4 The macro economy

Employment/unemployment,
The circular flow of income
 Difficulties involved in measuring unemployment
Measuring unemployment seems at first easy: just In addition to the possibility of different measures,
count up all those who are unemployed. It is not, there are a number of other problems:
however, that simple. Firstly, there are different ways
of measuring unemployment and these can vary
• Inactive workers.
between countries.
• Discouraged workers
The International Labour Organization (ILO) uses the
• Part-time workers
labour force survey and this is used for international
comparisons. The UK also use the claimant count, • Unreported legal employment
which relates to those registered as unemployed and
• Unreported illegal employment
'claiming the jobseeker's allowance. Those people
who are not eligible for this, or-who have not
registered/are not included-This-results in the labour
force survey giving a higher figure than the claimant
count. The labour force survey, however, is subject to
sampling errors and may not be entirely
representative.

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 Policies to correct unemployment
Policies depend both on how the causes of unemployment
are viewed and also on the time period.
In the short term both fiscal and monetary policies can be
used. Fiscal . policy will involve: the cutting of taxes for
consumers, both direct and indirect, so as to increase
consumption (C); cutting of taxes on companies, such as
corporation or profits tax, so as to encourage greater
investment (I); and a direct increase in government
expenditure (G). As C,I and G are all part of aggregate
demand (AD) this will then increase, leading to a rise in
output, income and employment, see Figure 1.
Figure 1 shows that any increase in a component of AD will
shift it from AD to AD I leading to greater output, income
and employment at Y1 1£ however, AD increases by too 1. An increase in aggregate demand
much to AD2, then inflation rises from p to P1' This could
lead to the long run Phillips curve

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where attempts to reduce unemployment have no
real effect except to increase inflation.
Using monetary policy, the rate of interest can be cut
or a policy such as quantitative easing used. Reducing
interest rates -ill: encourage consumers to save less
and spend more (as the opportunity cost of doing so
has fallen) and to borrow more; encourage firms to
invest more as the cost of borrowing has fallen; cause
a fall in the exchange rate leading to a rise in exports.
The effect on AD can again be shown by figure 2.

In the long run, supply-side policies would be effective

in improving labour productivity by training or
retraining and by providing better education and
health services. Figure 2 shows that shifting AS to 2. Operation of supply-side policy
AS1 will overcome any inflationary effects of increasing
AD and at the same time increase output, income and
employment from Y to Y1.

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 The circular flow of income:
Closed and open economies
The circular flow of income is a way of Showing that money flows between households, or individuals, firms and
government in an economy. If there is no foreign trade then this is called a closed economy. With foreign trade
it becomes an open economy.

Componentsof different types of economies

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 The circular flow of income between household firms,
government and the international economy
The circular flow of income refers to the idea that In an open economy we would need to show money from
money is provide to the factors of production in exports coming into the system and money for imports
exchange for their services. In turn the owners of leaving the system.
these factors then spend the money on the goods and
services which are provided. In other words, the flow
of money is like a circle. In Figure households supply
labour and in return receive income. They spend this,
consumption, and get in return goods and services.

In reality some people save and this is a withdrawal or

leakage from the system, reducing the circular flow.
This is the same with taxes and imports where the
money flows out to other economies. Equally, more
money can be injected into the system through
investment by firms, government expenditure and
exports where money flows in from other economies .

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 Average and marginal
propensities to save and consume
The average propensities measure the total of
consumption or saving as a proportion of total
income. The average propensity to consume
(APC) is total consumption as a proportion of total
income (Y). It is measured as:
As a person's income rises the APC will fall as that person
can now afford to save out of their income and thus
consume less of any increase. The opposite will be true of
the average propensity to save (APS). Indeed, at low levels
of income consumers mar i save by drawing on savings to
help their consumption level. APS is measured by:

The marginal propensity to consume ( MPC) where zx stands for change in. Similarly, the Marginal
refers to the proportion of any change in income propensity to save (MPS) is the proportion of any change
which is consumed, and is measured as: in income that is saved:

** As with APC and APS, MPC declines as income rises, while MPS rises
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 The multiplier
The multiplier effect happens all the time in an economy.
It represent the amount by which any change in injections
(J) is increased or decreased to give the final change in
national income. If a government, for example increases
its expenditure this results in a greater change in national
income.
To explain, this assume that we have a very simple
economy with only consumers (C) and investors (I). If
investment increases by $100 and consumers always
spend 80 per cent of any increase in the income (MPC =
0.8) then they will, in turn, spend $80 and save (S) $20.
This will continue until there is nothing left to spend as
shown below.
I = $100 + C = (8O+ 64 + 51.2 + ..... ) = $500
S = (20 + 16 + 12.8 + ….) = $100
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There are two different, but related, changes to note:
1. National income has risen by $500 which is 5X the initial
injection. This because the value of the multiplier (k) is 5. This is
derived from the following equation:
2. Savings have increased to $100, which equals the amount
invested.
This is because Injections = Withdrawals.
In a simple economy Y = C + S. In this situation
which is same as 1- MPC. In the equation in point 1 above, the
MPS is 0.2.
8
If all withdrawals (W) are considered then the multiplier
will be:
Here MRT is the marginal rate of tax. and MPM is the
marginal propensity to import.
This means that if the marginal propensity to save is 0.2
and of imports is 0.1 while the marginal rate of tax is 0.1
then the value
multiplier is:
Notice that the effect of increasing the withdrawals is to
reduce the value of the multiplier because more money
leaks out of the circular flow.
If the multiplier is now put together with injections the
formula is : Y = (I + G + X) k = ΔJ X k.
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Keynesian multiplier
There are many different multipliers, bur the one
used here is the traditional Keynesian multiplier.
Many economists now doubt whether there is a
real multiplier effect for some injections, but it is
clear that the opening of a new factory in an area
will not only create jobs directly, bur will lead to
more demand in shops, increasing their incomes
and thus demand for labour, leading to these
people having more money, and so on.
9
 Aggregate expenditure (AE)
Using a Keynesian model of income determination. and Aggregate
assuming that aggregate supply is horizontal in the short expenditure
run, en the equilibrium level of real national income is equilibrium
determined by demand . In the circular flow of income, for it
to be in equilibrium planned expenditure must equal
planned production.
AE function, meaning, components and
their determinants
In a closed economy AE consists of Consumption(C),
Investment (I) and Government expenditure (G ).
In Figure , the 45° line is where planned expenditure equals
to real national income. An open economy adds net exports (exports (X) - imports
In many cases even when Y = 0 there will be some (M)) so AE = C + 1+ G + (X-M).
consumption. This is called autonomous consumption. The slope of the consumption line is determined by the
The consumption line is shown by the equation relationship between consumption and income, called the
C = a+b(MPC)Y. marginal propensity to consume. This is calculated as follows:
Y,Y1 and Y2 are points of equilibrium. The effect of adding in where C is greater than Y and APS is greater than 1, then
investment is to increase equilibrium income from Y to Y 1 household must be using their savings, or borrowing, in order
while the addition of government expenditure shifts it to Y 2. to support their consumption. This is called dissaving. In the
Figure this is anywhere to the left of the 450 line.

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 Determinant of consumption
The level of consumption is determined by:

 Income, as shown above.

 Wealth, i.e. assets. If a consumers' wealth increases then the consumption function will shift upwards.
This could be because house prices rise faster than inflation.
 Rate of interest - if this falls then consumers are likely both to save less and to borrow more, both
increasing consumption.
 Expectations - if consumers are optimistic about the future, e.g. the expect their incomes to rise, then
they may increase consumption in anticipation of this happening.
 Income distribution - the rich tend to have a lower MPC than the poor so if income is redistributed
from the rich to the poor consumption is likely to rise.

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 Determinant of Investment
The level of investment is determined by:
 The rate of interest: as interest rates fall investment increases because it is cheaper to borrow money.
 Demand: firms will want to invest more if they expect demand to increase as the return on investment will
rise.
 Innovation and technology: innovations and new technology will both lead to more investment as they
raise the productivity of capital goods.
 Taxes on company profits: many governments, e.g. Ireland, have lowered corporation tax to encourage
greater investment.

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 Determinant of Government Expenditure

The level of government expenditure is determined by:

 Political factors - governments have found it easy co increase expenditure, but politically difficult co
reduce it. This can be seen in many European countries in the period 2010 onwards.
 The need to maintain low inflation, full employment and economic growth
 Provision of merit and public goods to help reduce income inequality.
 Ability to borrow money.

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 Determinant of Net Export
The level of net exports is determined by:
 GDP of a country: as this increases so do imports.
 GDP of other countries: if other countries' GDP rises so should exports to them.
 Exchange rates: a fall in a country's exchange rates should assuming the Marshall-Lerner condition improve
net exports.
 Competitiveness: if this increases, e.g:-higher productivity, then also should net exports.

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 1. Cambridge International AS and A Level Economics
by Colin Bamford and Susan Grant
2. AS And A level Economics
by Andrew Gillespie
3. AS Economics
by Terry Cook
4. Economics for IBDP
by Jocelyn Blink and Ian Dorton
5. Principles of Economics for ISC class XII
by Asis Banerjee and Debashis mazumdar
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