongly

influence their belief about how the tax system should be used.

In addition, different economists may use different economic

models and forecasting techniques, and this may lead them to

disagree about the need for, size of, or timing of policy

changes.

Market Failures

Types of market failure

A market failure is a situation where free markets fail to

allocate resources efficiently. Economists identify the

following cases of market failure:

Productive and allocative inefficiency

Markets may fail to produce and allocate scarce resources in

the most efficient way.

Monopoly power

Markets may fail to control the abuses of monopoly power.

Missing markets

Markets may fail to form, resulting in a failure to meet a need

or want, such as the need for public goods, such as defence,

street lighting, and highways.

Incomplete markets

Markets may fail to produce enough merit goods, such as

education and healthcare.

De-merit goods

Markets may also fail to control the manufacture and sale of

goods like cigarettes and alcohol, which have less merit than

consumers perceive.

Negative externalities

Consumers and producers may fail to take into account the

effects of their actions on third-parties, such as car drivers,

who may fail to take into account the traffic congestion they

create for others. Third-parties are individuals, organisations,

or communities indirectly benefiting or suffering as a result of

the actions of consumers and producers attempting to pursue

their own self interest.

Property rights

Markets work most effectively when consumers and producers

are granted the right to own property, but in many cases

property rights cannot easily be allocated to certain resources.

Failure to assign property rights may limit the ability of

markets to form.

Information failure

Markets may not provide enough information because, during a

market transaction, it may not be in the interests of one party to

provide full information to the other party.

Unstable markets

Sometimes markets become highly unstable, and a stable

equilibrium may not be established, such as with certain

agricultural markets, foreign exchange, and credit markets.

Such volatility may require intervention.

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Inequality

Markets may also fail to limit the size of the gap between

income earners, the so-called income gap. Market transactions

reward consumers and producers with incomes and profits, but

these rewards may be concentrated in the hands of a few.

Remedies

In order to reduce or eliminate market failures, governments

can choose two basic strategies:

Use the price mechanism

The first strategy is to implement policies that change the

behaviour of consumers and producers by using the price

mechanism. For example, this could mean increasing the price

of harmful products, through taxation, and providing subsidies for the beneficial products. In this way, behaviour is changed through financial incentives, much the same way that

markets work to allocate resources.

Use legislation and force

The second strategy is to use the force of the law to change

behaviour. For example, by banning cars from city centers, or

having a licensing system for the sale of alcohol, or by

penalising polluters, the unwanted behaviour may be

controlled.

In the majority of cases of market failure, a combination of

remedies is most likely to succeed.

Exchange rate policy

The exchange rate of an economy affects aggregate demand

through its effect on export and import prices, and policy

makers may exploit this connection.

Deliberately altering exchange rates to influence the macro-

economic environment may be regarded as a type of monetary

policy. Changes in exchanges rates initially work there way

into an economy via their effect on prices.

For example, if 1 exchanges for $1.50 on the foreign

exchange market, a UK product selling for 10 in the UK will

sell for $15 in New York. If the exchange rate now appreciates,

so that 1 buys $1.60, the UK product in New York will now

sell for $16. Assuming that demand in New York is price

inelastic, this is good news for UK exporters because revenue

in USDs will rise. However, if demand is elastic in New York,

the effect of the appreciation of the Pound would be damaging

to UK exporters.

If the UK also imports goods from the USA, the rise in the

exchange rate would mean that a $10 US product is now

cheaper in London, falling from 6.67p to 6.25p. Importers do

relatively well from the appreciation of the pound, in that the

cost of imported raw materials or finished goods falls.

Therefore, whenever the exchange rate changes there will be a

double effect, on both import and export prices. Changes in

import and export prices will lead to changes in import and

export volumes, causing changes in import spending and

export revenue.

Exchange rates can be manipulated so that they deviate from

their natural equilibrium rate. To stimulate exports, rates would

be held down, and to reduce inflationary pressure rates would

be kept up. While the Bank of England does not specifically

target the exchange rate, the Monetary Policy Committee

(MPC) will take exchange rates into account. Clearly, the MPC

would prefer a relatively high rate, as this reduces the price of

imports and works against inflationary pressure. However, the

MPC must keep an eye on export competitiveness, and, if rates

rise excessively, UK exports will become uncompetitive.

How exchange rates are manipulated

Exchange rates can be manipulated by buying or selling

currencies on the foreign exchange market. To raise the value

of the pound the Bank of England buys pounds, and to lower

the value, it sells pounds. Rates can also be manipulated

through interest rates, which affect the demand and supply of

Sterling via their effect on inflows of hot money. Altering

exchange rates is commonly regarded as a type of monetary

policy.

Effects of a reduction in the exchange rate

Assuming the economy has an output gap, a reduction in the

exchange rate will reduce export prices, and, assuming demand

is elastic, export revenue will increase.

A fall in the exchange rate will also raise import prices, and

assuming elasticity of demand, import spending will fall. The

combined effect is an increase in AD and an improvement in

the UK balance of payments.

Cost push inflation

A fall in the exchange rate is inflationary for a second reason -

the cost of imported raw materials adds to production costs and

creates cost-push inflation.

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Evaluation of exchange rate policy

The main advantage of manipulating exchange rates is that,

because a large share of UK output is traded internationally,

changes in exchange rates will have a powerful effect on AD.

For example, lowering exchange rates, called devaluation, can:

1. Raise aggregate demand

2. Increase national output (GDP)

3. Create jobs, amplified through the multiplier effect

4. In addition, assuming the demand for imports and exports are price sensitive (price elastic), devaluation

will lead to an improvement in the balance of

payments - although this can also lead to inflation

Alternatively, raising exchange rates (revaluation) can:

1. Help reduce excessive aggregate demand

2. Keep inflation down

3. Although the export sector may suffer and jobs might be lost

On balance, UK policy makers in recent years have preferred

to allow the financial markets to determine exchange rates,

rather than manipulate them for policy objectives. The last time

exchange rates were directly targeted was between 1985 and

1992, when the UK shadowed movements in the Deutschmark,

and then, from 1990 to 1992, when the UK became a member

of the exchange rate fixing Exchange Rate Mechanism

(ERM).

Sustainable growth

Economic growth occurs when real output increases over time.

Real output is measured by Gross Domestic Product (GDP) at

constant prices, so that the effect of price rises on the value of

national output is removed.

Sustainable economic growth means a rate of growth which

can be maintained without creating other significant economic

problems, especially for future generations. There is clearly a

trade-off between rapid economic growth today, and growth in

the future. Rapid growth today may exhaust resources and

create environmental problems for future generations,

including the depletion of oil and fish stocks, and global

warming.

Periods of growth are often triggered by increases in aggregate

demand, such as a rise in consumer spending, but sustained

growth must involve an increase in output. If output does not

increase, any extra demand will push up the price level.

Growth based on debt

In terms of sustainability, it may be argued that growth based

on short-term public debt, rather than long term productivity, is

unsustainable - hence worries about the build-up of sovereign

debt in Europe.

PPFs and economic growth

For an economy to continue to grow in the future, it needs to

increase its capacity to grow. An increase in an economys productive potential can be shown by an outward shift in the

economys PPF.

Standards of living

Gross domestic product per capita is often regarded as the key

indicator of the standards of living of the citizens of an

economy, and of their economic welfare, though broader

measures of economic welfare are increasingly used in

preference to narrow GDP measures.

Measuring growth

GDP is the official base measure of output used in most

economies, including the UK. Gross measurements record the

output of all goods and services, including capital goods which

have been purchased to replace existing capital goods.

Replacing capital is called capital consumption, or

depreciation. The alternative to Gross output is Net output,

which indicates that depreciation is taken into account and

deducted from the gross measurement.

Domestic product is the value of all UK goods and services

produced, including those produced for export. It does not

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include property income which flows into and out of the UK

economy. Property income refers to income from various types

of investment abroad, such as profits and dividends. When this

is added, the measure becomes national product, called Gross

National Product, GNP.

Growth can be measured as an annual percentage increase in

real GDP, and in terms of a general trend. The trend rate of

growth is the long term non-inflationary average rate of growth

for an economy. In the UK it is around 2.5% per year.

Why is stable growth an economic objective?

If growth rises significantly above or below the trend rate, the

economy is experiencing excessive growth or low growth. If

the rate becomes negative for at least 2 quarters in succession,

the economy is in recession.

The trade (growth) cycle

Changes in real national income tend to be cyclical, but it is

desirable that this cycle is stable rather than unstable. Unstable

growth is popularly called boom and bust.

Although an economys growth is cyclical in nature, the underlying trend can be derived from annual growth statistics. Trends can be calculated by using a technique called

moving averages. The UK trend rate over the last 25 years is

around 2.5%.

Excessive growth can lead to:

1. Goods and service inflation

2. House price inflation

3. Wage inflation

4. Labour shortages

5. Falling savings

6. Excessive credit

7. Trade difficulties

Low or negative growth can lead to:

1. Goods deflation

2. House price deflation

3. Labour surpluses

4. Unemployment

5. Excessive debt burden

6. Public sector debt

Predicting turning points

Changes, or turning points, in the level of national income can

be predicted and confirmed using economic indicators. Leading

indicators typically monitor changes in interest rates, business

confidence and new housing starts-ups - all of which provides

clues to the next turning point in an economys growth cycle. Changes in these indicate that GDP is likely to change in 12 to

18 months time. The OECDs main indicator, the Composite Leading Indicator (CLI), tracks deviations from the long-term

trend, which provides an early warning system for policy

makers.

A short leading indicator can be used to monitor changes in

consumer credit and new car registrations. A lagging indicator

monitors changes in unemployment and real investment and

confirms that the turning point has occurred. All indicators help

policy makers decide when to implement a policy and by what

degree.

The advantages of growth

Economic growth is associated with a number of material

benefits which increase economic welfare. These include the

following:

Higher GDP per capita

A rise in real national income means that wages and profits are

likely to rise. Assuming a stable population, this will raise GDP

per capita.

More public and merit goods

A growing economy means that the public sector can receive

more tax revenue and more resources can be allocated to public

and merit goods, such as more roads, hospitals and schools.

Positive externalities

Public and merit goods generate considerable external benefits.

More hospitals and schools mean a healthier and better-

educated population, which generates other economic benefits

in terms of the effectiveness of the labour force, and increases

in long-term aggregate supply.

More employment

Growth is clearly likely to stimulate demand for labour, and it

is likely that more people will be employed and fewer

unemployed.

The disadvantages of growth

Economic growth also brings some costs which reduce

economic welfare, including:

Negative externalities

As production and consumption increase, negative

externalities, such as pollution and congestion, are likely to

arise. There is also the likelihood of increased depletion of

non-renewable resources, such as fossil fuels.

Inflation and balance of payments difficulties

Too rapid a rate of growth can also lead to two significant

economic problems: inflationary pressure and a balance of

payments deficit, as imports rise to satisfy an increasingly

active household sector.

Widening income gap

Growth can also widen the distribution of income, because

some groups may benefit much more than others. Certainly in

the UK, the relative income gap has widened during the growth

years of 1992 to 2008.

Limitations of using GDP per capita over time

There are several limitations of using GDP statistics for

comparing changes in economic well-being over time,

including:

Changes in the distribution of income

Average GDP per capita may rise over time, but the

distribution of income may widen. For example, a rise in the

mean average income per head can be misleading because the

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average may rise because just a few of the population increase

their personal income. Indeed, the mean average can rise, but

the median, the mid-point in a range of numbers, can fall.

Differences in hours worked

People may be working longer hours, in which case some of

the growth may be through increased work, rather than through

increased efficiency.

Unpaid work is not recorded

People may undertake unpaid work, and this may not be

officially recorded.

Price changes

Prices are unlikely to remain constant over time, so GDP

figures must be converted to at constant prices and measured

from a base year. This process is called indexing and is required to avoid the distorting effects of inflation.

Negative externalities

The quality of life may suffer as GDP increases, although this

is not included in GDP statistics. For example, more driving

raises GDP, but also adds to CO2 emissions, which can reduce

the quality of life.

Changes in the quality of products

Over time the quality of products tends to increase, so a given

amount of income per capita in 2010 may purchase a higher

quality product than it did in 2000. This is certainly true with

high-technology consumer products, like PCs, laptops and

mobile phones.

Limitations of using GDP statistics for international

comparisons

Limitations of using GDP statistics for international

comparisons include:

Differences in the distribution of income

Although two countries may have similar GDP per capita

figures, the distribution of income in each country may be very

different.

Differences in hours worked

As when comparing a country over time, the number of hours

worked to generate a given level of income may be quite

different. For example, workers in the UK tend to work longer

hours than those in France, and this would falsely inflate the

GDP figures in the UK relative to France.

International price differences

International prices will also vary. This is significant because

an individual's purchasing power is based on price in relation to

income. To solve this problem, GDP statistics can be re-

calculated in terms of purchasing power. The purchasing power

of a currency refers to the quantity of the currency needed to

purchase a given unit of a good, or common basket of goods

and services. Purchasing power is clearly determined by the

relative cost of living and inflation rates in different countries.

Achieving purchasing power parity means equalising the

purchasing power of two currencies by taking into account cost

of living and inflation differences.

For example, if we simply convert GDP in Japan to US dollars

using market exchange rates, relative purchasing power is not

taken into account, and the validity of the comparison is

weakened. By adjusting rates to take into account local

purchasing power differences, known as PPP adjusted

exchange rates, international comparisons are more valid.

Difficulty of assessing true values

The true value of public goods and merit goods, such as

defence, education and transport infrastructure is largely

unknown. This means that it is difficult to compare two

countries with very different levels of spending on these goods

and assets.

The unofficial economy

Similarly, the existence of a large unofficial economy may

make comparisons based on official GDP very misleading. For

example, comparing the official GDP of the UK and Russia

may be misleading because of the size of Russia's unofficial

economy. While all countries have unofficial economies, their

size and significance can vary considerably.

Currency conversion

GDP figures for different countries must be converted to a

common currency, such as the US dollar, and this may give

misleading figures. For some countries, exchange rates against

the US dollar may be unrepresentative of the true value of the

currency, especially where international trade is relatively

small. In such cases, converting to US dollars may significantly

under-value national output. This explains why conversion to

purchasing power parity is often preferred to conversion to US

dollars.

Sustainable development and quality of life

In recognising that economic welfare is not simply about

economic growth, in 1999 the UK government introduced a

policy for sustainable development, and refined this further in

2005.

Sustainable development is considered in four main categories

using 20 main indicators, and 68 indicators in total. The

categories are:

1. Sustainable consumption and production

2. Climate change and energy

3. Natural resource protection and enhancing the environment

4. Creating sustainable communities and a fairer world

National income

National income is the total value a countrys final output of all new goods and services produced in one year. Understanding

how national income is created is the starting point for

macroeconomics.

The national income identity

This relationship is expressed in the national income identity,

where the amount received as national income is identical to

the amount spent as national expenditure, which is also

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identical to what is produced as national output. Throughout

macroeconomics the terms income, output and expenditure are

interchangeable.

See also: the circular flow of income

National income accounts

Since the 1940s, the UK government has gathered detailed

records of national income, though the collection of basic data

goes back to the 17th Century. The published national income

accounts for the UK, called the Blue Book, measure all the economic activities that add value to the economy.

Adding value

National output, income and expenditure, are generated when

there is an exchange involving a monetary transaction.

However, for an individual economic transaction to be

included in aggregate national income it must involve the

purchase of newly produced goods or services. In other words,

it must create a genuine addition to the value of the scarce resources. For example, a transaction that involves selling a

second-hand good, and which was new two years ago does not

add to national income, though the original production and

purchase does. Transactions which do not add value are called

transfers, and include second-hand sales, gifts and welfare

transfers paid by the government, such as disability allowance

and state pensions.

The creation of national income

The simplest way to think about national income is to consider

what happens when one product is manufactured and sold.

Typically, goods are produced in a number of 'stages', where

raw materials are converted by firms at one stage, then sold to

firms at the next stage. Value is added at each, intermediate,

stage, and, at the final stage, the product is given a retail selling

price. The retail price reflects the value added in terms of all

the resources used in all the previous stages of production.

Final output

In accounting terms, only the value of final output is recorded.

To avoid the problem of double counting, only the value of the

final stage, the retail price, is included, and not the value added

in all the intermediate stages - the costs of production, plus

profits. In short, national income is the value of all the final

output of goods and services produced in one year.

Example

For example, consider the production of a motor car which has

a retail price of 25,000. This price includes 21,000 for all the

costs of production (6,000 for components, 10,000 for

assembly and 5,000 for marketing) plus 4,000 for profit. To

avoid double-counting, the national income accounts only

record the value of the final stage, which in this case is the

selling price of 25,000.

When goods are bought second-hand, the transaction does not

add new value and will not be included in national output. If

second-hand goods are included, double-counting will occur,

and this would falsely inflate the value of national income.

For example, if the car in question is sold in two years time for 15,000 it would provide the owner with money, but the sale

will not add to national income. If it were included in national

income, it would make the value of the car 35,000 - the initial

25,000 plus the second hand value of 15,000. This is clearly

not the case, so any future second-hand sales are not included

when valuing national income. Such second-hand transactions

are called transfers.

Calculating national income

Any transaction which adds value involves three elements expenditure by purchasers, income received by sellers, and the

value of the goods traded. For example, if a student purchases a

textbook for 30, spending = 30, income to the bookseller =

30, and the value of the book = 30. All of the transactions in

an economy can be looked at in this way, giving us three ways

to measure national income.

There are three methods of calculating national income:

1. The income method, which adds up all incomes received by the factors of production generated in the

economy during a year. This includes wages from

employment and self-employment, profits to firms,

interest to lenders of capital and rents to owners of

land.

2. The output method, which is the combined value of the new and final output produced in all sectors of the

economy, including manufacturing, financial services,

transport, leisure and agriculture.

3. The expenditure method, which adds up all spending in the economy by households and firms on new and

final goods and services by households and firms.

Chained value measurement

The components of national output are valued according to

their importance to the overall economy. The weights used

were based on estimates made every 5 years, but, from 2003,

an annual adjustment to the weightings was introduced to

improve the reliability of the weighting - a process called

annual chain linking. This allowed for a more up-to-date, and

therefore a more accurate measure of changes to the level of

national income.

The main components of UK National Income

In 2010, UK Gross National income at current prices was

1,458 billion, up from 1,392 in 2009.

The percentage contribution of different components in the

three different measures are shown below:

National Income, by 'type' of income:

GDP - Income method, 2010, BnTaxes - subsidies,

179Other - inc rents, 168Corporate profits,

307Wages and salaries, 799Taxes - subsidiesOther

- inc rentsCorporate profitsWages and salaries

With around 30m workers in the UK, and over 2m firms*,

wages and profits contribute the majority of income in the UK.

(*2.15m according to the ONS)

National output, by sector of the economy:

GDP - Output method, 2010, BnConstruction,

90Water and services, 148Energy, 172Government

inc education, 261Health activities, 104Distribution

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and transport, 238Manufacturing, 131Mining,

28Agriculture, 7.5ConstructionWater and

servicesEnergyGovernment inceducationHealth

activitiesDistribution

andtransportManufacturingMiningAgriculture

In terms of output, services dominate the UK economy, with

manufacturing a distant second. However, this is a typical

profile for a developed economy the more developed the economy the more that income is allocated towards purchasing

services rather than manufactured goods.

National spending, by sector

GDP - Expenditure method, 2010, BnImports,

%A3476bnExports, %A3436bnInvestment,

%A3224bnGovernment, %A3338bnNon-profit

organisations, %A338bnHousehold spending,

%A3900bnImportsExportsInvestmentGovernmentNo

n-profitorganisationsHouseholdspending

In terms of spending, UK households account for the majority

of spending, export spending the next most

important. Spending on capital goods by firms, and spending

on public goods, merit goods, and transfers by government

accounts for the rest.

Source - ONS

Gross Domestic Product - GDP

Gross Domestic Product (GDP) is the most important

aggregate of national income for accounting purposes, and for

economic analysis. In the UK, GDP is derived from the gross

value added (GVA) of all the UK's individual producers,

industries or sectors over one year, using the 'output' method.

Current and constant prices

As the level of economic activity between households and

firms increases, output is also likely to increase. However,

under certain circumstances the price level may also be driven

up.

The nominal value of national income, or any other aggregate,

is the value of national output at the prices existing in the year

that national income is measured - that is, at current prices. In

simple terms the nominal value of national income can be found by multiplying the quantity of output by the retail

(market) price of this output.

If demand increases at an unsustainable rate, resources become

increasingly scarce, and firms will raise prices. Similarly,

wages are likely to rise as the labour market clears and

unemployment falls. The more that workers are needed the

higher the wage rate. This will act as an incentive for workers

to enter this industry. The combined effect of higher wages and

prices is that the nominal value of national output may be

driven up, rather than its real value.

To find the real value of changes in output under inflationary

conditions, the effects of any general price increase (price

inflation) must be taken into account. This is done by holding

prices constant from a starting measure, called the base year.

Example

For example, if, in a hypothetical economy, 100 pens are

produced and sold for 1 each in year 1, the nominal value of

these transactions is 100. If, in year 2, inflation pushes prices

up to 1.20p per pen, but, as in year 1, only 100 pens are sold,

the nominal value at current (year 2) prices will rise to 120.

However, the nominal value has only risen because of

inflation, so to adjust the nominal value to find the real value

we take the constant price of 1 which is the price of pens at the start of our measurement in the base year, year 1. However,

if in year 3 110 pens are sold at 1.20, the nominal value at

current prices will be 132 (an increase of 32%), but the real

value at constant (year 1) prices will be only 110 (a real

increase of only 10%). Therefore, to arrive at real values the

economist must take out the effects of price inflation by

holding prices constant in terms of the prices existing in the

base year.

Recent changes to UK national income

After a sustained period of rising national income from the

previous recession, which ended in 1992, the UK, like most

other advanced economies, entered a recession in the third

quarter of 2008. The recession lasted until the fourth quarter of

2009. Growth returned in 2010, but, following negative growth

in the fourth quarter of 2010, the UK economy failed to recover

fully, with growth in the third quarter of 2011 a modest 0.5%,

with a further drop to 0.2% in the last quarter of 2011.

Performance indicators

The performance of an economy is usually assessed in terms of

the achievement of economic objectives. These objectives can

be long term, such as sustainable growth and development, or

short term, such as the stabilisation of the economy in response

to sudden and unpredictable events, called economic shocks.

Economic indicators

To know how well an economy is performing against these

objectives economists employ a wide range of economic

indicators. Economic indicators measure macro-economic

variables that directly or indirectly enable economists to judge

whether economic performance has improved or deteriorated.

Tracking these indicators is especially valuable to policy

makers, both in terms of assessing whether to intervene and

whether the intervention has worked or not.

Useful indicators include:

1. Levels of real national income, spending, and output. National income, output, and spending are three key

variables that indicate whether an economy is

growing, or in recession. Like many other indicators,

income, output, and spending can also be measured in

per capita (per head) terms.

2. Growth in real national income.

3. Investment levels and the relationship between capital investment and national output.

4. Levels of savings and savings ratios.

5. Price levels and inflation.

6. Competitiveness of exports.

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7. Levels and types of unemployment.

8. Employment levels and patterns of employment.

9. Trade deficits and surpluses with specific countries or the rest of the world.

10. Debt levels with other countries.

11. The proportion of debt to national income.

12. The terms of trade of a country.

13. The purchasing power of a country's currency.

14. Wider measures of human development, including literacy rates and health care provision. Such

measures are included in the Human Development

Index (HDI).

15. Measures of human poverty, including the Human Poverty Index (HPI).

The circular flow of income

National income, output, and expenditure are generated by the

activities of the two most vital parts of an economy, its

households and firms, as they engage in mutually beneficial

exchange.

Households

The primary economic function of households is to supply

domestic firms with needed factors of production - land, human

capital, real capital and enterprise. The factors are supplied by

factor owners in return for a reward. Land is supplied by

landowners, human capital by labour, real capital by capital

owners (capitalists) and enterprise is provided by

entrepreneurs. Entrepreneurs combine the other three factors,

and bear the risks associated with production.

Firms

The function of firms is to supply private goods and services to

domestic households and firms, and to households and firms

abroad. To do this they use factors and pay for their services.

Factor incomes

Factors of production earn an income which contributes to

national income. Land receives rent, human capital receives a

wage, real capital receives a rate of return, and enterprise

receives a profit.

Members of households pay for goods and services they

consume with the income they receive from selling their factor

in the relevant market.

Production function

The simple production function states that output (Q) is a

function (f) of: (is determined by) the factor inputs, land (L),

labour (La), and capital (K), i.e.

Q = f (L, La, K)

The Circular flow of income

Income (Y) in an economy flows from one part to another

whenever a transaction takes place. New spending (C)

generates new income (Y), which generates further new

spending (C), and further new income (Y), and so on. Spending

and income continue to circulate around the macro economy in

what is referred to as the circular flow of income.

The circular flow of income forms the basis for all models of

the macro-economy, and understanding the circular flow

process is key to explaining how national income, output and

expenditure is created over time.

Injections and withdrawals

The circular flow will adjust following new injections into it or

new withdrawals from it. An injection of new spending will

increase the flow. A net injection relates to the overall effect of

injections in relation to withdrawals following a change in an

economic variable.

Savings and investment

The simple circular flow is, therefore, adjusted to take into

account withdrawals and injections. Households may choose to

save (S) some of their income (Y) rather than spend it (C), and

this reduces the circular flow of income. Marginal decisions to

save reduce the flow of income in the economy because saving

is a withdrawal out of the circular flow. However, firms also

purchase capital goods, such as machinery, from other firms,

and this spending is an injection into the circular flow. This

process, called investment (I), occurs because existing

machinery wears out and because firms may wish to increase

their capacity to produce.

The public sector

In a mixed economy with a government, the simple model

must be adjusted to include the public sector. Therefore, as

well as save, households are also likely to pay taxes (T) to the

government (G), and further income is withdrawn out of the

circular flow of income.

Government injects income back into the economy by spending

(G) on public and merit goods like defence and policing,

education, and healthcare, and also on support for the poor and

those unable to work.

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Including international trade

Finally, the model must be adjusted to include international

trade. Countries that trade are called open economies, the households of an open economy will spend some of their

income on goods from abroad, called imports (M), and this is

withdrawn from the circular flow.

Foreign consumers and firms will, however, also wish to buy

domestic products, called exports (X), and this is an injection

into the circular flow.

The multiplier effect

Every time there is an injection of new demand into the

circular flow there is likely to be a multiplier effect. This is

because an injection of extra income leads to more spending,

which creates more income, and so on. The multiplier effect

refers to the increase in final income arising from any new

injection of spending.

The size of the multiplier depends upon households marginal decisions to spend, called the marginal propensity to consume

(mpc), or to save, called the marginal propensity to save (mps).

It is important to remember that when income is spent, this

spending becomes someone elses income, and so on. Marginal propensities show the proportion of extra income allocated to

particular activities, such as investment spending by UK firms,

saving by households, and spending on imports from abroad.

For example, if 80% of all new income in a given period of

time is spent on UK products, the marginal propensity to

consume would be 80/100, which is 0.8.

The following general formula to calculate the multiplier uses

marginal propensities, as follows:

1/1-mpc

Hence, if consumers spend 0.8 and save 0.2 of every 1 of

extra income, the multiplier will be:

1/1-0.8

= 1/0.2

= 5

Hence, the multiplier is 5, which means that every 1 of new

income generates 5 of extra income.

The multiplier effect in an open economy

As well as calculating the multiplier in terms of how extra

income gets spent, we can also measure the multiplier in terms

of how much of the extra income goes in savings, and other

withdrawals. A full open economy has all sectors, and therefore, three withdrawals savings, taxation and imports.

This is indicated by the marginal propensity to save (mps) plus

the extra income going to the government - the marginal tax

rate (mtr) plus the amount going abroad the marginal propensity to import (mpm).

By adding up all the withdrawals we get the marginal

propensity to withdraw (mpw). The multiplier can now be

calculated by the following general equation:

1/1- mpw

Applying the multiplier effect

The multiplier concept can be used any situation where there is

a new injection into an economy. Examples of such situations

include:

1. When the government funds building of a new motorway

2. When there is an increase in exports abroad

3. When there is a reduction in interest rates or tax rates, or when the exchange rate falls.

The downward or 'reverse' multiplier

A withdrawal of income from the circular flow will lead to a

downward multiplier effect. Therefore, whenever there is an

increased withdrawal, such as a rise in savings, import

spending or taxation, there is a potential downward multiplier

effect on the rest of the economy.

Economic integration

There are several stages in the process of economic integration,

from a very loose association of countries in a preferential

trade area, to complete economic integration, where the

economies of member countries are completely integrated.

A regional trading bloc is a group of countries within a

geographical region that protect themselves from imports from

non-members in other geographical regions, and who look to

trade more with each other. Regional trading blocs increasingly

shape the pattern of world trade - a phenomenon often referred

to as regionalism.

Stages of integration

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Preferential Trade Area

Preferential Trade Areas (PTAs) exist when countries within a

geographical region agree to reduce or eliminate tariff barriers

on selected goods imported from other members of the area.

This is often the first small step towards the creation of a

trading bloc. Agreements may be made between two countries

(bi-lateral), or several countries (multi-lateral).

Free Trade Area

Free Trade Areas (FTAs) are created when two or more

countries in a region agree to reduce or eliminate barriers to

trade on all goods coming from other members. The North

Atlantic Free Trade Agreement (NAFTA) is an example of

such a free trade area, and includes the USA, Canada, and

Mexico.

Customs Union

A customs union involves the removal of tariff barriers

between members, plus the acceptance of a common (unified)

external tariff against non-members. This means that members

may negotiate as a single bloc with 3rd

parties, such as with

other trading blocs, or with the WTO.

Common Market

A common market is the first significant step towards full

economic integration, and occurs when member countries trade

freely in all economic resources not just tangible goods. This means that all barriers to trade in goods, services, capital, and

labour are removed. In addition, as well as removing tariffs,

non-tariff barriers are also reduced and eliminated. For a

common market to be successful there must also be a

significant level of harmonisation of micro-economic policies,

and common rules regarding monopoly power and other anti-

competitive practices. There may also be common policies

affecting key industries, such as the Common Agricultural

Policy (CAP) and Common Fisheries Policy (CFP) of the

European Single Market (ESM).

Economic Union

Economic Union is a term applied to a trading bloc that has

both a common market between members, and a common trade

policy towards non-members, but where members are free to

pursue independent macro-economic policies.

Monetary Union

Monetary union is the first major step towards macro-economic

integration, and enables economies to converge even more

closely. Monetary union involves scrapping individual

currencies, and adopting a single, shared currency, such as the

Euro for the Euro-16 countries, and the East Caribbean Dollar

for 11 islands in the East Caribbean. This means that there is a

common exchange rate, a common monetary policy, including

interest rates and the regulation of the quantity of money, and a

single central bank, such as the European Central Bank or the

East Caribbean Central Bank.

Video

Fiscal Union

A fiscal union is an agreement to harmonise tax rates, to

establish common levels of public sector spending and

borrowing, and jointly agree national budget deficits or

surpluses. The majority of EU states agreed a fiscal compact in

early 2012, which is a less binding version of a full fiscal

union.

Economic and Monetary Union

Economic and Monetary Union (EMU) is a key stage towards

compete integration, and involves a single economic market, a

common trade policy, a single currency and a common

monetary policy.

Complete Economic Integration

Complete economic integration involves a single economic

market, a common trade policy, a single currency, a common

monetary policy (EMU) together with a single fiscal policy, tax

and benefit rates in short, complete harmonisation of all policies, rates, and economic trade rules.

Foreign Direct Investment (FDI)

FDI refers to the flow of capital between countries. According

to the United Nations Conference for Trade and Development

(UNCTAD), FDI is 'investment made to acquire lasting

interest in enterprises operating outside of the economy of the

investor.'*

FDI is distinguished from 'portfolio' investment in that, as well

as being 'lasting', it means that the investor has control over the

assets invested in. A single flow of capital between two

countries is described as outward for the investing country and

inward for the recipient country. FDI is undertaken by both

private sector firms and governments.

FDI associated with cross-border mergers and aquisions can be

horizontal - where the firms are at the same stage of

production; vertical - where firms are at different stages of

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production; and conglomerate - where firms are in different

industries.

*Source: UNCTAD.ORG : http://www.unctad.org

The growth of FDI has accompanied the rise of globalisation.

According to the World Investment Report, FDI flows in 2013

increased to $1.45 trillion, with developing countries

increasing their share of inflows to (a record level of) 54 per

cent, with Asia now ahead of both the EU and USA.

The benefits of investing abroad

Investing overseas can generate many benefits to multinational

organisations, including:

1. Transport costs can be reduced by locating manufacturing plant within a consuming country. This

is especially important for bulk increasing products,

such as motor vehicles.

2. Inward investors gain easier access to a countrys markets, especially where the product can be made

with local ingredients. For example, it makes clear

commercial sense for McDonalds to establish local

restaurants that use local ingredients, rather than

export ingredients from the USA. In addition,

investing firms gain access to a range of resources,

including cheap or skilled labour and local knowledge

and expertise.

3. Firms that build factories and plant in other territories can exploit of economies of scope, such as spreading

fixed management costs between territories, or where

plant in one territory can be used to produce output for

many territories.

4. Firms based outside one trading bloc can avoid barriers to trade such as tariffs and quotas, as in the

case of Japanese car producers, such as Toyota and

Nissan, locating in the EU.

Investment income

Outward investment can lead to increased overseas investment

income for a country, including:

1. Profits from overseas subsidiaries.

2. Dividends from owning shares in overseas firms.

3. Interest payments, from lending abroad, such as lending by UK banks.

FDI in the balance of payments accounts appears in two ways:

1. The initial outflow of FDI is entered as an outflow (debit) on the capital account

2. The resulting investment income is entered as an inflow (credit) on the current account.

Inward investment

Countries receiving inward investment gain in a number of

ways, including:

1. An increase in GDP, initially through the FDI itself, but this will be followed by a positive multiplier effect

on the receiving economy so that the final increase in

national income is greater than the initial injection of

FDI.

2. The creation of jobs.

3. An increase in productive capacity, which can be illustrated by a shift to the right in the Aggregate

Supply (AS) or the Production Possibility Frontier

(PPF).

4. Producers have access to the latest technology from abroad.

5. Less need to import because goods are produced in the domestic economy.

6. The positive effect on the countrys capital account - FDI represents an inflow (credit) on the capital

account.

7. FDI is a way of compensating for the lack of domestic investment, and can help 'kick-start' the process of

economic development.

Global FDI

Global FDI has declined as a result of the financial crisis and

global recession.

Comparative advantage

It can be argued that world output would increase when the

principle of comparative advantage is applied by countries to

determine what goods and services they should specialise in

producing. Comparative advantage is a term associated with

19th Century English economist David Ricardo.

Ricardo considered what goods and services countries should

produce, and suggested that they should specialise by

allocating their scarce resources to produce goods and services

for which they have a comparative cost advantage. There are

two types of cost advantage absolute, and comparative.

Absolute advantage means being more productive or cost-

efficient than another country whereas comparative advantage

relates to how much productive or cost efficient one country is

than another.

Example

In order to understand how the concept of comparative

advantage might be applied to the real world, we can consider

the simple example of two countries producing only two goods

- motor cars and commercial trucks.

Comparative advantage

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Using all its resources, country A can produce 30m cars or 6m

trucks, and country B can produce 35m cars or 21m trucks.

This can be summarised in a table.

In this case, country B has the absolute advantage in producing

both products, but it has a comparative advantage in trucks

because it is relatively better at producing them. Country B is

3.5 times better at trucks, and only 1.17 times better at cars.

However, the greatest advantage - and the widest gap - lies

with truck production, hence Country B should specialise in

producing trucks, leaving Country A to produce cars.

Economic theory suggests that, if countries apply the principle

of comparative advantage, combined output will be increased

in comparison with the output that would be produced if the

two countries tried to become self-sufficient and allocate

resources towards production of both goods. Taking this

example, if countries A and B allocate resources evenly to both

goods combined output is: Cars = 15 + 15 = 30; Trucks = 12 +

3 = 15, therefore world output is 45 m units.

Opportunity cost ratios

It is being able to produce goods by using fewer resources, at a

lower opportunity cost, that gives countries a comparative

advantage.

The gradient of a PPF reflects the opportunity cost of

production. Increasing the production of one good means that

less of another can be produced. The gradient reflects the lost

output of Y as a result of increasing the output of X.

Having a comparative advantage in X, Country A sacrifices

less of Y than Country B. In terms of two countries producing

two goods, different PPF gradients mean different opportunity

costs ratios, and hence specialisation and trade will increase

world output.

Only when the gradients are different will a country have a

comparative advantage, and only then will trade be beneficial.

Identical PPFs

13

If PPF gradients are identical, then no country has a

comparative advantage, and opportunity cost ratios are

identical. In this case, international trade does not confer any

advantage.

Criticisms

However, the principle of comparative advantage can be

criticised in a several ways:

1. It may overstate the benefits of specialisation by ignoring a number of costs. These costs include

transport costs and any external costs associated with

trade, such as air and sea pollution.

2. The theory also assumes that markets are perfectly competitive - in particular, there is perfect mobility of

factors without any diminishing returns and with no

transport costs. The reality is likely to be very

different, with output from factor inputs subject to

diminishing returns, and with transport costs. This

will make the PPF for each country non-linear and

bowed outwards. If this is the case, complete

specialisation might not generate the level of benefits

that would be derived from linear PPFs. In other

words, there is an increasing opportunity cost

associated with increasing specialisation. For

example, it may be that the maximum output of cars

produced by country A is only 20 million (compared

with 30), and the maximum output of trucks produced

by country B might only be 16 million instead of 21

million. Hence, the combined output from trade might

only be 46 million units (instead of the 51 million

units initially predicted).

4. Complete specialisation might create structural unemployment as some workers cannot transfer from

one sector to another.

5. Relative prices and exchange rates are not taken into account in the simple theory of comparative

advantage. For example if the price of X rises relative

to Y, the benefit of increasing output of X increases.

6. Comparative advantage is not a static concept - it may change over time. For example, nonrenewable

resources can slowly run out, increasing the costs of

production, and reducing the gains from trade.

Countries can develop new advantages, such as

Vietnam and coffee production. Despite having a long

history of coffee production it is only in the last 30

years that it has become a global player. seeing its

global market share increase from just 1% in 1985 to

20% in 2014, making it the world's second largest

producer.

7. Many countries strive for food security, meaning that even if they should specialise in non-food products,

they still prefer to keep a minimum level of food

production.

8. The principle of comparative advantage is derived from a highly simplistic two good/two country model.

The real world is far more complex, with countries

exporting and importing many different goods and

services.

9. According to influential US economist Paul Krugman, the continual application of economies of scale by

global producers using new technology means that

many countries, including China, can produce very

cheaply, and export surpluses. This, along with an

insatiable demand for choice and variety, means that

countries typically produce a variety of products for

the global market, rather than specialise in a narrow

range of products, rendering the traditional theory of

comparative advantage almost obsolete.

14

10. However, the underlying principle of comparative advantage can still be said to give some shape to the pattern of world trade, even if it is becoming less

relevant in a globalised world.

Trade liberalisation

Two opposing forces have shaped the changing pattern of

world trade over the last 200 years; the promotion of free trade

and the protection against free trade. Trade protection is the

process of erecting barriers to trade, such as taxes on imports,

called tariffs, and trade liberalisation is the process of making

trade free from such barriers.

The advantages of free trade

It can be argued that free trade creates the following

advantages:

Specialisation and comparative advantage

Free trade encourages countries to specialise and benefit from

the application of the principle of comparative advantage.

Increased world output

If countries specialise and trade, world output is likely to

increase as scarce resources will be used more efficiently. Mass

production will generate considerable economy of scale, which

reduce average costs.

Increased competition and lower prices

Free trade increases competition, which generates further

benefits, including lower prices, greater use of new technology

and technology transfer between countries. Free trade will also

encourage the breakdown of domestic monopolies, and provide

greater choice for consumers and firms.

Higher quality

Open economies are likely to see an increase in the quality of

products available as overseas firms compete on non-price

factors, such as design and reliability.

Terms of trade

A countrys terms of trade measures a countrys export prices in relation to its import prices, and is expressed as:

For example, if, over a given period, the index of export prices

rises by 10% and the index of import prices rises by 5%, the

terms of trade are:

110 x 100 / 105

= 104.8

This means that the terms of trade have improved by 4.8%.

When the terms of trade rise above 100 they are said to be

improving and when they fall below 100 they are said to be

worsening.

Improving terms of trade

If a country's terms of trade improve, it means that for every

unit of exports sold it can buy more units of imported goods.

So potentially, a rise in the terms of trade creates a benefit in

terms of how many goods need to be exported to buy a given

amount of imports. It can also have a beneficial effect on

domestic cost-push inflation as an improvement indicates

falling import prices relative to export prices.

However, countries may suffer in terms of falling export

volumes and a worsening balance of payments.

The danger of an improving terms of trade is that it can worsen

the balance of trade if UK and overseas consumers are elastic

in their response to the relative export and import price

changes.

Worsening terms of trade

A worsening terms of trade indicates that a country has to

export more to purchase a given quantity of imports. According

to the Prebisch-Singer hypothesis, this fate has befallen many

developing countries given the general decline in commodity

prices in relation to the price of manufactured goods. However,

globalisation has tended to reduce the price of manufactured

goods over the past 15 years, so the advantage that

industrialised countries had over developing countries may be

falling.

The impact of globalisation has tended to halt the decline in the

terms of trade of developing economies.

The WTO

The WTO attempts to promote free and fair trade an increasingly difficult task, which it undertakes with varying

success. The WTO was established in 1995 when it replaced

the General Agreement on Tariffs and Trade (GATT). It has its

headquarters in Geneva, Switzerland and, by 2012, had 153

member countries, including China, which was the last major

nation to join.

The purpose of the WTO is to promote free and fair trade

through multilateral talks and negotiations, and to arbitrate

between countries that are in dispute. The WTO itself claims

that, unlike GATT that preceded it, its rules of trade have been

worked out by the direct involvement of all countries, and not

just a few powerful ones.

Evaluation of the WTO

Trade liberalisation clearly brings many economic and political

benefits, but many argue that the WTO has had limited success

in certain areas. The main criticisms are:

Too few agreements

Critics argue that the number of trade disputes settled through

the WTO's DSU (Dispute Settlement Understanding) is

inadequate given the number of disputes. However, the number

of settlements did rise from 20 in 1990 to 157 in 2007. But

still, by January 2008, only 136 of the 370 cases had reached

the full panel process.

(Sources: UNCTAD and WTO).

Failure to confront ethical issues

Many argue that the WTO has failed to confront ethical issues,

such as the use of child labour and poor working conditions in

developing economies.

Failure to tackle environmental issues

15

Similarly, many argue that it has failed to tackle environmental

issues, such as the depletion of global fish stocks,

deforestation, and climate change.

Takes too long to arbitrate

Critics also complain that the WTO takes too long to arbitrate

and settle disputes. For example, it can take over five years

from the initial receipt of a complaint from one member to the

final panel ruling.

See: Example of WTO process

Favours the powerful

Critics also argue that the WTO has an inbuilt bias favouring

developed and powerful nations and trading blocs such as the

USA and the EU, and operating against weaker, developing

ones.

Failure to promote multilateralism

Despite the WTO operating as a multilateral organisation,

many member countries and trading blocs favour bilateral

discussions with partners or competitors. This is because

bilateral negotiations can be fully focussed and relatively quick

to complete. The result is that many countries prefer to bypass

the WTO process, and deal directly with other countries. The

failure of the most recent round of WTO negotiations, the

Doha round, is widely regarded as evidence of the inherent

problems of multilateral discussions. While the WTO is likely

to argue that it encourages such agreements when they do not

have a negative impact on third parties, it is very difficult to

find cases where third-party countries are not, at least

indirectly, negatively affected by a specific bilateral agreement.

The Doha round

The most recent round of talks is the Doha Round, which

began in 2001, with major summit meetings in Cancun,

Mexico, Hong Kong, and Davos in 2003, 2005, and 2007

respectively. The Doha round of talks is also called the

development round, reflecting its emphasis on promoting free

trade for the benefit of developing nations. In particular, the

Cancun talks focussed on three areas: reducing agricultural

subsidies and industrial tariffs imposed by developed nations,

which limit the market access of developing nations;

harmonising competition rules within different countries; and

helping poor countries.

The talks collapsed for a number of reasons. Significantly,

while the US and EU failed to agree reductions in agricultural

support, many developing countries refused to agree new

investment rules which would make it easier for multinationals

to invest in their countries. Since the collapse, the USA and EU

have returned to bilateral agreements with favoured nations,

rather than entering into multilateral agreements. This

highlights a major limitation of the WTO in not gaining a

complete consensus that multilateral negotiations should be the

method of choice of its members.

The failure of the Doha round means that the rich countries of

the world still protect themselves from goods produced by the

poor nations. By 2005, average agricultural tariffs imposed by

the USA and EU were 60%, against average industrial tariffs of

only 5%*.

Trade protectionism

Trade protection is the deliberate attempt to limit imports or

promote exports by putting up barriers to trade. Despite the

arguments in favour of free trade and increasing trade

openness, protectionism is still widely practiced.

The motives for protection

The main arguments for protection are:

Protect sunrise industries

Barriers to trade can be used to protect sunrise industries, also

known as infant industries, such as those involving new

technologies. This gives new firms the chance to develop,

grow, and become globally competitive.

Protection of domestic industries may allow they to develop a

comparative advantage. For example, domestic firms may

expand when protected from competition and benefit from

economies of scale. As firms grow they may invest in real and

human capital and develop new capabilities and skills. Once

these skills and capabilities are developed there is less need for

trade protection, and barriers may be eventually removed.

Protect sunset industries

At the other end of scale are sunset industries, also known as

declining industries, which might need some support to enable

them to decline slowly, and avoid some of the negative effects

of such decline. For the UK, each generation throws up its own

declining industries, such as ship building in the 1950s, car

production in the 1970s, and steel production in the 1990s.

Protect strategic industries

Barriers may also be erected to protect strategic industries,

such as energy, water, steel, armaments, and food. The implicit

aim of the EUs Common Agricultural Policy is to create food

security for Europe by protecting its agricultural sector.

Protect non-renewable resources

Non-renewable resources, including oil, are regarded as a

special case where the normal rules of free trade are often

abandoned. For countries aiming to rely on oil exports lasting

into the long term, such as the oil-rich Middle Eastern

economies, limiting output in the short term through

production quotas is one method employed to conserve

resources.

Deter unfair competition

Barriers may be erected to deter unfair competition, such as

dumping by foreign firms at prices below cost.

Save jobs

Protecting an industry may, in the short run, protect jobs,

though in the long run it is unlikely that jobs can be protected

indefinitely.

Help the environment

Some countries may protect themselves from trade to help limit

damage to their environment, such as that arising from CO2

emissions caused by increased production and transportation.

Limit over-specialisation

Many economists point to the dangers of over-specialisation,

which might occur as a result of taking the theory of

comparative advantage to its extreme. Retaining some self-

16

sufficiency is seen as a sensible economic strategy given the

risks of global downturns, and an over-reliance on international

trade.

In addition to the economic arguments for protection, some

protection may be for political reasons.

Economic development

Economic development is a broader concept than

economic growth and reflects social and economic

progress and requires economic growth. Growth is an

important and necessary condition for development, but it

is not a sufficient condition. Growth alone cannot

guarantee development.

Indicators of development

The extent to which a country has developed may be assessed

by considering a range of narrow and broad indicators,

including per capita income, life expectancy, education, and

the extent of poverty.

The Human Development Index (HDI)

The HDI was introduced in 1990 as part of the United Nations

Development Programme (UNDP) to provide a means of

measuring economic development in three broad areas - per

capita income, health and education. The HDI is used to track

changes in the global position of specific countries over time.

Each year the UNDP produces a development report providing

an update of changes during the year, along with a report on a

special theme, such as global warming and development, and

migration and development.

The introduction of the index was an explicit acceptance that

development is a considerably broader concept than growth and

should include a range of social and economic factors.

The HDI has two main features:

A scale from 0 (no development) to 1 (complete development).

A composite index based on three equally weighted

components:

1. Longevity, measured by life expectancy at birth

2. Knowledge, measured by adult literacy and number of years children are enrolled at school

3. Standard of living, measured by real GDP per capita at purchasing power parity

What the figures mean:

An index of 0 0.6 means low development - for example, in 2006 Ethiopia had an index number of

0.38 while in Bangladesh it was 0.51

An index of 0.61 0.85 means medium development for example, in 2006 Croatia had an index of 0.85, while Brazil and the Ukraine had 0.80 and 0.79

respectively.

An index of greater than 0.90 means high development - for example, the HDI for France and

the UK in 2006 were 0.95 and 0.94. respectively.

The HDI is a very useful means of comparing the level of

development of countries. GDP per capita alone is clearly too

narrow an indicator of economic growth, and fails to indicate

other aspects of development, such as enrolment in school and

longevity. Hence, the HDI is seen as a broader and more

encompassing indicator of development than GDP, though

GDP still provides one third of the index.

Life expectancy

A variety of factors may contribute to differences in life

expectancy, such as the stability of food supplies, war and the

incidence of disease and natural disasters.

According to World Bank figures, between 1980 and 1998

average life expectancy rose from 61 to 67 years, with the

largest increases occurring in low and middle income

countries. However, the changes are not evenly distributed, and

in many countries in sub-Saharan Africa, life expectancy is

falling due to the AIDS epidemic.

(Source: www.worldbank.org/depweb/)

Adult literacy

Adult literacy is usually defined as the percentage of those

aged 15 and above who are able to read and write a simple

statement on their everyday life.

More extensive definitions of literacy include those based on

the International Adult Literacy Survey. This survey tests the

ability to understand text, interpret documents, and perform

simple arithmetic.

GDP per capita

GDP per capita is the commonest indicator of material

standards of living, and hence is included in the index of

development. It is found by measuring Gross Domestic Product

in a year, and dividing it by the population.

Evaluation of the HDI

Despite the widespread use of the HDI, there are a number of

criticisms that are often made. These include:

1. The HDI index is for a single country, and as such does not distinguish between different rates of

development within a country, such as between urban

and traditional rural communities.

2. Critics argue that the equal weighting between the three main components is rather arbitrary.

3. Development is ultimately about freedom, and there is nothing in the index which directly measures this. For

example, access to the internet might be regarded by

many as a freedom which improves the quality of

individual's lives.

4. As with GDP per capita, the more narrow measure of living standards, there is no indication of the

distribution of income.

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5. In addition, the HDI excludes many aspects of economic and social life that could be regarded as

contributing to or constraining development, such as

crime, corruption, poverty, deprivation and negative

externalities.

6. GDP is calculated in terms of purchasing power parity, and this value can frequently change.

Poverty

The alleviation of poverty is increasingly seen as a

fundamental economic objective. Poverty creates many

economic costs in terms of the opportunity cost of lost output,

the cost of welfare provision, and the private and external costs

associated with exclusion from normal economic activity.

These costs include the costs of unemployment, crime, and

poor health. In addition, the poor have little disposable income,

and so cannot spend and generate income for firms and jobs for

other individuals.

Widespread poverty is also an important constraint preventing

economic development.

There are two ways to define poverty:

Absolute poverty

Absolute poverty is poverty that is unrelated to a particular

economic or social context. In other words it is a general

definition of poverty which is valid at all times and for all

economies. Agreeing such a definition is extremely hard to do.

One straightforward definition of absolute poverty is being unable to subsist that is, unable to eat, drink, have shelter and clothing. A common universal measure of extreme poverty

is .receiving less than $1.25 a day. Extreme poverty if defined

as not being able to buy enough food to survive.

Relative poverty

It can be argued that poverty is best understood in a relative

way what is poor in New York is not the same as in Mumbai.

One approach is to look at deprivation, the poor being defined as those who are deprived from the benefits of a

modern economy, such as clean water and education.

The Human Poverty Index - HPI

The Human Poverty Index (HPI), which was introduced in

1997, is a composite index which assesses three elements of

deprivation in a country - longevity, knowledge and a decent

standard of living.

There are two indices; the HPI 1, which measures poverty in developing countries, and the HPI-2, which measures poverty

in OCED developed economies.

HPI-1 (for developing countries)

The HPI for developing countries has three components:

1. The first element is longevity, which is defined as the probability of not surviving to the age of 40.

2. The second element is knowledge, which is assessed by looking at the adult literacy rate.

3. The third element is to have a decent standard of living. Failure to achieve this is identified by the

percentage of the population not using an improved

water source and the percentage of children under-

weight for their age.

As a region of the world, Sub-Saharan Africa has the highest

level of poverty as a proportion of total population, at over

60%. The second poorest region is Latin America, with 35% of

its population living in poverty.

HPI-2 (for developed - OECD countries)

The indicators of deprivation are adjusted for advanced

economies in the following ways:

1. Longevity, which for developed countries is considered as the probability at birth of not surviving

to the age of 60.

2. Knowledge is assessed in terms of the percentage of adults lacking functional literacy skills, and;

3. A decent standard of living is measured by the percentage of the population living below the poverty

line, which is defined as those below 50% of median

household disposable income, and social exclusion,

which is indicated by the long-term unemployment

rate.

Part 2: IS Curve

This video is the second in a set of four explaining

the Hicks-Hansel model of Keynes' theory of Aggregate

Demand, specifically the IS-LM interpretation. This model

is very important to short run macroeconomics and

attempts to explain shifts in the aggregate demand curve.

These topics are usually taught in an intermediate

Macroeconomics class, and these videos are intended as

a visual aid to further your understanding of the

models.This video covers the investment demand curve,

integrates investment into the aggregate demand curve,

introduces the IS-curve and provides an overview of the

factors that determine the slope and position of the IS

curve. If you did not view the introductory video, you can

find it here

The I - S stands for Investment and Saving and the IS

curve displays the equilibrium in the goods and service

market for various interest rates.

Investment

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To begin we revisit the aggregate demand equation.

While investment was previously considered to be

exogenous, we're going to see how it relates to interest

rate, so it becomes endogenous and loses the bar above

the variable.

There is, however, still a portion of investment that is

unaffected by interest rate. It is represented by "I-bar"

and called exogenous investment. Next we have interest

rate, represented by "i". And as you see by the minus

sign, investment is negatively related to the interest rate.

The degree to which firms adjust investment spending

relative to the interest rate is called interest sensitivity

which is represented by "b". This coefficient will be

anywhere between zero and one.

Investment Curve

Now we'll examine this relationship graphically.

Investment is on the x-axis and interest rate is on the y-

axis. Typically the independent variable (in this case,

investment) is put on the Y-axis, but we will be using

interest rate as the independent variable when we graph

the IS curve, so it's put here now for consistency.

Exogenous investment determines the initial level. Again,

a higher interest rate results in lower investment

spending. A high interest rate means firms reduce their

investment spending to avoid high interest payments. A

low interest rate means firms can increase their capital

spending and pay relatively low interest.

Slope & Position

The slope of the investment curve is determined by the

interest sensitivity coefficient. A high interest sensitivity

results in a more gradual slope. In this case, there is a

drastic increase in investment spending in reaction to a

relatively small reduction in the interest rate, because of

the higher sensitivity.

The position of the curve is determined by the exogenous

investment. An increase would result in an outward shift

of the curve.

Incorporated Investment into the Aggregate Demand

Equation

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Now we're going to incorporate this investment function

into the aggregate demand equation. Recall in the first

video we separated the components into exogenous and

endogenous to arrive at this formula. Investment was

previously grouped with the exogenous components, but

our new formula has endogenous as well as exogenous

components. The "I-bar" will go back into the exogenous

group, while the interest and sensitivity coefficient move

to the back of the equation.

Review: AD for aggregate demand. A-bar for exogenous

demand, lower case c is the marginal propensity to

consume. lower case t for tax rate, Y for income, lower

case b for interest sensitivity and i for interest rate. You

will notice that all of the lower case variables are rates

between zero and one.

Aggregate Demand Curve with Investment

We're going to display this function graphically, and just

as before the 45 degree line where aggregate demand =

income is our equilibrium criteria. Here is upward sloping

demand function. Higher levels of national income lead to

higher levels of aggregate demand. The y-intercept is

given by exogenous demand minus interest rate *

sensitivity. The intersection of the lines gives us the

equilibrium level of national income.

Reduction in Interest Rate

A reduction in the interest rate results in an upward shift

in the aggregate demand curve. This results in a higher

equilibrium level of national income. So the interest rate

went down and the equilibrium income went up.

Increase in Interest Sensitivity

An increase in interest sensitivity results in a downward

shift in both aggregate demand curves. The downward

shift is more pronounced for the curve with the higher

interest rate (i-1). This means that the distance between

the two resulting equilibrium levels of income is larger.

IS Curve

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Now we can move on to the IS Curve, which denotes the

equilibrium levels of national income for different interest

rates. Just as we did in the previous slide, we will be

graphing the aggregate demand curve for different

interest rates in the top graph. The bottom graph also has

income on it's x-axis and will show the different interest

rates.

Here is the curve for interest rate #1. The equilibrium

level of income is the same for both graphs. When we put

interest rate #1 on our bottom graph we have the first

point of our IS curve. The second aggregate demand

curve has a lower interest rate, so its parallel and higher

up. On the lower graph the intersection of interest rate #2

and equilibrium income #2 produce the second point of

the IS curve. This could be repeated for every different

interest rate in this range to produce the IS curve. Since

this model only uses linear curves, we need a minimum

of two points to graph the IS curve. There you have it, at

any point on this IS curve the goods & services market is

in equilibrium.

Slope of IS Curve - Interest Sensitivity

Now we're going to discuss the determinants of the IS

curve's slope. Holding other factors constant, an increase

in interest sensitivity will result in a more grad