Unit 4 Summary

Government & The Macroeconomy

1. The Role of Government

- The Difference
- Important Macroeconomic Objectives
- Factors influencing the role of the government
- Government’s Role - Local Level
- Government’s Role - National Level
- Government’s Role - International Level

2. Stable Economic Growth

- Economic Growth
- Why is Economic Growth Important?
- How can we show Economic Growth?
- The Production Possibilities Curve (PPC)
- Economic Growth 1: Increase in Output
- Economic Growth 2: Increase in Production Possibilities
- Aggregate Demand
- Economic Growth and Aggregate Demand
- Increasing Aggregate Demand
- Economic Growth 1 through the Aggregate Demand graph
- Aggregate Supply and Short-run Aggregate Supply
- Economic Growth 1 through the Short-run Aggregate Supply graph
- Long-run Aggregate Supply
- Economic Growth 2 through the Long-run Aggregate supply graph
- Price stability and full employment
- Stability and Change
- What is inflation?
- How much is too much?
- Why does Economics care about Unemployment?
- What is unemployment in Economics?
- Unemployment is the enemy?
- The Labour Force
 - Basic Concepts Review
- How do we measure Unemployment?
- Balance of payments stability
- Redistribution of income
- Progressive taxation
- Possible Conflicts
- Possible Macroeconomic Conflicts

3. Fiscal Policy

4. Monetary policy
- Definitions of money supply and monetary policy
- Monetary policy measures
- Monetary policy tools: Expansionary
- Monetary policy tools: Contractionary
- Effects of monetary policy measures on governments’ macroeconomic aims
- Limitations of Monetary Policy

5. Supply-side policy
- Supply-side policies
- The PPC and Production Capacity (potential output)
- Increase in the Production Capacity
- Definition of supply-side policies
- Supply-side policy measures: direct intervention
- Supply-side policy measures: market-based
- Effects of supply-side measures on governments’ macroeconomic aims
- Limitations of supply-side policies

6. Economic Growth

7. Employment and unemployment

8. Inflation and deflation

The Difference
- What did Microeconomics study?
▻ How individual consumers and producers make decisions on the allocation of scarce
resource

- What does Macroeconomics Study?

▻ The economic behaviour of the entire economy

Important Macroeconomic Objectives

- What are some basic policy objectives of Macroeconomics?
▻ Low and stable inflation/price stability
▻ Full employment/low unemployment
▻ Stable economic growth and an increase in GDP
▻ Equitable distribution of income
▻ Balance of trade and payments
- Objectives:
▻ Achieve low and stable rate of inflation in general levels of price
▻ Achieve high and stable level of employment; low unemployment
▻ Encourage economic growth in national output and income
▻ Encourage trade & secure favourable balance of international transactions
▻ Additional objectives:
• Reduce poverty & inequalities in income & wealth
• Reduce pollution waste; sustainable growth
- Conflicting Aims
▻ Spending more money to stimulate growth can lead to rising prices because of
increased demand
▻ If spending is reduced to stop inflation, this will lead to a fall in growth
▻ If government tries to create full employment, labour becomes increasingly scarce
▻ Employers must compete more strongly to attract labour
▻ They raise wages, which leads to wage inflation
▻ If the government tries to redistribute income, richer workers may feel that they are
unfairly penalized for working hard & may decide to migrate
▻ This may slow down economic growth

Factors influencing the role of the government

- Type of economic system
▻ Planned Economy
 ▻ Free-Market Economy
▻ Mixed Economy

Government’s Role - Local Level

- Local governments have the authority to collect taxes and use the local budget for the welfare
of the community.

- What are the responsibilities of the local government?

▻ Provide goods and services such as public libraries, local roads, housing, public parks,
hospitals, schools and refuse collection

- Where does it get the money from?

▻ Local budgets are taken out of taxes collected, toll charges and, often, financial
grants from the national government.

Government’s Role - National Level

- As a producer, the government:
▻ Can provide public goods and merit goods
▻ Can provide public services such as education and health care.
▻ Can own industries:
• Strategic industries?
• Natural monopolies: Single firms that can produce at a lower cost for the
entire market

- As a consumer, the government:

▻ Can demand goods and services from the private sector.

- As an employer, the government :

▻ Employs workers
▻ Can control wages
▻ Can increase the productivity of its employees through training and pension schemes.

Government’s Role - International Level

- National governments determine their trade policies:
▻ Free-trade policies: having no restrictions on exports and imports.
• Trading blocs
• World Trade Organization
▻ Trade restrictions
 • Tariffs
• Quotas

Economic Growth
- What is economic growth?
▻ An economy that grows is an economy that produces more

- Economic growth: increase in the quantity of goods and services produced in an economy over
a period of time

- What’s another way to talk about “the quantity of goods and services produced in an economy
over a period of time”?
▻ Real GDP
▻ Real GDP: The total value of goods and services in the economy over a period of time
(usually one year), adjusted for inflation.

- What’s another way to say economic growth then?

▻ increase in real GDP

Why is Economic Growth Important?

- The aim of the government in increasing economic growth is to raise people’s living standards
and increase their purchasing power.

- Economic growth also brings:

▻ More employment
▻ More tax revenue

How can we show Economic Growth?

- Through the Production Possibilities Curve (PPC)
- Through the Aggregate Demand and Aggregate Supply model

The Production Possibilities Curve (PPC)

- The PPC shows combinations of maximum output that can
be produced by an economy

- Are economies usually utilizing all their resources?

▻ Economies usually underutilize resources (i.e.,
labour) or can be in a recession
 ▻ Economies are usually situated inside their PPC

- How can an economy produce more?

▻ Using more of their resources (i.e.: employing more people)
▻ Wasting less or producing at the lowest cost (increasing productive efficiency)

- If an economy uses more resources or wastes less resources, graphically, it will move closer to
its PPC.

Economic Growth 1: Increase in Output

- Factors that can cause growth of output (economic growth):
▻ Reductions in unemployment
▻ Increases in productive efficiency

Economic Growth 2: Increase in Production

Possibilities
- The PPC shows the productive capacity/limit of an economy

- As the economy moves closer to its PPC, it reaches a limit of

growth

- Will it be possible to increase the productive capacity of an

economy?

- How can an economy increase its production possibilities?

▻ Get better resources (FOP) – e.g.:
• Better labour (more human capital): more educated workers
• better physical capital: more technology
▻ Get more resources (FOP) : more factors of production in the economy

- Increase of production possibilities:

▻ Increases in the quantity of resources (FOP) in the economy
▻ Improvements in the quality of resources (FOP)
▻ This kind of growth is called long-term economic growth

Aggregate Demand
 - What does aggregate mean?
▻ the total or sum of the parts
▻ So aggregate demand refers to all the demand in an economy

- How do you get all the demand in an economy?

▻ You add up all the production that consumers, firms, the government and people
abroad want to buy from an economy

- Aggregate Demand (AD): the total quantity of goods and

services that are demanded in an economy over a period of
time at a given price level.

Economic Growth and Aggregate Demand

- Since:
▻ Economic growth is an increase in quantity of goods and services produced in an
economy
▻ And Aggregate Demand is the quantity of goods and services that are demanded in an
economy

- How can we get economic growth?

▻ By increasing Aggregate Demand

Increasing Aggregate Demand

 - How do we increase aggregate demand?
▻ By increasing any of its components

- If the components of aggregate demand are Consumption, Investment, Government spending

and Net Exports (X-M)
▻ Aggregate Demand increases when we increase…

By increasing any of the components of AD we increase AD and also get economic growth

Economic Growth 1 through the Aggregate Demand graph

Aggregate Supply and Short-run Aggregate Supply

- Aggregate supply (AS): the total amount of goods and
services produced in an economy over a period of time at a
given price level.

- Short-run aggregate supply (SRAS) is when resource prices

(such as labour wages) are constant

- If prices in the economy went down, but your costs

(resource prices) didn’t, will you produce more or less?

Economic Growth 1 through the Short-run Aggregate Supply graph

Long-run Aggregate Supply
- Long-run aggregate supply (LRAS) is when prices of all
resources (including labour) are flexible and can be changed.

- If the LRAS increases, it means that the potential production

capacity of the economy increases.

- If the LRAS increases, there is also economic growth

Economic Growth 2 through the Long-run Aggregate Supply graph

Stability and Change
- Does the price of things generally change or stay the same?
▻ Prices generally increase and decrease regularly

- Is there something wrong with prices changing all the time?

▻ If prices increase too much too quickly, people will not be able to afford as much
▻ If prices change too much too quickly, it will be harder for firms to make investment
decisions
▻ If domestic prices increase too much, exports will be relatively expensive in the
international market and revenue will decrease

- Because of issues like these, every country aims for price stability

- Price stability: although prices increase and decrease in an economy, they stay relatively
stable.

What is inflation?
- Inflation: sustained increase in the price level over a period of time
▻ Price level: average of prices of goods and services in the economy
▻ Sustained: price level increases but does not fall back right away

- If there’s inflation, does the price of all goods and services in the economy increase?
▻ Not necessarily, inflation means that prices increase on average
▻ Not every single good and service has a higher price, some could even be cheaper

How much is too much?

- A stable increase in prices of goods and services is important for the economy to grow:
▻ An increase in prices will make firms want to produce more, as increased prices means
increased revenue.
▻ An increase in production will require more workers and so employment will increase.

- Governments usually aim for a 2% increase in prices every year

Why does Economics care about Unemployment?

- Since:
▻ Work is good and necessary for people in an economy
 ▻ Work allows people to earn an income and satisfy their wants and needs
▻ Work allows a country to produce what’s capable of producing

- Then:
▻ Reducing the lack of work (achieving low unemployment or full employment) is one of
the most important Macroeconomic Objectives.

What is unemployment in Economics?

- Unemployed: people of working age who are actively looking for a job but are not employed

Unemployment is the enemy?

- If a mother looking to provide for her family can only find part-time jobs, is she unemployed?

- If a PhD in Economics can only find jobs as a delivery guy, is s/he unemployed?

- Unemployment is bad, but economists should also consider underemployment

- Underemployment: people of working age who are employed at less than full-time jobs or at
jobs inadequate with respect to their training or economic needs.

- Unemployment and underemployment waste scarce resources ( e.g.:labour and education)

The Labour Force

- Does the labour force include all the people of working age?
▻ What about stay-at-home moms?
▻ What about full-time adult students?
▻ What about people who cannot work because of a disability?
▻ What about people who do not want to work?

To be considered part of the labor force, a person must be available, willing to work, and actively
looking for a job or currently employed.

Basic Concepts Review

- Unemployed: people of working age who are actively looking for a job but are not employed
 - Underemployment: people of working age who are employed at less than full-time jobs or at
jobs inadequate with respect to their training or economic needs.

- Labour Force: people who are employed plus the unemployed

- Resource waste due to unemployment and underemployment: labour and education

How do we measure Unemployment?

- As a number and as a percentage or rate

- Unemployment rate:
Unemployment rate = number of unemployed x 100
Labour force

Balance of payments stability

- What do you call the money countries get for selling exports to other countries?
▻ Export revenue

- What do you call the money countries get for selling exports to other countries?
▻ Import expenditure

- When exports > imports, the government earns more than it spends, and there is a surplus in
the balance of payments

- When imports > exports, the government spends more than it earns, and there is a deficit in
the balance of payments

- Why does the government want to have a balance between export revenue and import
expenditure?
▻ A surplus can reduce consumer choice
▻ A deficit can lead to government debt

- Any surplus or deficit in the balance of payments should be short term

- Balance of payments stability: A situation in which the difference between the funds coming
in and out of a country because of trade is sustainable.
Redistribution of income
- Redistribution of income: Government policies to transfer income and wealth from some
individuals to others

- Many economists believe that income inequality is a major problem

- The difference between the money that the rich get and the money that the poor get is called
income gap

- One of the reasons for this concern is that the income gap can have a negative impact on
economic growth

- Most countries want to reduce this gap and have income equality.

- How do some governments try to achieve income equality?

- Progressive taxation: taxing higher percentages as income increases.

▻ High-income people are taxed more than low-income people.

Progressive taxation
- What are governments supposed to do with the tax collected?
▻ Give it to people who have been unemployed for a long period of time
• If you are given money when you don’t work, will you want to find a job?
▻ Give it to people who are unable to work due to sickness, disability, or to retired people
▻ Provide poor people with housing, education, health benefits, and other merit goods

- All these are ways in which the government redistributes (distributes in a different way) the
income people get.

Possible Conflicts
- Can a government achieve all macroeconomic goals at the same time?

- You are named minister of economy, what will you do to achieve economic growth and take the
country out of the recession?
▻ You can try to increase aggregate demand
• This will increase employment
▻ What’s another effect of increasing aggregate demand?
 • Prices can increase, which can lead to inflation
▻ In the end, by trying to achieve economic growth, you can cause inflation

- Now that you caused inflation, what will you do to reduce it?
▻ You can decrease government expenditure
• The government buys less goods and services, so the prices in the economy go
down
▻ What will companies do if they sell less and less?
• Since they make less money, they will have to cut costs, which will lead to
unemployment
▻ In the end, by trying to reduce inflation, you can cause unemployment

- Now that you caused unemployment, what will you do to reduce it?
▻ You can try to increase investment
• This will increase employment
▻ If employment increases, what will increase as a consequence?
• Demand for goods and services:
~ Imports increase
~ Prices increase
▻ In the end, by trying to achieve more employment, you can cause a deficit in the
balance of payments and inflation

Possible Macroeconomic Conflicts

Fiscal Policy
- Budget: It is an estimate made by the govt., of income and expenditure for a future period.

- Reasons for Government Spending:

 ▻ To supply goods and services that are not supplied by the private sector, such as
defence; merit goods such as education
▻ To achieve improvements in the supply-side of the macro-economy, like providing
subsidies

- Reasons to Tax:
▻ To finance public expenditure; building schools and infrastructure
▻ To discourage certain activities; e.g. taxes on cigarette
▻ To discourage import of goods; tariffs are import taxes and can be levied as a % of
value of imports or a set tax on each item
▻ To redistribute income from the rich to the poor
▻ To achieve other macro-economic objectives

- Principles of Tax
▻ Equitable
▻ Economic
▻ Transparent
▻ Convenient

- Fiscal Policy: It is the use of taxation and government spending to influence aggregate
demand

- Effects of fiscal policy on govt. macroeconomic aims:

 ▻ Expansionary fiscal policy can reduce unemployment
▻ Expansionary fiscal policy can increase economic growth
▻ Contractionary fiscal policy can reduce high inflation
- Monetary Policy: It is the use of interest rates, direct control of the money supply and the
exchange rate to influence aggregate demand

- Effects of monetary policy on govt. macroeconomic aims

▻ Expansionary monetary policy can reduce unemployment
▻ Expansionary monetary policy can increase economic growth
▻ Contractionary monetary policy can reduce high inflation

Definitions of money supply and monetary policy

- Money supply: total amount of money circulating in an economy at any one given time.
Includes currency and money in deposit and current/saving accounts.

- Monetary policy: demand-side policy that determines interest rates, exchange rates and the
money supply in the economy.
▻ The central/federal bank of a country is responsible
▻ Manipulates interest rates and money supply to achieve macroeconomic objectives

- Interest (rate): the extra amount (price) a borrower must pay for a loan, or a bank pays for a
deposit.

Monetary policy measures

- Changes in interest rates and aggregate demand:
▻ Recession: interest rates are lowered, consumers (Consumption) and businesses
(Investment) borrow and spend/invest more, and aggregate demand (AD) increases. To
lower AD, the opposite is done.

- Changes in money supply: central bank print money and influence how much banks can lend
 ▻ Recession: central bank prints more money and allows banks to lend more. Consumers
(Consumption) and businesses (Investment) borrow and spend/invest more, and
aggregate demand increases.
▻ To reduce inflation, the central bank can do the opposite.

- Changes in exchange rates (value of a currency in terms of another)

▻ To increase Exports: the central bank reduces the value of their currency.

Monetary policy tools: Expansionary

- Implemented by the central bank at times of low aggregate
demand (i.e., recession)

- Aim: increase Money supply and decrease interest rates

- Borrowing money is cheaper:

▻ Consumers buy more consumer goods
▻ Businesses invest (expand or do R&D) more
▻ Consumption and Investment increase, and so does
AD

Monetary policy tools: Contractionary

- Implemented by the central bank when there is inflation

- Aim: decrease Money supply and increase interest rates

- Cost of borrowing money rises:

▻ Consumers buy less consumer goods
▻ Businesses invest (expand or do R&D) less
▻ Consumption and Investment decrease, and so does
AD and PL

Effects of monetary policy measures on governments’ macroeconomic

aims
- Economic growth
▻ With expansionary monetary policy, demand for goods/services and for factors of
production in the economy increases
 ▻ More demand leads to more production, so the economy grows

- Increasing employment levels

▻ With expansionary monetary policy, businesses can easily expand, invest, and hire
more workers.
▻ Greater demand for goods/services also leads to businesses hiring more

- Low and stable inflation

▻ Contractionary monetary decreases spending, aggregate demand decreases, and the
price level (i.e. inflation) decreases

- Healthier balance of payments

▻ Central banks reduce the value of the currency so that national production becomes
cheaper for other countries.
▻ Demand for exports and export revenue increases, and there is a healthier balance of
payments.

Limitations of Monetary Policy

- Households and businesses take time to react to the changes in interest rates in the economy.

- Consumption and investment not only depend on interest rate changes.

▻ At times of deep recession, consumer and business confidence is low, even with 0%
interest rates, and demand will not increase.

Supply-side policies
- Why are monetary and fiscal policies called Demand-side policies?
▻ They tried to change Aggregate Demand

- What will supply-side policies try to change?

▻ Aggregate Supply

- What is the ultimate goal of supply-side policies?

▻ Create economic growth

- How can they do that?

▻ By increasing the production capacity of an economy
 - How can they do that?
▻ Think of the PPC

The PPC and Production Capacity (potential output)

- The PPC shows the maximum amount of goods and services an economy can produce
▻ Shows the production capacity (potential output) of an economy

- Can an economy normally produce more than its capacity (at G)? Why?
▻ Fixed quantity of factors of production
▻ Fixed quality of factors of production
• Fixed technology

Increase in the Production Capacity

- How can an economy increase production capacity (PPC shift) ?
▻ Increase in the quantity of factors of production
▻ Increase in the quality of factors of production
• Improvement in technology

- What happens if the production capacity (potential output) increases?

▻ The economy can produce more, and there can be economic growth.

Definition of supply-side policies

- Supply-side policies: policies that seek to increase the production capacity of an economy by
▻ Increasing the quality and quantity of factors of production
▻ Increasing production efficiency

- How can the government increase the quality and quantity of factors of production?
▻ improvements in education, healthcare, training, and improvements in technology and
infrastructure.

- How can the government increase production efficiency

▻ deregulation, lowering taxes, and subsidies

Supply-side policy measures: direct intervention

- Education and training: to increase workers’ skills, making labour more productive.
 - Research and development: Governments give tax rebates and low interest rates to businesses
to invest in R&D to increase technology and therefore productivity.

- Infrastructure: Governments invest in building roads, railways, etc, to make it cheaper to

produce. This brings investment and so more production.

- Support to Small and medium-sized enterprises (SMEs): Governments provide low-interest

loans or tax exemptions to SMEs.

Supply-side policy measures: market-based

- Encouraging competition
▻ Privatisation: Making public enterprises into private enterprises to increase
efficiency.
▻ Deregulation: reduction of regulations to make it easier for private firms to enter the
market, compete, innovate, increase efficiency and production.

- Incentive-related policies
▻ Lowering direct taxes: reducing income and/or corporate taxes so that investors/rich
people can consume and invest more
▻ Increasing work incentives: lowering income taxes so that workers have more
motivation (incentives) to work better

- Labour market reforms

▻ Decreasing unemployment benefits: unemployed people will be encouraged to work,
increasing the number of people in the labour force.
▻ Ending the minimum wage: making it cheaper to hire workers, increasing employment,
reducing costs of production and improving workers’ skills.
▻ Reducing the power of trade unions: making it cheaper to hire workers, increasing
employment, and reducing costs of production

Effects of supply-side measures on governments’ macroeconomic aims

- Economic growth
▻ A reduction in taxes increases investment. This increases aggregate demand and
employment, so production increases.
▻ Investments in human capital lead to more labour productivity and more production.

- Increasing employment levels

 ▻ Investments in education and training make workers more employable.
▻ More productive workers increase production, which leads to even more employment.

- Low and stable inflation

▻ Supply-side policies increase the productive capacity of the economy without inflation

- Healthier balance of payments

▻ Since prices don’t increase, local production exported is at lower prices.

Limitations of supply-side policies

- Policies take a long time to reap their benefits. (e.g.: education and infrastructure)

- Increasing production may lead to pollution.

- Economic growth may increase the gap between the rich and poor as supply-side policies do
not aim to improve income distribution.

Economic Growth
- Economic growth is when there is an increase in real output over time, i.e. increased GDP &
national income
- Important as it increases the standard of living

- Measurement of Economic Growth

▻ Gross Domestic Product (GDP) is the main measure of total value of all the goods and
services produced in a
▻ given period of time
▻ An increase in prices will increase nominal GDP but this is measured in current dollars
thus includes inflations

- Recession
 ▻ It is a significant decline in economic activity spread across the economy, lasting more
than a few months, normally visible in real GDP growth, real personal income,
employment, industrial production, & wholesale-retail sales
▻ A recession would cause the economy to produce at a point that is within the PPC

- Causes of Economic Growth:

▻ Discovery of more natural resources
▻ Investment in new capital and infrastructure
▻ Technical progress
▻ Increasing the amount and quality of human resources
▻ Reallocating resources

- Consequences of Economic Growth

▻ An increase in output can improve living standards of people
▻ Higher output and incomes increase government tax revenue. This can increase govt.
spending without increasing tax rates
▻ However, it can increase pollution, lead to depletion of non-renewable resources and
damage the natural environment

- Policies to Promote Economic Growth:

▻ Expansionary fiscal policy
▻ Expansionary monetary policy
▻ Supply-side policies
Employment and Unemployment

- Types of Unemployment
▻ Cyclical Unemployment: occurs during recession due to falling consumer demand &
income
• Firms reduce output & lay off workers
▻ Structural Unemployment: caused by changes in industrial structure of an economy
• Entire industries close due to a permanent fall in demand for their
goods/services
▻ Frictional Unemployment: refers to short-lived unemployment; e.g. moving to
different job
▻ Seasonal Unemployment: occurs because consumer demand for goods/services changes
with seasons; e.g. no job for ski instructor when/where there is no ice

- Measurement of Unemployment
▻ Taking claimant count
▻ Labour force survey
 - Consequences of Unemployment

- Policies to Reduce Unemployment

▻ Expansionary monetary policy
▻ Expansionary fiscal policy
▻ Increase in quality and quantity of education and training

Inflation and deflation

- Inflation: general & sustained increase in the level of prices of goods/services in an economy
over a period of time
- Deflation: decrease in general price level of goods and services and occurs when the inflation
rate falls below 0%

- Measurement
▻ Base year: first year with which the prices of subsequent years are compared
▻ Inflation rate: percentage change in annual CPI

- Causes of Inflation
▻ Demand-pull Inflation: caused by total demand rising faster than total output,
causing market prices to rise
▻ Cost-push Inflation: cost of production increases, so firms try to pass cost to
consumers through higher prices

- Causes of Deflation
▻ Fall in the money supply
▻ Decline in confidence
▻ Lower production costs
▻ Technological advances
▻ Increase in unemployment
▻ Increase in the real value of debt
- Policies to Control Inflation & Deflation
▻ Contractionary fiscal and monetary policy for inflation
▻ Expansionary fiscal and monetary policy for deflation
▻ Supply-side policy can increase aggregate supply and thus control both inflation and
deflation