THE FUNDAMENTAL

CONCEPTS OF
MACROECONOMICS

Erandathie Pathiraja
Outline

 Overview of Macroeconomics
 Measuring National Income
 Economic Growth and Technology
 Business Cycle and Unemployment
1. Overview of Macroeconomics
Scope of macroeconomics

 has a broad scope of analysis and the minimum level of analysis or the unit of analysis is a
country (or a state) –economy as a whole
 it can be broadened even further upto global level depending on the requirement.
Why do we need to study macroeconomics?

 The importance of studying functioning or working of an economy was understood after the great
recession in 1929
 the economies contracted and the unemployment rates increased
 in 1939, John Maynard Keynes, a British economist developed economic theories to understand the
great recession and to show how the government’s policies can address or prevent recessions
 He introduced Monetary and Fiscal policies as the primary tools to manage the economy and to reduce
the unemployment
 Macroeconomic variables - total income, total output, unemployment, inflation
 Those are aggregate variables of an economy
 Micro units are operating within the macro unit
Why an engineer needs to study macroeconomics?

 Generally, engineers involve in building, designing and creating a product or a service

which ultimately reach the consumer
 Businesses may lose or gain when the economic environment changes regardless of how
well they manage.
 Economic wellbeing or the purchasing power of the consumers is also influenced by the
changes in interest rates, inflation rate and the unemployment.
 helps an engineer to allocate scarce resources wisely
Macroeconomic Issues

 There are three main macroeconomic issues in an economy

unemployment,
inflation
economic growth
 Additionally- trade cycle, stagflation, exchange rate and the balance of
payment
unemployment

 percentage of labour force that is unemployed

 Labour force is defined as all employed persons and unemployed individuals seeking jobs but
it excludes the individuals who are voluntarily without work or not seeking for jobs
 If unemployment exists, that economy’s actual output is less than its potential output
 A high unemployment rate is an issue for a country
 One of the objectives of a government is to ensure full employment of its workforce through
avoiding any type of involuntary unemployment
inflation
 The phenomenon of constantly increasing prices of goods and factor input
prices is referred to as inflation
 This creates an uncertainty in the market
 people get confused about relative prices and tend to make mistakes in
investment and spending decisions
 affects the households with fixed income levels by reducing their real income
or the purchasing power
 most people lose and changes the pattern of income distribution
 one of the objectives of the government policy is to ensure the stability of
the price level of a country
 many countries set inflation targets which varies between 1 to 3 percent
economic growth

 The long term growth of per capita output of a country is the main goal of macroeconomics
 most important factor in determining increase in real wages and living standards
 some countries grow while other countries decline
 Key determinants- well established and regulated private markets for most of the economic
activities, a stable macroeconomic policy, high rates of investments and savings, open economic
policies for international trade and accountable and non-corrupt governing institutions
Business cycle
periodic fluctuations in national output over time
Every econmy has to face this cyclical pattern
We need to have a good understanding where we are
Stagflation

 co-existence of inflation and unemployment in a stagnant economy

 Generally, inflation rises with more employment and with the economic
growth
 caused by cost-pushed inflation which occurs due to increased cost of
production - Increase in taxes or shortage of resources or war conditions
exchange rate

 rate at which country’s economy is exchanged to another currency

 Appreciation - value of the domestic currency rises with respect to the foreign currency -
favourable for imports -unfavourable for exports since foreign country finds goods are
expensive
 Depreciation- the value of domestic currency drops against the foreign currency - facilitates
more exports
Balance of payments (B.O.P)

 This is the record of all economic transactions of a country with the rest of
the world during a specific time period
 It shows whether the county saves enough to pay for imports
 a deficit in B.O.P, that country imports more than it exports and it has to
borrow from other sources to pay for imports
Macroeconomic Goals

 increasing the growth of output - a government should use correct policy

instruments to meet the demand of the people,
 high level of employment - people are getting highly paid jobs without much
delay, job security and expected benefits
 stability of price level- low and stable inflation rates are maintained
Policy Instruments

 Monetary policy is the process by which the monetary authority of a country control its money
supply through various instruments
Central Bank sets short term interest rates to change the expenditure and investment
pattern (housing, business, durables, exports, imports) of people. It can influence the stock
prices, housing prices, and foreign exchange rates.
 Fiscal policy: Use of taxes and government expenditures in achieving the macroeconomic goals
come under Fiscal policy
Government can purchase goods and services from the economy and can transfer payments
to identified groups. Government spending affects the overall spending in the economy and
thereby the GDP
Taxation- reduces the disposable income of the households, private spending and private
savings are influenced -prices of goods and inputs are also affected
Components of Macro-economy

 Households
 Firms
 Government
 Rest of the world
The ‘theory of circular flow of income’ explains the relationship of these
components in an economy
Some macroeconomic issues and possible reasons

 Is it easy to find a job?

 As a consumer, have you ever felt that you cannot afford the things you consumed last year
with thousand rupees at the current year?
 Is there a period of financial excitement with stock prices rising rapidly?
 Is the central bank using monetary policy to prevent the falling of housing prices/construction
sector or to prevent a financial crisis?
 What are the impacts of globalization and foreign trade on domestic employment and output?
2. Measuring National Income

 Assessing the macroeconomic variables are important to measure the performance of an

economy
 National income accounts provides us estimates for Gross Domestic Product (GDP) which is the
key indicator of measuring an economy’s performance in producing goods and services
 Gross Domestic Product (GDP)
 Gross National Product (GNP)
 Net Domestic Product (NDP)
 Real and Nominal GDP
Gross Domestic Product (GDP)

 GDP is the value of all final goods and services produced in a country during a given period of
time.
 Generally it is measured annually.
 𝐺𝐷𝑃 = 𝐶 + 𝐼 + 𝐺 + 𝑋
 consumption (C), gross investment (I), government purchases of goods and services ( G ), and
net exports ( X )
 value of final goods and services to avoid double counting
 currently produced output of a product or service
 Goods and services are valued at the market price
GNP-Gross National Product

 value of final goods and services produced using domestically owned factors of production
during given period.
 Measuring GDP is easier than GNP due to the poor data availability on foreign earnings.
For example, Sri Lanka has invested its capital in Singapore and the profit earned by that
investment is included in Sri Lanka’s GNP but not in Sri Lanka’s GDP
income earned by Sri Lankan workers abroad is included in GNP, but not in GDP

 Most of the countries use GDP and it facilitates international comparisons

Net Domestic Product (NDP)

 NDP = GDP – Depreciation

 Capital is being used in producing output and it depreciates or wears out.
 Therefore, capital consumption allowance is used as a measure of depreciation which is nearly
11 percent of the GDP.
 NDP is about 89 percent of the GDP
Real and Nominal GDP

 Nominal GDP measures the value of goods and services produced in a given period using
the market prices at that time.
 for comparison purposes the output is valued using the market prices of a base year. It
gives real GDP
 Price indices - The GDP Deflator, The Consumer and Producer Price Index
 The GDP Deflator  The Consumer and Producer Price Index
 The Consumer Price Index (CPI) measure the
value of a fixed basket of goods and services
purchased by urban consumers
 used as an indicator for inflation
 It is used as a measure of inflation
 Producer Price Index (PPI) measures the cost
 All the goods and services of a given basket of goods which includes raw
materials and semifinished goods that is
measured at the first significant level of
commercial transaction
Measuring National Income

 GDP can be measured in two different ways.

income approach
total output approach
The circular floor of income diagram describes the two approaches which gives the same
result
 Flow-of Product Approach -Households spend their income on final goods and
services produced by the nation. The total money spent on these final goods
and services during a given period is the GDP.

 Earnings or Income Approach - The income paid to the households for their
factors of production in terms of wage, rent, interest and profits during a
given period is considered as GDP
Components of GDP – Output Approach

= + + +
 Consumption (C) - durable goods, nondurables and services
 Government Purchases (G)- goods and services such as national defense, road construction
and paying salaries , transfer payments
 Investment Spending (I) - additions to the stock of physical capital- gross investment
housing construction, machineries, construction of offices and factories, and additions to a
firm’s inventories, human capital development with education, expenditure on research
and development
 Net Exports (X) -difference between the exports and imports
GDP and Personal Disposable Income

 the level of available income for spending and saving by households in an economy

𝑃𝑒𝑟𝑠𝑜𝑛𝑎𝑙 𝐷𝑖𝑠𝑝𝑜𝑠𝑎𝑏𝑙𝑒 𝐼𝑛𝑐𝑜𝑚𝑒 ≡ 𝐺𝐷𝑃 + 𝑛𝑒𝑡 𝑓𝑎𝑐𝑡𝑜𝑟 𝑖𝑛𝑐𝑜𝑚𝑒 𝑓𝑟𝑜𝑚 𝑎𝑏𝑟𝑜𝑎𝑑 − 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
− 𝑟𝑒𝑡𝑎i𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 + 𝑡𝑟𝑎𝑛𝑠𝑓𝑒𝑟𝑠 − 𝑡𝑎𝑥𝑒s

the total GDP is not consumed by the households and some amount is kept aside for maintaining the
economy’s productive capacity – depreciation 11%
Firms keep certain amount, pensions and unemployment benefits, taxes

Useful in understanding the behaviour of households and businesses

composition of GDP and other terms we used in national
income accounting

(Y = C + I + G + NX)
(Yd = Y+ TR –TA)
Y= Yd - TR + TA
𝐶 + 𝐼 + 𝐺 + 𝑁𝑋 ≡ 𝑌 ≡ 𝑌𝑑 + (𝑇𝐴 − 𝑇𝑅) ≡ 𝐶 + 𝑆 + (𝑇𝐴 − 𝑇𝑅)
Limitations of the GDP Concept
 measuring GDP is not that accurate
 non-traded output in the market for example, government services, volunteer work and household activities
is difficult –unpaid work
 Unreported work to the government and underground activities are also excluded in GDP -tips, drug dealing,
smuggling and prostitution
 exclusion of environmental pollution and degradation overestimate the GDP- cost of environmental damage is
omitted
 Improvements in quality of goods are not completely included
 Economists consider new approaches for the inclusion of these activities
 GDP as a measure of social welfare is still argued as it is difficult to measure the quality of life of people
even in the presence of a high GDP level.
 Distribution of output among people, unsustainable indebtedness of businesses and households,
environmental sustainability, human development aspects are considered for a healthy economy and a
healthy society which are not measured by GDP
 Human Development Index (HDI), GDP per capita, Gini coefficient are some attempts
3.ECONOMIC GROWTH AND TECHNOLOGY

 What is economic growth and how it is measured?

it is an improvement of the standards of living over time
change in real GDP per capita
 A country’s ability to provide health, education, transport and other facilities are
determined by the income or the output which is measured by real GDP
 A country’s policy focus is extremely important as it directly influences the living standards
of people
 If we take countries around the world, the differences in their living standards is clearly
visible
 health, nutritious food, housing, clothing, transport and education
 temporal and spatial variations in living standards due to income/output and growth
 Economic growth of a country is determined by productivity
 Productivity ids determined by – pillars of economic growth
physical capital per person,
human capital per person,
natural resource availability per person and
technological knowledge
 Different countries have achieved their growth using different approaches while other countries
are still struggling to realize
 Long run economic growth-If a country can maintain an upward trend in per capita real GDP, that
country achieves long term economic growth. -UK, USA, Australia, Germany and Canada sustained
a positive growth over centuries

 Otherwise, the countries stagnate or decline in their real income and standards of living -
inconsistencies in political environment and changed their approach for example Soviet Union and
Eastern Europe.

Determinants of economic growth
 productivity, which is defined as the quantity of output produced from a unit of labour input.
 It decides the living standards of people.
 factors that determine the productivity of workers
human capital, natural resources, physical capital and technological knowledge
 A production function is used to explain the input output relationship of a production process; given a
specific technology
= ( , , , )
 Y - Quantity of output A - Technology L - Quantity of labour K - Quantity of physical capitalH - Quantity of
human capital N - Quantity of natural resources

 Dividing the equation by L gives the productivity of labour force

 Y - Quantity of output A - Technology L - Quantity of labour K - Quantity of physical capitalH -
Quantity of human capital N - Quantity of natural resources
 technology can shift the production possibility frontier outwards
 Human Resources/human capital -knowledge, skills and experiences acquired from early
childhood, school education, university education, on the job training and life experiences
improve the ability to work
 Natural Resources -These are the resources provided by nature for the production process.-
land, water, mineral deposits, soils, fossil fuels, vegetation and animals
 renewable – forests and animals
 non-renewable-fossil fuels and mineral deposits
 A country’s natural resource endowments is an important factor in determining the standards
of living
 USA- availability of a large land area suitable for agriculture
 middle east countries - fossil-fuels
 However, Japan and Singapore- developed through international trade, skilled labour and most
importantly through stable economic policies.
 Capital / physical capital- A country’s stock of equipment and structures used in producing
goods and services
 appropriate tools , sophisticated machines - Workers become more productive
 Capital is an output of a production process- and as a factor of production in a production
process
 Technological Change and Innovation
 Technological knowledge - understanding of a society on best ways of producing goods and
services
 When the best technologies are available in a country, the worker productivity is increased
 Technology can overcome the scarcity of resources through enhancing overall efficiency and
finding alternatives for the scarce resources
Ex mechanisation in agriculture
 Patent rights
Growth and public policy

 government policies play a vital role in improving the living standards of a country
 direction of a country’s monetary policies- capital accumulation is promoted by
enhancing the investment of a country-people have to consume less at present
and need to save more- less consumer goods and more capital goods – worker
productivity increases
 catch-up effect-poor courtiers can achieve a higher rate of growth through high
labour productivity
 Most of the rich countries achieved growth through capital accumulation over
decades
 facilitating foreign direct investments and foreign portfolio investments –enhances capital
accumulation
 productivity and wages of a country are increased
 learns the novel technologies used in developed countries
 However, part of the profit is taken back to the foreign country

 Investment on human capital development - better schools and subsidies for education
 improves the standards of living by increased wage rates
 positive externalities to the society- new knowledge on better producing the goods and
services
 brain-drain- poor countries face problems in retaining the educated people, workers sent for
better education do not return
 human capital in those countries further reduces and people who retain in the country
become worse off
 Having a healthy workforce improves the labour productivity.
 investment in improving health facilities and nutrition of people is important
for economic growth
 Poor countries- unhealthy workforce

 political stability and property rights

 If there are uncertainties of governing political parties and their decisions,
people tend to do less investments and foreign investors are discouraged as
well
 Property rights are equally important for making investments
 Having an efficient system of justice, honest government officials (with least corruption) and
a stable Constitution are important in realizing high standards of living
 Small countries find it difficult to influence the markets and to be self-sufficient. The
standards of living declines due to inward looking policies
 Small countries such as Singapore, South Korea and Taiwan adopted free trade policies in
achieving a higher growth rate
 Having sea ports facilitates international trade which is a limitation for some landlocked
countries
 Research and development policy influences the technological knowledge generation –
productivity shifts
 Population growth - positive on improving the workforce of a country - China
Theories of economic growth

when the production possibility frontier of an economy moves outwards, it

achieves a growth. Different countries have achieved the growth through
different ways and at different rates of growth
the best way to achieve the economic growth is in debate among policy makers

 The Classical Dynamics of Smith and Malthus

 The Neoclassical Growth Model
 New Growth Theory
a)The Classical Dynamics of Smith and Malthus

 Adam Smith and

T. R. Malthus
real wage
 land was freely declines
available
 real wage
remains constant
 no capital
accumulation
considered
b) The Neoclassical Growth Model-capital accumulation

 Malthus has ignored the role of capital accumulation and technological innovation in addressing the
diminishing marginal returns from lands
 industrial revolution- land did not become a limiting factor -Invention of power-driven machines,
steel
and iron - Rail roads and steam ships opened employment
invention of telephone, electricity and automobiles
 Robert Solow
Q = F (K, L)
The model assumes that a single homogeneous output is produced
labour growth is given and the economy is competitive and operating at the full employment level.
Constant dollar value of the capital goods are taken as the value of capital (K) and number of workers is
taken as the labour (L)
 In the absence of a technological change, when the amount of capital available per worker
increases, the labour productivity increases.It increases the real wage of the workers
 However, the returns to capital declines showing diminishing marginal returns
 land, natural resources, quality of labour and technology becomes constant
 Eventually, the economy reaches a steady state of growth where returns to capital is constant
 living standards become constant - a better condition than Malthus’s subsistence wage
 does not explain the ability of achieving economic growth through technological innovations
Technology
 the real-world examples does not show stagnating economies over the time
 The increase in real wages and growth of the economies over the years can be explained when the
capital accumulation is coupled with the technological changes

A to C – capital accumulation
C to D - technology
c) New Growth Theory/Theory of Endogenous
Technological Change

 Paul Romer of Stanford University -ability of non-rival nature of ideas to boost the
endogenous economic growth
 attempts to identify the sources of technological change
 technological change is treated as an output of the country’s economic system- policy
decisions by the government, market forces and other institutions
 inventions - bring about enormous profits, may end up with losing their investments,
considered as a public good (it can easily be reproduced by the others), intellectual
property rights, public grants
 a country’s growth policies have to be well focused on enhancing technological
improvements
Growth accounting
 Sources of economic growth - capital, labour and technology
 Growth accounting- a country needs to analyse relative contribution of these factors to
economic growth
 Q = A F(K, L, R)
 Q- Growth in output
 L- Growth in labour * weight , K- Growth in capital * weight
 A- technological change, R- Lands (resources) are a constant
 For example, 60 percent of USA’s growth is attributed to labour and capital , rest 40% that
determine technological innovations or the total factor productivity - (investments on
education, research & development, advances is knowledge , innovations and other
factors)
Growth in developing countries
 The four wheels of development in both rich and poor countries remain the same.
 combination of these factors and strategies they use varies
 high population growth rates, poor standards of living with poor health, education, life expectancy, labour
outmigration and high rates of corruption
 Human resources- birth rates are high- per capita income becomes low, low standards of living. slow down
growth rates through education and birth control- as a substitute of quality for quantity- parents have
much time and income to allocate- women education discourages the time spending on childbearing
Labour quality is low- health of population
 Natural resources: poor resource endowments compared to the developed world- arable lands, corrupted
rulers - Nigeria and Congo failed to get the benefit of their mineral resources
 Capital: developed economies invest nearly 20 percent of their income on capital formation, 5% in
developing countries due to consumption needs. developing countries need to first develop their social
overhead capital -roads, schools, hospitals, public parks and libraries
 Technological change and innovation:This is an important aspect from which developing countries can get
benefits. there should be an encouraging environment for entrepreneurs to invest with skilled labour and
other inputs
 The governments can nurture entrepreneurship through extension and education services for
farmers, training the workforce and establishing management schools
 Corruption is another aspect that hinders economic growth.
 Vicious cycle of poverty- In addition to the difficulties of combining the four elements of
economic growth, poor countries are trapped into a vicious cycle of poverty
Strategies of economic development

 Different countries have used different paths

 lack of strong decision structures and having interest groups that prevent social and
economic change hinder economic growth
 There are some approaches developed over a period in achieving economic growth
breaking the vicious cycle
 The Backwardness Hypothesis: ability of developing countries to adopt new technologies
developed in the rich countries
 Industrialisation vs Agriculture: Many of the developed countries get substantial income
through industrial and service sector, - productivity and real wages in agriculture can be
substantially increased and the excess labour can be diverted to other sectors which will
increase consumption demand
 Promoting a market economy: facilitate the functioning of market mechanism with less
restrictions and allowing competition. Openness of the economy and consistency or the
predictability of macroeconomic structures are most important factors for the investors.

 Outward orientation of economies: international trade- They have a dilemma in whether to

achieve self-sufficiency or to open up the economies with less trade barriers which facilitate
efficiency and competitiveness
opening up the economy does not merely make any sense unless the governments have careful
planning and a selective intervention
Singapore, Taiwan and South Korea were successful with outward orientation
Sustainability of growth & environment
 growth is a continuous process given the limited natural resources
 resources become available with new inventions for example energy sector
 people tend to be conservative and use the resources efficiently inventing resource efficient
technologies
 impact on environment- with the rapid economic development in China, air pollution in the
cities also increased rapidly- in London and USA when they were achieving a higher growth rate
with industrial development
 Currently, the developed economies have achieved better water and air quality through
environmental regulations
 negative impacts of production activities are included in market prices as externalities
 creating market-based instruments value the cost of negative impacts to balance the economic
growth.
4: BUSINESS CYCLE AND UNEMPLOYMENT
 We observe that economies in the world sometimes prosper and sometimes faces
downfalls
 A crisis situation influences the employment of people making it hard to find jobs,
poor functioning of businesses, declining profits and crises in financial institutions.
 economic contractions exists for a short period of time while it may extend for a
year or more
 great recession in 1930s which began in USA and then in most of the countries
existed for two years and the world GDP was dropped by 15 percent
 In 2008, another recession started in USA and in Western Europe which existed for
less than one year period.
 These short term fluctuations in economic growth are called business cycles.
 A business cycle indicates the macroeconomic performance of an economy since it
shows economic growth rate, unemployment rate and inflation rate at the same time
Business Cycle
 “economy wide fluctuations in total national output, income, and employment,
usually lasting for a period of 2 to 10 years, marked by widespread expansion or
contraction in most sectors of the economy” (Samuelson & Nordhaus, 2010; 429pp).
 Peaks and troughs are the turning points of the cycle. It shows the movement of real
GDP along the trend path of GDP.
 During a recession, an economy experiences a reduction in output,
employment and income. Generally, a recession lasts for 6 to 12 months
 When it prolongs and the impact is significant, it is called a depression
 Similarly, expansion shows a boom in the economy.
 A recession can be predicted or identified at the beginning by falling of stock
market prices, business profits, interest rates, wholesale prices, investment
and inflation
 in reality we do not observe regular or smooth patterns of these cycles
Business cycle theories
 Exogenous theories - reasons outside economic system such as wars, oil price hikes, climate
change, innovations, discovering new resources, elections and technological revolutions
 Internal theories - mechanisms in the economic system- recessions create expansions and
expansions create recessions - most of the recessions are related to financial crises of an economy
- Most of these fluctuations in an economy can be explained by the aggregate demand.

 The theory of aggregate demand

Aggregate Demand (AD) in an economy is defined as the amount of output willingly purchased
at a given level of prices given the other factors held constant
The sum of the components (C+I+G+X) shows the AD at a given price level.
a shift in AD occurs when the factors that held constant changes such as a disaster or a
technological advancement
shifts in AD are the causes for fluctuation in economic output, employment and price
level.
A shift in AD represents recessions and expansions. Policies and large government sector
can prevent recession reaching a depression.
Keynesian Multiplier Model
 to explain the behaviour of spending on changing the behaviour of AD and employment. It
explains the way the short run output is determined
 Keeping the monetary policy, wages and prices constant and the economy at autarky; and
availability of unutilised resources
 the model explains the interaction of consumption and investment with income in
determining the output level
 This is called the total expenditure approach
 no taxes and transfers and the economy is closed;
 consumption (C) and investment (I) form the total expenditure where personal income equals the
national income and the GDP
 The 450 line shows when the Total Expenditure (TE) exactly equals the income (=GDP)
 The equilibrium (E) shows when the TE (desired expenditure) exactly equals to the income. This is
called the macroeconomic equilibrium of the economy
 it is assumed that the investment is exogenous and constant at any level of GDP
 Generally, an increase in exogenous investment leads to an increase in the output
and employment
 However, the amount by which it is increased is shown by the multiplier. It is
defined as the ‘impact of a unit change in exogenous expenditure on the total
output”
 In a simple model (C+I), the multiplier is the ratio of the change in output to the
change in exogenous spending or the investment. It depends on Marginal
Propensity to Consume (MPC) and the multiplier is greater than one

 In order to identify the impact of government fiscal policies on output level, we

need to incorporate government expenditure in to the equation
 𝑇𝐸 = 𝐶 + 𝐼 + 𝐺 (For a closed economy)
 Similar to the investment, we will add up government expenditure vertically
to the TE curve.
 The fiscal policy multiplier or the government expenditure multiplier is
defined as the increase in GDP due to an increase in one unit of expenditure
on government purchase.
 The effect is similar to the investment.
 Both investment and government expenditure multipliers are called
expenditure multipliers. An increase in government expenditure can increase
the output of the economy. Therefore, government purchases can influence
the business cycles
 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑢𝑡𝑝𝑢𝑡 = 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 × 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐺
 𝑇𝑎𝑥 𝑚𝑢𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 𝑀𝑃𝐶 ∗ 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟
 The multiplier model and the business cycle
 This is the simplest form of model which can describe the shifts in output level with respect
to its determinants.
 when government expenditure increases due to a disaster, the output level increases by
multiple of the change in G. (TE=C+I+G).
 when the economy grows, investments will be high and due to the multiplier effect, the
output will grow more. This process will continue until the economy reaches its capacity
level.
 After that it slows down and the growth rate will be low. A slow growth rate inhibits or
slows down investments and it reduces the output level by a multiple amount due to the
multiplier effect. This is called a recession and continues until a trough is reached.
 These theories are based on fiscal policies. However, monetary policies are important too.
Unemployment

 short term unemployment and long-term unemployment.

 natural rate of unemployment is the amount of unemployment an economy
normally experiences.
 Short term unemployment arises due to the short term fluctuations of
economic activity around the natural rate of unemployment and we call it
‘cyclical unemployment’
 The natural rate of unemployment exists even in the long run irrespective of
economic activity. This cannot be eliminated since people are in search of
jobs, minimum and efficient wages and unions.
Okun’s Law
The Phillips Curve