BASIC MACROECONOMIC

RELATIONSHIPS & THE

AGRREGATE EXPENDITURE
MODEL
BASIC MACROECONOMIC RELATIONSHIPS
Objectives

▪Income-Consumption Income-Savings relationship

▪Other factors that can affect Consumption and
Savings
▪Interest Rate Investment relationship
▪The Multiplier effect
▪Aggregate Expenditure & equilibrium GDP in a closed
& open economy.
▪Injections & leakages in the circular flow.
Basic Macroeconomic Relationships

▪ One aim of economists is to build economic models that can

explain economic growth, business cycles, recession, and
inflation.
✓Here we begin to develop tools to explain these events.
▪ We focus on the three basic macroeconomic relationships.
▪ Income and consumption (and income and saving)
▪ The interest rate and investment.
▪ Changes in spending and changes in output.
Basic Relationships cont…

▪ Income-Consumption
▪ Income-Saving
▪ Yd = Disposable Income(DI) is the most significant factor that
determines a nations level of consumption & saving among others.
▪ Recall: DI or Yd is allocated to either consumption ( C) or savings (S).
- It implies that consumption & savings directly depend on disposable
income (Yd) i.e. a change in Yd will result in a change in both C & S.
▪ 𝐶 + 𝑆 = 𝑌𝑑
▪ 𝑆 = 𝑌𝑑 − 𝐶
▪ 𝐶 = 𝑌𝑑 − 𝑆
The Consumption Schedule

❖reflects the various amounts that hhs plan to consume at each

level of income.
▪ There is a direct r/ship between consumption & Yd
✓an increase in income will result in an increase in consumption
expenditure & vice versa.
▪ Consumption depends on income, ∴ it’s a function of income.
consumption function is expressed as:
𝑪 = 𝒂 + 𝒃𝒀
▪ a – constant, point where the consumption schedule intersects
the consumption axis (autonomous consumption)
▪The consumption schedule intersects the C-axis above zero
implying that at zero income, consumption is positive.
▪Even if a hh has zero income it must consume to survive, so
it will borrow or use its savings (dissaving).
▪b - slope of the consumption function which is equal to
∆ 𝒊𝒏 𝑪𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏
∆ 𝒊𝒏 𝑫𝒊𝒔𝒑𝒐𝒔𝒂𝒃𝒍𝒆 𝑰𝒏𝒄𝒐𝒎𝒆
a.k.a the marginal propensity to consume (MPC).
- Shows the change in consumption as a result of a change in
income.
▪Yd- is the disposable income
 Consumption Schedule

Consumption (millions of pula)

Saving Consumption
Schedule

Dissaving

45°

Disposable Income (millions of pula)

Consumption Schedule cont…

• Vertical distance from the 45- degree line to the horizontal axis
is the DI (𝑌𝑑).
• Vertical distance btwn consumption & 45 degree line is saving
• If the c-schedule is below the 45-degree line, the difference is the
amount of income that is saved.i.e. 𝑌𝑑 > 𝐶
• If the c-schedule is above the 45-degree line, there is dissaving
where 𝐶 > 𝑌𝑑
✓ hhs must borrow or use some of their wealth
The Saving Schedule

❖Shows the various amounts that hhs plan to save at each level of
disposable income.
• Since 𝑌𝑑 = 𝐶 + 𝑆, whatever income remains after consumption
is allocated to savings so that 𝑆 = 𝑌𝑑– 𝐶.
▪ There is a direct r/ship between disposable income & saving.
✓an increase in disposable income will result in an increase in the
level of saving & vice versa.
∆ 𝒊𝒏 𝑺𝒂𝒗𝒊𝒏𝒈
▪ Marginal propensity to save 𝑴𝑷𝑺 =
∆ 𝒊𝒏 𝑰𝒏𝒄𝒐𝒎𝒆
Consumption and Saving

▪Because 𝑆 ≡ 𝑌 − 𝐶 we can derive a saving function from a

consumption function.
▪When DI (Yd) is P200million, C is P250million
- Savings: 𝑆 ≡ 𝑌 − 𝐶
≡ 200 − 250
𝑆 ≡ −50
▪When DI is P800million, C is P700million
- Savings: 𝑆 ≡ 𝑌 − 𝐶
≡ 800 − 700
𝑆 ≡ +100
▪When Y = 𝐶, then 𝑆 = 0. This is the break-even income
where hhs consume their entire income
 Consumption and Saving Schedules

Consumption (millions of pula)

700

400
250

45°
200 400 800
(millions of pula)

Disposable Income
Saving

100
S
0
-50

200 400 800

Average Propensities

Average Propensity to consume(APC) – the fraction/% of total income

that is consumed.
𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
𝐴𝑃𝐶 =
𝑖𝑛𝑐𝑜𝑚𝑒
e.g. If consumption is P90m & income is P100m then APC =0.9 i.e on
average hhs consume 90 thebe of every P1 of Yd.
Average propensity to save (APS) – the fraction/% of total income that is
saved.
𝑠𝑎𝑣𝑖𝑛𝑔
𝐴𝑃𝑆 =
𝑖𝑛𝑐𝑜𝑚𝑒
▪ What is not consumed is saved, hhs save P10m &
APS =0.1.
❖YD is either consumed or saved , APC & APS must use all the total
income; APC + APS = 1.
From the example: 0.9 +0.1 = 1
Marginal propensities

Marginal Propensity to Consume (MPC)

 the fraction or proportion of any change in income that is
consumed.

𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
𝑀𝑃𝐶 =
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒

 MPC is the slope of the consumption schedule

 If Yd changes from P400m to P800m and consumption
changes from P100m to P400m, then
(400 − 100) 300
𝑀𝑃𝐶 = = = 0.75
(800 − 400) 400
 Marginal Propensity to Save (MPS)

 the fraction or proportion of any change in

income that is saved.
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑣𝑖𝑛𝑔
𝑀𝑃𝑆 =
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒

 MPS is the slope of the saving schedule

The sum of MPC & MPS for any change in disposable

income must always be 1. (MPC + MPS = 1)
In the example: 0.75 + 0.25 = 1
Consumption fn is expressed as: 𝐶 = 𝑎 + 𝑏𝑌𝑑
▪Where:
C - consumption
a – autonomous consumption
b – marginal propensity to consume
𝑌𝑑 – disposable income

▪Autonomous consumption is consumption that is

independent of income.
Savings function
Saving is that part of income that is not consumed.
- Savings fn shows us the r/ship between saving &
income.
Recall: 𝑌 = 𝐶 + 𝑆
𝑆 = 𝑌 − 𝐶 𝑏𝑢𝑡 𝐶 = 𝑎 + 𝑏𝑌 𝑡ℎ𝑒𝑛,
𝑆 = 𝑌 − 𝑎 + 𝑏𝑌
= 𝑌 − 𝑎 − 𝑏𝑌
= −𝑎 + 𝑌 − 𝑏𝑌
𝑆 = −𝑎 + 𝑌(1 − 𝑏)

S→savings, Y→ income, (1-b)→ MPS

Example

1. given the consumption function 𝐶=100+0.75𝑌 , what will be the

level of consumption & saving if Y=900m?
2. Suppose Yd =120, b= 0.75 and a=120. Calculate consumption &
saving.
Non-income Determinants of Consumption & Saving

Recall: the amount of DI(𝑌𝑑 ) determines the amount that

hhs will consume & save.
❖But the’re other determinants apart from income that
affect consumption & saving patterns of the hhs namely:
wealth, borrowing, expectations & real interest rates.
➢Changes in non-income determinants will shift the
position of the consumption & saving schedules.
✓These can cause pple to spend or save more or less at
various levels of income.
Wealth

▪The value of all assets owned minus the amount of

liabilities i.e. Assets– Liabilities.
▪A change in hh wealth: changes both the present &
future consumption possibilities & shifts the position of
the schedules.
✓An increase in wealth shifts the consumption schedule
up & the saving schedule down.
• i.e. hhs tend to increase their spending & reduce their
saving when their wealth increases.
Borrowing

▪allows hhs to consume more & consumption will shift

up.
▪Saving schedule shifts down as a result of borrowing.i.e
they will save less.
Taxation - Lower taxes will shift both schedules up since
taxation affects both spending and saving, and vice versa
for higher taxes.
N.B. Consumption and saving schedules will always shift
in opposite directions unless a shift is caused by a tax
change.
Expectations

▪Changes in expected future prices or wealth can affect

consumption spending today.
▪If hhs expect an increase in prices in future, they may
increase current consumption (resulting in an upward
shift of the consumption schedule) & save less
(downward shift of the saving schedule).
▪If hhs expect a decrease of prices in future they may
save more and consume less today. The C-schedule
shifts down & savings up.
Real interest rates

▪These are interest rates adjusted for inflation.

▪A decrease in the real interest rate causes hhs to borrow
more & consume (the loans are now cheaper) and the
C-schedule shifts up.
▪The fall in interest rate will cause a reduction in saving
(low interest accrues to the saver) and the S-schedule
shifts down.
Consider:

▪𝑁𝑜𝑡𝑒: there is a difference btwn a change in the

amount consumed/saved and a shift of the
consumption & saving schedule.
 A change in the amount consumed

▪ movement from one point to another along the same

consumption/saving schedule.
- Movement is caused by a change in real GDP(income) only.
A shift of the consumption/saving schedule
▪ change in the position of the consumption/saving schedule either
upwards or downwards.
- caused by changes in one or more of the non-income determinants
of consumption & saving.
Stability - Economists believe that C & S schedules are generally
stable unless shifted by govt action .e.g. i-rates, taxes
The interest rate – Investment relationship

▪Recall: investment - spending on new plants, capital

equipment, additions to inventories, construction etc, all
of which add to the firm’s capital stock.
▪Investment decision involves comparing Marginal
benefits & Marginal Costs.
✓Marginal benefit (MB) is the expected rate of return
(profits) which businesses expect to gain.
✓Marginal cost (MC) is the interest (cost) that must be
paid for borrowed funds.
▪Expected returns and the interest rate are the two basic
determinants of investment spending.
▪Expected rate of return (r) is found by comparing the
expected economic profit (total revenue minus total
cost) to cost of investment. 𝜋 = 𝑇𝑅 − 𝑇𝐶
▪The real interest rate, i (nominal rate corrected for
expected inflation), determines the cost of investment.
✓ If real interest rate exceeds the expected rate of return (i>r), the investment
should not be made.
✓ If expected rate of return is greater than the real interest rate (r>i) investment
should be made.
✓ Firms should invest up to the point where r = i.
Investment demand curve

▪Shows the amount of investment at each level of real

interest rate.
▪The curve slopes downward showing that there is a
negative r/ship between the real interest rate & the
amount of investment demanded.
✓ When interest rate rises fewer projects will be profitable hence quantity of
investment demand will be low.
✓ When interest rate decreases the quantity of investment will be high.
The Investment Demand Curve

16

14

12
r and i (percent)

10

4
ID
2

0
5 10 15 20 25 30 35 40
Investment (millions of pula)
Shifts in the Investment demand curve

▪Will occur when any determinant apart from the

interest rate changes.
▪Greater expected returns create more investment
demand; shift curve to right.
▪Changes in expected returns result because:
✓Acquisition, maintenance, and operating costs of capital goods
may change. Higher costs lower the expected return.
• E.g. if utility costs such as electricity & water were to increase
the expected rate of return from potential investments will fall.
The ID curve will shift to the left. Lower costs will shift ID curve
to the right.
Shifts in the Investment demand curve cont…

✓Business taxes may change. Increased taxes lower the

expected return. The ID curve shifts to the left.
- i.e if firms are to pay more tax to government it means the profits
they expect to earn will be low hence they will invest less.
✓Technology may change. Technological progress such as
the development of new products, improving existing
products can stimulate investment.
▪ E.g. development of a more efficient machine will lower the
prodn costs (now able to produce more within a less period of
time), cause investment to increase, shifting the ID curve to the
right.
▪Stock of capital goods on hand will affect new
investment.
✓If there is abundant idle capital on hand because of
weak demand or recent investment, new investments
would be less profitable. ID curve shifts to the left.
- i.e when the economy has more prodn facilities (firms) than it
needs & when firms have huge amounts of inventories (produced
but unsold goods). There is no need to invest on new prodn
facilities & products that are already there in inventories.
- If the economy is understocked (few prodn facilities) & when firms
are selling their output as soon as it is produced the expected
return on new investment will increase & the ID curve shifts to the
right.
▪ Expectations about future economic and political
conditions, both in the aggregate and in certain
specific markets, can change the view of expected
profits.
✓i.e firms’ expectations about future business conditions can
change quickly when some event suggests significant possible
changes in future business conditions .e.g. indications of
war/political instability, financial crisis. Investment will
decrease and the ID shifts to the left.
 The multiplier effect

▪ Recall: 𝐺𝐷𝑃(𝑌) = 𝐶 + 𝐼 + 𝐺 + 𝑋𝑛
▪ Changes in spending ripple through the economy to generate larger
changes in real GDP.
▪ Multiplier effect – a change in component of total spending leads to a
larger change in GDP.
▪ Multiplier determines how much larger that change will be.
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃 ∆ 𝑖𝑛 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃
▪ 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 𝑜𝑟 (k = )
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔 ∆ 𝑖𝑛 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔

Rearranging will give:

▪ ∆ 𝑖𝑛 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃 = 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 𝑥 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔
 example

▪ Investment falls by P20 million & real GDP falls by P60 million.
∆ 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃
Calculate the multiplier. (𝑘 = )
𝑖𝑛𝑖𝑡𝑖𝑎𝑙 ∆ 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔
Note

▪ initial change in spending is usually associated with investment

spending because its the most unstable component of total
spending. i.e. most of the changes in output & employment are
as a result of an increase/decrease in investment
▪ Initial change linked to Investment, results from a change in the
real interest& or a shift of the ID curve.
▪ Multiplier works in both directions( up or down)
The Multiplier & Marginal propensities

• Size of the MPC & multiplier are directly related & the size of
the MPS & multiplier are inversely related.
1
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟(𝑘) =
(1 − 𝑚𝑝𝑐)

▪ Since MPC + MPS = 1,

∴MPS = 1 – MPC, which means we can write the multiplier
formula as
1
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
𝑚𝑝𝑠
➢ The importance of the multiplier is that a small change in investment
plans or consumption-saving plans can trigger a much larger change in
the equilibrium level of GDP & income.
Equilibrium GDP: 2-sector economy
• There are no taxes coz there is no govt so, disposable income
(Yd)=total income(Y)=GDP.
• Then, C=a+bY
• Equilibrium GDP can be calculated as:
𝑌 = 𝐶 + 𝐼𝑔
𝑌 = (𝑎 + 𝑏𝑌) + 𝐼
𝑌 = 𝑎 + 𝑏𝑌 + 𝐼
𝑌 − 𝑏𝑌 = 𝑎 + 𝐼
𝑌(1 − 𝑏) = 𝑎 + 𝐼
1
𝑌= ∗ (𝑎 + 𝐼)
1−𝑏
1
is the investment multiplier: it measures the amount by which
1−𝑏
equilibrium GDP will increase/decrease whenever investment expenditure
increases by one unit.
Example:

• Given that Investment I is fixed at P35 billion & that

C=100+0.75Y.
• Calculate the equilibrium level of GDP & consumption.
• Calculate & interpret the investment multiplier.
• If Investment were to increase by P40 billion, what will be the
new equilibrium GDP?
 AE model and Equilibrium GDP

• We looked at 3 basic relationships:

✓ How income relates to consumption & saving
✓ How interest rate affects investment spending
✓ How changes in spending work through the system to create
larger changes in output
• Now, we look at a theoretical explanation for these
relationships – the Aggregate expenditures (AE) model to
answer the two most critical questions in macroeconomics
❖ What determines the level of GDP, given the nation’s production
capacity?
❖ What causes real GDP to rise in one period and fall in another?
The model is a.k.a the “Keynesian Cross”
• The theory emphasizes the importance of aggregate demand
for economic performance
• Basic idea of the model is that the amount of goods & services
produced (real GDP) & therefore the level of employment
depend directly on the level of aggregate expenditures (total
spending)
➢Therefore when aggregate expenditures fall, total output &
employment decrease & vice versa
▪ So the equilibrium level of GDP is the level at which the total
quantity of goods produced (GDP) equals the total quantity of
goods purchased - Output/Real GDP is equal to aggregate
expenditure/demand
▪ The aggregate expenditure is the sum of all the
expenditures undertaken in the economy by the
factors during a specific time period. The equation is:
𝐴𝐸 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋 (𝑜𝑝𝑒𝑛 𝑒𝑐𝑜𝑛𝑜𝑚𝑦).
▪ The aggregate expenditure determines the total
amount that firms and households plan to spend on
goods and services at each level of income.
AE& equilib. GDP in a private closed
Economy (C+I)

▪ In a 2 sector economy (hhs & businesses) we

assume that 𝐴𝐸 = 𝐶 + 𝐼
▪ Private closed economy
 AE=C+I
GDP>AE

(AE=GDP) E
AE/GDP

GDP<AE

Y*
(Y)

At equilibrium, 𝐺𝐷𝑃 = 𝐴𝐸 = 𝐶 + 𝐼 and there are no unplanned

changes in inventories i.e 𝑈𝐼 = 0
• Any other level of output other than equilib. GDP represents a
level of disequilibrium
✓ .i.e. there is either underproduction or overproduction.
• Underproduction : production is less than what the economy
wants to spend .i.e. 𝐺𝐷𝑃 < 𝐴𝐸.
- g/s are sold at a faster rate than what the economy is
producing, hence a decline in inventories, 𝑈𝐼 < 0.

- Firms respond by increasing production (thus increasing

employment & income) & the economy will move towards
equilibrium.
• Overproduction is when production is more than what the
economy wants to spend .i.e. 𝐺𝐷𝑃 > 𝐴𝐸
- Thus firms will be accumulating undesired/unplanned
inventories, 𝑈𝐼 > 0.
- Firms will cut back on production (thus reducing employment
& income) & the economy will fall back towards equilibrium.
Adding the Government sector

❖ aggregate expenditure (AE) will increase to

𝐴𝐸 = 𝑌 = 𝐶 + 𝐼 + 𝐺 hence the equilibrium level of output will
be at a higher level.
❖ Note: the characteristics of equilibrium apply to all the models
of economies (private closed, & open economies).
✓ When 𝐺𝐷𝑃 < 𝐴𝐸 there is underprodn, 𝑈𝐼 < 0 firms increase
prodn, increasing output, employment & income.
✓ When 𝐺𝐷𝑃 > 𝐴𝐸 there is overprodn, 𝑈𝐼 > 0 firms reduce
production, decreasing output, employment &income.
✓ 𝑌 = 𝐶 + 𝐼 + 𝐺 & 𝐶 = 𝑎 + 𝑏𝑌 ∴
1
𝑌= ∗ (𝑎 + 𝐼 + 𝐺)
1−𝑏
Note: Taxation & equilibrium GDP

• With govt introdn we introduce the tax component into the

model.
• Because of taxes, consumption & saving will fall at each level of
GDP since consumption now depends on disposable income
instead of total income.
• Before 𝐶 = 𝑎 + 𝑏𝑌 and now 𝐶 = 𝑎 + 𝑏𝑌𝑑 & 𝑌𝑑 = 𝑌 − 𝑇
• Say govt increases income tax, the increase in taxes will
decrease consumption spending resulting in a decrease in
AE/AD.
• So taxes represent a withdrawal from the income spending
stream.
• govt spending represents an injection into the income spending
stream.
Adding the foreign sector

❖ Up to now, we have assumed a simple closed economy where

𝐴𝐸 = 𝐶 + 𝐼𝑔 + 𝐺.
• We relax the assumption & open up the economy to
international trade. Now,
𝐴𝐸 = 𝐶 + 𝐼 + 𝐺 + 𝑋𝑛 where 𝑋𝑛 = 𝑋 − 𝑀

▪ N.B. Aggregate expenditure for a open economy is greater than

that of a private closed economy because of net exports
implying that equilibrium will be at a higher level of output.
• Exports –expenditure by foreigners on domestic output. So,
exports are an injection of spending into the economy.
• Imports –expenditure by citizens on g/s from the rest of the
world, so imports are a withdrawal from the income-spending
stream.
• Equilibrium GDP for the open economy:
𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑋𝑛
𝑌 = 𝑎 + 𝑏𝑌 + 𝐼 + 𝐺 + 𝑋𝑛
𝑌 − 𝑏𝑌 = 𝑎 + 𝐼 + 𝐺 + 𝑋𝑛
𝑌 1 − 𝑏 = 𝑎 + 𝐼 + 𝐺 + 𝑋𝑛
1
𝑌= ∗ (𝑎 + 𝐼 + 𝐺 + 𝑋𝑛)
1−𝑏
 Exercise: calculating equilibrium income.

1. Given C=100+0.75Y and I=35, Xn=15, G=100 calculate

equilibrium income & consumption.
2. Given the consumption function (C)=100+0.8Yd, I=250,G=350,
Taxes=150, where Yd=Y-T
i) Calculate equilibrium level of income, consumption and
saving.
ii) Investment increases by 50, what is the new equilibrium level
of income and consumption
iii) Calculate and interpret the size of the investment multiplier
Note:

• 𝑆 = 𝐼 at equilibrium. Recall: 𝑌 = 𝐶 + 𝑆.
• At equilib. 𝑌 = 𝐶 + 𝐼. Since output (GDP) & income are
equal at equilib. We can substitute
𝐶+𝑆 =𝐶+𝐼
𝐶−𝐶+𝑆 =𝐼
𝑆 = 𝐼 in equilibrium
▪ Saving is income that is not spent/consumed ∴ it
represents a leakage from the income-spending stream.
▪ Investment represents an injection into the income-
spending stream.
▪ To maintain the balance at equilibrium leakages must
equal injections.
Leakages & injections

• Note; for the open economy imports &taxes are additional

leakages while exports & govt purchases are additional
injections.
• So; saving, imports, paying taxes are leakages from the income
spending stream. i.e. they subtract from the income spending
stream.
• And; investment, exports, govt purchases are injections into the
income spending stream.
• At equilibrium the sum of injections must equal the sum of
leakages.
i.e. at equilibrium 𝑆 + 𝑀 + 𝑇 = 𝐼 + 𝑋 + 𝐺
2.MACROECONOMIC PROBLEMS
2.0 UNEMPLOYMENT
OBJECTIVES

▪How economic growth is measured & its

importance
▪About the business cycle and its primary
phases
▪How unemployment & inflation are measured
▪About the types of unemployment & inflation
and their economic impacts
ECONOMIC GROWTH

•measured as either the

•Increase in real GDP, which occurs over a
period of time, ‘real’ because prices are kept
constant over time
•The increase in real GDP per capita, which
occurs over time.
Per capita is the average share of each citizen
-Growth in real GDP doesn’t guarantee growth
in real GDP p/capita
• Growth: NB economic goal because it means
more material abundance & ability to meet the
economizing problem i.e. lessens the burden of
scarcity.
• Economic growth can be interrupted by periods
of economic instability which are usually
associated with business cycles
❖Unemployment and inflation are associated with
business cycles
• i.e. fluctuations in economic activity – output,
employment and price level

• Unemployment rate measures the % of people

who are willing and able to work, but cannot find
jobs

• Inflation rate measures the % increase in the

general price level
Tut Q: What are the four phases of a business
cycle?
Business Cycle : Phases

▪These are fluctuations in economic activity – output,

employment and price level
▪Peak – temporary maximum of economic activity
• Economy is at full employment
• Output, employment and incomes are at their highest level
• Prices are likely to increase during this period
▪Recession – period of decline in economic activity
• total output, income and employment are declining
▪Trough – the lowest point of economic activity
• Output, employment and incomes are at their lowest level
▪Recovery – expansion of economic activity
• output, income and employment increase towards the full
employment level
 BUSINESS CYCLE

▪The business/economic/trade cycle: refers to economy-

wide fluctuations in production or economic activity over a
period of time (several months or years).
▪ These fluctuations occur around a long-term growth trend.
 Causes of Business Cycles
Several theories advanced
(i) Innovations – these influence both investment and consumption
spending – thus output, employment and the price level: such innovations
occur irregularly and thus contribute to fluctuations in economic activity

(ii) Changes in productivity – when productivity expands, the economy

expands as well; when productivity falls, economic activity contracts as well

(iii) Some believe it is a monetary phenomenon; such that when “too much
money chases too few goods” there is inflationary boom in the economy;
too little money in the economy causes output, employment and prices to
decline.
(iv) Changes in total/aggregate spending – a fall in
aggregate spending reduces the incentive for businesses to
invest, thus output, income, employment decline
▪A rise in aggregate expenditure increases the incentive to
invest (profitable); output, employment and income
increase:
▪continued increases in spending may increase the general
price level
 UNEMPLOYMENT

People able, available and willing to find work and actively

seeking work but not employed.

▪Unemployment rate: the % of people who are willing and

able to work, but cannot find employment

𝑼𝒏𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅
𝑼𝒏𝒆𝒎𝒑𝒍𝒐𝒚𝒎𝒆𝒏𝒕 𝒓𝒂𝒕𝒆 = ∗ 𝟏𝟎𝟎
𝑳𝒂𝒃𝒐𝒖𝒓 𝒇𝒐𝒓𝒄𝒆
 Labour Force

▪is the total number of economically active people (15

years and above) who are willing and able to work.
▪It consists of both the employed and the unemployed who
are actively looking for employment
▪Excludes people who are less than 15; those who are
institutionalized (prisons, mental hospitals etc.); fulltime
students; retirees; homemakers, and adults who are not
employed but not actively seeking work
Note:
▪The labour force participation rate (LFPR) is the % of
working age population that is part of the labour force.
- measures the proportion of a country's population that is
employed or actively looking for employment.
𝑙𝑎𝑏𝑜𝑢𝑟 𝑓𝑜𝑟𝑐𝑒
𝐿𝐹𝑃𝑅 = ∗ 100
𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑎𝑔𝑒 𝑛𝑜𝑛 − 𝑖𝑛𝑠𝑡𝑖𝑡𝑢𝑡𝑖𝑜𝑛𝑎𝑙𝑖𝑠𝑒𝑑 𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛

𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑 + 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
𝐿𝐹𝑃𝑅 = ∗ 100
𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑎𝑔𝑒 𝑛𝑜𝑛 − 𝑖𝑛𝑠𝑡𝑖𝑡𝑢𝑡𝑖𝑜𝑛𝑎𝑙𝑖𝑠𝑒𝑑 𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛
example

• Say the working age non-institutionalized population in

2010 was 200,000. Employed people were 120 000 &
the unemployed were 10 000: Find:
(i) the labour force
(ii) the labour force participation rate
(ii) unemployment rate
 Types of Unemployment

▪Frictional unemployment,
▪Structural unemployment
▪and Cyclical unemployment
 Frictional (search) Unemployment
▪caused by people moving between jobs (quit jobs and
look for other jobs; others fired and seeking re-
employment; new entrants into the labour market i.e.
those who have just finished school.)
▪people are either searching for jobs or waiting to take up
jobs in the near future, ∴known as search and wait
unemployment
▪both workers and firms need time to find each other, &
sometimes its very difficult for both firms and workers to
locate each other.
▪Remedy – is to narrow down the gap between people
searching for jobs and the firms that are looking for
workers.
✓Through providing information about job openings and
providing firms with information on unemployed workers,
▪ for example facilities like Labour office, internet sites such as BW
JOBS 4 Graduates on Facebook.
 Structural unemployment
▪due to changes in the structure of demand for labour; e.g.,
when certain skills become outdated or when jobs disappear
coz of structural changes in the economy.
▪Examples
➢Certain workers lack the necessary education, training or skills
required to obtain a job, even when the economy is booming.
➢Changes in production methods/techniques can reduce the
demand for people with particular qualifications or skills.
✓E.g, the introduction of automatic teller machines reduced the
number of job opportunities for bank tellers.
▪Changes in the types of g/s being produced ( coz of
changing consumer preferences)
✓E.g , a fall in the demand for cigarettes because of
the health risk associated with smoking can lead to
unemployment in the tobacco industry.
➢Foreign competition can also result in a loss of jobs.
✓E.g. the growth of the highly competitive textile and
clothing industries in Asia has destroyed many jobs
in the textile and clothing industries in the industrial
countries
➢structural decline in certain industries can lead
to job loss.
✓E.g.In Bots, the closure of copper & nickel
mines and the general decline in copper prices
has destroyed many job opportunities
Remedy
▪ retraining of workers to align their skills with new
production methods;
▪ Initiating a dialogue between the education sector and
industry so that there can be collaboration, hence
assist in producing the skills required by the industry.
▪ Value addition to our exports to ensure
competitiveness.
 Cyclical Unemployment
▪caused by a decline in aggregate spending,
▪likely to occur during a period of economic recession
▪a.k.a deficient demand unemployment;
▪as the demand for goods and services declines, output and
employment fall; thus unemployment increases.
Remedy: increase or stimulate aggregate demand;
▪through expansionary fiscal policy or expansionary monetary
policy
▪As aggregate demand increases, firms demand more labour in
order to increase production; this results in an increase in
employment, thus a fall in unemployment;
▪as output also increases, & people’s incomes also increase
further boosting aggregate expenditure, consequently output
and employment growth
▪ Stimulus packages to deal with the economic recession – meant to boost
aggregate demand, and increase output and employment growth
Full employment
▪ Note that unlike cyclical unemployment (countered through increasing
AD) frictional and structural unemployment are largely unavoidable
▪ Thus the economy is considered to have reached full employment when
it is experiencing only frictional and structural unemployment
▪ The unemployment rate which is consistent with full employment is
referred to as the natural rate of unemployment (NRU) = frictional plus
structural unemployment.
▪At the NRU (i.e. at full employment), the economy is said
to be producing at its potential output
▪Note
✓The natural rate is achieved when labour markets are in
balance; the number of job seekers equals the number of
job vacancies.
✓Underemployment – a situation where workers skills are
somewhat underutilized
 Economic costs of Unemployment

▪Basic cost of unemployment: forgone output

▪When the economy fails to employ all who are ailing
& able to work, there’s loss of potential output.
▪This loss is measured through the
▪ 𝑮𝑫𝑷 𝒈𝒂𝒑 = 𝒂𝒄𝒕𝒖𝒂𝒍 𝒐𝒖𝒕𝒑𝒖𝒕 − 𝒑𝒐𝒕𝒆𝒏𝒕𝒊𝒂𝒍 𝒐𝒖𝒕𝒑𝒖𝒕
▪ Recall: potential output is consistent with full employment
/natural rate of unemployment
▪ GDP gap will be –ve if actual < potential GDP
▪ And the higher the unemployment rate (above the NRU) the
larger the GDP gap
▪ The r/ship between unemployment & the GDP gap was
quantified by Macroeconomist Arthur Okun
▪ Okun’s law suggests that for every 1% point by which actual
unemployment rate exceeds the natural rate of unemployment,
a GDP gap of about 2% occurs.
▪ i.e. for every 1 percentage point the unemployment rises, real
GDP will decrease by 2%.
▪ employed workers assist in producing g/s & the unemployed do
not, increases in UR are associated with a decline in real GDP.
✓Loss in output is the main economic cost
Economic Costs of unemployment

▪ Unemployment leads to loss of skills

▪ Individuals have no income, and therefore likely to fall
into poverty
Non-economic costs of unemployment

▪loss of self-respect and social and political

unrest.
 Unemployment in Botswana

▪Unemployment in Botswana has been rising, it used to

be around 10% in the 80’s, more than 20% in the 90’s
and fell to 17.6 in 2005/2006, & currently at 18.1%.
Nature of unemployment
▪Higher for females
▪Higher for people with no training
▪Higher for the youth because they have little experience
 Causes of unemployment

▪Demand side
▪Inability of the economy to diversify away from mining
which employs about 5% of the whole labour force
mainly because its capital intensive.
▪No new jobs from the government.
✓Some say that government should be more involved in
job creation
✓while the government says it merely create a platform
for the private sector to thrive.
▪Decline in agriculture- low productivity and low rainfall
▪Supply side
▪labour force growing faster than job creation
▪Unwillingness of the youth to participate in agriculture
and other low wage activities
▪Geographical concentration of jobs in urban areas.
Policies or solutions of unemployment
▪ Create more jobs
▪ How and who should?
 Controlling Unemployment

▪Expansionary Fiscal Policy: reduction in taxes or

increase in govt spending.
✓This increases spending, thus stimulating AD.
Firms increase production (hire more workers)
thus increasing employment.
▪Expansionary Monetary Policy: lowering i-rates.
businesses borrow more money to invest in
their businesses. As they invest & expand they
will eventually hire more workers thus
increasing employment.