The National

Economy
 The National Economy

The Scope of Macroeconomics

 Macroeconomic aims of governments

 Microeconomics v.s. Macroeconomics

 Major macroeconomic aims of Govts
 high and stable (i.e. sustainable) economic growth
 Improves standard of living
 low unemployment
 Unemployment represents a waste of human resources (i.e. productive
inefficiency; producing within PPC).
 Unemployment benefits are a drain on government’s revenues.
 low and stable inflation
 High inflation makes local goods more expensive relative to foreign
goods, hence deteriorating balance of payments.
 Thinking Time!

 Why do governments seek to stabilize growth?

What happens if growth is fluctuating?
 It causes uncertainty for consumers and businesses.
When there’s uncertainty, would you spend or invest?
 For that matter, why do governments want to
stabilize inflation? What would happen if
inflation rate fluctuates a lot?
 Thinking Time! (Ans)

 Why do governments seek to stabilize growth?

What happens if growth is fluctuating?
 It causes uncertainty for consumers and businesses.
When there’s uncertainty, would you spend or invest?
 For that matter, why do governments want to
stabilize inflation? What would happen if
inflation rate fluctuates a lot?
 Aids the process of economic decision making; e.g.
businesses can make investment decisions with far more
confidence.
 Fluctuating inflation makes it very difficult to determine
the rate of return on investment. What looks like a good
investment now may not be so in the future!
 Macroeconomic aims of governments

 Major macroeconomic aims of Govts (Cont’d)

 balance of payments (BOP) and exchange rates
 Avoidance of deficits in BOP
 a shortfall of foreign currency will result and the government will
have to borrow money from abroad, or draw on its foreign
currency reserves to make up the shortfall.
 if it goes on for too long, foreign debts will mount and the cost of
servicing (i.e. interest rates) those debts will rise.
 low currency reserves may cost the country its ability to defend its
currency against speculators.
 Stable exchange rates
 too much fluctuations creates uncertainty for traders and can
damage international trade and economic growth.
 Economic growth (average % per annum),
Unemployment (average %), Inflation (average % per annum)
France Germany Japan UK USA EU (12)a OECDb Brazil Malaysia Singapore China
Growth
1960–9 5.6 4.4 10.4 2.9 4.3 5.8 5.5 5.9 6.5 9.5 3.0
1970–9 4.1 3.1 5.4 2.4 3.3 3.8 3.7 8.5 7.7 9.2 7.4
1980–9 2.3 2.0 3.7 2.4 3.1 2.3 2.9 3.0 5.9 7.5 9.8
1990–9 1.9 2.3 1.5 2.1 3.1 2.2 2.5 1.6 7.2 7.6 10.0
2000–9 1.9 1.5 1.6 2.4 2.4 2.0 2.4 3.5 5.5 5.6 9.8
Unemployment
1960–9 1.5 0.9 1.3 2.2 4.1 2.5 2.5 n.a. n.a. n.a. n.a.
1970–9 3.7 2.3 1.7 4.5 6.1 4.0 4.3 n.a. n.a. 3.6 n.a.
1980–9 8.9 7.0 2.5 10.2 7.3 9.3 7.2 3.9 7.2 3.7 2.6
1990–9 11.1 8.1 3.1 8.1 5.8 10.5 7.0 6.9 3.3 2.8 2.8
2000–9 9.0 8.9 4.5 5.1 5.2 8.1 6.4 9.6 3.5 3.3 4.0
Inflation
1960–9 3.8 3.2 5.5 3.8 2.4 3.7 3.1 46.1 0.8 1.2 n.a.
1970–9 8.9 5.0 9.1 12.6 7.1 9.5 9.2 30.6 5.5 5.9 n.a.
1980–9 7.4 2.9 2.5 7.4 5.6 6.5 8.9 354.5 3.7 2.8 7.5
1990–9 1.9 2.4 1.2 3.7 3.0 2.9 4.4 843.3 3.7 1.9 7.8
2000–9 2.0 1.9 0.0 2.7 2.8 2.3 2.5 6.9 2.6 1.6 2.6
Conflicts of macroeconomic policies

 Conflicts between Govt policies

 dilemma in choosing order of priority
 e.g. policy designed to accelerate economic growth rate may lead to
higher inflation rate and a BOP deficit.
 The National Economy

The Circular Flow of Income

 The circular flow of income

 Money v.s. Income

 Money is a stock concept.
 At any given point in time, there is a certain quantity of money in the
economy (e.g. the total number of notes and coins)
 Income is a flow concept
 So is expenditure. It is measured as so much per period of time.
 Annual National Income = Money x Velocity of
circulation
 e.g. $1 billion of money with each $1 gets paid out 5 times per year on
average, annual national income will be $5 billion.

 The inner flow:

 The circular flow of income

Firms

Consumption of
Factor domestically
payments produced goods
and services (Cd)

Households
 The circular flow of income

 Withdrawals
 net saving = household savings – household borrowings
 net taxes = taxes – transfer payments
 Transfer payments: Money transferred from one person to another
without production (e.g. unemployment benefits, pension, etc)
 import expenditure
 Injections
 investment
 government expenditure
 export expenditure
 The circular flow of income

INJECTIONS

Export
expenditure (X)
Investment (I)
Government
Consumption of expenditure (G)

Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)

WITHDRAWALS
 Equilibrium in the Circular Flow

 The relationship between injections and

withdrawals
 indirect links between them (e.g. savings & investments)
 planned injections may not equal planned withdrawals
 links not guaranteeing S = I or G = T or X = M, hence W ≠ J is plausible

 Equilibrium in the circular flow

 Injections > Withdrawals: AD (i.e. NI) will rise
 Withdrawals > Injections: AD will fall
 Until Withdrawals = Injections; i.e. W = J
 Circular flow & 4 macroeconomic objectives

 The circular flow and the four macroeconomic

objectives
 Injection > Withdrawals
 Level of expenditure will rise; AE≡AD will rise.
 Economic growth
 Unemployment falls
 Inflation tends to rise, especially when close to productive capacity
 Current account tends to deteriorate; increase in demand sucks more
import while higher domestic inflation makes exports less competitive.

 GDP and National Income will rise; the extra spending

increases firm’s sales which encourages production.
 The National Economy

Measuring National Income

 Measuring national income (GDP)

 The three ways of measuring GDP

 the product method

 the income method

 the expenditure method

The circular flow of national income and expenditure
(1) Production

(2) Incomes (3) Expenditure

 Product method

 The product method

 the problem of double counting
 the measuring of value added
 gross value added (GVA)
 some qualifications
 stocks
 government services
 ownership of dwellings
 taxes and subsidies on products
UK GVA (product-based measure): 2007
Agriculture, forestry and fishing £8,910m 0.7
Mining, energy and water supply £51,127m 4.1

Manufacturing
£157,728m 12.6

Construction £79,623m 6.4

Wholesale and retail trade; repairs £142,402m 11.4

Percentage of GVA
Hotels and restaurants £36,645m 2.9
Transport and communication £85,326m 6.8

Banking, finance, insurance, etc.

£95,398 7.7

Letting of property £302,605m 24.3

Public administration and defence £64,012m 5.1

Education, health and social work £159,794m 12.8

Other services £64,151m 5.1

Total GVA £1,247,721m 100.0

 Income method

 The income method

 adding factor earnings
 some qualifications
 stock appreciation
 transfer payments
 direct taxes; taxes and subsidies on products
UK GVA by category of income: 2007

Compensation of employees
(wages and salaries) 59.7
£744,857m

Percentage of GVA
Operating surplus
(gross profit, rent and interest of firms
government and other institutions) 32.3
£403,540m

Mixed incomes 6.7

£83,628m
Tax less subsidies on production
(other than those on products) plus 1.3
statistical discrepancy £15,696m
Total GVA £1,247,721m 100.0
 UK GDP (product-based measure): 2007

GVA (gross value added at basic prices) £1,247,721m

plus Taxes on products £158,704m

less Subsidies on products –£5,383m

GDP (at market prices) £1,401,042m

 Expenditure method

 The expenditure method

 C + G + I + (X – M)

 Gross national income (GNY)

 GNY = GDP + Net income from abroad

 Net national income (NNY)

 NNY = GNY − Depreciation (i.e. capital consumption)

UK GDP by category of expenditure, GNY and NNY: 2007
£million
Consumption expenditure of households and NPISH (C) 893 414
Government final consumption (G) 296 900
Gross capital formation (I) 257 513
Exports of goods and services (X) 368 337
less Imports of goods and services (M) –415 817
Statistical discrepancy 695

Gross domestic product (GDP) (at market prices) 1 401 042

plus Net income from abroad 6 818

Gross national income (GNY) 1 407 860

less Capital consumption (depreciation) –158 143

Net national income (NNY) 1 249 717

 Real GDP, GDP per capita, PPP

 Households' disposable income

 Disposable income = NNY − Taxes paid by firms +
Subsidies received by firms − Retained profits of firms −
Personal taxes + Benefits
 Taking account of:
 Inflation (Norminal vs Real GDP)
 Is there real economic growth or just inflation?
 Population (Significance in per head figures)
 GDP is aggregate figure, which is not meaningful for comparing
between performances of economies.
 purchasing power (PPP measures)
 Exchange rate a poor indicator of purchasing power
GDP per head as a percentage of the EU15 average: 2007

GDP per head GDP (PPS) per head

Luxembourg 259.2 253.8
Ireland 147.0 131.0
Denmark 143.4 111.4
Sweden 124.9 110.8
Netherlands 117.5 117.8
UK 114.5 105.8
USA 114.4 138.6
Germany 101.3 102.3
France 101.0 98.1
Italy 89.0 91.0
Japan 86.1 102.0
Spain 80.5 93.5
Greece 70.6 88.2
Portugal 52.8 66.1
Czech Republic 42.7 72.7
Poland 27.7 48.8
 GDP as measures of living standards?

 National income statistics: suitable measures of living

standards?
 items that are excluded
 non-marketed items
 the underground economy

 production: poor indicator of welfare?

 production does not equal consumption
 human costs of production

 externalities

 the production of 'regrettables'

 distribution of income

 The use of ISEW

 Contributions to the Index of Sustainable Economic
Welfare (ISEW) (£ per capita, 1990 prices)
Year 1950 1973 1996

Consumer expenditure 2435 4067 6402

Adjustment for inequality –201 –316 –917
Services of household labour 948 1470 2368
Public expenditure on health and education 89 192 365
Difference between expenditure on & services from goods –206 –446 –1160
Defensive private expenditures on health & education –14 –25 –109
Costs of commuting –52 –127 –206
Costs of personal pollution control – –8 –58
Costs of car accidents –30 –43 –36
Costs of water and air pollution –504 –537 –376
Costs of noise pollution –36 –36 –39
Costs of loss of habitat and farmlands –35 –28 –88
Depletion of non-renewable resources –332 –920 –1812
Long-term environmental damage –292 –718 –1321
Ozone depletion costs –8 –209 –621
Net capital growth – 382 1
Change in net international position 37 52 –41

Per capita ISEW 1799 2713 2349

Per capita GDP 3507 6151 8890

 ISEW 1950-96 (maximum = 100)
100

90

80
ISEW: maximum = 100

UK
70
Netherlands
60
USA
50

40

30

20
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995
 The National Economy

Short-term Growth and the

Business Cycle
 Actual growth & potential growth

 Actual and potential national income

 actual growth (rate)
 the % increase in actual output

 potential economic growth (rate)

 the % increase in the economy’s capacity (i.e. productive capacity)
 2 major factors
 increase in resources
 increase in efficiency with which these resources are used

 potential output (stock concept)

 the level of economy’s capacity (i.e. productive capacity)
 the maximum level an economy can produce given full
employment of resources. (Sloman, 6th Edition)
 sustainable level of output that could be produced in the economy:
i.e. one that involves a ‘normal’ level of capacity utilisation and
does not result in rising inflation. (Sloman, 7th Edition)
 Economic growth & PPC

 Economic growth & the production

possibility curve
 Growth and the production possibility curve

Growth in
actual output
Good X

b
a

O
Good Y
 Growth and the production possibility curve

Growth in
potential output
Good X

I II
O
Good Y
 Growth and the production possibility curve

Growth in
actual and
potential output
Good X

I II
O
Good Y
 Economic growth & the business cycle

 Economic growth and the business cycle

 fluctuations in actual growth
 mainly caused by variations in growth of AD = C + I + G + (X - M)
 UK growth rates
10

8
Annual growth rate (%)

-2

-4

-6
1970 1975 1980 1985 1990 1995 2000 2005 2010
 Growth rates in selected industrial economies
10
UK EU12
8 USA Japan
Annual growth rate (%)

-2

-4

-6
1970 1975 1980 1985 1990 1995 2000 2005 2010
 Phases of the business cycle

 Economic growth and the business cycle

 fluctuations in actual growth
 mainly caused by variations in growth of AD = C + I + G + (X - M)
 the phases of the business cycle
 upturn
 expansion
 peaking out
 slowdown or recession
 The business cycle

Full-capacity
output
National output (GDP)

3
4
3 2 Actual
output
4
2 1

O
Time
 Thinking Time! (Ans)

 Is economic stability always desirable? Is a

recession necessarily an evil?
 thesis
 Lowers business confidence which causes firms to be cautious and
unwilling to make long-term commitments such as building factories,
resulting in lower investmenst and lower long-term economic growth.
 Some people suffer more in times of recession
 Governments are largely judged as success or failures according to the
state of the economy and recessions are seen as failures.
 anti-thesis
 A rosy economic environment may breed inefficiencies. When times
are tough, firms may take a closer look at how their businesses is
operated and find new more efficient methods of production or new
and better products. If they cannot, they may not survive.
 If the market is where the fittest survive, bad times are when you need
to be fit – or rapidly become so.
 Thinking Time! (Ans)

 Is economic stability always desirable? Is a

recession necessarily an evil?
 thesis
 Lowers business confidence which causes firms to be cautious and
unwilling to make long-term commitments such as building factories,
resulting in lower investmenst and lower long-term economic growth.
 Some people suffer more in times of recession
 Governments are largely judged as success or failures according to the
state of the economy and recessions are seen as failures.
 anti-thesis
 A rosy economic environment may breed inefficiencies. When times
are tough, firms may take a closer look at how their businesses is
operated and find new more efficient methods of production or new
and better products. If they cannot, they may not survive.
 If the market is where the fittest survive, bad times are when you need
to be fit – or rapidly become so.
 Sustainable growth

 Economic growth and the business cycle

 fluctuations in actual growth
 mainly caused by variations in growth of AD = C + I + G + (X - M)
 the phases of the business cycle
 upturn
 expansion
 peaking out
 slowdown or recession
 long-term output trend
 sustainable national income
 assuming sustainable level of output which is one which involves
‘normal’ level of capacity utilization and does not result in rising
inflation; i.e. lowest point of AC curve
 The business cycle

Full-capacity
output
National output (GDP)

Output
trend

Actual
output

O
Time
 Output gaps

 Economic growth and the business cycle

 fluctuations in actual growth
 mainly caused by variations in growth of AD = C + I + G + (X - M)
 the phases of the business cycle
 upturn
 expansion
 peaking out
 slowdown or recession
 long-term output trend
 sustainable national income
 assuming sustainable level of output which is one which involves
‘normal’ level of capacity utilization and does not result in rising
inflation; i.e. lowest point of AC curve
 output gaps (‘normal’ level of capacity utilization for potential output)
 difference between actual output & potential output
 Output gaps in selected countries: 1980–2010
7
Output gap (actual output minus sustainable outpu

6 UK Germany
5 USA Japan
4
as a % of sustainable output)

3
2
1
0
-1
-2
-3
-4
-5
-6
1980 1985 1990 1995 2000 2005 2010
Note: 2009 and 2010 based on forecasts; Source: based on data in Economic Outlook (OECD, various years)
 Business cycle in practice

 The business cycle in practice

 irregular fluctuations in actual growth
 the length of the phases
 booms/recessions may be shortlived while others are much longer,
lasting perhaps 3 or 4 years.
 the magnitude of the phases
 Can be very high while others are milder; maybe bubble or depression.
 The business cycle in the UK
10
9
8
Annual growth rate (%)

7
6
5
4
3
2
1
0
-1
-2
-3
1970 1975 1980 1985 1990 1995 2000 2005 2010
 Causes of fluctuations in growth

 The business cycle in practice

 irregular fluctuations in actual growth
 the length of the phases
 booms/recessions may be shortlived while others are much longer,
lasting perhaps 3 or 4 years.
 the magnitude of the phases
 Can be very high while others are milder; maybe bubble or depression.
 Causes of fluctuations in growth
 changes in aggregate demand (AD)
 changes in aggregate demand relative to potential
output
 the lower the actual output relative to potential output, the more room
for rapid growth in actual output.
 The National Economy

Long-term Economic Growth

 Causes of long-term economic growth

 Causes of long-term growth

 increases in the quantity of factors: labour, land and
capital
 the problem of diminishing returns

 increases in factor productivity (i.e. quality)

 total factor productivity

 effects of actual growth on potential growth

 stimulates investment and development of new technology

 firms are ONLY likely to invest if they are convinced that the
growth is not temporal; any growth in potential capacity is
permanent and the initial outlay cost is very high.
 Examples to achieve long-term growth

 Some examples to achieve long-term growth

 capital accumulation
 both quantity and quality of capital
 human capital
 increase quantity and/or quality of labor through foreign talents
 increase quality or productivity through training & development,
education, etc
 foreign trade and investments
 increases AD through exports which may stimulate potential growth
 Foreign Direct Investments (FDI) helps increase AD and potential
growth
 techonological advancements
 applied R&D
 Theories of growth: Classical

 Theories of growth

 the classical theory

Long-run stationary state in the classical model
£
WS

Total subsistence wages

O
Working population
Long-run stationary state in the classical model
£
WS

Y
e

Long-run equilibrium
with wages at bare
Y1 subsistence level

WS1

O N1 NL
Working population
 Theories of growth: Endogenous

 Theories of growth

 the classical theory

 modern endogenous growth theory

 spread effects of technology

 positive externalities of investment

 Policies to achieve growth

 Policies to achieve growth

 demand-side policies
 supply-side policies
 increase incentives to invest in R&D
 increase spending on education and training
 Increase spending on infrastructures (e.g. transport, communication)

 the twin roles of investment

 increases AD through the investment spending of firms.
 increases AS as investment increases the stock of capital & the
development of new technologies.
 Benefits of economic growth

 The benefits of economic growth

 increased consumption

 reduces other macro problems

 scope for redistribution

 Costs of economic growth

 The costs of economic growth

 current opportunity costs
 current consumption or future consumption (i.e. capital investment)
 High and low growth paths

High growth
Consumption

Low growth

C1

C2

Now t1
Time
 Costs of economic growth

 The costs of economic growth

 current opportunity costs
 current consumption or future consumption (i.e. capital investment)

 may generate extra wants

 effect on the distribution of income
 the impact of change, including unemployment as skills
become irrelevant
 environmental costs
 depletion of resources