nationaleconomy

Week 7: The National Economy

Week 7: The National Economy

Key termsmacroeconomic issuesmacroeconomic objectiveseconomic growthemployment /

unemployment inflationBalance of Paymentsexchange ratepolicy conflict

circular flow of incomewithdrawals

savings, taxation, imports

injections Investment, government

spending, exports

aggregate demand

4 Key Macroeconomic Issues1. Economic growth

2. Employment

3. Inflation

4. Balance of Payments and the exchange rate

Macroeconomic issues

1.Economic growth

‘the growing ability of the economy to produce goods and services’

government objective Achieve high but stable growth rates over a sustained

period of time

[UK = up from -0.4% to 1% but mostly due to the 2012 Olympics]

Macroeconomic Issues2. Employment

employment is the total number of people currently employed

unemployment is the total number of people actively looking for work but who are not currently employed

government objective: full employment (reducing unemployment) such

that there is no waste of human resources[UK = down from 8.1% to 7.9%]

Macroeconomic Issues3. Inflation

the general rise in prices

the rate of inflation measures the annual percentage increase in prices

government objective: control inflation such that it is low and stable [UK CPI = down from 2.5% to 2.2% - target is 2%]

Macroeconomic Issues4. Balance of Payments

all payments made to other countries (import purchases, outward spending, interest paid)

all payments received from other countries (export sales, inward investment, interest earned)

if a country spends more foreign currency than it earns, there will be a BofP deficit (currency surplus, exchange rate falls)

government objective: achieve balance of country’s trade and capital flows over

a period of years – BofP equilibrium [UK = deficit £49b]

Macroeconomic IssuesKey problem: policy conflict

eg goal of high economic growth may conflict with goal of low inflation

Solution: trade-offs (opportunity costs, rational choices, and

cost- benefit analyses)

Economic Aggregates

Aggregate Demand (AD) =

* total spending on goods and services made within the country over a given period of time (planned spending)

Aggregate Demand 4 components

1. Consumption (C)2. Investment (I)3. Government Spending (G)4. Net Exports (X-M)

AD = C + I + G + X-M

Relationship between 4 macro objectives and AD – see circular flow of income

The Circular Flow of IncomeThe inner flow

Firms and Households

Factorpayments

Factorpayments

Consumption ofdomestically

produced goodsand services (Cd)



The circular flow of income

Firms

Households

Beyond the inner flowWithdrawals (W)

net saving (S)

net taxes (T)

import expenditure (M)

Total withdrawals are the total of net saving, net taxes and expenditure on imports

W = S + T + M

Factorpayments



BANKS, etcBANKS, etc

Netsaving (S)

Netsaving (S)

GOV.GOV.

NetNettaxes (taxes (TT))


ABROAD

ImportImportexpenditure (expenditure (MM))


The circular flow of incomeThe circular flow of income

WITHDRAWALS

Beyond the inner flowInjections (J)

Investment (I)

Government expenditure (G)

Export expenditure (X)

Total injections are the sum of investment, government expenditure, and exports

J = I + G + X

Aggregate demand (total spending on output) is Cd + J

Factorpayments



Investment (Investment (II))Investment (Investment (II))

GovernmentGovernmentexpenditure (expenditure (GG))

GovernmentGovernmentexpenditure (expenditure (GG))

ExportExportexpenditure (expenditure (XX))

ExportExportexpenditure (expenditure (XX))

BANKS, etcBANKS, etc

Netsaving (S)

Netsaving (S)

GOV.GOV.



ABROAD



The circular flow of incomeThe circular flow of income

WITHDRAWALS

INJECTIONS

The Circular Flow of Income

The relationship between injections and withdrawals

the links between them are complex due to many different decisions made by many different people

planned injections may not equal planned withdrawals

eg

S ≠ I, T ≠ G, X ≠ M

The Circular Flow of Income

The relationship between injections and withdrawals

Disequilibrium when J ≠ W

This will set in motion a process to bring economy back to state of equilibrium where J = W

Relationship between W and JIf J > W then the level of expenditure will

rise; a rise in ADExtra spending will increase firms’ sales,

encourage them to produce moreTotal output in the economy will riseFirms pay out more in wages, profits, rents,

interestNational income will rise

Effect of rise in AD on 4 macro objectives1. Economic growth

The greater the excess of J over W, the bigger the rise in national income

2. UnemploymentWill fall as firms take on more workers to meet

the extra demand in output

continued

Effect of rise in aggregate demand on 4 macroeconomic objections - continued

3. InflationWill tend to rise. The greater rise in AD

relative to capacity of firms to produce, the more firms struggle to meet demand so likely to raise prices

4. Balance of PaymentsWill tend to deteriorate. Higher demand

means more M and higher inflation means X less competitive and imports relatively cheaper. So M tend to rise and X tend to fall

Disequilibrium and a chain reaction ‘automatic stabilisers’

J ˃ W As national income rises: Households will spend more [Cd]Households will save more [S]Households will pay more taxes [T] [and government

will spend less on welfare benefits]Households will buy more imports [M]

So withdrawals increase

Eventually, equilibrium: J = W

[ie automatic stabilisers can avoid unsustainable growth, high inflation]

QuestionThis time: J < W

Step 1: What will be the effect on each of the four objectives if planned injections are less than planned withdrawals?

Step 2: Explain how the chain reaction returns the economy to equilibrium [J = W] [ie how the automatic stabilisers work to limit the fall in growth to avoid high inflation]

If planned injections are less than withdrawals, national income will fall. Other things being equal, this will have the following effects on the four objectives:

Growth will be negative. Unemployment will rise. The rate of inflation will fall. Exports will tend to rise (as their relative prices fall) and imports will tend

to fall (as they become less competitive with home-produced goods and as incomes at home fall and thus people cannot afford to buy so many imports). These effects are collectively known as the international substitution effect

As national income falls Households will spend less (Cd) Households will save less (S) Households will pay less taxes (T)[government will pay more welfare benefits] Households will buy fewer imports (M) Demand from abroad for X tends to increase. So withdrawals decrease Government spends more (borrows).

If J < W National income will rise / fall Ceteris paribus, this will have the following effects on the four

macro-economic objectives: Growth will be negative / positive Unemployment will rise / fall The rate of inflation will rise / fall Exports will tend to rise / fall Imports will tend to rise / fall So the balance of payments will improve / deteroriate

Automatic stabilisers can limit fall in growth by:

Aggregate Demand – components1. Consumption (C)

The amount of consumer spending on goods and services produced in the country (the largest part of AD)

It is influenced by: Disposable income (the largest part of C) Expected future incomes/consumer confidence Household wealth The financial system/interest rates New technology

Aggregate Demand – components2. Investment (I)

Expenditure by firms in the country on ‘capital goods’ (eg buildings, equipment NOT stocks, bonds)

It is influenced by: Increased consumer demand Expectations and business confidence Financial system/interest rates Technological advances Cost of capital goods Level of company profits

Aggregate Demand – components3. Government spending (G)

on goods and services (eg defence, education, health, housing etc)

it is influenced by: Government policy (political issue) National income – short-term National income – long-term (includes issue of tax

revenue) Demographic changes Demand for merit and public goods

Aggregate Demand – components3. Government spending (G) - continued

G directly increases/decreases ADeg consider wartime spending

T indirectly increases/decreases ADeg lower tax rate = consumers keep more of what

they earn thereby increasing their disposable income

Aggregate Demand – components3. Government Spending (G) - continued

Budget deficit (G > T): expansionary fiscal policy = increase AD

Budget Surplus (G < T): contractionary fiscal policy + decrease AD

Balanced Budget (G = T): neutral effect on AD

Aggregate Demand – components4. Net Exports [X - M)

Net exports is the difference between the value of exports and the value of imports

[M subtracted from X because M not part of the country’s production]

Export sales lead to flow of funds into country so AD increases

Import purchases lead to flow of funds out of country so AD is reduced

Aggregate Demand – components4. Net exports (X -M) continued

Spending on X depends on Level of income in other countries Exchange rate

Spending on M depends on Level of income in own country Exchange rate

Education

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