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Macro Economy Review
Sectors & Functions
1. Household sector: all people seeking to satisfy unlimited wants and needs … responsible for consumption
2. Business sector: those combining resources to produce goods and services … responsible for the production.
3. Government sector: federal, state and local governments … responsible for regulation, pass laws, collect taxes and force other
economic sectors to do things that they wouldn't do voluntary
4. Foreign sector: everyone and everything beyond the boundaries of the domestic economy
Sector Expenditures
1.
2.
3.
4.
Household consumption of final goods & services
a. Nondurable goods lasting less than a year
b. Durable goods lasting more than a year
c. Services / Intangible activities
Business investment in final goods and services, mainly capital goods … most volatile of the four expenditures
a. Fixed structures — buildings, factories, housing
b. Equipment — machinery and tools
c. Inventories — raw materials and unsold goods
Government purchases of final goods & services produced by the economy … does not include transfer payments
Foreign net exports — exports (purchases of domestic production by everyone who is not a citizen of the domestic economy) minus
imports (purchases of foreign production by the domestic economy)
Markets
1. Product markets: The combination of all markets in the economy that exchange final goods and services. These markets are the
mechanism that exchanges gross domestic product. These are also called the aggregate market.
2. Resource markets: These markets exchange the services of the economy's resources, or factors of production — labor, capital, land
and entrepreneurship. These are also called factor markets.
3. Financial markets: These are markets that trade financial instruments like stocks and bonds. They play an important role in capital
investment.
Flows
1.
2.
Physical flow — the physical movement of goods and services
Payment flow — the movement of money payments from the household to the business sector in exchange for final goods and services
and from the business to the household sector in exchange for the services of resources
Circular Flow Model
The circular flow is a model of the continuous production and consumption interaction among the
four major sectors that takes place through the three aggregated markets.
HOUSEHOLD SECTOR & BUSINESS SECTOR
The physical flow is the flow of resources from the household to business sector and
production from the business to household sector:
 Production flows from the business sector (supply) to the household sector (demand)
through product markets.
 Resources flow from the household sector (demand) to the business (supply) sector
through resource markets.
 The household sector sells resources through resource markets and buy goods through
the product markets.
 The business sector buys resources through the resource markets and sells goods through
the product markets.
The payment flow goes in the opposite direction of the physical flow:
 The household sector buys production from the business sector in exchange for payment through product markets.
 The business sector buys resources from the household sector in exchange for payment through resource markets.
 Revenue received by the business sector for selling goods is used to pay the resources of production.
 Factor payments become income used by household sector to buy production from the business sector.
Financial markets divert income from household consumption to business investment. Saving is not consumption … it does not disappear, it is
income diverted away from the consumption flow and supplied, or loaned, to the financial markets.
GOVERNMENT SECTOR
The government sector plays a key role in the economy and the circular flow with government spending and taxes.
 Government spending is divided into government purchases and transfer payments.
 Government purchases include: national defense, roads, educational system, post offices, fire and police protection, parks, sewage
treatment plants, and more.
 Taxes are used to divert household sector income to the government sector to pay for these purchases.
 When government does not collect enough taxes to pay for purchases, it borrows through the financial markets.
 The diversion of income into taxes used to purchase government production shows up in the circular flow model.
FOREIGN SECTOR
The foreign sector is made up of households, businesses and governments outside the domestic economy. Market exchanges are a natural
means of addressing the scarcity problem. Mutually beneficial exchanges aren't limited by geographic location or political boundaries.
Foreign trade, the exchange among buyers and sellers in different nations, is an extension of mutually beneficial exchanges among people
of the same country.
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Exports are goods & services produced by the domestic economy and purchased by the foreign sector.
Imports are goods & services produced by the foreign sector and purchased by the domestic economy.
Exports flow from the foreign sector and join GDP before reaching the business sector.
Imports flow away from the consumption, investment and government purchases streams and go to the foreign sector.
Total spending doesn’t always match total output at the desired full-employment–price-stability level. The circular flow of income illustrates
how this undesirable outcome happens and how it might be resolved.
A LEAKAGE is income not spent directly on domestic output, but instead diverted from the circular flow. Saving is a primary leakage from the
circular flow. It represents income not directly returned to the product markets. Imports and taxes represent leakage from the circular flow.
Business saving is also a leakage from the circular flow of income.
INJECTIONS of investment, government spending and exports help offset leakages from saving, imports and taxes.
An injection is an addition of spending to the circular flow of income.
Measuring the Macro Economy
The Gross Domestic Product equals the total market value of all final goods and services produced in the economy in a given period of time,
usually one year. A larger GDP means that we have more goods and services to satisfy our unlimited wants and needs.
The four sectors of the economy buy ALL current economic production and those aggregated sectors give us GDP.
The four sectors and their expenditures:
1. Household — Consumption (C).
2. Business — Investment (I).
3. Government — Government Expenditures (G).
4. Foreign — Net Exports (X), the difference between exports and imports
Expenditures on GDP:
GDP = C + I + G + X
 C, I and G buy not just domestic goods and services, but also imports.
 When we aggregate C, I, G and X we have domestic production plus net exports. To measure only domestic production, we subtract
imports.
Economic Goals:
 Full employment — using all available resources for production
 Stability — avoiding inflation and/or fluctuations in the economy
 Growth — lessening the problem of scarcity by increasing production capabilities … an outward shift in the PPC
Business Cycles
The macro economy is unstable. It has periods of falling production, rising inflation and/or high
unemployment.
Business cycles are recurring expansions and contractions of the aggregate economy.
 EXPANSION is a general period of increasing economic activity, or rising production, which is
associated with low or falling unemployment and high or rising inflation.
 CONTRACTION is a general period of decreasing economic activity, or falling production, which
is associated with high or rising unemployment and low or falling inflation.
Causes of Instability
1. Consumption: If households decide to buy more or less, the rest of the economy follows suit. Aggregate demand (see below) is the
prime source of economic instability.
2. Capital Investment: Big swings in investment levels can create upward or downward spirals of total production.
3. Government Purchases and Taxes: Government purchases can have a contractionary or an expansionary effect over the economy.
Taxes affect the ability of the household and business sectors to buy production.
4. Net Exports: Changes in exports can trigger expansions and contractions of the domestic economy.
5. Circulating Money: Too much money can trigger an inflationary expansion, too little money can trigger contraction and unemployment.
6. Resource Supply Considerations: Resource supply changes (energy prices, technology, wages, etc.) can trigger expansions and
contractions.
AD/AS Analysis
The aggregate market (AD/AS analysis) is the key model used to explain and analyze the workings of the macro economy. The aggregate
market operates through:
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
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aggregate demand (expenditure)
aggregate supply (production)
price level
AGGREGATE DEMAND
Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.
It refers to the collective behavior of all buyers in the marketplace.
1.
Household consumption on final goods & services (66% of total spending)
a. Nondurable goods lasting less than a year
b. Durable goods lasting more than a year
c. Services / Intangible activities
2.
Business investment in final goods and services, mainly capital goods … most volatile of the
four expenditures
a. Fixed structures — buildings, factories, housing
b. Equipment — machinery and tools
c. Inventories — raw materials and unsold goods
3.
Government purchases of final goods & services produced by the economy … does not
include transfer payments
4.
Foreign net exports — exports (purchases of domestic production by everyone who is not a citizen of the domestic economy) minus
imports (purchases of foreign production by the domestic economy)
Aggregate demand shows the relationship between total expenditures (measured as real GDP) and the price level (measured as the GDP price
deflator) — How much will be purchased at various price levels?
The AGGREGATE DEMAND CURVE shows the aggregate demand for various price levels. The AD curve has a negative slope — from top left to
bottom right — because sectors are inclined to increase their aggregate spending if the price level decreases and decrease spending if the
price level increases.
Negative slope due to:
 real-balance effect — a change in price level changes aggregate expenditures on real production because the purchasing power of
money changes
 interest-rate effect — a higher price level leads to a higher interest rate which increases the cost of borrowing and discourages
investment and consumption … and vice versa
 net-export effect — an increase in the US price level discourages foreign buyers from buying US goods, and encourages US buyers to
buy relatively cheaper foreign goods … and vice versa
AGGREGATE SUPPLY
Aggregate supply is the total quantity of output producers are willing and able to supply at alternative price levels in a given time period,
ceteris paribus.
1.
2.
3.
4.
Labor — the people who work
Capital — tools and equipment used by producers
Land — raw materials used in production
Entrepreneurship — those who assume the risk of production
The AGGREGATE SUPPLY CURVE shows the relation between total real production (measured as real
GDP) and the price level (measured as the GDP price deflator) — How much will be produced at
various price levels?
We study aggregate supply over two time periods — the short run and the long run. How the price
level affects real production depends on the difference between the short run and long run.
1.
LONG RUN
a.
b.
c.
d.
2.
period in which all prices are flexible so that that all markets (product, resource, financial) are in equilibrium
prices rise to eliminate market shortages and fall to eliminate market surpluses, resulting in equilibrium
price level does not affect the aggregate supply of real production
the LRAS curve is a straight, vertical line — equilibrium with all resources fully employed
SHORT RUN
a. period in which some prices are flexible and some are rigid
b. rigid prices prevent markets (especially resource & labor) from eliminating surpluses and reaching equilibrium, e.g.
unemployment
c. the price level does affect the aggregate supply of production
d. the SRAS curve is a positively-sloped line — higher price levels correspond to higher levels of real production
AGGREGATE MARKET
The aggregate market (AD/AS analysis) combines aggregate demand and aggregate supply as a way of understanding the macro economy,
especially the problems of inflation and unemployment.
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The aggregate demand force is
lowest price level possible.
The aggregate supply force is the
at the highest prices possible.
Equilibrium in the aggregate
aggregate demand and aggregate
A market is in equilibrium when
that generates the same quantity
Long-run equilibrium: All three
financial)
achieve
equilibrium
Short-run equilibrium: Price and
resource markets, even though
equilibrium.
the four sectors who want GDP at the
scarce resources who want to sell GDP
market occurs when the forces of
supply are balanced.
buyers and sellers come upon a price
demanded and quantity supplied.
aggregate markets (product, resource,
simultaneously.
wage rigidity prevent equilibrium in the
the product and financial markets are in
Classical Theory
1.
2.
3.
4.
Prices and wages are flexible.
The economy “self-adjusts” to deviations from its long-term growth trend.
Say’s Law — supply creates its own demand
Unsold goods and unemployed labor disappear as soon as people have time to adjust prices and wages.
Keynesian Theory
1.
2.
3.
A market-driven economy is inherently unstable and requires government intervention.
Changes in aggregate demand (or aggregate expenditures) especially investment expenditures are the primary source of businesscycle instability and the most important cause of recessions.
Effective Demand — the principle that consumption expenditures are based on the disposable income (personal income after personal
taxes) actually available to the household sector rather than income that would be available at full employment. (consumption
function)
Variables in addition to the interest rate influence saving and investment — household saving is based on household income and
business investment is based on the expected profitability of production. (investment function)
5. Prices are inflexible or rigid, especially in the downward direction. and can prevent markets from achieving equilibrium.
6. Markets, especially resource markets, do not automatically achieve equilibrium, meaning full employment is not guaranteed.
7. Persistent unemployment problems are caused by a lack of aggregate demand.
8. Full employment is maintained through government intervention, especially fiscal policy changes in government purchases.
9. Discretionary government policies, especially fiscal policy, are the primary means of stabilizing business cycles.
10. AE = C + I + G + X
4.
HOUSEHOLD SECTOR
consumption function — the relationship between planned consumption and various levels of disposable income
autonomous consumption — Household consumption expenditures that are unrelated to and unaffected by the level of income …
minimum level of consumption the household sector undertakes if income falls to zero
induced consumption — consumption expenditures that are based on the level of disposable income
marginal propensity to consume — only a portion of additional income is used for consumption … MPC is the proportion of each
additional dollar of household income that is used for consumption expenditures, what the household section does with additional
income … MPC = ∆ consumption / ∆ disposable income (MPC + MPS = 1)
saving function — the difference between income and consumption
dissaving — negative saving that occurs during a given period of time in which consumption expenditures exceed income … only
possible by spending past or future income on current consumption — using income saved from previous periods or borrowing income
to be earned in future periods
induced saving — saving based on the level of
disposable income
marginal propensity to save — only a portion
of additional income is used for saving … MPS
is the proportion of each additional dollar of
household income that is used for saving,
what the household section does with
additional income … MPS = ∆ saving / ∆
disposable income (MPC + MPS = 1)
multiplier — A measure of the interaction between consumption, production, resource payments and income that magnifies autonomous
changes in investment, government spending, exports, taxes or etc. Relatively small changes in autonomous expenditures cause relatively
large overall changes in aggregate production and income.
MPC + MPS = 1
Multiplier = 1 / (1—MPC)
OR
1 / MPS
Multiplier X ∆ autonomous spending (consumption) = ∆ equilibrium GDP
BUSINESS SECTOR
investment function — the relationship between planned investment (expenditures on (production of) new plant, equipment, and structures
(capital) in a given time period, plus changes in business inventories) and various levels of interest rates. An increase in investment spending
shifts the aggregate demand curve to the right.
autonomous investment — changes in investment expenditures by the business sector that are unrelated to income … influenced by
factors such as interest rates, technology, expectations and wealth
marginal propensity to invest — indicates the extent to which
investment expenditures are induced by changes in income or
production. If, for example, the MPI is 01, then each dollar of
extra income in the economy induces 10 cents of investment
expenditures … MPI = ∆ investment / ∆ disposable income
GOVERNMENT SECTOR
Discretionary Fiscal Policy: The discretionary changing of
government expenditures and/or taxes in order to achieve national
economic goals, such as high employment with price stability. If
consumption and investment spending decline, the subsequent
decline in state-local government spending aggravates the
leftward shift of the AD curve.
A FISCAL STIMULUS is tax cuts or spending hikes intended to increase
(shift) aggregate demand.
FISCAL RESTRAINT is using tax hikes or spending cuts intended to
reduce (shift) aggregate demand.
Obstacles
Indirect Crowding Out
The Ricardian Equivalence Theorem
Direct Expenditure Offsets
The Supply-Side Effects of Changes in Taxes
Time Lags
FOREIGN SECTOR
The principal role played by the foreign sector in the circular flow is two-fold: (1) to add to the supply of output flowing into the product
markets that can be purchased by the three domestic sectors (imports) and (2) to purchase part of the output supplied to the product
markets by the domestic economy (exports). If exports exceed imports, then the overall flow increases. If imports exceed exports, then the
overall flow decreases. Net exports can be both uncertain and unstable, creating further shifts of aggregate demand.