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MACROECONOMICS
Macroeconomics examines the interactions and behavior of entire nations' economies, such as
why recessions occur, what causes economic growth, and how countries can bene t from
specialization and trade.

Circular Flow of Economy

Explains how economic activity and national income are determined.

- It shows ows of goods and services and factors of production between rms (businesses
that produce or supply goods) and households (individuals with effective demand for
goods and services)
- The circular ow shows how national income or Gross Domestic Product is calculated
Businesses produce goods and services and in the process of doing so, incomes are
generated for factors of production (land, labour, capital and enterprise)

Leakages- withdrawal (Not all income ows directly from households to businesses)

Three types of withdrawal:

• Put aside for future spending, i.e. savings (S) in banks accounts and other types of
deposit
• Paid to the government in taxation (T) e.g. income tax and national insurance
• Spent on foreign-made goods and services, i.e. imports (M) which ow into the
economy

For national income equilibrium, S+T+M= G+I+X

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

Three types of injections (J):

1. Capital spending by rms, i.e. investment expenditure (I) e.g. on new technology
2. The government, i.e. government expenditure (G) e.g. on the NHS or defence
3. Overseas consumers buying UK goods and service, i.e. UK export expenditure
An economy is in equilibrium when the rate of injections = the rate of withdrawals from the
circular ow.

The level of economic activity depends on the relative size of injections and withdrawals
(I>W= economy ourishes) ; (W>I= economy declines)
*Income: rent + wages + interest + pro t
=> Income is the earnings that people gain from work. This is true for people only able to
supply their labour services.
=> Those with factors of production: are able to gain other sources of income.
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The circular ow of economic activity is a model showing the basic economic relationships
within a market economy. In the circular ow of the economy, money is used to purchase
goods and services. Goods and services ow through the economy in one direction while
money ows in the opposite direction.

Level of economic activity depends on the injections and withdrawals.

If W>J, then economic activity declines, and vice versa
Income is the sum of the returns for use of the four factors of production:
- Return for land= rent
- Return for labour= wages and salaries
- Return for capital= interest
- Return for enterprise= pro t
Hence, income= rent + wages + interest + pro t

Closed economy:
=> Households— supply factors of production (land, labor, capital and enterprise) to rms to
generate output of goods and services.
=> In return, rms— provide incomes to households, rent, wages, interest and pro t.
=> Households spend their money on goods and services produced by rms— creating
expenditure revenue with their income for the rms.
Therefore, income ow= expenditure ow and output ow

Open economy:
=> there is a government sector, nancial markets and foreign trade
=> government needs taxes: transfer payments
=> Financial sector, savings (S) = a withdrawal whilst investments (I) are injections
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=> With a government sector, taxes (T) represent a withdrawal, whereas government
spendings (G) is an injection.
=> Export revenue (X) represents an injection to the circular ow, import expenditure (M) is a
leakage.
=> Circular ow of income and expenditure will change based on all withdrawals (W=
S+T+M) and all injections (J= G+X+I).

MEASURES OF ECONOMIC ACTIVITY

(the value of national output, national income, national expenditure)
- O=Y=E (the expenditure becomes the national income to households and rms that
produced the output.
- GDP: Value of all nal output of goods and services produced by rms within a country,
per year.
GDP: Consumption expenditure + investment expenditure + government expenditure +
export earning - amount spent on imports
Calculated by: [C+I+G+(X-M)]
- GNP: Value of all nal output of goods and services produced by a country’s citizens, both
domestically and abroad.
Calculated by: GDP + net property income from abroad (incomes earned - incomes paid
abroad)

The use of national income statistics

National income statistics gives an indication of standards of living in a country. Higher the
GDP is associated with higher standards of living for the average person because usually,
consumption rates become higher as a person gets richer.

However, limitations of using national income to measure standards of living:

- Distribution of income and wealth in a country
- Varying rates of direct and indirect tax between countries (for example: Qatar: zero rate of
income tax)
- Differences in the cost of living, for example, housing, education, healthcare
- Alternative measures of standards of living, for example, the Human Development Index

Green GDP: measure of GDP that accounts for environmental destruction of economic
activity by deducting the environmental costs associated with the output of goods and
services.
Green GDP= nominal GDP - environmental production costs

The Business Cycle: uctuations in the economic activity

Economic growth: increase in the level of economic activity, the annual percentage growth in
national output.
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Economic growth increases the long term productive capacity of thee economy, illustrated by
an outwards shift of the production possibility curve. It suggests that the economy is more
prosperous so the average person earns more income.

AGGREGATE DEMAND
Value of total demand for all goods and services in the economy, per time period.
AD= C+ I + G (X-M)
Consumption— total spendings on goods and service by households
Investment— capital expenditure of rms in the economy
Government spending— total expenditure on goods and services by the government
Net exports— (X-M), measures the difference between the value of export earnings and import
expenditure.
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Three reasons for the downwards sloping AD curve:

- The Pigou wealth effect— for any given nominal value of income, a lower price level
allows households, rms and the government greater purchasing power— greater
consumption, investment and government spending.
- Keynes’s interest rate— a fall in the general price level causes interest rates to drop, thus
boosting the demand for money, ceteris paribus. This results in greater consumption,
investment expenditure and government spending—- hence, higher aggregate demand.
- Mundell- Fleming’s exchange rate effect— as general price level falls— the interest rate
also tends to fall, resulting in a depreciation of the exchange rate. This will tend to increase
the demand for net exports because domestic products are cheaper, thus boosting AD.
FACTORS THAT AFFECT THE LEVEL OF CONSUMPTION

Consumer con dence The more con dent consumers are about the economy, the greater level
of consumption will be. Consumer con dence is low during a recession
and higher during a boom.
Interest rates Higher interest rates tend to reduce consumption as households with
loads and mortgages have lower income to use at their discretion.
Wealth Changes in household wealth have a positive impact on the level of
consumption, the wealthier households are, the more they tend to
consume.
Personal income tax If the level of disposable incomes falls due to higher income tax,
consumption will also fall, ceteris paribus.

FACTORS THAT AFFECT THE LEVEL OF INVESTMENT

Interest rates Higher interest rates => reduce investment because cost of borrowing
funds to invest will increase.
Business con dence The greater the level of business con dence in the economy => higher
the level of investment will be. High business con dence=> boom in
economy.
Technology Technological progress and the associated productivity gains will tend
to boost the level of investment expenditure.
Business taxes The lower the rate of taxes in the economy, the more attractive
investment becomes as rms are more able to make a return on their
investment. Eg- Bahamas and Estonia have zero rate of cooperation tax
to attract FDI.

Factors that affect the LEVEL OF GOVERNMENT SPENDINGS

1. Political priorities— government spending will vary depending on the political priorities.
2. Economic priorities— the austerity measures following the global nancial crisis of 2008
have meant that governments across Europe and other parts of the world need to cut
their spending in order to reduce their budget de cits.
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Factors that affect the LEVEL OF NET EXPORTS

1. Income of trading partners— due to globalization and interdependence, when a country
suffers from an economic downturn, there are negative impacts on its trading partners.
2. Exchange rates— a higher exchange rate tends to reduce the demand for exports.
3. Changes in the level of protectionism— trade barriers such as tariffs and quotas raise the
price of imports, thus tending to reduce the demand for foreign goods and services.

AGGREGATE SUPPLY
Amount of real national output that rms are willing and able to produce at each price level. It
is a measure of an economy’s potential output.

FACTORS THAT AFFECT THE COSTS OF PRODUCTION

Changes in resource prices Price of oil and other raw materials changes

Changes in business taxes Higher cooperation taxes

Changes in subsidies Increases in subsidies in many industries

Supply shocks Financial crisis, natural disasters, war, epidemic

EQUILIBRIUM
=> AD= AS
Full employment exists when economy is operating at full capacity, it is not possible to
increase real national output as all resources are fully utilized.

MACROECONOMIC OBJECTIVES
=> Low unemployment
- Higher employment complements economic growth, leading to greater national
expenditure
- Increases tax revenues from a sources such as income tax (from employment), sales tax
(from increased expenditure) and stamp duty (from the sale and purchase of property)
- Reduces the tax burden on the government because there is less of a need for taxpayers
to fun welfare bene ts as more people are earning.
- Prevents a brain drain from economy, whereby skilled workers pursue better employment
opportunities in other countries.

Dif culties in measuring unemployment

• Hidden unemployment— some people escape the of cial measure of unemployment,
resulting in an underestimation of the true rate of unemployment.
— discourage workers are not willing to work, hence, excluded from the calculation of
unemployment.
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— overstaf ng occurs in rms that employ workers who are not fully utilized, perhaps due to
seasonal uctuations in demand or due to legal constraints.
• Underemployment— exists when people are inadequately employed, re ecting the
underutilization of the employed population, they are technically employed but in jobs
that do not fully use their skills or abilities, such as:
— involuntary part time workers who cannot nd full-time employment
— overquali ed workers, who have education, experience, skills and quali cations beyond the
requirements of their jobs.

• Regional disparities— measurement of unemployment is an average measure, so therefore

ignores disparities in regional rates of unemployment.

• Ethnic disparities— ethnic minority groups tend to suffer from higher than average rates of
unemployment, and for longer periods.

• Age disparities— unemployment rates among the young and older people are higher than
those of cially reported for the nation.

• Gender disparities— females tend to experience higher average rates of unemployment

than men. Men also re-enter the labor market quicker. According to the ILO, gender
inequalities in unemployment rates are exceptionally high in the Middle East and North
Africa.

Consequences of unemployment
- Loss of GDP
- Loss of tax revenue
- Loss of income for individuals
- Greater disparities in the distribution of income
- Social consequences
1. Stress (depression, health problems)
2. Crime (causes deprivation and desperation, thus leading to increased crime such as theft
and vandalism)
3. Indebtedness (can lead to bankruptcy, leading to absolute poverty, hunger, disease,
homelessness)
4. Social deprivation (poverty, falling house prices)

Types and causes unemployment

• Frictional unemployment
Occurs when people are in transition between jobs due to the time delay between leaving a
job and nding or starting a new one. — always present because it takes time for the labor
market to match available jobs with suitable candidates.

• Structural unemployment
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Occurs when the demand for products in a particular industry continually falls, thus reducing
the demand for particular labor skills. It can also be caused by changes in geographical
locations of industries (for cost advantages) and labor market rigidities.

• Seasonal unemployment
Caused by regular and periodical changes in demand for certain products.

• Cyclical unemployment (or demand- de cient unemployment)

Most severe type— affects every industry in the economy. It is caused by a lack of aggregate
demand, which causes a fall in national income.

Government policies to deal with unemployment

— Frictional unemployment: can be reduced by improving information services to aid job
seekers. However, imperfect information in the labour market can worsen frictional
unemployment as people are unaware of available jobs.

— Seasonal unemployment: improving the skills of seasonally unemployed workers helps to

reduce occupational immobility. Policies to improve education and training will give these
people a better change of re-employment and the incentive to nd work.

— Structural unemployment: introducing a broader range of vocational training programmes,

greater access to university course and offer more job training opportunities.— come at an
opportunity cost.

— Cyclical unemployment: to combat this demand-de cient unemployment, the

government might choose to use expansionary scal policy and/or expansionary monetary
policy to stimulate economic activity and hence to reduce the level of unemployment.

Four generic politics for reducing unemployment:

1. Fiscal policy: reduction in taxes and/or increased government expenditure should, all
other things being equal, boost aggregate demand and hence the derived demand for
labor.
2. Monetary policy: a cut in interest rates and/or a devaluation of the currency should
stimulate consumer and business con dence levels, alongside increased consumption
and net exports. — posting the derived demand for labor.
3. Supply side policy: deal with imperfections in the labor market and to reduce
unemployment cause by supply-side factors.
- Investment in education and training helps unemployed people to gain new skills.
- Reduction in trade union powers will mean that labor unions are not in such a strong
bargaining position for higher wages in excess of in ation. — reduces the in uence and
power of trade unions can help to reduce unemployment.
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- Employment incentives can be offered to rms for training and hiring the long term
unemployed— like tax allowances/subsidies to reduce the costs of training and hiring
workers.
- Reviewing of unemployment bene t— incentives to seek employment rather than to rely on
state welfare bene ts. By making it more dif cult for people to claim unemployment
bene ts, people become more proactive in searching for jobs.
4. Protectionist policies: trade barriers can be used to safeguard domestic jobs from the
threat of international competition.
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LOW STABLE RATE OF INFLATION
INFLATION, DISINFLATION, DEFLATION

- In ation: sustained rise in the average price level in an economy over time. This does
mean that the price of every good and service increases, but on average the prices are
rising. Governments set a target in ation rate as a key macroeconomic objective.
- De ation: persistent fall in the average price level in an economy over time, in ation rate
is negative. It is caused by continual decline in AD/AS caused by technological progress.
- Disin ation: when there is a fall in the rate of in ation rather than an actual fall in the
general price level. Disin ation can lead to de ation is not controlled, with negative
consequences for the economy and standards of living in the country.

Creeping in ation (mildest form of in ation and present few problems for the economy) is
good for MEDCs.
Hyperin ation: uncontrollable rates of in ation, for example: Zimbabwe’s macroeconomic
mismanagement between 2003-2009 resulted in hyperin ation of 231,000,000%.

Measuring in ation and de ation

The statistical weighting in the CPI is based on the proportion of the average household’s
income spent on the items in the representative basket. Therefore, items of expenditure that
take a greater proportion of income are assigned a larger weighting.
- CPI does not necessarily measure changes in average price levels (and hence the cost of
living) for all stakeholders in the economy:
• CPI only considers the expenditure of the ‘average’ household; whatever this might actually
mean in a multicultural society in the real world.
• Different income earners can experience a different rate of in ation because their pattern of
expenditure is not necessarily or accurately re ected by the CPI.
• In ation gures and calculations may not accurately re ect changes in consumption
patterns due to time lags in collecting data to compile the CPI.

Calculating an underlying rate of in ation (core rate of in ation), which is an adjusted

measure of in ation that eliminates the sudden or volatile uctuations in prices of essential
items of expenditure such as oil or food or energy.
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Calculation of a producer price index (PPI) useful for predicting in ation or de ation by
measuring changes in the prices of manufacturers and producers. Consists of—
— raw materials
— intermediate goods such as components or other semi- nished goods
— nish goods that are sold to retailers

Calculating in ation
Consumer prices index (CPI)— average consumer prices of goods and services over time. It is
the most common measure to measure in ation for a typical household in the economy.

- Base year: with an index number of 100, is used as the starting period when calculating a
price index such as the CPI.
- Percentage changes in the index number are used to show in ation in subsequent years.

=> measured on a monthly basis but reported for a 12 month period.

=> gives the rate of in ation
1. Collection of the price data (for the representative basket of goods and services of the
average household), collected on a monthly basis.
2. Assigning statistical weighing to each item of expenditure, representing different patterns
of spending over time.

Consequences of in ation
- Menu costs: in ation impacts on the prices charged by rms.

- Shoe leather costs: in ation causes uctuations in price levels, so customers spend more
time searching for the best deals, be it physically or online. They might also have to make
more regular cash withdrawals. Shoe leather costs— represent an opportunity cost for
customers.

- Consumers: purchasing power of consumers declines when there is in ation, there is a fall
in the real income because money is worth less than before. Cost of living increases,
consumers need more money to buy the same amount of goods and services.

- Savers: lose out from in ation, assuming there is no change in interprets rates for savings.
Hence, in ation discourages savings as money becomes less effective as a store of value.

- Lenders: creditors, will also lose from in ation. This is because the money lent out to
borrowers becomes worth less than before due to in ation.

- Borrowers: borrowers tend to gain from in ation as the money they tend to repay is worth
less than when they initially borrowed it.
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- Fixed-income earners: worse off tan before as the purchasing power of their xed income
declines with higher prices.

- Low income earners: in ation harms the poorest members of society far more than those
on high incomes. They tend to have a high price elasticity of demand for goods and
services. Those on high incomes and accumulated wealth are not so affected by higher
prices.

- Exporters: international competitiveness of a country tends to fall when there is domestic

in ation as exports become less price competitive. — causes a drop in pro ts, leading to a
fall in export earnings, lower economic growth and higher unemployment.

- Importers: imports become more expensive for individuals, rms and the government due
to the decline in the purchasing power of money. Hence, in ation can cause problems for
countries without many natural resources like oil, steel, rice.

- Employers: workers are likely to demand a pay rise during times of in ation to maintain
their level of real income. As a result, labor costs of production rise and pro ts margins
decline.

- Business con dence levels: combination of uncertainty and the lower expected real rates
of return on investment (due to higher costs of production) tends to lower the amount of
planned investment in the economy.

- A wage-price spiral: occurs when trade unions negotiate higher wages to keep income in
line with in ation, but this simply fuels in ation as rms raise prices to maintain their pro t
margins.

Consequences of de ation
Benign de ation is generally positive as the economy is able to produce more, thus
boosting national output and employment, without an increase in the general price level.

Malign de ation is generally harmful to the economy due to a decline in aggregate demand
for goods and services, often associated with an economic recession and rising levels of
unemployment.

Consequences of malign de ation:

- Cyclical unemployment: as de ation usually occurs due to a fall in aggregate demand in
the economy, this causes a fall in the derived demand for labor, de ation can cause huge
job losses in the economy.
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- Bankruptcies: consumers tend to spend less during periods of de ation, so rms suffer
from lower sales revenues and pro ts. This makes it more dif cult for them to pay their
costs and liabilities, thus causing a large number of bankruptcies.

- Lower investment expenditure: rms have less of an incentive to invest because they
receive lower prices and hence pro tability. This can have a detrimental impact on
economic growth.

- Rise in the real value of debts: real costs of debts increases when there is de ation
because real interest rates rise when the price falls.

- A fall in the value of wealth: due to declining pro tability, share prices fall during times of
de ation. This means that divided and the capital returns on holding shares also fall, thus
reducing the wealth of shareholders.

- Government debt: more bankruptcies, unemployment and lower levels of economic

activity, tax revenues fall whilst the amount of government spending rises (due to the
economic decline associated with malign in ation). — cremates a budget de cit for the
government.

- Declining con dence levels: de ation and subsequent rising real values of debts, both
consumer and business con dence levels fall, further adding to the economic problems in
the country. — consumers postpone their spending and rms postpone their investments.

Causes of in ation
1. Demand-pull in ation— triggered by higher levels of aggregate demand in the economy,
which drives up the general price level. Hence, an increase in any determinant of
aggregate demand (changes in consumption, investment, government spendings and net
exports) will cause this type of in ation.

2. Cost-push in ation— triggered by higher costs of production thus shifting aggregate

supply to the left and forcing up average prices. Causes of cost-push in ation include
higher imported prices for raw materials, components (semi- nished goods) and nished
goods for sale, higher wages in the economy, increased corporation taxes and soaring
rents for commercial properties.

Types of in ation
TYPES OF INFLATION

Creeping in ation Occurs when prices are rising slightly, very low rates of in ation up to around
3% per annum. It is the mildest form of in ation and presents few problems
for the economy. More economically developed countries tends to
experience creeping in ation.
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TYPES OF INFLATION

Moderate in ation Single digit in ations rates. It is a stable rate of in ation and is not a serious
economic problem.
Strato in ation Double digit in ation and often triple digit. Occurs if moderate in ation
persists and is not controlled. Prolonged periods of start in ation can lead to
hyperin ation or chronic in ation.
Hyperin ation Extortionately high and uncontrollable rates of in ation.

Government policies to deal with in ation

- controlled by limiting the factors that cause demand pull in ation and cost push in ation.
For example, raising the taxes and interest rates to limit consumption and investment
expenditure in the economy

Policies to deal with demand-pull in ation:

- De ationary scal policy to reduce aggregate demand— raising both direct and indirect
taxes to reduce consumption or lowering government expenditure.
- Contractionary monetary policy— raising interest rates or reducing growth of the money
supply to limit consumption and investment expenditure.
- Supply side policies to boost national output— improving productivity or labor relations in
order to increase aggregate supply, thus dampening the impact of in ation.
- Import controls to reduce the changes of experiencing imported in ation

Policies to deal with cost-push in ation:

- Negotiations: with labor unions to match any annual wage rises with higher productivity
levels, thus limiting in ationary pressures by boosting aggregate supply.
- Subsidizing production to moderate costs, and hence prices.
- Government intervention to limit annual nominal wage increases, thus preventing a
potential wage-price in ationary spiral.
- Revaluation of the currency on the foreign exchange market, as the higher exchange rate
helps to lower the cost of imported raw materials, components and nished goods.

Collectively, however, contractionary policies are likely to reduce the level of economic
activity, thus possibly harming economic growth, employment opportunities and international
trade.

Possible relationships between unemployment and in ation

The short run Phillips curve shows a potential trade off between in ation and unemployment.
A fall in unemployment, due to an increase in aggregate demand— creates more
consumption expenditure in the economy, thereby fueling in ation.

Model names after New Zealand economist William Phillips: shows the trade off between the
unemployment rate and the rate of change in nominal wages (correlates to price stability).
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Short run Phillips curve shows that there is a natural rate of unemployment— the
unemployment rate that exists when the in ation rate is 0. The NRU is the unemployment rate
that exists at full employment, where the demand for labor=supply of labor. It exists at the full
employment level of output [the sum of frictional, seasonal and structural unemployment].

*when employment is above its natural rate, de ation occurs because the in ation rate
becomes negative.
Increase in aggregate demand— unemployment falls whilst average price level begins to rise.

ECONOMIC GROWTH
Sustained economic growth is an important macroeconomic objective because it is the most
practical measure of standards of living in a country.
— low term expansion in the productive capacity of the economy, i.e, the annual percentage
change in GDP.
— occurs when there is an increase in the quantity and quality of factors of production, such as
an increase in labor productivity or improvement in the state of technology.
— negative economic growth— recession in the business cycle

Calculating economic growth

Measured by GDP:
Changes in nominal GDP gure gives GDP at the current prices, whereas changes in real GDP
gures give GDP at constant prices.

GDP de ator— index number used to covert nominal GDP to real GDP by eliminating the
impact of in ation on the calculation of GDP. It can therefore seen as a measure of the
general level of in ation in the economy.

* Real GDP— dividing nominal GDP by the GDP price de ator and then multiplying the result
by 100.

Causes of economic growth

— Factor endowments: quantity and quality of a country’s factors of production.
— Discovery of raw materials: any tradable commodity in a country, will increase its
productive capacity and so tend to shift the PPC outwards.
— Size and skills of the labor force
— Mobility of labor: the extent to which workers are willing and able to change jobs
(occupational mobility) and move to different locations for employment (geographical
mobility).
— Labor productivity: output produced in a given time period.
— Investment expenditure: in capital and human resources is vital for long-term
competitiveness and economic growth as it boosts the country’s productive capacity.
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Consequences of economic growth

1. Impacts on living standards: high real income per head enables people to spend more
money to meet their needs and wants, thus helping to eliminate absolute poverty in the
country.
2. Unemployment: economic growth leads to high employment— raises consumption and
encourages further investment in capital— sustaining growth
3. In ation: if the economy grows rapidly due to excessive aggregate demand— there is the
danger of demand-pull in ation. This can lead to the prices of goods and services rising
to unstable levels, with a negative impact on the economy’s international competitiveness.
4. Income distribution: creates greater disparities in the distribution of income and wealth,
widening the gap between rich and poor. However, economic growth leads to greater tax
revenues, enabling the government to redistribute income and wealth.
5. The current account of the balance of payments: the current account tends to improve
with economic growth due to a higher value of net exports.
6. Sustainability: growth usually creates problem for scarce resources and economic
wellbeing (resource depletion, pollution, congestion

Equity in the distribution of income

Meaning of equity in the distribution of income
Equity— based on the argument that income inequalities are needed to create incentives for
people to study and work harder.
Equality— equal distribution of income in the economy

— Inequitable distribution of income due to natural unequal ownership of factors of

production in a free market economy.

Indicators of income equality/inequality

Degree of income equality— measured by the relative share of national income earned by
given percentages of the population.
— Deciles: statistical method of splitting data into tenths, with each part accounting for 10% of
the population.
— Quintiles: divides statistical data into fths, with each part
representing 20% of the population.

Lorenz curve is a graphical representation of income

distribution in a country. It shows the degree of income
inequality, such as the poorest 10% of income earners
accounting for just 1% of the nation’s income.

Greater area between the 45 degrees line of total income

equality and the Lorenz curve (area between the two curves),
the greater income inequality in the country.
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Gini Coef cient

Measures income inequality, with the outcome ranging from 0 (complete equality) to 1 (total
inequality).
=> In general, low income countries or those that suffer from a high degree of corruption
have a high Gini coef cient.
Most governments strive to achieve greater income equality over time. They can use this to
measure whether income distribution is increasing or decreasing.

Poverty
Refers to the state of an individual, household or country being extremely poor, not having
enough money to meet basic human needs such as food, clothing, shelter, healthcare and
education.
— prevents countries from reaching their full economic potential
— humanitarian crisis

Relative poverty— examining the percentage of the population with earning less than a
predetermined percentage of the median income within that country.
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Consequences of poverty
— low living standards
— lack of access to healthcare and education
— con ict and war

Role of taxation in promoting equity

— promotes income equality by redistributing income to help the relatively less well-off in
society
Direct taxes— on earning (used as a mechanism to redistribute income from rich to poor)
Indirect taxes— on spending (on demerit goods as well)

To create incentives to work, individuals are granted a personal tax allowance, they can earn
up to a certain amount before they are taxed. The allowances tended to rise with in ation.

Categorization of direct and indirect taxes:

— Progressive taxation- charges a higher percentage tax as an individual’s income rises,
those who earn more pay a greater proportion of their income in tax.

— Regressive taxation- charges a greater proportion of tax on lower-income earners— sales

taxes (VAT, GST), account for a greater proportion of tax paid by the relatively poor.

— Proportional taxation- charges the same at rate percentage tax, irrespective of how much
an individual earns. Whilst more tax is paid in absolute terms as an individual’s income rises,
the percentage tax paid is xed.

Drawback of using proportional and progressive taxation to redistribute income is that they
can create disincentives to work, thereby harming economic ef ciency and economic growth.

Calculating the marginal and average rates of tax

Marginal rate of tax— percentage of direct tax paid on the last dollar of an individual’s income,
the change in tax rate paid from a given change in income.

Average rate of tax— amount of tax paid compared with the amount of income earned, the
total tax paid divided by the total income for an individual.

• Under regressive tax system, the average rate of tax falls when incomes rise.
• Under progressive tax system, an individual’s marginal rate of tax is greater than his/her
average rate of tax.
• Under a progressive tax system, as the rate of tax is xed, the marginal and average rate of
taxation are the same.
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Other measures to promote equity

Government expenditure enables socially desirable goods and services to be provided. They
might do this directly or by subsiding the output of these services.

Subsides—
- Enable rms to provide socially desirable goods and services in order to redistribute
income, by making these merit goods available to everyone.
Provision of essential infrastructure helps to promote equality for those on low incomes and
to eradicate absolute poverty.

Transfer payments— promote income equality by making payments to the less af uent
without any corresponding exchange or change in output.
- Old age pensions
- Unemployment bene ts
- Child allowances or child bene ts

Relationship between equity and ef ciency

Main ways of government intervention to promote equality-
1. Taxation policy
2. Government expenditure
3. Transfer payments

Whilst taxation provides necessary funds to pay for government expenditure, it puts extra
pressure on taxpayers and can cause disincentives to work.

Evaluating taxation policies must be-

— Equitable
— Economic
— Convenience
— Certainty

Transfer payments are costly and drain the limited budgets of governments. They can also
cause laziness amongst the workforce.
There is an opportunity costs in the direct provision of goods and services to redistribute
income.
Subsidies encourage rms to become reliant on government funding, thus hindering
economic ef ciency in the allocation of resources.

FISCAL POLICY
Government budget
Taxation policies:
- Redistribute income and wealth to bene t less wealthy members of society
- Help control the rate of in ation in the economy— affecting international competitiveness
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Government spending can then be used to— improve standards of living (build schools,
hospitals, transportation networks).
— key component of aggregate demand, so an increase in government spending helps to
boost national output, jobs and economic growth.

Sources of government revenue

Main source of government revenue- TAXES (direct— levied on earning and income or
indirect— levied on expenditure)

Other sources of government revenue

- Sale of goods and services— come from state-owned enterprises)
- Sale of state-owned enterprises— privatization proceeds can be earned by selling
government-owned assets and enterprises. However, this is a short-term policy as state
owned assets can only be sold once to the private sector.
- Sovereign wealth funds— state-owned investment funds such as stocks and shares, the
bonds of other governments, investment in property and gold reserves. These sources
help to generate income to fund government spending.
- Public-sector borrowing— used by government when its sources of revenue do not meet
its spending needs.
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Types of government expenditure

- Current expenditure- government spending on goods and services consumed within the
current year— it is expenditure for immediate operations and bene ts, for example wages
and salaries for public-sector workers or current expenditure on education.
- Capital expenditure- long-term items of government spending (investment) that boost
the economy’s productive capacity.
- Transfer payments- welfare payments from the government to third parties without any
corresponding return.

The Budget Income

- A budget de cit: government spending > government revenue— might occur during a
recession when welfare payments tend to rise whilst tax revenues fall due to rising
unemployment.
- A budget surplus: government revenue > public-sector expenditure— might occur during
an economic boom when tax revenues will be higher (due to increased earnings and
consumption), whilst government spending on transfer payments will tend to fall.
- A balanced budget: government spending = value of its revenues

Governments strive to balance their budgets. Budget surplus tend to be politically unpopular.
Budget de cit require government borrowing, which can be rather expensive due to interest
charges on the loans.

Negative correlation— government debt and the budget, the more money a government
owes, the more likely that its budget will be in de cit.

Budget surplus— help to reduce public-sector debt caused by budget de cits in previous
years, whereas a budget de cit will tend to increase government debt.

ROLE OF FISCAL POLICY

Fiscal policy and short-term demand management
Government expenditure (G)= component of aggregate demand
AD= C+I+G (X-M)
Thus, the change in the level of government expenditure will in uence the level of AD in the
economy, ceteris paribus.
Consumption ©= is a component of aggregate demand (changes in taxes— in uence level of
consumption— affecting the level of AD)

Expansionary scal policy

Used to stimulate the economy— increase government spending and lowering taxes
This can boost domestic consumption during an economic recession, thereby helping to
close a de ationary gap.
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Contractionary scal policy

Reduces the level of economic activity by decreasing government spending and raising
taxes. It is used to reduce in ationary gap.

Impact of automatic stabilizers

Progressive tax system and welfare bene ts for the unemployed are good examples of
automatic scal stabilizers that help to cushion short-term uctuations in economic activity:
— During an economic boom: progressive tax system— government automatically receives
more tax revenue from increased tax revenues on income and spending.

— Government spending on welfare bene ts falls due to rising levels of economic activity,
thus dampening the increase in consumption expenditure.

— Automatic stabilizers (higher tax revenues and lower welfare bene ts causes by higher
levels of employment) help to reduce the growth rate, thereby avoiding the risks of an
unsustainable economic boom and uncontrollable in ation.

Economic growth is negative in a recession

Automatic stabilizers (like more government spending on unemployment bene ts) help to
limit the fall in economic growth— helps to inject some money into the circular ow of income
to boost aggregate demand.

Effectiveness of automatic stabilizers in reducing uctuations depend on-

1. Size of the government sector: government spending as a percentage of GDP— greater
level of government involvement- more effective are automatic stabilizers.

2. The degree of progressivity of the tax system: more progressive— more effective

3. Scope of the welfare bene ts system: automatic stabilizers will be more effective in
countries with a wide-reaching welfare system.

Fiscal policy and its impact on potential output

Government spending and consumptions— most directly affected by scal policy
Capital expenditure: can help to promote long term economic growth (the increase in
potential national output).

Fiscal policy can be used to directly promote long-term economic growth-

1. Government spending on physical capital goods— capital goods are tangible assets used
to produce other goods and services.
2. Government spending on human capital formation— human capital formation is the
transformation process of using education and/or training to create knowledge and skills
to create a more skilled labor force.
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3. Provision of incentives for rms to invest— government provision of tax breaks and tax
incentives helps to create an economic environment that is conducive to investment.
Government spending on infrastructure can also help to encourage FDI.

Fiscal policy— indirectly promote long-term economic growth by creating an environment of

low taxation that is favorable to private sector investment by domestic and foreign rms.

Expansionary scal policy— increase both consumer and business con dence levels. — creates
further incentives for rms to invest in their labor force and in the economy. However, the
effectiveness depend on the shape of the AS curve.

Evaluation of scal policy

- The ability of target sectors of the economy— scal policy measures will have a greater
impact on some areas compared to others due to regional disparities in income and
spending habits.
- Direct impact on aggregate demand— expansionary scal policy can achieve economic
growth but tax cuts and increased government spending can fuel demand-pull in ation.
- Contractionary measures to control in ation can cause disincentives to work, lower
productivity and unemployment.
- Spillover effects of government expenditure— contractionary scal policy via reduced
public sector spending can effect public services— causing economic inef ciencies and
market failure.
- Budgetary constraints— the effectiveness of scal policy depend on the extent to which
the government can afford to sustain a budget de cit.
- Time lags- causes three problems:
1. Recognition of time lags
2. Administrative time lags
3. Impact time lags ‘
- Political constraints— political cycle can cause arti cial shocks to the business cycle
- Crowding out— occurs when increased government borrowing causes interest rates to
rise, thereby reducing private-sector investment expenditure due to higher costs.
- Supply-side shocks— scal policy is unable to deal with supply-side causes of instability to
the economy.

MONETARY POLICY - PAGE 101

INTEREST RATES
— price of borrowing money or the return from saving money at nancial institutions such as
banks.
— money supply: entire quantity of money circulating an economy (notes, coins, loans and
saving deposits at banks)
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Direct control of the money supply is relatively dif cult as the de nition of money is quite
loose and banks can create credit fairly easily. Hence, most governments rely on interest rate
policy to achieve economic stability.

Interest rate determination

Interest rate— return for lenders of money or the price of borrowing money.
— expressed as a percentage of the money loaned to or borrowed by others.

Price of money— interest rate

Quantity of money— money supply

The equilibrium interest— determined by the interest ion of the demand for, and supply of,
money.
=> demand for money: desire to hold money to nance consumption and current
expenditure. Interest rates tend to rise when the quantity of money demanded exceeds the
quantity supplied.

=> supply of money: total amount of money circulating in the economy at any point in time. It
will include bank notes and coins, bank deposits, loans and credit. An increase in the money
supply will tend to decrease interest rates, and vice versa.

=> change in either the demand or supply of money will change the equilibrium interest rate.
Increase in the money supply caused by an in ow of funds from abroad or due to a lower
cash reserve ratio— lowers the interest rate.

CENTRAL BANKS
— Do not control the demand for money, it has a key role in in uencing the supply of money
by manipulating interest rates.
— Use monetary policy to in uence rather than to directly determine rate of in ation.

Factors that central bank considers when setting interest rates:

> State of the economy (a de ationary gap may require a reduction in interest rates to
prevent the economy from going into a deep recession)

> Rate of growth of nominal wages (higher costs of labor usually mean that rms will increase
prices. Higher interest rates might then be used to combat in ationary pressures)

> Business con dence levels (lower interest rates— incentives for investment expenditure due
to the lower costs and hence risks of investment)

> House prices (house prices which are a valuable asset have a direct impact on the level of
consumer con dence and hence the value of consumption and potential economic growth)
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> Exchange rate (lower interest rates might be needed to reduce the demand for the
currency on the foreign exchange market— encouraging sale of exports)

Role of central banks

• Executor of monetary policy— responsible for managing interest rates and exchange rate
for its currency in order to achieve macroeconomic objectives.
• Government’s bank— responsible for the money of the government, including its foreign
currency reserves. It maintains the accounts of the government in the same way that
commercial banks maintain the accounts of their customers.
• Banker’s bank— regulator of the country’s commercial banking system.
• Sole issuer of legal tender— sole issue of bank notes and coins within the country. This
helps to control the money supply and brings uniformity and con dence to the monetary
system.
• Lender of last resort— provides loans to commercial banks when necessary to prevent the
risk of a nancial crisis caused by limited cash reserves and liquidity problems— helps to
ensure that the banking system runs smoothly.
• Credit control— by controlling the cash reserves— credit creation is managed more
effectively.

ROLE OF MONETARY POLICY AND SHORT-TERM DEMAND MANAGEMENT

Monetary policy and in ation targeting
In ation rate target or in ation targeting refers to the practice of central banks to use
monetary policy to achieve a speci c rate of in ation— used to provide a transparent goal in
order to help control in ation— price stability will enhance con dence in the economy.

=> if in ation is predicted to be higher than the target rate of in ation, perhaps due to a
housing boom or increased consumer con dence in the economy— contractionary monetary
policy can be used.

Evaluation of monetary policy

- Independence of central bank allows decision makers to act in the best interest of the
economy.
- Ability to adjust interest rates incrementally means that policy makers can monitor of the
effectiveness of monetary policy— reduces the risks of causing huge disruptions to the
economy.
- Ability to implement changes in interest rates relatively quickly means that monetary policy
can be used to in uence and ne-tune macroeconomic rates accordingly, often on a
monthly basis.
- Monetary policy is implemented quicker than scal policy. Tax changes require carful
planning, also time consuming.
- However, there are time lags to the reaction of households and rms to change in interest
rates in the economy— makes the effectiveness of monetary policy less certain.
- Changes in interest rates and the money supply can be destabilizing to the economy.
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- Consumption and investment are not entirely dependent on interest rates.

- Households and rms have different interest elasticity of demand, some groups are more
affected by changes in interest rates than others. This can make it dif cult to estimate the
effectiveness of monetary policy in in uencing macroeconomic objectives.
- Effectiveness of monetary policies aimed at increasing aggregate demand is limited if the
economy is in deep recession because con dence levels are low.
- Firms will not borrow money to invest even at low rates of interest, if the demand for their
products remains low.
- Effectiveness of monetary policies aimed at reducing aggregate demand is limited, as hot
money (the ow of money into the country to gain from higher rates of interest) — will
increase the exchange rate— making exports more expensive.
- Con icts among government economic objectives exist, so a cut in interest rates or an
increase in the money supply can con ict with macroeconomic objectives.
- Use of tight monetary policy can be counterproductive as it restricts economic activity and
discourages FDI.
- Monetary policy in uences aggregate demand rather than having a direct impact on the
economy’s long run aggregate supply.
- In the short run— monetary policy is generally more effective in dealing with demand-pull
in ation than in getting an economy out of an economic depression, which might require
the use of scal and supply-side policies.

SUPPLY-SIDE POLICIES
ROLE OF SUPPLY-SIDE POLICIES
Supply-side policies and the economy
Aimed at increasing the production side of an economy, boosting aggregate supply. This is
achieved by improving the instructional framework and the economy’s productive capacity to
produce.

Productive capacity— improved by increasing the quantity and quality of the factors of
production.
— used to increase in the productive capacity of the economy can only be achieved through
an increase in the economy’s long-run aggregate supply, they are designed to make the
economy more productively ef cient in the long run.

Example of supply-side policies:

— Cuts in welfare bene ts, such as unemployment bene ts, to create incentives.
— Labor market reforms.
— Using tax cuts to create incentives to work.
— Removal of labor markets imperfections, such as reducing the power of trade unions.

INTERVENTIONIST SUPPLY-SIDE POLICIES

Potential output: productive capacity if all factors of production are used ef ciently.
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Institutional framework: established systems, structures and contexts that shape the economic
behavior in a country.

Short term— these policies increase aggegcate demand but in long term— increase the
economy’s aggegcate supply.

Investment in human capital

Human capital— stock of knowledge, skills, expertise and experiences of the workforce.
— spending on education (supply-side policy)
— training to raise skills, mobility and productivity of the labor force

=> enhances the demand for and supply of labor— improving labor mobility
=> increases national income as the expenditure— increases aggregate demand in short run
=> improves the productive capacity— increases a country’s long run aggregate supply and
drives economic growth and development.
=> improved communication— to reduce frictional unemployment

Investment in new technology

Short term effect— increased aggregate demand (policies like low interest rate and tax
rebates— also encourage FDI)

Long term effect— increases the productive capacity and productivity of the economy (shifts
the country’s LRAS curve outwards)

Spending on research and development— improve work processes— enhancing ef ciency.

— also generates new products for consumption and export.
— source of International competitive advantage

Investment in infrastructure
AD= C+I+G+ (X-M) => investment is a key component
The expenditure on improving the nation’s infrastructure will increase AD— short run—
boosting economic growth.
Long run— investment in infrastructure— shifts the LRAS curve to the right— attracts FDI

Examples of investment: spending money on transportation networks, telecommunications

network, electricity grids, waste disposal systems and sewerage systems.

INDUSTRIAL POLICIES
Industrial policies — target speci c key industries to promote economic growth— tax
allowances to protect domestic infant industries from large foreign rms.
- A combination of tax breaks and subsidies on commercial loans can create incentives for
rms to locate in less prosperous areas of a country— reducing unemployment and
increasing the economy’s long run aggregate supply.
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- Subsidies can also be granted to rms that hire youth workers, mature staff and
discouraged workers.
- Subsidies also offered on loans to encourage business start-ups.
- Improve welfare in terms of lower unemployment and increased earnings for those
working in these industries.

MARKET BASED SUPPLY-SIDE POLICIES

Can be used to increase long run aggregate supply of the economy— boosting its potential
output.
Examples:
- Income tax reforms to improve the incentives to work
- Labor market reforms to increase aggregate supply
- Policies to encourage competition and ef ciency
- Tax incentives to encourage FDI

Policies to encourage competition

• Privatization: sale or transfer of state-owned assets and operations to the private sector—
make rms become more ef cient to make pro ts and survive.
• Deregulation: reduction or removal of barriers to entry into certain industries to make
markets more competitive and ef cient.
• Anti-monopoly regulation: promote competition in targeted industries. This refers to
competition law that controls the restrictive practices of monopolists, hence, limiting their
market power in the industry.
• Trade liberalization: involves reduction or removal of trade barriers— to encourage
competition and ef ciency. Allowing the free movement and capital ows and encouraging
FDI are some examples.

Labor market reforms

• Underlying causes of imperfections in the labor market are high rates of income tax and
excessive regulations that reduce incentives to work.
• Supply side policies that target labor market reforms— motivate people to seek
employment opportunities.

• Market based supply side policies— make the labor market more ef cient, responsive to
changes in the market forces of demand and supply.
• Reducing unemployment bene ts can make labor market more responsive to market
forces, as the unemployed can no longer rely on welfare payments— greater incentive or
need to seek employment.
• Reducing the power of trade unions— improves ef ciency of the labor market.

Incentive-related policies
Reducing direct taxes— create incentives for people to work or to seek employment
opportunities. — hence, market-based supply-side policies
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Cuts in business taxes— create incentives to invest by reducing the nancial risks of
investment. Cut in capital gains taxes— also encourage risk taking and investments.

EVALUATION OF SUPPLY-SIDE POLICIES

Strengths and weaknesses of supply-side policies

SHARING ECONOMY
- Providing consumers with convenient and cost ef cient access to resources without the
nancial, emotional, or social burdens of ownership.
- People are interested in lower costs and convenience than they are in fostering social
relationships with the company or other consumers.
Access Economy
- Competition between companies will not hinge on which platform can provide the most
social interaction and community, contrary to the current sharing economy rhetoric.
- Consumers simply want to make savvy purchases, and access economy companies allow
them to achieve this, by offering more convenience at a lower price.
- Consumers think about access differently than they think about ownership. And most of
our best practices in marketing are built upon an ownership model.
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• For example, being a part of a brand community is important to consumers for many
products and services that they own, as they represent who they are, and consumers
appreciate being able to share identity building practices with like-minded others.

Conclusion: A successful business model in the access economy will not be based on
community, however, as a sharing orientation does not accurately depict the bene ts
consumers hope to receive.
=> It is important to highlight the bene ts that access provides in contrast to the
disadvantages of ownership and sharing.
=> These consist of convenient and cost-effective access to valued resources, exibility, and
freedom from the nancial, social, and emotional obligations embedded in ownership and
sharing.
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