Вы находитесь на странице: 1из 198

1. Introducing Macroeconomics

What is macroeconomics?

Macroeconomics considers the economy as a whole i.e. the quantity of goods and services produced by all businesses and the government sector. Macroeconomics also studies relationships between one country and another.

The scope of macroeconomics includes looking at the success or failure of government policies. Here are some examples of recent news headlines covering macroeconomic issues:

Introduction to the UK economy

ever trade deficit in 2006‘ Introduction to the UK economy The City of London is a

The City of London is a centre for global finance and a major source of income for our balance of payments

and a major source of income for our balance of payments The spending decisions of millions

The spending decisions of millions of consumers add up to affect the performance of the whole economy

add up to affect the performance of the whole economy Searching for work – unemployment has

Searching for work unemployment has been

© Tutor2u Limited

www.tutor2u.net

for work – unemployment has been © Tutor2u Limited www.tutor2u.net Anticipating demand – Businesses need to

Anticipating demand Businesses need to

for work – unemployment has been © Tutor2u Limited www.tutor2u.net Anticipating demand – Businesses need to

low in the UK recently but it is now starting to rise again

forecast demand changes when setting production levels

again forecast demand changes when setting production levels Brief background on the UK economy The UK

Brief background on the UK economy

The UK is one of the world‘s advanced economies . It has the second largest economy in the European Union behind Germany advanced economies. It has the second largest economy in the European Union behind Germany and it is the second biggest exporter of services in the world. In 2008 the UK will contribute around 3 per cent to global output.

In terms of per capita income , the UK is ranked in the top fifteen nations and in per capita income, the UK is ranked in the top fifteen nations and in 2006 the UK had a per capita income of $34,370.

Britain has enjoyed continuous economic growth that stretches back to 1992, the longest sustained expansion for over forty years. economic growth that stretches back to 1992, the longest sustained expansion for over forty years. That may come to an end in 2009!

Over a quarter of the UK‘s GDP comes from exports of goods and services. Imports are around 30 per cent of national income which exports of goods and services. Imports are around 30 per cent of national income which means that the UK runs a large trade deficit with other countries.

The UK joined the European Union (EU) in January 1973 and it is a founder member of the World European Union (EU) in January 1973 and it is a founder member of the World Trade Organisation (WTO) which it joined in 1995. The UK retains its own currency (sterling) having decided not to consider entry to the EU single currency area, the Euro Zone.

What are the main sectors of the macro-economy?

Whereas microeconomics deals with individual markets such as oil, housing and farming and the behaviour of households and individual businesses, in macroeconomics we tend to look at things ‗in the whole‘ and, in doing so, we tend to use these terms when describing different groups:

Households: receive income from their jobs and from their investments and then buy the output : receive income from their jobs and from their investments and then buy the output of firms (this is known as consumption or consumer spending and is labelled as C)

Firms: Businesses hire land, labour and capital inputs to produce goods and services for which : Businesses hire land, labour and capital inputs to produce goods and services for which they pay wages and rent etc (income). Firms receive payment from consumers and profitable businesses may choose to invest (I) a percentage of profits in new producer goods.

Government: collect direct and indirect taxes (T) to fund spending on public services such as : collect direct and indirect taxes (T) to fund spending on public services such as education, healthcare and defence. Government spending is given the label (G).

© Tutor2u Limited

www.tutor2u.net

such as education, healthcare and defence. Government spending is given the label (G). © Tutor2u Limited
International sector : The UK buy overseas products known as imports, (M) and overseas businesses

International sector: The UK buy overseas products known as imports, (M) and overseas businesses and consumers buy UK products known as exports (X). International trade is important for the UK. Millions of jobs depend directly or indirectly on the UK remaining competitive in overseas markets.

This table provides links to country profiles of each nation from the Economist website this is a highly recommended resource for students of AS macroeconomics.

© Tutor2u Limited

www.tutor2u.net

Africa India OPEC Nigeria Russia inc Brazil Saudi Arabia © Tutor2u Limited www.tutor2u.net

2. Measurement of Macroeconomic Performance

Macroeconomic performance is a term that is used frequently in the media and in exam questions! It refers to an assessment of how well a country is doing in reaching some of the objectives of government policy. The main aim of policy is usually an improvement in the real standard of living for the majority of the population. The term „real‟ means that we have taken into account the effects of rising prices so that we measure how many goods and services we can afford to buy.

But, as we shall see, macroeconomic policy is not solely concerned with living standards. The bigger picture would take into account some of the following:

1. Jobs are more people finding work in the jobs that they are suited to and which pay a living wage? How high is unemployment? Is the economy creating enough new jobs for people entering the labour market each year?

2. Prices are price rises under control creating the conditions for price stability?

3. Trade is the economy performing well in trading goods and services with other countries? Is the economy living within its means by exporting enough to pay for imported products?

4. Growth how successful has the economy been in achieving growth in the short term and in laying the foundations for expansion in the future?

5. Public services have the benefits of growth flowed through into greater and improved provision of key public services such as education, health and transport?

6. The environment the effects of economic activity on our natural and built environment have become ever more important over the years. Many economists now focus on whether an expanding economy is sustainable in terms of its environmental impact.

Big numbers!

We have to deal with some big numbers when we study macroeconomics! For example, the value of national output in the UK is now well above £1.3 trillion! But we still stand well below the United States, whose national output (GDP) accounts for over a quarter of world output each year. China is fast catching up and is now the 4 th largest country by GDP measuring in US dollars.

Ranking of the World‘s Biggest Economies

Gross Domestic Product

Gross Domestic Product

Data is for 2007

(Million US dollars)

(PPP adjusted)

United States

13,811,200

13,811,200

Japan

4,376,705

4,283,528

Germany

3,297,233

2,751,843

China

3,280,053

7,055,079

United Kingdom

2,727,806

2,081,549

France

2,562,288

2,053,695

Italy

2,107,481

1,780,135

Spain

1,429,226

1,372,717

Canada

1,326,376

1,178,205

© Tutor2u Limited

www.tutor2u.net

1,780,135 Spain 1,429,226 1,372,717 Canada 1,326,376 1,178,205 © Tutor2u Limited www.tutor2u.net

Brazil

1,314,170

1,833,601

Russian Federation

1,291,011

2,088,207

India

1,170,968

3,092,126

Source: World Bank web site accessed 7 th July 2008 http://siteresources.worldbank.org/DATASTATISTICS/Resources/GDP.pdf

The Economic Cycle

The national output of a country does not rise in a steady fashion from one year to the next! All countries experience what is called an economic cycle which tracks the fluctuations in the rate of growth of a country‘s Gross Domestic Product (GDP). Have a look at the chart below:

The Economic Cycle - Growth in UK National Output

Annual percentage change in GDP at constant prices

6 6 5 5 4 4 3 3 2 2 1 1 0 0 -1
6
6
5
5
4
4
3
3
2
2
1
1
0
0
-1
-1
-2
-2
-3
-3
-4
-4
-5
-5
80
82
84
86
88
90
92
94
96
98
00
02
04
06
08
Percent

Source: Reuters EcoWin

The cycle is also known as the business or the trade cycle. The chart shows the annual rate of growth of national output for the UK since 1980. We can see that the rate of growth varies from year to year (the data is published every three months, so we get four data points in any one year showing how fast the economy has expanded over the previous twelve months.)

Notice that there have been two recessions in the last twenty-eight years. The early 1980s downturn was a particularly deep recession – in fact it was the worst in the UK‘s post-war history. There was another recession in the early 1990s before the UK climbed out of the downturn in

1993.

© Tutor2u Limited

www.tutor2u.net

another recession in the early 1990s before the UK climbed out of the downturn in 1993.

From 1993 through to the time of writing (the summer of 2008) our economy has continued to expand. Indeed national output has risen in every quarter of the year for the last sixteen years which is a remarkable achievement! This is known as sustained growth and it is an important target of government policy.

This is not to say that we will not suffer another recession! The economic cycle is still with us and we will learn more about it as we get further into this macroeconomics course. There are some pessimistic economists who are predicting a recession for the UK in 2009!

Our chart shows the beginning of a slowdown but the economy is still some way off a recession. Keep an eye on the news in the papers to see how our cycle develops over the next few years!

UK growth forecast is cut

UK economic growth will slow to its lowest level since 1992 in 2009 according to a new forecast from the Confederation of British Industry - a leading employers' group.

Gross Domestic Product is now forecast to rise by just 1.3% next year as households tighten belts due to higher food and fuel prices. The CBI said a "prolonged period of sluggish growth" was in prospect for the UK but it was not predicting a full-scale recession.

There are a number of definitions of a recession, with economists often differing on what is required. However, the most-used definition of a recession is when there are two quarters in a row of economic contraction, or negative growth.

High oil prices have caused a rise in inflation and have given the Bank of England less room to cut official interest rates. Increased prices for essentials such as food, electricity, gas and fuel has squeezed household incomes and companies' profit margins.

Source: Adapted from news reports, June 2008

Key terms

Variations in the annual rate of growth of an economy over time

Forecast

A

prediction made about the likely future performance of an economy

Macroeconomic

The overall performance of an economy in terms of output, prices, jobs, global trade and living standards.

performance

A period of at least six months when an economy suffers a fall in output

A fall in the rate of growth of an economy but not a full-scale recession

Sustainable economic growth is known as the rate of economic growth ―which meets the needs of the present without compromising the ability of future generations to meet their own needs‖.

Sustained growth

Growth of output that is sustained for several years in succession

Target

A

target is an objective of government policy e.g. low inflation

Suggestions for further reading on introductory macroeconomics

© Tutor2u Limited

www.tutor2u.net

e.g. low inflation Suggestions for further reading on introductory macroeconomics © Tutor2u Limited www.tutor2u.net

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on an introduction to macroeconomics.

© Tutor2u Limited

www.tutor2u.net

news on the UK economy (BBC news) Latest news on the UK economy (The Guardian) ©

3. The Circular Flow of Income

A basic model of the economy can be developed using the idea of the circular flow of income and

spending. The circular flow of income is a simple model showing the connections between different sectors of our macroeconomic system. It revolves around flows of goods and services and factors

of production between firms and households.

Leakages from the circular flow

Not all income will flow from households to firms directly. The circular flow shows that some part of household income will be:

(1) Put aside for future spending, i.e. savings (S) (2) Paid to the government in taxation (T) (3) Spent on foreign made goods and services, i.e. imports (M)

Withdrawals are increases in savings, taxes or imports so reducing the circular flow of income and leading to a multiplied contraction of output.

Flows of factor incomes e.g. wages, rent, interest and dividends

of factor incomes e.g. wages, rent, interest and dividends Households Firms Consumption of goods and services
of factor incomes e.g. wages, rent, interest and dividends Households Firms Consumption of goods and services

Households

Firms
Firms
e.g. wages, rent, interest and dividends Households Firms Consumption of goods and services (household spending)
Consumption of goods and services (household spending)
Consumption
of goods and
services
(household
spending)
Consumption of goods and services (household spending) LEAKAGES Savings (S) Taxation (T) Imports (M) INJECTIONS

LEAKAGES

Savings (S)

Taxation (T)

Imports (M)

INJECTIONS

Investment (I)

Government

Spending (G)

Exports (X)

Injections into the circular flow are additions to investment, government spending or exports so boosting the circular flow of income leading to a multiplied expansion of output.

(1) Capital spending by firms, i.e. investment expenditure (I) (2) The government, i.e. government expenditure (G)

© Tutor2u Limited

www.tutor2u.net

i.e. investment expenditure (I) (2) The government, i.e. government expenditure (G) © Tutor2u Limited www.tutor2u.net

(3) Overseas consumers buying UK produced goods and service, i.e. UK export expenditure

 

(X)

 

Economic event

Change in an injection or change in a leakage in the circular flow

Likely effect on the level of national income expansion or contraction (ceteris paribus)

(circle your preferred answer)

1.

A

fall in business confidence among

Injection / Leakage / Both

Expansion / Contraction

UK manufacturing firms

2.

The pound rises by over 5% against the US dollar in the global currency

Injection / Leakage / Both

Expansion / Contraction

markets

3.

The government announces an above-inflation pay rise for nurses in the NHS

Injection / Leakage / Both

Expansion / Contraction

4.

Nissan decides to reduce investment spending at their main Sunderland plant and shift some car production to the Czech Republic

Injection / Leakage / Both

Expansion / Contraction

5.

A

survey shows that consumers

Injection / Leakage / Both

Expansion / Contraction

expect to see a sizeable rise in unemployment over the next twelve

months

 

6.

The government announces a fall in

Injection / Leakage / Both

Expansion / Contraction

the rate of taxation applied to the interest paid on savings in bank

accounts

 

7.

The UK reduces the size of an import tariff imposed on imports of Chinese clothing and footwear

Injection / Leakage / Both

Expansion / Contraction

8.

The annual rate of economic growth

Injection / Leakage / Both

Expansion / Contraction

in

the United States increases

following a fall in US interest rates

 

9.

The government decides to increase the UK road-building programme by

Injection / Leakage /Both

Expansion / Contraction

£600m

10.

The Bank of England‘s Monetary Policy Committee decides to cut interest rates from 5% to 4%

Injection / Leakage / Both

Expansion / Contraction

11.

Ahead of a general election, the government announces a reduction in the basic rate of income tax from 22% to 20%

Injection / Leakage / Both

Expansion / Contraction

© Tutor2u Limited

www.tutor2u.net

of income tax from 22% to 20% Injection / Leakage / Both Expansion / Contraction ©

12.

The government increases revenues from taxes on high-income earners by £2bn and uses the money to increase spending on welfare payments to low- income families at £2bn

Injection / Leakage / Both

Expansion / Contraction

© Tutor2u Limited

www.tutor2u.net

income families at £2bn Injection / Leakage / Both Expansion / Contraction © Tutor2u Limited www.tutor2u.net

4. Measuring National Income

To measure how much output, spending and income has been generated in an economy over a given time period we use national income accounts. These measure three things:

1. Output: i.e. the total value of the output of goods and services produced.

2. Spending: i.e. the total amount of demand.

3. Incomes: i.e. the total income earned by the factors of production from supplying goods

and services

What is National Income?

National income measures the monetary value of the flow of output of goods and services produced over a period of time. Measuring the level and rate of growth of national income (Y) is important for seeing:

The rate of economic growth

Changes over time to average living standards

Changes over time to the distribution of income between groups within the population

Consumer spending accounts for over two thirds of total spending in the UK economy. Consumer spending has been strong in recent years, a reflection of rising living standards and low unemployment, but this may now be coming to an end because of the mountain of household debt and the recession in the housing market.

Were there to be a sharp fall in household spending, the risks of a recession would increase considerably.

Gross Domestic Product

would increase considerably. Gross Domestic Product Gross Domestic Product (GDP) measures the value of output

Gross Domestic Product (GDP) measures the value of output produced within the domestic boundaries of the UK over a given time period.

An important point is that our GDP includes the output of foreign owned businesses that are located in the UK following foreign direct investment. For example, the output of motor vehicles produced at the giant Nissan car plant on Tyne and Wear and by the many foreign owned restaurants and banks all contribute to the UK‘s GDP.

There are three ways of calculating GDP - all of which should sum to the same amount since the following identity must hold true:

© Tutor2u Limited

www.tutor2u.net

all of which should sum to the same amount since the following identity must hold true:

National Output = National Expenditure (Aggregate Demand) = National Income

Firstly we consider total spending on goods and services produced within the economy:

(i) The Expenditure method - aggregate demand

This is the sum of spending on UK produced goods and services measured at current prices. The full equation for GDP using this approach is GDP = C + I + G + (X-M) where

C: Household spending

I: Capital Investment spending

G: Government spending

X: Exports of Goods and Services

M: Imports of Goods and Services

The Income method adding factor incomes

Here GDP is the sum of the incomes earned through the production of goods and services. This is:

Income from people in jobs and in self-employment

+

Profits of private sector companies

+

Rent income from land

=

Gross Domestic product

Only those incomes that are come from the production of goods and services are included in the calculation of GDP by the income approach.

We exclude the following items:

o

Transfer payments e.g. the state pension paid to retired people; income support for families on low incomes; the Jobseekers‘ Allowance given to the unemployed and other welfare assistance including child benefit and housing benefit.

o

Private transfers of money from one individual to another.

o

Income not registered with the Inland Revenue or Customs and Excise. Every year, billions of pounds worth of activity is not declared to the tax authorities. This is known as the shadow economy where goods and services are exchanged but the value of these transactions is hidden from the authorities. It is impossible to be precise about the size of the shadow economy but perhaps 8 15 per cent of income is unrecorded by the official figures.

Output method of calculating GDP using the concept of value added

© Tutor2u Limited

www.tutor2u.net

figures. Output method of calculating GDP – using the concept of value added © Tutor2u Limited

There are three main wealth generating sectors of the economy manufacturing, farming & fishing and service-sector industries. This measure of GDP adds together the value of output produced by each of the productive sectors in the economy using the concept of value added.

Value added is the increase in the value of a product at each stage of the production process. We use this approach to avoid the problems of double-counting the value of intermediate inputs.

The UK is an advanced economy where the majority of GDP comes from the service industries such as banking and finance, tourism, retailing, education and health and a vast range of other businesses services. In 2008 less than half of one per cent of our GDP came from the agricultural sector. Manufacturing accounted for only 15% of GDP and construction a further 6%. In contrast, the service industries now contribute nearly three quarters of national income.

Index of

productio

n

 

All

Productio

Manufacturin

Oil and

Chemical

Engineerin

Food,

Textiles

n

g

gas

s and

g and allied

drink

, leather

industries

extractio

man-

industries

and

and

 

n

made

tobacc

clothing

 

fibres

o

2003

100.0

100.0

100.0

100.0

100.0

100.0

100.0

2004

100.8

102.0

91.6

103.4

104.3

101.6

90.1

2005

98.8

100.8

82.0

103.5

103.2

102.5

88.2

2006

99.1

102.4

74.3

106.1

107.9

101.6

89.6

2007

99.4

103.0

72.5

104.9

109.7

100.7

87.7

Our table above provides evidence of the difficulties that the industrial sector has had in recent years. It shows an index of production with a base year for the index of 2003. Since then the output of oil and gas extraction businesses has declined by over a quarter and production in textiles, leather and clothing has also contracted by more than 12 per cent. Some industries have expanded including engineering and chemicals and man-made fibres. But overall, the production sector was supplying less in 2007 than it had been four years earlier.

It is important to remember that manufacturing and service industries are not completely separate! The health of a car exporting business will have a direct bearing on demand, output, profits and jobs in many service businesses such as transportation, design, marketing and vehicle retailing. Equally service businesses such as online banking require plenty of physical inputs such as machinery and infrastructure to be successful.

The rise of the service industries

Nonetheless, as our chart below indicates, the service industries have enjoyed strong growth, leading to a process of structural change away from heavy industries towards service businesses.

© Tutor2u Limited

www.tutor2u.net

a process of structural change away from heavy industries towards service businesses. © Tutor2u Limited www.tutor2u.net

The main service sector industries in the UK are as follows:

Distribution Hotels and restaurants Transport, storage and communication Business services and finance Government and other services Motor trades Wholesale trades Retail trade Land transport Air transport Post and telecommunications Real estate activities Computer and related activities Education Health and social work Sewage and refuse disposal Recreational, cultural and sporting activities

Manufacturing and Service Industry Output

Index of Value Added, Constant Prices, Seasonally Adjusted

120 120 110 110 100 100 Manufacturing 90 90 80 80 70 Services 70 60
120
120
110
110
100
100
Manufacturing
90
90
80
80
70
Services
70
60
60
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
Index of output, 2002=100

Source: Reuters EcoWin

A decline in the contribution that manufacturing industry makes to national income, trade and employment is called de-industrialization. Many other countries have seen a similar process although it seems to have run further in the UK than elsewhere. In the summer of 2008, figures

© Tutor2u Limited

www.tutor2u.net

it seems to have run further in the UK than elsewhere. In the summer of 2008,

show that only three million people are now working in manufacturing businesses many of which are foreign owned. What has happened is a switch in production and jobs away from the UK towards other centres of manufacturing in the world economy. This is especially true in industries such as textiles and clothing, footwear and the mass production of many household goods and toys.

GNP (Gross National Product)

Gross National Product (GNP) measures the final value of output or expenditure by UK owned factors of production whether they are located in the UK or overseas.

In contrast, Gross Domestic Product (GDP) is concerned only with the incomes generated within the geographical boundaries of the country. Fr example the value of the output produced by Toyota and Deutsche Telecom in the UK counts towards our GDP but some of the profits made by overseas companies with production plants here in the UK are sent back to their country of origin adding to their GNP.

GNP = GDP + Net property income from abroad (NPIA)

NPIA is the net balance of interest, profits and dividends (IPD) coming into the UK from our assets owned overseas matched against the flow of profits and other income from foreign owned assets located within the UK. There has been an increasing flow of direct investment into and out of the UK. Many foreign firms have set up production plants here whilst UK firms have expanded their operations overseas and become multinational organisations.

In recent years, the figure for net property income for the UK has been positive meaning that our GNP is above the figure for GDP. For other countries who have been net recipients of overseas investment (a good example is Ireland) their GDP is higher than their GNP.

© Tutor2u Limited

www.tutor2u.net

of overseas investment (a good example is Ireland) their GDP is higher than their GNP. ©

GDP and GNP for the UK

Gross Domestic Product (GDP) and Gross National Product (GNP) annual data, at constant prices, £ trillion

1.3 1.3 1.2 1.2 1.1 1.1 1.0 1.0 0.9 0.9 0.8 0.8 0.7 0.7 0.6
1.3
1.3
1.2
1.2
1.1
1.1
1.0
1.0
0.9
0.9
0.8
0.8
0.7
0.7
0.6
0.6
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
Gross national income at market prices
Gross Domestic Product
£s (thousand billions)
thousand billions

Measuring Real National Income

Source: Reuters EcoWin

Say you read a newspaper article which says ―the economy has grown by 5% this year‖. How much of that might be simply the effects of rising prices which leaves very few people better off and how much is actually the result of a rise in the economy‘s output of goods and services?

When we want to measure growth in the economy we have to adjust for the effects of inflation.

Real GDP measures the volume of output. An increase in real output means that AD has risen faster than the rate of inflation and therefore the economy is experiencing positive growth. Consider this example

The money value of a country‘s GDP is calculated to be $4,000m in 2007 In 2008, the money value of GDP expands to $4,500m but during the year, inflation is 3% causing the general index of prices to rise from a 2007 base year value of 100 to 103 in 2008.

The real value of GDP in 2008 is calculated thus:

Real GDP = money value of GDP in 2008 x 100 / general price index in 2008

= £4,500 x 100/103 = $4,369 (measured at constant 2007 prices)

© Tutor2u Limited

www.tutor2u.net

price index in 2008 = £4,500 x 100/103 = $4,369 (measured at constant 2007 prices) ©

Note here that the real GDP data is expressed at constant prices which mean that we have made an inflation adjustment. Look for this in the data response questions in the exam.

Income per capita

How much does each person earn on average? We use per capita measures to give us a guide to this. Income per capita is a way of measuring the standard of living for the inhabitants of a country. The table below shows incomes per head for a selection of OECD countries the data is for 2005.

GDP per capita $s

GDP per capita $s

Luxembourg

57 704

EU (established 15 countries)

28 741

United States

39 732

Germany

28 605

Norway

38 765

Italy

27 699

Ireland

35 767

Spain

25 582

Switzerland

33 678

Korea

20 907

United Kingdom

31 436

Czech Republic

18 467

Canada

31 395

Hungary

15 946

Australia

31 231

Slovak Republic

14 309

Sweden

30 361

Poland

12 647

Japan

29 664

Mexico

10 059

France

29 554

Turkey

7 687

Source: OECD World Economic Factbook, 2006 edition

By international standards, the UK is a high-income country although we are not at the top of league tables for per capita incomes countries such as Norway, Japan, the USA and Switzerland has much higher per capita incomes than we do. We do have an income per head that is about ten per cent higher than the average for the established EU countries. But we are some distance behind countries such as the United States (where productivity is much higher).

Key terms

Constant prices

Constant prices tells us that the data has been inflation adjusted

De-industrialization

A

decline in the share of national income from manufacturing industries

GDP

The monetary value of the output of goods and services produced inside

a

country regardless of ownership

GNI

Gross National Income income generated from the resources owned by inhabitants and businesses of a given country

Nominal GDP

A

measure of national income, output and expenditure. This is the

monetary value of all goods and services produced in the economy expressed at current prices.

Per capita incomes

Income per head of the population a measure of average living

© Tutor2u Limited

www.tutor2u.net

capita incomes Income per head of the population – a measure of average living © Tutor2u
 

standards

Real income

Nominal income adjusted for the effects of price changes (inflation) and expressed at constant prices

© Tutor2u Limited

www.tutor2u.net

adjusted for the effects of price changes (inflation) and expressed at constant prices © Tutor2u Limited

5. The Standard of Living

The standard of living is a measure of our material welfare. The baseline measure is real national output per head of population or real GDP per capita - the value of national output divided by the resident population. Other things being equal, a sustained increase in real GDP increases a nation‘s standard of living providing that output rises faster than the total population. However it must be remembered that real income per capita is an inaccurate and insufficient indicator of true living standards both within and across countries.

National income data can be used to make cross-country comparisons. This requires

1. Converting GDP data into a common currency (normally the dollar or the Euro).

2. Making an adjustment to reflect differences in the cost of goods and services in each country to produce data expressed at a ‗purchasing power parity‘ standard.

Is income the same as wealth?

No! Income is a flow concept, for example your monthly salary cheques or the interest and dividends from your savings and stock market investments.

Financial wealth is a stock concept wealth can be held in many different forms such as pension funds, ownership of property and deposits in savings accounts. Income can flow from wealth.

Problems in using national income statistics to measure living standards

‗Improving living standards is about poor families gaining access to what is available at the time to make life comfortable, healthy and rewarding. In the end, economic statistics only measure what they measure, which may not bear much relation to how well off we are.‘ Source: Adapted from the Independent

Per Capita Incomes for EU Countries EU-25 = 100

1997

2007

1997

2007

Luxembourg (Grand-Duchy)

202.9

260.1

Cyprus

81.1

87.6

Norway

139.3

171.6

Greece

71.4

85.6

Ireland

108.6

139.8

Slovenia

71.5

84.7

Netherlands

120.1

125.5

Czech Republic

68.9

78.1

Austria

125.3

123.1

Malta

76.1

74

Denmark

125.9

121.6

Portugal

71.9

69.5

United Kingdom

109.8

117.5

Estonia

38.8

69

Belgium

118.7

117.1

Hungary

48.6

63.9

Sweden

115.3

116.5

Slovakia

49

63

Finland

104.6

112.7

Lithuania

36

57.5

Germany (inc ex-GDR from 1991)

117.5

110.1

Latvia

32.7

57.2

France

108.4

106.2

Poland

44.2

53.4

Italy

112.5

98.5

Romania

:

37.5

Spain

88.2

97.6

Bulgaria

25

36.3

The table above provides time series data on per capita national incomes for the twenty seven nations of the European Union plus Norway. Ireland has made huge strides in improving her relative standard of living. In 1994 Ireland‘s GDP per capita was just 84% of the EU average but rapid economic growth allowed the Irish economy to surge past the EU15 average in 1999 and this progress has been maintained. In contrast, Germany‘s slow growth has seen erosion in her relative advantage in living standards from a level 17% above the EU average in 1997 to a level only 10% above the average in 2007. Britain has a per capita income (adjusted for differences in living costs) nearly 18 per cent higher than the European average.

Official data on GDP tends to understate the true growth of real national income per capita over time due to the expansion of the shadow economy and also the value of unpaid work done by millions of volunteers and people caring for their family members.

The "shadow economy" embraces a range of illegal activities such as drug production and distribution, prostitution, theft, fraud and concealed legal activities such as tax evasion on otherwise-legitimate business activities such as un-reported self-employment income. The scale of the ―shadow economy‖ varies across countries at different stages of development. According to the IMF, in developing countries it may be as high as 40% of GDP; in transition countries of central and Eastern Europe it may be up to 30% of GDP and in the countries of the OECD, the shadow economy may be in the region of 15% of GDP.

Estimates are drawn from those published by the World Bank (2006 Development Report)

Country

Year

GNI per

Informal

Year

GNI per

Informal

 

capita

economy

capita

economy

(US$)

estimate (%

(US$)

estimate (%

 

GNP)

GNP)

Georgia

2006

1,350

67.3

France

2006

34,810

15.3

Bolivia

2006

1,010

67.1

Singapore

2006

27,490

13.1

Panama

2006

4,630

64.1

China

2006

1,740

13.1

Azerbaijan

2006

1,240

60.6

Netherlands

2006

36,620

13

Peru

2006

2,610

59.9

New Zealand

2006

25,960

12.7

Zimbabwe

2006

340

59.4

UK

2006

37,600

12.6

Tanzania

2006

340

58.3

Japan

2006

38,980

11.3

Nigeria

2006

560

57.9

Austria

2006

36,980

10.2

Thailand

2006

2,750

52.6

United States

2006

43,740

8.8

Ukraine

2006

1,520

52.2

Switzerland

2006

54,930

8.8

Here are reasons why GDP data may give a distorted picture of living standards in a country:

1. Regional Variations in income and spending: National GDP data can hide regional variations in output, employment and income per head of the population.

© Tutor2u Limited

www.tutor2u.net

regional variations in output, employment and income per head of the population . © Tutor2u Limited

2.

Inequalities of income and wealth: The Lorenz Curve and the Gini-coefficient are two ways of measuring inequality and relative povertyan outward shift in the Lorenz Curve would indicate a widening of income and wealth inequality. Since 1979, there has been a rise in inequality as the gap between the rich and poorer sections of society has widened. The distribution of wealth is even more unequal than that for income in the UK.

3. Leisure and working hours: An increase in real GDP might have been achieved at the expense of leisure time if workers are working longer hours. Several reports have highlighted the fact that British workers have the longest working week in Europe which can cause stress and damage family life two social indicators that potentially create some negative externalities for society as a whole.

4. Imbalances between consumption and investment: If an economy devotes too many scarce resources to satisfying the short run needs & wants of consumers, there may be insufficient resources for capital investment and over-consumption can lead to an over- exploitation of scarce finite resources thereby limiting future growth prospects.

5. Changes in life expectancy: Improvements in life expectancy have a huge impact on people‘s living standards but don‘t always show through in the GDP accounts. Reductions in infant mortality have been accompanied by the prevention or cure of diseases that might have led to the premature death of even the richest of our ancestors at any time. Putting a monetary value on the benefits of increased longevity is difficult, but surely it must be factored into any overall assessment of living standards and the quality of life.

6. The value of non-marketed output including work done in the home

Much useful and valuable work is not produced and sold in markets at market prices. The value of the output of people working unpaid for charities and of housework might reasonably be added to national income statistics.

7. Innovation and the development of new products: One of the problems in comparing and contrasting living standards and the quality of life across different generations is that new goods and services become available because of competition, investment, invention and innovation that simply would not have been available to the richest person on earth less than fifty years ago. About half of what we spend our money on now was not invented in 1870. Examples include air travel, cars, computers, antibiotics, hip replacements, insulin and many other life-enhancing and life-saving drugs

8. Environmental considerations: Rising output might have been accompanied by an increase in air and noise pollution and other externality effects that have a negative effect on our social welfare. Faster economic growth may cause long term damage to our eco- systems, threatening the long-term sustainability of the economy.

Defensive expenditures: Much spending is on defensive expenditure not on tanks and armaments! But spending to defend yourself against an ―economic or social bad‖ e.g. crime, or spending to recover the damage from externalities (e.g. cleaning up the effects of pollution, managing the huge and growing volume of waste; driving long distances to work etc.)

Alternative measures of economic and social welfare

 

Year

1990

1995

2000

2004

Cable television subscribers (per 1,000 people)

3

24

57

74

Internet users (in 1000s)

 

1100

18000

23505

Mobile phones (per 1,000 people)

 

19

98

727

883

Personal computers (per 1,000 people)

108

201

338

367

© Tutor2u Limited

www.tutor2u.net

© Tutor2u Limited www.tutor2u.net

One of the simplest ways of judging whether we are better off materially than we were a few years ago is to track ownership of consumer durables. The table above draws on some of the information provided over the years 1990 2004. Ownership levels are affected by the trend in price levels, household incomes, changes in tastes and preferences, the emergence of new general purpose technologies and factors such as consumer borrowing and confidence.

The Human Poverty Index (HPI)

The Human Poverty Index (HPI) published annually by the United Nations focuses on four basic dimensions of human life -longevity, knowledge, economic provisioning and social inclusion. The latest published data shows the UK ranked only 15th out of 17 leading industrialized countries with only Ireland and the United States below us. The most recent data for the Human Poverty Index is shown in the table below together with the factors that go into creating the Human Poverty Index ranking.

Country

Human

Probability at

People lacking

Long-term

Proportion of

Poverty

birth of not

functional

unemployment

the

Index

surviving to age

literacy skills

(as % of

population

Ranking

60

(% age

labour force)

living on less

 

(% of cohort)

16-65)

2001

than 50% of

1990-2000

2000-05

1994-98 c

median

 

income

Sweden

1

7.3

7.5

1.1

6.6

Norway

2

8.3

8.5

0.2

6.9

Finland

3

10.2

10.4

2.4

5.4

Netherlands

4

8.7

10.5

1.6

8.1

Denmark

5

11

9.6

0.9

9.2

Germany

6

9.2

14.4

4.2

7.5

United Kingdom

15

8.9

21.8

1.3

12.5

Ireland

16

9.3

22.6

3.2

12.3

United States

17

12.6

20.7

0.3

17

The Measure of Domestic Progress

The Measure of Domestic Progress (MDP) is designed to reflect progress towards a sustainable economy by factoring in the social and environmental costs of growth, and benefits of unpaid work such as household labour. According to their data, over the last thirty years UK GDP increased 80 per cent, but MDP has never regained its 1976 peak.

The Gross National Happiness Index

Bhutan, the Himalayan kingdom the size of Switzerland with no McDonalds, no ATM machines, no traffic lights, and until five years ago no TV, is for many people a species of Shangri-La. Bhutan is ranked 130th in the UN Development Program's ratings, close to Haiti and Bangladesh. Most visitors rate it almost infinitely higher, however, and the measure they use is one let fall by the country's king in 1987 "Gross National Happiness."

“Un” Happy Planet Index

© Tutor2u Limited

www.tutor2u.net

king in 1987 "Gross National Happiness." “Un” Happy Planet Index © Tutor2u Limited www.tutor2u.net

The South Pacific island nation of Vanuatu is the happiest place on the planet according to the Happy Planet Index which uses three factors: life expectancy, human wellbeing and damage done via a country's "environmental footprint". Life satisfaction varies greatly from country to country:

questioned on how satisfied they were with their lives, on a scale of one to 10, 29% of Zimbabweans, who have a life expectancy of 37, rate themselves at one and only 6% rate themselves at 10.

Source: Adapted from the Guardian, 12 th July 2006 and BBC news online

Suggestions for further reading on measuring the standard of living

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on measuring living standards:

Bhutan - Gross National Happiness (BBC news, February 2008) Briton‘s grow richer but wealth gap widens (Financial Times, April 2008) Grossly distorted picture (The Economist, March 2008) UK top for length of working hours (June 2007) Very rich get richer under Labour (Financial Times, January 2008) Wealth may not lead to health (BBC news, February 2008)

© Tutor2u Limited

www.tutor2u.net

Times, January 2008) Wealth may not lead to health (BBC news, February 2008) © Tutor2u Limited

6. What are the objectives of macroeconomic policy?

All governments have targets or aims whilst they are in charge of running the economy in this chapter we consider the main objectives of macroeconomic policy.

What are objectives and how are they different from instruments?

1. Objectives are the aims or goals of government policy

2. Instruments are the means by which these aims might be achieved

So for example, the government might want to achieve an objective of a low rate of inflation. The main instrument to achieve this might be the use of base interest rates and since May 1997 they have been set by the Bank of England. Fiscal policy could be another instrument to achieve this aim.

The government might have another objective namely to make the distribution of income and wealth more equal. It would then choose the policy instruments it thinks are best suited to reaching to this aim, perhaps a change in the income tax system or a rise in the national minimum wage.

Only a limited number of policies can be used to achieve the government‘s objectives. There is a huge amount of research conducted in trying to determine the effectiveness of different policies in meeting key objectives.

The main policy instruments available to meet macroeconomic objectives are

Monetary policy changes to interest rates, the supply of money and credit and also changes to the value of the exchange rate

Fiscal policy changes to government taxation, government spending and borrowing

Supply-side policies designed to make markets work more efficiently

The Objectives of UK Economic Policy

―The Government‘s economic objective is to build a strong economy and a fair society, where there is opportunity and security for all. Macroeconomic stability, characterised by sustainable rates of output growth and low inflation, allows businesses, individuals and the Government to plan more effectively for the long term, improving the quality and quantity of investment in physical and human capital, and helping to raise productivity.‖

Source: UK Budget Statement, March 2008

The Labour Government has set several macroeconomic objectives:

o

Stable low inflation - the Government‘s inflation target is 2.0% for the consumer price index. The Monetary Policy Committee sets interest rates at a level it thinks will meet the inflation target over a two year forecasting horizon. Inflation targets were first introduced into the UK in1992 and have played a role in keeping inflation expectations under control.

o

Sustainable economic growth as measured by the growth of real gross domestic product sustainable both in terms of maintaining low inflation and also in terms of the environmental impact of growth.

© Tutor2u Limited

www.tutor2u.net

maintaining low inflation and also in terms of the environmental impact of growth. © Tutor2u Limited

o

Improvements in capital investment and labour productivity this is designed to improve the UK‘s competitiveness and boost our trade performance. The pressures of globalisation and the increasing competition within the European Union Single Market make this one of the most important long-term objectives of the government.

o

High employment - the government wants to achieve full-employment a situation where all those able and available to find work have the opportunity to work. At the time of writing, unemployment in the UK is at low levels, with less than three per cent of the labour force out of work and claiming the Jobseeker‘s Allowance.

o

Rising living standards and a fall in relative poverty for example the objective of cutting child poverty and reducing pensioner poverty over the next few years.

o

Sound government finances - including control over the size of government borrowing and the total national debt.

We have focused here on the UK but it is important to remember that the aims of macro policy will vary from one country to another. Much depends on the stage of development that they have reached and also where a country is in its economic cycle. For many of the emerging market countries, economic growth and development has been a top priority. For Japan, the major problem in recent years has been a combination of slow growth, rising unemployment and price deflation. And for countries newly integrating into the European Union, high inflation and a huge loss of migrant workers to other countries have become dominant macro-policy concerns.

An end to boom and bust

The 1970s and 1980s were often described as years of stop-go and boom and bust meaning that growth and inflation from one year to the next was often highly volatile and unpredictable. The government always emphasizes macroeconomic stability as one of its main aims it believes that the stability of the economy is necessary for encouraging increased investment, productivity, company profits and employment. For many years the UK has enjoyed economic stability but in 2007-08 this has come under threat partly because of the credit crunch and the steep increase in global commodity prices.

Of course uncertainties in the global economy make this a difficult objective to pursue. A dose of good luck as well as sound judgement is required given the unpredictable shocks that can affect the British economy at any time!

Key terms

A

fall in the willingness of financial institutions such as banks to (a) lend

to

themselves and (b) lend to businesses and households.

Unpredictable events such as volatile prices for oil, gas and foodstuffs.

Economic stability

When the main indicators such as growth, prices and unemployment do not change much from one year to another.

The deepening of relationships between the countries of the world reflected in an increasing level of trade and investment between countries.

Government finances

The amount the government must borrow to finance its own spending. The government has introduced its own rules on how much it can afford to borrow over the course of an economic cycle. See the chapter on fiscal policy.

© Tutor2u Limited

www.tutor2u.net

to borrow over the course of an economic cycle. See the chapter on fiscal policy. ©

Price stability occurs when there is low inflation and the price changes that do occur have little impact on day-to-day decisions of people in the economy.

© Tutor2u Limited

www.tutor2u.net

that do occur have little impact on day-to-day decisions of people in the economy. © Tutor2u

7. Interpreting Economic Data

In this chapter we will look at some of the ways that macroeconomic data can be presented. In

particular we will consider:

1. Tables of data

2. Graphs and index numbers

3. The difference between percentages and percentage changes

4. Distinguishing between real and nominal economic data

Tables of data

A lot of the information that you might encounter during your study of the subject comes in table

format. We will look at an example using data linked to aspects of consumer income and spending.

The table below is known as time series data showing what has happened to a data series over time, in this case the eight years covering the period 2000-2007.

Column 1

Column 2

Column 3

Column 4

New car registrations

Household saving ratio

Real Disposable

 

Income

Growth of consumer credit

Number

Annual % change

% of disposable income

Annual % change

Annual % change

2000 2,337

5.1

4.5

14.5

2001 2,578

10.3

6.4

4.3

13.4

2002 2,682

4.0

5.0

1.7

15.9

2003 2,646

-1.3

4.9

2.4

14.9

2004 2,599

-1.8

3.7

1.7

14.2

2005 2,444

-6.0

5.6

2.9

12.5

2006 2,340

-4.3

4.8

0.9

7.6

2007 2,390

2.9

1.8

6.1

Source: UK economic indicators, HM Treasury website, accessed July 2008

Column one shows the number of new car registrations and is presented in two ways. Firstly the actual number each year and secondly the year-on-year change measured as a percentage. When we want to calculate a percentage change from one year to another, we take the change in the value and divide by the original value and then multiply by one hundred.

So if we take the % change from 2006 to 2007 as an example

The change in new car registrations is 60,000 / divided by the 2006 figure and then multiplied by 100 to give us a percentage change.

© Tutor2u Limited

www.tutor2u.net

/ divided by the 2006 figure and then multiplied by 100 to give us a percentage

= (60,000 / 2,340,000) 100 = 2.6% (to one decimal place)

We can see that in most years the number of new car registrations has been falling. Is this a longer term trend? We would need to have data covering a larger number of years for a trend to emerge.

Column 2 provides information on the household saving ratio. Notice here that the data is measured in a different way, namely the amount of saving that households are doing expressed as

a percentage of people‘s disposable income. It would seem from the data that the saving ratio has fallen between the years 2000 and 2007 and this is indeed the case! But the data needs to be described carefully:

1. Although the savings ratio has fallen, over the same time period, average incomes have grown so we should be cautious about saying that the total amount that people save has declined.

2. The figure is an average across the whole economy and average values must always be treated with care because for most people, their own savings ratio will either be higher or lower than the published figure, depending on their own financial situation, how much income they have. And also what stage they have reached in their life-cycle.

Columns 3 and 4 show the annual growth of real disposable income and consumer credit two important variables that affect how much people have available to spend on goods and services.

A quick comparison of the two data series shows that consumer credit has been rising more

strongly in each of the years shown. If you are given this data in an exam it might be worth doing a

rough estimate of the average growth each year for your answer.

But the main point of using this particular data is to warn you of the difference between a change in the level of a variable and a change in the rate of growth of a piece of economic data.

Consider the change in real disposable income between the years 2005 and 2006. In 2005, real take-home incomes rose by 2.9% but in 2006 that growth dipped to just 0.9%. Does this mean that, on average, real disposable incomes fell in 2006? Lots of students assume that they did but the answer is NO! What happened was that the growth of real disposable income fell but that growth was still positive! We saw a slowdown in real incomes rather than an actual fall.

Index numbers

Index numbers are a useful way of expressing pieces of information and collections of data. This section shows you how to express data in index number format and some examples of data which

is commonly presented as an index number.

In economic data, an index number is a figure reflecting price or quantity compared with a standard or base value. The base value usually equals 100 and the index number is usually expressed as 100 times the ratio to the base value.

Examples of data expressed in index number format

We start with a simple data chart that is expressed in index number format.

© Tutor2u Limited

www.tutor2u.net

format We start with a simple data chart that is expressed in index number format. ©

Our example is a topical one given the rising demand for rail travel at a time of record high fuel prices. It tracks the average index of rail fares and compares it with the change in the overall consumer price index that is used to measure inflation.

Index of Rail Fares in the UK

Monthly fare index, Jan 1987 = 100

300 300 275 275 250 250 225 225 200 200 Rail Fares 175 175 150
300
300
275
275
250
250
225
225
200
200
Rail
Fares
175
175
150
150
Overall Consumer Price Index
125
125
100
100
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08

Source: Reuters EcoWin

Note that the base year for both data series is January 1987 so the index for each has a base value of 100. One of the advantages of presenting the data in this way is to make it easier to see whether rail fares have increased more quickly that consumer prices they have and also to calculate quickly the percentage change. By the summer of 2008 the rail fares index was at 275 a % rise of 175% over the 1987 level. Consumer prices on the other hand were only around 120% higher than twenty one years earlier. In real terms, it has become more expensive to travel by train! And this is likely to continue in the years ahead.

Converting data in index number format: Measuring the level of real national output

When we are measuring the level of national income we often make use of index numbers to track what is happening to real GDP. In the table below we see the value of consumer spending and also real GDP expressed in £ billion. I have chosen 1997 as the base year for our index of spending and output. So the data for consumer spending and real GDP has an index value of 100.0 in 1997.

To calculate the index number for consumer spending in 1998 we use the following formula

Index (1998) = (consumer spending (1998) / base year consumer spending) x 100

© Tutor2u Limited

www.tutor2u.net

formula Index (1998) = (consumer spending (1998) / base year consumer spending) x 100 © Tutor2u

Household

Consumption

Index of Household Consumption

Real GDP

Index of Real GDP

 

£ bn

1997 = 100

£ bn

1997 = 100

1997

558.1

100.0

942.2

100.0

1998

579.3

103.8

973.7

103.4

1999

606.6

108.7

1003.4

106.5

2000

633.7

113.5

1041.5

110.5

2001

653.3

117.1

1066.2

113.2

2002

676.8

121.3

1088.1

115.5

2003

697.2

124.9

1118.2

118.7

2004

721.4

129.3

1154.7

122.6

2005

732.0

131.2

1175.9

124.8

2006

746.0

133.7

1209.3

128.4

Using 1997 as our base year for the index, we can see that consumer spending has grown more quickly than real national income over the period 1997-2006.

Calculating a price index

We will now see how information on prices can be used to create a weighted price index for the economy this is the sort of data which is then used to calculate the rate of inflation

Category

Price Index

Weighting

Price x Weight

Food

106

18

1908

Alcohol & Tobacco

110

6

660

Clothing

97

12

1164

Transport

103

15

1545

Housing

106

22

2332

Leisure Services

112

9

1008

Household Goods

95

7

665

Other Items

105

11

1155

 

100

10 437

A weighted price index calculates changes in the average level of prices. In the data shown in the table above we have split consumer spending into eight categories and given each a ―weightingbased on the share of total spending given over to each category. So for example, housing and food costs are assumed in our example to take up 40% of the total. These two items will have a heavy influence on the overall price index.

The price index for shows what has happened to the price level since a base year value.

To generate a weighted price index we multiply the price index for each category by its weight and then sum these.has happened to the price level since a base year value. We then divide by the

We then divide by the sum of the weights (100) to find an overall price index (104.37) or 104.4 rounded to one decimal place.index we multiply the price index for each category by its weight and then sum these.

© Tutor2u Limited

www.tutor2u.net

(100) to find an overall price index (104.37) or 104.4 rounded to one decimal place. ©

You will discover lots of index numbers in your study of macroeconomics including the consumer price index, the sterling exchange rate index and also the Financial Times Stock Exchange index!

© Tutor2u Limited

www.tutor2u.net

the sterling exchange rate index and also the Financial Times Stock Exchange index! © Tutor2u Limited

8. Understanding Aggregate Demand

You won‘t spend too long on a macroeconomic course before you come across the term aggregate demand! Aggregate means ‗total‘ and in this case we use the term to measure just how much is being spent by all of the major players in the economy consumers, businesses, the government and people and firms overseas.

The Components of Aggregate Demand

Aggregate demand measures total spending on goods and services. The identity for calculating aggregate demand (AD) is as follows:

Where

AD = C + I + G + (X-M)

C: Consumers' expenditure on goods and services: Also known as consumption, this includes demand for durables e.g. washing machines, audio-visual equipment and motor vehicles & non-durable goods such as food and drinks which are ―consumed‖ and must be re-purchased. Consumer spending is the biggest single component of aggregate demand.

I: Capital Investment This is investment spending on capital goods such as new plant and equipment and buildings which will allow us to produce more consumer goods in the future. Investment also includes spending on working capital such as stocks of finished goods and work in progress.

Capital investment spending in the UK accounts for between 16-20% of GDP in any given year. Of this investment, 75% comes from private sector businesses such as Tesco, British Airways and British Petroleum and the remainder is spent by the government for example investment in building new schools or in improving the railway or road networks. So a mobile phone company such as O2 spending £100 million on extending its network capacity and the government allocating £15 million of funds to build a new hospital are both counted as capital investment. Investment has important effects on the supply-side as well as being an important although volatile component of aggregate demand.

A small part of investment spending is the change in the value of stocks i.e. unsold products. Producers may find either than demand is running higher than output (i.e. stocks will fall) or that demand is weaker than expected and less than current output (in which case the value of unsold stocks will rise.)

G: Government Spending This is spending on state-provided goods and services including public goods and merit goods. Decisions on how much the government will spend each year are affected by developments in the economy and the political priorities of the government.

Government spending on goods and services is around 18-20% of GDP but this tends to understate the true size of the government sector in the economy. Firstly some spending is on investment and a sizeable slice (nearly £190 billion in 2007) goes on welfare state payments. Transfer payments in the form of benefits (e.g. state pensions and the job- seekers allowance) are not included in general government spending because they are a transfer from one group (i.e. people in work paying income taxes) to another (i.e.

© Tutor2u Limited

www.tutor2u.net

a transfer from one group (i.e. people in work paying income taxes) to another (i.e. ©

pensioners drawing their state pension having retired from the labour force, or families on low incomes).

The next two components of aggregate demand relate to international trade between the UK economy and the rest of the world.

X: Exports of goods and services - Exports sold overseas are an inflow of demand (an injection) into our circular flow of income and spending adding to aggregate demand.

M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from the circular flow of income and spending.

Net exports measure the value of exports minus the value of imports. When net exports are positive, there is a trade surplus (adding to AD); when net exports are negative, there is a trade deficit (reducing AD). The UK has been running a large trade deficit for several years now as has the United States.

Our table below shows the components of aggregate demand that we have covered in this chapter.

Components of Aggregate Demand for the UK Economy

Consumer

Government

Gross

Change

Exports

Imports

Real

spending

consumption

Investment

in stocks

of goods

of goods

GDP

 

and

and

services

services

£ billion

£ billion

£ billion

£ billion

£ billion

£ billion

£ billion

1999 579.3

198.6

164.2

4.3

238.3

238.8

973.7

2000 606.6

205.9

169.1

5.8

247.3

257.8

1003.4

2001 633.7

212.3

173.7

4.6

269.8

281.1

1041.5

2002 653.3

217.4

178.2

5.6

277.7

294.4

1066.2

2003 676.8

224.9

184.7

2.3

280.6

308.7

1088.1

2004 697.2

232.7

186.7

4.0

285.4

314.8

1118.2

2005 721.4

240.1

197.7

4.6

299.3

335.7

1154.7

2006 732.0

246.5

200.7

3.6

323.7

359.6

1175.9

2007 745.7

250.6

216.0

2.4

358.4

394.8

1210.3

Source: Office for National Statistics and HM Treasury

Consumer spending as a share of GDP has grown from 59.4% of real GDP in 1999 to 61.6% in 2007. Although this might seem like a small percentage change, because the scale of consumer demand is so huge (in 2007 it amounted to over £2 billion per day!) then a shift in the share of GDP towards household spending has had a major impact on the economy. Much of this extra demand has gone on imported products leading to a rising trade deficit. But it has also been spent on domestically supplied goods and services providing a boost to the home economy. If consumer

© Tutor2u Limited

www.tutor2u.net

supplied goods and services providing a boost to the home economy. If consumer © Tutor2u Limited

spending was to fall in real terms, then the risks of a recession in the UK would be much higher. We will return to this in our chapter on consumer spending.

Shocks to the level of aggregate demand

One of the really interesting things about being a macroeconomist is that lots of unexpected events can happen which cause changes in the level of demand, output and employment. The headwinds can alter direction with great speed leading to uncertainty about where the economy is heading.

These unplanned events are called “shocks” and many of them happen in other countries or parts of the global economy but they have an effect across many different countries.

One of the causes of fluctuations in the level of macroeconomic activity is the presence of demand-side shocks.

Some of the main causes of demand-side shocks are as follows:

o

A capital investment boom e.g. a construction boom to increase the supply of new houses or to build new commercial and industrial buildings.

o

A big rise or fall in the exchange rate affecting net export demand and having follow-on effects on output, employment, incomes and profits of businesses linked to export industries.

o

A consumer boom abroad in the country of one of our major trading partners which affects the demand for our exports of goods and services.

o

A large slump in the housing market or a slump in share prices.

o

An event such as the international credit crunch involving a sharp fall in the amount of credit available for borrowing by households and businesses.

o

An unexpected cut or an unexpected rise in interest rates or change in government taxation.

These shocks will bring about a shift in the aggregate demand curve and we turn to this next.

The Aggregate Demand Curve

The AD curve shows the relationship between the general price level and real GDP. In most macroeconomics textbooks the aggregate demand curve is drawn as a straight line but you can draw a curve as well. Don‘t worry the examiners will accept both versions!

© Tutor2u Limited

www.tutor2u.net

you can draw a curve as well. Don‘t worry the examiners will accept both versions! ©
The AD curve shows the relationship between aggregate demand and the UK i i l
The AD curve shows the relationship between aggregate demand and the UK
i
i
l
l
ll
d i
t
f th
i
d
General
Price
Level
1. A rise in the general
price level from P1 to P2
causes a contraction in
aggregate demand
P2
P1
2. A fall in the general price
level from P1 to P3
causes an expansion of
aggregate demand
P3
AD
Y2
Y1
Y3
Real National Income
Aggregate demand and the price level

There are several explanations for an inverse relationship between AD and the price level in an economy. These are summarised below:

1. Falling real incomes: As the price level rises, so the real value of people‘s incomes fall and consumers are less able to buy the items they want or need. Imagine that over the course of a year all prices rose by 10 per cent whilst your nominal income remained the same. This would put a squeeze on your real purchasing power.

2. The balance of trade: A high and persistent rise in the price of level of Country X could make foreign-produced goods and services more attractive (cheaper) in price terms, causing a fall in exports and a rise in imports. This will lead to a reduction in net trade (X-M) and a contraction in AD.

3. Interest rate effect: if the price level rises, this causes inflation and an increase in the demand for money and a consequential rise in interest rates with a deflationary effect on the economy. This assumes that the central bank (in our case the Bank of England) is setting interest rates in order to meet a specified inflation target.

Shifts in the AD curve

A change in the factors affecting any one or more components of aggregate demand i.e. households (C), firms (I), the government (G) or overseas consumers and business (X) changes planned spending and results in a shift in the AD curve.

Consider the diagram below which shows an inward shift of AD from AD1 to AD3 and an outward shift of AD from AD1 to AD2. The increase in AD might have been caused for example by a fall in interest rates or an increase in consumers‘ wealth because of rising house prices.

© Tutor2u Limited

www.tutor2u.net

interest rates or an increase in consumers‘ wealth because of rising house prices. © Tutor2u Limited

Price

Level

P2

P1

P3

In the short run, shifts in aggregate demand cause fluctuations in the economy‘s output of
In the short run, shifts
in aggregate demand
cause fluctuations in
the economy‘s output
of goods and
services.
AD2
In the long run, shifts
in aggregate demand
affect the overall
AD1
i l
l b
t d
t
AD3
Y3
Y1
Y2
Real National Income

Short exercise on aggregate demand

State whether each factor is likely to increase or decreases the level of aggregate demand for the UK economy (other factors remaining the same).

 

Economic Event

Likely impact on aggregate demand (rise / fall / uncertain)

1

The government decrease the rate of income tax from 22% to

 

20%

2

There is a 20% fall in average UK house prices over a two year period

 

3

There is a consumption boom in the countries of the Euro Zone

 

4

The exchange rate between sterling and the Euro appreciates by 15% (i.e. goes up in value) over the course of a year

 

5

A new survey finds that business confidence has hit a 5-year low

 

6

The government announces a £400m plan to build a series of wind farms across the UK

 

7

Consumers decide to increase their savings ratio

 

8

Bank of England signals rise in interest rates of ½%

 

9

The government increases government spending by £1 billion but raises the amount it takes in income tax by £1 billion

 

© Tutor2u Limited

www.tutor2u.net

by £1 billion but raises the amount it takes in income tax by £1 billion  

10

A Scottish distillery announces that it will now source its bottles from Sweden rather than a bottling manufacturer in the West Midlands

11

Chancellor announces tax exemption scheme on new investments for small to medium sized businesses.

12

Government increase tax burden to highest level for 50 years

Factors causing a shift in AD

Changes in Expectations

Current spending is affected by anticipated future income, profit, and inflation

Changes in Monetary Policy i.e. a change in interest

(Note there is more than one interest rate in the economy, although borrowing and savings rates tend to move in the same direction)

Changes in Fiscal Policy

Fiscal Policy refers to changes in government spending, welfare benefits and taxation, and the amount that the government borrows

Economic events in the international economy

International factors such as the exchange rate and foreign income (e.g. the economic cycle in other countries)

The expectations of consumers and businesses can have a powerful effect on planned spending. E.g. expected increases in consumer incomes, wealth or company profits encourage households and firms to spend more boosting AD.

When confidence turns lower, we see an increase in saving and some companies postpone capital investment projects because of worries over a lack of demand and a fall in the expected rate of profit.

An expansionary monetary policy will cause an outward shift of the AD curve. If interest rates fall this lowers the cost of borrowing and the incentive to save, thereby encouraging consumption. Lower interest rates encourage firms to borrow and invest.

There are time lags between changes in interest rates and the changes on the components of aggregate demand.

For example, the Government may increase its expenditure e.g. financed by a higher budget deficit - this directly increases AD

Income tax affects disposable income e.g. lower rates of income tax raise disposable income and should boost consumption.

An increase in transfer payments increases AD particularly if welfare recipients spend a high % of the benefits they receive.

A fall in the value of the pound (£) (a depreciation) makes imports dearer and exports cheaper - the net result should be that UK AD rises the impact depends on the price elasticity of demand for imports and exports and also the elasticity of supply of UK

© Tutor2u Limited

www.tutor2u.net

elasticity of demand for imports and exports and also the elasticity of supply of UK ©

exporters in response to an exchange rate depreciation.

An increase in overseas incomes raises demand for exports and therefore UK AD rises. In contrast a recession in a major export market will lead to a fall in UK exports and an inward shift of aggregate demand.

Changes in household wealth

Wealth refers to the value of assets owned by consumers e.g. houses and shares

A rise in house prices or the value of shares increases consumers‘ wealth and allow an increase in borrowing to finance consumption increasing AD. In contrast, a fall in the value of share prices or a recession in the housing market ca lead to a decline in household financial wealth and a fall in consumer demand.

Let us look at the components of demand for the UK economy. These are presented in the chart below. Notice first that the data has been adjusted for the effects of inflation; we confirm this because the figures are expressed at constant 2003 prices.

The Components of Aggregate Demand

£bn per year at constant 2003 prices

800 800 700 700 600 600 Consumer Spending 500 500 Imports 400 400 300 300
800
800
700
700
600
600
Consumer Spending
500
500
Imports
400
400
300
300
Exports
Government spending
200
200
Investment
100
100
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
2003 GBP (billions)
billions

Source: Reuters EcoWin

Consumer spending is overwhelmingly the biggest single part of AD. A large and rising share of spending goes on imported goods and services but the UK economy has also managed to achieve a sizeable increase in the real value of our exports. However, the value of imports has exceeded exports leading to a trade deficit. This means that net trade has had the effect of reducing total aggregate demand, in this sense it has acted as a pressure valve taking away some of the excess demand for goods and services in the British economy.

© Tutor2u Limited

www.tutor2u.net

taking away some of the excess demand for goods and services in the British economy. ©

Key terms

When the government is spending more than it receives in tax revenue the effect is a rise in aggregate demand

Consumption

Consumer spending on goods and services

How we expect the future to unfold this can have powerful effects on the spending decisions of households, businesses and the government

Exports

Goods and services sold overseas an injection of demand

Government spending

Government provided goods and services and social security payments

Household wealth

The value of assets owned by households including property, shares, savings and pension fund assets

Imports

Goods and services bought from overseas a withdrawal of demand

Investment

Spending on capital goods including plant & machinery and infrastructure

Net Trade

The balance between the value of exports and imports

Time lags

The time it takes for one change e.g. a change in interest rates to affect other variables e.g. consumer confidence and spending

© T