Download Macroeconomics

Macroeconomics
issues
relatingto an economyasa whole,suchas unemployment,
Macroeconomics
examines
is thuson
Thefocusof macroeconomics
inflation,groMh and the balanceof payments.
agEregateeconomicvariables.
goals
Macroeconomi€
the following:
governments
aim at achieving
and policymakers
Generally,
growth;
satisfactoryand sustainablereal(non-inflationary)
pricestability(whichimplieslow or no inflation);
(andlow unemployment);
highlevelsof employment
rate(or,that the
and the exchange
in the balanceof payments
long+unequilibrium
policyobjectives);
domestic
on
achieving
foreignsectorshouldnot imposea constraint
(fair)
of income.
equitable
distribution
activity
Measuring
overalleconomic
Grossdomestic
Grossdomesticproduct(GDP)is perhapsthe singlemost
variable
and it is definedasthe
importantmacroeconomic
valueof all flnal goodsand servicesproduceduzlthlnan
economyover a certainperiodof time, usuallya yearor a
quarter(by faclorsof productionresidingin the counlry)
Bearin mindthat:
. Onlyfinalgoodsand services
are included..Intermediate
goods(goodsusedin the productionof other goods)
(definedasthe
Onlythe 'value-added'
are not included.
a
firm
collectsfrom
total
revenues
differencebetweenthe
services
good
materials,
the
cost
of
raw
of
a
and
the sale
to producethe
and components
the firm purchased
good) contributedby eachfirm is included.lf a// produced
goodsand services
doublecountingwould
were included,
of the true valueof output.
resultandthusoverestimation
Usedgoodstransactions(e.9.the saleof a usedcar)are
currentproduction.
not includedsinceGDPmeasures
(suchasthe buyingand sellingof
Financial
transactions
shares,etc.)are not includedsincethey representonly
(of the financialasset)and theydo
transferof ownership
not refleda contribution
to currentproductlon.
payments
(suchaspensions
and unemployment
Transfer
do not reflecta
since
they
benefits)
are not included
current
output.
contribution
to
Thus:
. Nominal GDP(or moneyGDP,or GDPai currentprices)
Note that eventhough we are truly interestedln an
is a measureof output of a cerlainperiodvaiuedat the
output measure,we are forcedto sum values(pricestimes
pricesprevailingin that sameperiod.
dependentnot
quantities)
whichmakesour GDPmeasure
. RealGDP(or GDPat constantprices)is a measure
of
but
onlyon outputchanges(inwhichwe areinterested)
pricesprevailing
period
valued
at
the
output
of
a
certain
alsoon pricechanges(whichtypicallydo not interestus).
period(knownasthe 'base'periodor,
at some'reference'
years
lhr,s companson
of GDPlguresi't successive
year).
measure
of oulpul after having isolated
base
lt
is
a
becomesa problemsince,assumingthat an increasein
(or adjustedfar) the effect of inflation.lt is thus measured
GDPis recorded,we cannotknow whetherthe bigger
in termsof goods.Rea/GDPfiguresreflectthe voiumeof
figure is due to an increasein output of goodsand services
production,not the vaiue.
(an
producedor whetherit is due to an increasein prices
. Toarriveat the realGDPfigurefor a certainyearwe
increasein the generalor averagepricelevel,i.e.due to
dividenominalGDPof that yearby a priceindexfor
inflation).In otherwords,we cannotknow to what extent
that year(usually
the retailor consumerpriceindex)and
the increasein the nominal(money)GDPfigure recordedis
rrLlt,ply
the
resulT
by 100:
'real'andto what extentit is'inflationary'.
RealcDP = (nominalGDP/priceindex) * 100
. Forexample.if GDPmeasured
at currentpricesincreased
from one yearto the next by 5.5%, it cannot be known
Ny'any
other economicvariablesare alsooften adjusted
what oroportionof this increaseis due to an output
for inflation.Oneof the mostimportantfor our purposes
is due to inflationlt could
increase
andwhat proDortion
is the money(or nominal)wagerate,the paymentto
by,say,4%(i.e.
that outputincreased
be,for example,
workers.The real wage is the wage rate adjustedfor
by 4%) and that the remaining1.5olo
realGDPincreased
inflationand it is found by dividingit by the averaqelevel
price
i.e. inflation,or that
levelincreases,
was due to
of prices.lt thus measures
what workerscan actuallybuy
onlyby 0.5% and pricesby 5 0%
outputincreased
with the moneytheyearn.lf a workergetsa 5yoincrease
NominalGDPvs.real GDP
63
Thedistinction
betweenmacroeconomics
and
microeconomics
did not alwaysexist.Asa matterof fact,
it is relatively
newandstartedto bewidelyknownonly
afterWorldWarll asa resultof the publication
in '1936of
lhe GeneralTheory
of Employment,lnterestand Money
writtenbyJohnMaynardKeynes
who transformed
the
theoretical
landscape
of economics.
. Figure3.1serves
asa verybroadguideto the evolution
of
ideasin macroeconomics
andpolicymaking.
Eg|.Fe3.1 Timeline
:---'
! . rsro
__-_______-_---___----_--_---------------l
|
1929
1935
: h-t929: The ctassical
thoughtl
3ld@ l o f
:'l-ssez-{aire, laissez. Fe/,
Marketforces
. tBrantee that an
: a(onolnywill rest at, or
. dce to {ullemolovment: There is thus no need {or
! tn government to
t ftervene. (non-€divistg)
Keyner'''General
Theo4/
is publishedin 1936.There
is no guaranteethata
marketeconomywill rest
at Sullemployment'.
Thus,
thereis an activerole{oa
the government.
Through
f iscalpolicythe governmentcanstabilizethe
economyand achievefull
employment.
Keynesian
int€rventionistideasreign
afterWWll until the mld
1970s.(activists)
In th€ 1970s,Monetariim
emerges
at the university
of chi(agowith Nobel
PrizelaureateMilton
FriedmEn
beingthe most
widely-knownadvocateo{
monetaristideas,
Monetarirtsslowly
deconstructed
the
Keynesian
edifice,initially
doubtingthe effectiveness
of fiscalpolicyand later
suggesting
that even
monetarypolicyshouldbe
avoided.Markets'rule',
In the 1980stheRational
ExpeatationsSchool(l{ew
Classic€l)
of thought
throughthe work of
Lucat,Sargentand others
emerges;
the SupplySlde
is emphasized.
Theroleof
the govelnmentisfurther
questionedand relian<e
on marketforcesisfurther
emphasized.
The Gen6ralTheorywas
written in response
to th€
GreatDepiesrionwhich
startedin 1929and
markedthe greatestand
longestcontractionof
output and employmentin
the 20thcentury
TheEestAsiancrisisin
1997{ (astdoubtson
extremepro-market
policiesand on the
'\ilrashingtonConJensus'.
lvlany5peak
of the
ne<essit}l
to manage
globalizatlon.
Inequalitiet
within and between
countriesare rising,
65
Theconcept
of equilibrium
in economics
Essentially,
the conceptmeansthe sameas in the scjences:
a systemis consideredto be in
equilibrium
if thereare no inherent(endogenous)
forcesinducingchange.
In our case,an economy(or economjcactivity,
i.e.nationalincome,GDi) is consjdered
to
be in equilibrium
if thereis no tendencyfor it to change(i.e.for the levelof total output
to riseor fall).
In equilibrium,
aggregate
demand(AD;seebelow)is equalto aggregate
supply(AS;see
page67) or, as explainedon page 69, injections(J)must equalwithdrawals
0iV).
Introducing
aggregate
demandandaggregate
supply
Aggregatedemand
. The term aggregate demand (AD)refersto total
Figure 3.2 The aggregate demand curve
s0endingon domesticgoodsand services.
. Spending
canoriginateeitherfrom the private sector
(households
andfirms)or from the oublic sector.
3
. Private
sectorspendingincludes
consumptjon
.9
expenditures
(C)thathouseholds
makeand investment
(l)that firmsmake.
expenditures
. Thepublicsectorexpenditures
areusuallytermed
government
(G)in whichboth consumption
expenditures
and capitalpublicspendingare incluaeo.
. Spending
on domesticAoodscanalsooriginatefrom
abroad.Theseare the exports(X)of an economy.Since
(=c+t+G+NX)
someof domesticspendingis on foreigngoods,imports
(M) are subtractedto arriveat aggregatedemand.
RealOutput/ Income(Yr)
A D= C+ l+ G + ( X -M )
Theaggregate
demandcurve(Fig.3.2) is downward
slopjngbut not for the samereasons
that the demandfor
a singlegood is downwardsloping,as on the verticalaxjs
we havethe averagepriceof all goodsand not of one
good.In macroeconomics
aggregate
demandis negatively
slopedbecause,as the averageprice levelincreases,
plannedspendingdecreases
peoplefeelpoorer
because
and domesticproductsbecomelesscompetitiveabroad.
Tips
DrawtheADeitherasa straight
lineor slightly
curved.
It iseasierthoughto drawit with a ruler.Makesure
youfullylabeltheaxes.
Thevertical
isnot ,price.
but
the'average
pricelevel'as
it isaggregate
demand
and
notdemand
for onegoodor a service.
Thehorizontal
is
oftendenoted
as'e'. Thisshouldbeavoided
asit again
,CDp,should
mayleadto confusion.
alsobeavoided
asGDPrefersto the actualoutputproduced
andnot
to planned
output.'Realoutpuvincome,
andyr are
oftenconsidered
anappropriate
choice.
Remember
that
outputandincome
areconceptually
identical
terms.
Aggregatesupply
Figure3.3Theshort-runaggregatesupply:the typicalcase
Aggregatesupply is definedasthe plannedlevelof
output per periodat differentpricelevels.
in
The shapeof aggregatesupplyis controversial
macroeconomics.
3
g
betweenthe longrun
It is instructive
to initiallydistinguish
(when all adjustmentshavebeenmade)and the short run
(whenonlysomeadjustments
arepossible).
In the long run,aggregate
supplyof an economyis
and by its
constrainedby the amount of its resources
technology.As a result,Iong-runaggregatesupply(LRAS)
level
fixed(vertical)
at the 'full employmenr'
is considered
areemployed.
of outputwhereall resources
Typically,
in the shortrun though.As canrisesincefirms
will be willingto offer moreif pricesrisebut money
wagesincreaseat a slowerrate.
Theslopeof the ASdetermines
to what extenta rrse(i.e.
as a risein real
a shift to the right) of AD will be expressed
RealOutput/ Income(Yr)
output and thus employmentand to what extent it will be
SeeFig.3.3.
asa risein prices(i.e.inflation).
expressed
Variationsin aggregatesupp
supplycurve
Keynesian
aggregate
Theextreme
TheintermediateKeynesian
aggregaiesupplycurve
demand
that, asaggregate
It is moreplausible
to consider
belowthe
Foran economythat is operatingsignificantly
increases,
some industrieswill reachcapacitylevelsof
full employmentlevelof output. the extremeKeynesian
output beforeothers.An economyafter all consistsof
aggregatesupplyis assumedperfectlyelasticat the
many differentindustrieseachemployingmany different
prevailingaverageprice level.
for example,
types
of factorsof production.Engineers,
'operatingsignificantly
means
belowfull employment'
than
bricklayers.
may
be
in
shorter
supply
but
to
work
many
workers
eager
that there are very
in AD, output
Thisimpliesthat,followingan increase
and
unableto find a job aswell as manymachines
but priceswill
in the economycancontinueto increase
factoriesavailablethat are not being used.
upward
givingriseto an 'intermediate'
alsobe increasing
in aggregate
demandwill be expressed
Thus,any increase
supplycurveasin
slopingsectionHFon the aggregate
in the
asa risein realoutputwithoutanyincrease
Fi g.3.5.
averagepricelevel.The expansionof output can take
As the economyis getting closerand closerto the
placewithout firms havingto offer higherwage ratesto
full employmentlevelof output Yfe the aggregate
attract moreworkersand face highercosts.
. Oncethe economyreachedthe full employmentlevelof
supplycurvebecomessteeperand steeperAt the full
employmentlevelof output it becomesvertical.
outputYfe asin Fig.3.4 then ASwould becomevertical.
. Any further increasein aggregatedemandcannot lead
aggregatesupplycurve
Figure3.5TheintermediateKeynesian
to an expansionof output asthere are no more factors
demand
in aggregate
available
to employ.Theincrease
will onlyleadto a higherpricelevel.
t
case
Figure3.4The aggregatesupplycurve:extremeKeynesian
;
.E
3
t
Y fe
RealOutput/ Income(Yr)
Yfe
RealoutDut/ In<ome(Yr)
67
.lt
E
o
c
(u
(o
|rt
Theclassical(andextrememonetarist)aggregatesupply
curve
. The Classical
Schoolaswell as the extrernel\y'onetarists
viewedthe economyas producingwhateverits resources
and technology
would permit.
. Aggregatesupplywouldthusbe vertical.
as in Fig.3.6,
at the full employment
levelof outputand anychangein
aggregate
demandwouldonlyaffectthe priceleveland
no realvariable.
Thelong-runaggregatesupplycurve
.
In the longrun,definedasthe periodwhen ail
adlustments
arepossible
and moneywagesarefiexible,
the aggregate
supplycurveis verticalat the full
(capacily)
employment
levelof outputasshownin Fig.
3.7. lt canbe thoughtof as roughlythe equivalent
of the
production
possibilities
f rontier
Figure3.7Thelong-runaggregate
supplycurve
Figure3.6 The aggregatesupplycurve:the classical
and
extreme monetarist case
d
3
g
g
RealOutput/ Income(Yr)
Real Output / Income (Yr)
WhichAS do I use?
Theansweris 'it depends'lTypically
one shouldemploy
an upwardslopingAS as in Fig.3.3or in sectionHFof
Fig.3.5. lt showsthat an increase
in aggregate
demand
will leadto an increase
in the averagepricelevel
(inflation)
aswell asto an increase
in realoutputandthus
employment.lt alsoshowsthat the effect on the average
pricelevelof a risein AD is more pronouncedthe steeper
the AS becomesor, in other words,the closerto capacity
(to full employment)
an economyis operating.
On the otherhand,if onewishesto illustrate
an economy
In long-runequilibrium
when all adjustments
aremade,
then a verticalASat the fu/l employment
levelof outputis
in order(Fig.3.7).
Lastly,
the extremeKeynesian
(Fi9.3.4; horizontalup
untilYfe)andthe extremelvonetarist
(Fig.3.6; aswell as
Classical
and New Classical)
casescouldbe employedonly
if one wishesto show the differencesin theseschoolsof
economicthought.
Injectionsand withdrawalsin
representation
Thecircularflow model is a simplified
unitsof an economy
of how the basicdecision-making
(households,
and,in an 'open'
firms,the government
economy,the foreignsector)interact.lt describesthe
flows betweentheseunits.
At the most basicversion,wherethereare only households
and firms, it is understoodthat householdsown the factors
of productionwhich they offer to firms.In exchange,firms
offer paymentsfor thesefacrorsin the form of wages,
rents,interestand profits,the sum of which is definedas
income.Firmscombinethesefactorsto producegoods
and services
whlch they offer to householdsin returnfor
paymentsthat constituteconsumptionexpenditures
on
producedgoods.
domestically
Also,part of incomemay be saved(a 'withdrawal'from
thissystem)
whilefirmswill alsospendon capitalgoods
(= investment
is an
Thislatterexpenditure
spending).
'injection'to the system.
(investment
spending)
Forequilibrium
to exist,injections
must equalwithdrawals(savings).
lf ihe governmentand a foreignsectorare added
then injections
alsoincludegovernment
spendingon
producedgoodsandservices
domestically
aswell as
expenditures
makeon our goods
that {oreigners
(= exports),
whilewithdrawals
alsoincludeexpenditures
that domesticentitiesmakeon foreign goods(= imports)
aswell astaxesthe governmentcollects.
Thetradeor business
cycle
. Lastly,
the ideaof potentialGDP(whenall resources
are
Theupsand downs(phases)
throughtime of the levelof
(in
fully
of
real
GDP)
are
employed)
canbe illustrated
eitherasa peak-to-peak
overalleconomicactivity otherwords
lineor asa separate
linelocatedslightlyaboveall peaksin
referredto as the trade cycle (or businesscycle).l\,4ore
the trade(business)
cyclediagram.
formally,the business
cycleis definedasthe short-run
fluctuations
of realGDParoundits long-runtrend.
Figure3.8 Thetrade(orbusiness)
cycle
Periodsof expansion('booms')are followed by periods
of contraction(recession,busts).The downturn3 major
lf on
is increasing
levelsof unemployment.
characteristic
the other hand expansionis 'too rapid' it rnaygive riseto
pressures.
inflationary
ldeally,
steady,
sustainable,
non-inflationary
long-termgroMh would be desirable.
average
Theeconomydepictedin Fig.3.8 is a growingeconomy.
annual
long run
GroMh existswhen totaloutputrisesthroughtime;
growm
a sustained
increase
in realcDP lt followsthat this
I boom
economyis growingbetweentime periodt2 and t3
l rough
but alsooverthe long run asthe 'trendline'is upward
sloping.The trendlinereflects
the averageannual
long-rungrowthof the economy.
Real
Betweentime t1 and t2 the economyis in recession.
for at leasttwo consecutive
GDPis decreasing(technically,
Tip
quarters)
negative
andthusthe economyis registering
groMh rates.At t1 it was at a peak(aswell as at t3). At
Makesurethatafteryoufinishdrawing
thetradecycle
t2 it is at a trough and it is about to enter recovery
there
is
only
one
level
of
real
GDP
corresponding
to each
(from,
Notethal if the groMh rate is decreasing
say,
period
time
a
t.
A
comrnon
error
is
to
draw
it
in
such
2.1% to 0.aok)realGDPcontinues
to increase
but at a
way
point
't'
that
horizontal
axis
there
at
each
on
the
slowerand slowerrate.Variousexpressions
are usedto
aremorethanonecorresoondino
levels
of realGDP
describe
thisphase,e.g.'the economyis losingsteam'or
'it is peakingout' 'approaching
An economy
recession'.
justto
aboutto enterrecession
is,in Fig.3.8,somewhere
the riohtof a oeak.
Thecomponents
of aggregate
demand
. Consumptionexpenditures(C)are madeby househoids
on goodsand services.
In manyadvanced
economies
consumption
expenditures
arethe largestcomponent
(about60% or more)of aggregate
demand.In other
economies
this proportionis significantly
lower
!,
ratesmeanthat borrowingto financethesepurchases
is now cheaperfor households.
Thesinglelargestexpenditure
of a typicalhousehold
is the purchaseof its house.Householdsborrowfrom
banksto financethis purchase
and thesespecialized
verylong-termloansare knownas mortgageloans.
The interestrate chargedon suchloansis often
'adjustable',
meaningthat if marketinterestrates
decrease,mortgagerateswill alsodecreaseand so will
the monthlypayments.
Households
with suchhousing
loanswill thus havemoremoneyavailable
everymonth
to spendon goodsand services.
A drop in interestrateswill makesaving(definedas
incomenot spenton goodsand services)
lessattractive
so households
will tendto savelessand spendmore.
The levelof consumerindebtedness
lf private(household)
debt(fromtakingout loans,
mortgagesfor housepurchase,and/orcreditcard
spending)
hasaccumulated,
household
spendingis bound
to declineas they will needto pay more and more to
servicetheir debt.
Severalfactorsmay affect spendingby householdsand lead
to a shiftin AD. Themostimportantfactorsinclude:
. Consumerconfidence
Households
feelingsecureand confidentabouttheir
futurewill tendto spendmore.A stableand growing
economywith low inflationand unemployment
will boost
consumerconfidenceand thus favorablyaffect household
spending,
shiftingAD to the right.On the otherhand,
uncertaintyoverfuture job prospectsand insecurityabout
one'sfuture incomeadverselyaffect presentconsumption.
Spending
on durablegoods,suchas carsand appliances,
aswell as on housing,aregreatlyaffectedby consumer
moods.
. Interest rates (the priceof borrowingmoneyover a
periodof time)
Lowerinterestrates(i.e.easymonetary policy)willtend
. Wealth
to increase
consumption
expenditures,
and consequently
The total valueof a household'sassetsmay affect the
the overalllevelof aggregate
demand,shiftingthe AD
levelof its spending.lf, for example,wealth increases
curveto the right. Thismay happenbecause:
then consumptionwill be positivelyaffected.A stock
. Consumer
goods(cars,
durable
appliances,
furniture,
marketboom or risingpropertyvaluestendsto increase
etc.)areusuallvpurchased
on credit.Lowerinterest
spendingand lowersavings.
Investmentspending
Investmentspending(l) is definedasspendingby firms
on capitalgoodsand is thusequalto the changein the
stockof capitalof an economyover a period.When firms
spendto acquirecapital (K)we saythat they invest.
Investmentis important both becauseof its short-run
Factorsaffectinginvestmentspending
.
Interest rates
Investment
spendingrequires
funds,whichareeither
borrowedfrom the banksor are part of past-retained
firm profits.lf firms borrow,they will be chargedinterest
on the loan,whileif they usetheirown funds,they
will sacrificethe return(interest)that they would have
earnedfrom investing
the funds.Consequently,
a fall in
the marketinterestrate will tend to rncre.tseInvesrmenr
spendingin the economyas at lower interestratesmore
investmentprojectswill be consideredprofitable.
influence
on aggregate
demandand because
in the
long run it affectsaggregatesupplyand thus the rate of
(actualand potential)groMh of an economy.Investment
spendingis the mostvolatilecomponentof aggregate
oemand.
Figure3.9 Investmentspendingand intered rates
c
f one plotsinvestment
spendingagainstthe marketinterest
rateas in Fig.3.9,the functionwill be negatively
sloped.
How responsive
investment
spendingof firmsisto a change
in lnterestrates(i.e.how elastic)
is an empirical
issue.
InvestmentSpending(l) per perio.
lnvestment
Business
confidence
The greaterthe degreeof businessconfidencein an
the morewillingfirmswill be to investand
economy,
expand.Economic
and politicalstabilityare necessary
for investmentsto take place.J. M. Keynesconsidered
with respectto private
the behaviourof entrepreneurs
similarto that of a herd('imitation')
investment
decisions
of investments
instability
and,in hisopinion,the observed
canbe
spirits'.Expectations
wasdue to these'animal
factors
by a hostof unpredictable
changedradically
business
climate
leadingto wild swingsin the prevailing
spendin9.
and thusto changesin the levelof investment
Publicpolicytoward investment
.
Governmentsoften attempt to influenceinvestmenlby
preferential
loan
firms,
subsidies,
incentives
to
offeringtax
terms,protectionfrom foreigncompetition,etc. Note
rhat the sizeitselfof the publicsectorin an economy
may influencethe growth of privaleinvestment.Also
bear in mind that'institutions'affect privateinvestments
(of'red tape')and complicated
A largebureaucracy
of firmsin a country
theoperation
regulations
burden
Investment
of
investment.
andnegatively
affectthe rate
paribus,
withlow
higherin countries
levels
are,ceteris
economic
levels
oi bureaucracy
andwilhtransparent
adversely
corruption
Lastly,
andbusiness
environments.
foreigndirectinvestment
affectsinvestment,
especially
(investments
in foreign
corporations
bymultinational
counlrresJ.
The overallmacroeconomicenvironment
where
environment
A 'sound'macroeconomic
policymakers
ensurelow inflation,low budgetdeficits,
publicdebtandflexiblelabourmarketsusually
sustainable
spending.
leadsto higherratesof investment
Incomeand its groMh
andthus
flisingincomeleadsto risingconsumption
may inducemore investmentsasfirms may be forcedto
increasetheir capacityto meetthis increaseddemandfor
goodsand services.
Thisis the ideaof the 'accelerator'
DrinciDle
discussed
below
principle
Theaccelerator
a shoemaker
needsone new machinefor
Forexample,
the level
Theaccelerator
is a theoryaimingat explaining
pairs
produced.
lf salesriseby 20,000
10,000
extra
every
of investmentin an economy.
his
stock
of capitalby two
then
he
will
need
to
change
on
depends
Thistheoryclaimsthat the levelof investment
to outputratio.
the
fixed
capital
extra
machines
to
maintain
(more
generally,
in
changes
changesin nationalincome
period
two
machines.
thus
equal
Investment
in
that
would
or
in
sales).
output,in demand,
instability
It provides
an additionalreasonfor the observed
that
for
annual
it
follows
Generalizing
for an economy,
of investmenl
spendingand,togetherwith the multiplier
investmentto remainstabletotal sales(total output or
of
(explained
the existence
later),it is a theoryexplaining
natronalincome)haveto be rsing at a constantrate.lf
the business(trade)cycle.
they meantne samething
output(or income;remernoer
theory eventhough
to rise
It is consideredpart of Keynesian
asthe one is the flip sideof the other)continues
Keyneshimselfconsideredexpectatlons(animalspirits)
but at a slower rate (thus,if groMh just slowsdown)
muchmoreimportant.
investment
will decrease.
that firmswishto
restson the assumption
Theaccelerator
Investment
is thusa veryvolatilecomponentof AD.
maintaina fixedcapitalto outputratio.
Governmentspending
a large
Governmentspending(G)is in manyeconomies
partof totalspendingon goodsand services.
into current
Government
spendingis distinguished
capital (public
spendingon goodsand services.
investment)
spendingwhichrefersto spendingon
schoolsand other
roads,ports,telecommunications,
infrastructureand alsoon transfer payments which
benefits.
and unemployment
basically
referto pensions
arenot includedin national
Notethat transferpayments
incomesincethey do not representrewardsfor current
productiveeffort.
Governmentsspendto ensurethat adequateamounts
areconsumed
of publicand meritgoodsand services
and health
services
suchas nationaldefence,educational
services.
Theyspendto regulatemarketsin their attempt
to guaranteeproductsafety,environmentalstandards,
compeiitiveconditions,etc. Theymay alsospendto
minimum
acceptable
redistribute
incomeso that a socially
statepensions,
is guaranteed.
suchspendingincludes
benefits,etc.
disability
unemployment
benefits.subsidies.
. Lastly,they spendto affect aggregatedemand.By
government
aggregate
spendjng,
increasing
or decreasing
shiftingto the rightor
demandwill increase
or decrease,
to the left.Thisis partof what is knownasfiscalpolicy.
G.'"'; ;;;;;p""ai"t .."*."J
(Net)exportdemand(NX,ot X-M)
Foreigners
spendto buy domesticallyproducedgoodsand
services
but sincepartof domesticspendingis on imports
it followsthat aggregatedemandis affectedand shifts
when net exportschange,the differencebetweenexport
revenues
and importspending.
Manyfactorscan changethe levelof net exportsand thus
shift AD, suchasthe exchangerate and the extent of
proteclonrsm.
supply
of aggregate
A closerexamination
Adversesupply shocks
Figure3.10 An adversesupplyshockasa resultof higher
that negatively
affecta country's
Thesearechanges
oil Drices
productive
Theyresultin a shiftto the left
capacity.
sustained
supplycurve.A sharpand
of the aggregate
suchexample.
increase
in thepriceof oil isa typical
andisusedasan
oil istheprincipal
formof energy
-9
thoughhas
inputbyvirtually
allfirms.ltssignificance
'i
in recentyearsasa
decreased
in advanced
economies
fromthe tertiary
biggerproportion
of GDPoriginates
sector(services).
A bankneedslessoil to operatethan
of an adverse
Anotherexample
a carmanufacturer.
in wagecostsfor firms
supplyshockisgeneralincrease
asa resultof powerfullabour(trade)unions.A broad
(raw
or highercommodity
increase
taxation
in indirect
pricesarealsopossible
sources
of suchadverse
material)
(suchasthose
supplyshocks.
Lastly,
naturalcatastrophes
a fewyears
agoor froman
resulting
fromthetsunami
attacks
wars,majorterrorist
earthquake
or a hurricane),
mayshrink
theprodudive
andinstitutional
setbacks
(Yr)
RealoutPut/ In(ome
andshiftASto the left.
capacity
of an economy
eitherby
An adverse
supplyshockcanbe illustrated
Figure3.11 An adversesupplyshockasa resultof a corrupt
leftwardshiftof an upwardslopingshort-runaggregate
governmenttaking power
supplycurveor by leftwardshiftof a verticallong-run
aggregate
supplycurveasit doesnot makemuch9f a
difference.
Asa broadrule,inputor factorprice-related
3
witha
illustrated
supply
shocks
shouldbepreferably
.;9l
curveshifting
supply
sloping
aggregate
short-run
upward
of a sharpand
left.Thus,the effecton an economy
I
sustained
increase
of the priceof oil canbe bettershown
through
Fig.3.10.
of a
shockis because
on the otherhand,if the adverse
(e.9.a new
setback
naturalcatastrophe
or an institutional
prone
government
or proves
mostindustries
nationalizes
byshifting
isperhaps
bestillustrated
to corruption)this
levelof output
letMarda verticalat the full employment
in
Fig.
3.'11.
long-run
supply
curve.
as
aggregate
Yfe2
Yfel
RealOutpul/ Income(Yr)
How could
Figure3.12 A rightwardshift in aggregatesupply
supplyisa positive
A rightwardshiftin a99regate
in
an increase
asit implies
development
for aneconomy
equivalent
Sinceit isconceptually
itsproductive
capacity.
possibilities
frontier
to an outwardshiftof the production
I
for shifting
anyfactorresponsible
of an economy,
.g
possibilities
frontierof an
outwardthe productlon
economy
willalsoshiftitsAScurveto theright.
may
of aneconomy
capacity
Firstof all,the productive
increase
supplyshiftto the rightif
anditsaggregate
aswellas
Investment
humanandphysical
capitalincrease.
increases
andhealthservices
moreandbettereducation
(outputperworker)andthusaggregate
labourproductivity
(e.9.the assembly
line
advancements
supply.
Technological
framework
institutional
or the internet)
andan improved
(including
business
simplified
a betterlegalsystem,
credible
betterbankingpractices,
rulesandregulations,
governance')
policymaking
Yfel
Yfe2
andmoregenerally'good
RealOutput/ Income(Yr)
supply.
shiftof the aggregate
bothleadto a rightward
asin the caseof oil
Lastly,
more'land'(throughdiscovery,
reserves
or annexation)
wouldalsodo thejob.
A rightwardshift of a verticallong-runAS curveshouldbe
to usean upwardsloping
employedbut it is acceptable
aggregatesupplycurveaswell.
obviouslygovernmentsattemptto and can influencethe
supplysideof an economy.Fewwould disagreethat a
governmentcan increaseaggregatesupplyby improving
and education.Or,for that matter,that
healthcareservices
publicinvestmentin infrastructure
would havethe same
effectas it createssignificantexternalbenefitsto firms
in the form of lower produdion costs.But beyondthese
which
disagreement,
obviouschoicesthere is considerable
laterin the sectionon supply-sidepolicies.
will be discussed
Note that rarelya shift to the right of As can be a source
of significantproblemsif this increasein the productive
in
capacityof an economyis not matchedby increases
spendingon domesticoutputi.e.on AD as it may leadto
deflation(examinedlater).Also,the discoveryof a natural
as many
resource
suchasoil canbe a mixedblessing
countrieshavefound out.
3
RealOutput/ Income(Yr)
Theeffectsof AD/ASshifts
The AD-AS
The aggregatedemand-aggregatesupplyf ramework
is very simplebut alsovery useful.Movementsof the
averagepriceleveland of realoutput provideinformation
on threemajorpolicygoals.Inflation (anddeflation)as
well as groMh can be directlyillustratedon the diagram
canbe
and unemployment
whilechangesin employment
indirectly
inferred.
lt follows that lfgovernment is in a position to affed
aggregatedemandthen it may be in a positionto
achievethe macroeconomic
Aoalsmentionedin the very
beoinninq.
Effectsof a rightward shift in
.g
E
o
o
l,
(u
(E
,rl
Aggregatesupplyin thiscaseis horizontalup untilthe full
employment
levelof outputYfewhereit becomes
vertical.
LetYfe be the full employment
levelof output.lf aggregate
demandis at AD1 then equilibrium
outputis at Y1 which
is way belowthe full employment
level.In the Keynesian
framework,equilibrium
outputis'demand-driven',
meaning
that it is aggregate
demandwhichdetermines
how much
the economywill be producing
and thusthe levelof national
Income.As a result:
. Equilibrium
income(output)doesnot needto correspond
Figure3.13 TheextremeKeynesian
case:perfedly elastic
aggregate
supply
I
.g
to full employment
(seeFig.3.13).
of resources
. A deflationary(or recessionary)
gap equalto distance
fh in Fig.3.13 results.
(or recessionary)
A deflationary
exists
when
equilibrium
output
is
lessthanfull
9ap
employment
output.
. lf aggregate
demandsomehowincreased
to AD* then
the economywill havereachedfull employment.
. Expansionary
policies
demand-side
canlift an economy
out of a recession
withoutanyinflationresulting.
Ontheotherhand,if aggregate
pastAD*
demand
increases
to AD2,theninflation
results
withoutanyfurtherincrease
n outputandemployment.
Distance
hj isknownasan
inflationary
9ap.
Effectsof a rightward shift in aggregate
Aggregatesupplyin thiscaseis perfectlyinelastic
(vertical)
at the full employment
levelof output,reflecting
the belief
that an economywill alwaysbe in equilibrium
at the full
employment
levelof output.
. Aggregatedemandin thiscasedoesnot determine
'real'variables,
suchas how muchoutputthe economy
will produce,or what the levelof employment
will be.
Realoutputis determined
by the quantityand qualityof
available
resources
and by technology.
. Aggregatedemandonlydetermjnes
the averageprice
level.ln Fig.3.14,if aggregate
demandincreases
from
AD1 to AD2,then realoutputwill remainat Yfe and only
inflationwill resultasthe averagepricelevelwill risefrom
P1to P2.
. lt followsthat expansionary
policies
demand-side
are totally ineffectivein increasingrealoutput and
employment
and canonlyproveinflationary.
In the long
run,the equilibrium
levelof realoutputcanbe increased
onlythroughpolicies
aimingat the supplysideof the
economy.
Figure3.14 Theextrememonetaristcase:verticalAScurve
at Yfe
q
9l
RealOutput/ Income(Yr)
Effects
Figure3.15 The intermediatecase:upward-sloping
aggregate
sloping,
Aggregate
supply
in Fig.3.15isdrawnupward
supprycurve
equilibrium
is assumed
reflecting
thetypicalcase.Originally,
at the intersection
of AD1andASwith Y1 beingthe
price
equilibrium
levelor realoutputandP'lthe average
tevet.
q
in aggregate
demandfromADl to AD2can
An increase
E
in increasing
realoutputfromYl to Y2 andthus
succeed
pricelevelis
but at a cost.Theaverage
employment,
isthepricepaid.
higherat P2soinflation
in aggregate
demandwill
Theextentto whichan increase
on
be expressed
asgroMhof outputor inflationdepends
in other
howcloseto capacity
the economyisoperating,
wordson how steepit is.
policies
can
thatdemand-side
Thisdiagramthusreveals
but at the cost
be usedto raiseoutputandemployment
of higherinflation,or to lowerinflationbut at the costof
slowergrowthor recession.
Effe€ts
aggregate Figure3.16 The possiblerole of rupply-sidepolicies
Thepossible
effectof policyattemptsto increase
supply
areillustrated
in Fig.3.16.
. lt is assumed
demandis risingthrough
thataggregate
3
are
timefromAD1to AD2.lf somehowpolicymakers
!u
aggregate
supplyof the economy
successful
in increasing
a risein outputwithouta
thentheywill haveachieved
groMh.
pricelevel,i.e.non-inflationary
risein the average
i rip
I
i
I
i
i
AScurves(A51
one canemploytypicalupward-sloping
to use
to A52)to arriveat thisresultbut it is preferable
long-runverticalaggregate
supplycurves(LRASIto
level
LRA52)
asthisshowsthatthefutl employment
of outputwillhaveincreased.
i
:
i
i
Yfel
Yfu2
RealOutput/ In@me(Yr)
policies
Demand-side
.
policiesattemotto increaseor decrease
(or,
Demand-side
in aggregate
moreprecisely,
to slow down the increase)
demandin orderto affectoutput (groMh),employment
and the averagepricelevel(laterit will be shownthat these
samepoliciesare alsousedto correcta trade imbalance
policies),
and are referredto asexpenditure-changing
Theyaredistinguished
intofiscalpolicyandmonetary
policy.Fiscal
policyrefersto the manipulation
of the
levelof government
and/orof taxeswhile
expenditures
policyrefersto changes
monetary
in interestrates.
E
Fiscalpolicy
(reflationary)fiscalpolicy
Expansionary
.
.
.
.
.
Keynesintroducedthe ideathat the (equilibrium)
level
of outputwas demand-driven.
The levelof aggregate
demanddetermines
the levelof overalleconomicactivity.
Thereisthusno guarantee
thatequilibrium
outputandfull
employmentoutputwill coincide.Therecouldverywell
gap(seeFigs3.13and3.33).Aggregate
be a deflationary
demandcouldbe insufficent if, for whateverreason,the
privatesector(households
and firms)decidesto hold back
on theirspending.A recession
couldthus result.Hethus
introducedthe ideaof expansionary
fiscalpoliry(seebelow).
(reflationary)
Expansionary
fiscalpolicyaimsat increasing
aggregate
demandto increase
nationalincomeand
employment
andthus closea def ationarygap.
lt requires
an increase
in government
spendng and a
decrease
in taxation.
Sincegovernment
spendingis a componentof AD, a rise
in G will directlyincrease
AD, shiftingit to the right.
In otherwords,if privatespending(C + l) is not sufficient
to generatefull employment
thenthe government
should
increase
its spending(G)by bonowingfrom the private
sector(deficitspending,G > T).
. A decrease
in taxation (T)will indirectlyalsoincreaseAD
asit will increase
disposable
income(definedasincome
minusdirecttaxes)that peoplehaveand inducemore
spendlng.
Contlactionary(deflationary)fiscalpolicy
. On the otherhand,an overheating
economy,
defined
asan economywhereaggregate
demandis rapidly
increasing
p.essLres,
creatinginflationary
requires
contractionaryfiscalpolicy.
. Thegovernment
government
mustdecrease
expenditures
and increasetaxesso that AD decreases.
In summary
.
E xpansi onary
fi scalpol i cy:rai seGandl ow erT
(deficitspending)
to increase
AD andthus incomeand
employment.
. Contradionaryfiscalpolicy:lowerG and increase
T to
decrease
AD andthus inflationary
pressures.
The multipliereffect
Expansionary
fiscalpolicyaccording
to the Keynesian
school tigure 3.17 The multipliereffect
is very powerfultool to lift an economyout of a recession
as
a resultof the operationof the multipliereffect.
. Assumethat a government
wishingto closea deflationary
gap decides
to increase
itsexpenditures
by someamount,
say,AG (the differencebetweenihe new levelof
spendingandthe originallevelof spending).
. Aggregatedemandwill automatically
increase
by AG
and shiftfrom AD1 to AD2 as in Fig.3.17.Butaccording
to the multipliereffectthe process
will not end there.
Aggregatedemandwill continueto increase
and shiftto
the rightall the way to AD3.
. The multiplier
effectstatesthat an jncrease
in government
(or,moregenerally,
expenditures
in anyinjection)
will
leadto a greaterchangein income:AY = KAG,whereAY
is the resulting
changein income,AG is the changein
government
spendingandK is the multiplier.
Why wil nationalincomeincrease
by morethanthe increase
in government
expenditures?
Theexplanation
restson two
ideas:
. Oneperson's
spendingis automatically
someoneelse's
.
income.
Economic
adivitytakesplacein successive
rounds.
RealOutput/ Income(Yr)
The multipliereffectcontinued
ExamDle
Assumethat the government
decides
to increase
expenditures
by 10,000,000poundsand hiressome
unemployed
workersto dig holesand burybottlesand
otherunemployed
workersto di9 them up. National
pounds,the income
incomehasincreased
by 10,000,000
they produced.
that theseworkersearnedfor the 'servlce'
Spending
by the government
is incomefor the workers.
But,economicactivitywill not stopthere.Thereis a
secondand a thirdand an nth roundthat follow Why?
Because
theseworkerswill spendpart of thisextra
incomeon domesticAoodsand services
that others
produceand the process
will continue
is
lf extraspendingon domesticgoodsand services
constantand equalto 0.8 (80%)of anyextraincome
then nationalincomewill riseby 50,000,000pounds.
Howdoesonearriveat thisfigure?
Definethe extraspendingon domesticAoodsinduced
to
by extraincomeearnedasthe marginalpropensity
consume(MPCd)
domesticAoods.ThemultiplierK is
equalto:
1/(1 - MPCd)
In the examplethe MPCdis assumed
to be 0.8 (as
8 millionpoundsarespentout of 10 millionpoundsof
extraincome)it followsthat the multiplier
K is equal10 5.
Giventhat the initialincrease
in government
spendingis
10,000,000
in income
and that AY = rAG, the increase
is equalto 5 times10 millionpounds,i.e.50 million
pounds.
Sinceonly8 out of the 10 millionwerespenton domestic
goodsit followsthat 2 millionwerenot spent.This
incomenot spenton domesticgoodsmusthavebeen
spenton foreigngoods(imports)
or paidin taxesor
simplysaved.
lmportexpenditures,
areall
tax payments
and savings
withdrawals
in the circular
flow model.
It followsthat (1 - MPCJis the marginalpropensity
to
withdraw(MPW)so if r = 1(1 - MPCd)
it is alsoequal
to 1(MPW)or 'l(MPM + N,4RT
+ MPS)whereN/PN/is
the marglnalpropensity
to spendon imporls,MRTis
the marginalrateof taxationand MPSis the marginal
propensityto save.
Themultipllereffectis greatetthe greaterthe proportion
of anyincrease
in ncomethat is spenton domesticaoods
and services
or the smalerthe proportionof anyincrease
jn incomethat is saved,spenton lmportsor taxedby the
9OVernmenl.
Tips
Notethat one mechanism
throughwhichtradecycles
aretransmitted
internationally
isthe exponmultiplier
A recessionin the USeconomywill leadto lower US
importsandthuslowerEuropean
and,say,Japanese
exports.Dependingon the sizeof this decreaseaswell as
on the opennessof theseeconomies,economicactivity
in EuropeandJapanwill be adversely
affected(theirAD
will shrink)andthiseffectwill be magnified
throughthe
exportmultiplier
wh;ch;sthe changein nationalincome
from a changein exportrevenues.
resulting
Also,notethat the effectis not instantaneous
asthere
is a time lagbetweenreceiptof incomeandsubsequent
spendrn9.
Evaluatingfiscalpolicy
in the
Fiscalpolirycan be usefuland hasbeenusedsuccessfully
pastand evenrecentlyin the U5.lt suffersthough from several
disadvantages
that were exposedmostlyby the monetarists
and whichweakenits effectiveness
or mayeventransformit to
a sourceof macroeconomic
instability.
Morespecifically;
. Fiscal
policyis characterized
by longand potentially
destabilizing
time lags.Thesereferto the time between
when an economy'gets
and
sick'(enters
a recession)
(theexpansionary
fiscalpolicy
the time the 'medicine'
administered)
is restored).
hasan impact(fullemployment
It maythus be the casethat by the time the impactof a
policyswitchis felt,the economyhasalreadymovedon
to a new cyclephasedestabilizing
ratherthan stabilizing
economicactivity.
. Fiscal
policyhasan expansionarybias.Thecyclical
natureof economicactivitywould requirethat
governments
and
alternatebetweencontractronary
in powerwho
expansionary
fiscalpolicy.But politicians
areresponsible
for economicpolicymay in generalbe
and raisetaxes
reluctant
to cut government
expenditures
theirpopularity.
asthischoicecoud drastically
decrease
Contractionaryfiscal policy is difficultto employnot only
becauseof reluctantpoliticiansbut alsobecausecertain
publicexpenditures
areconsideredinelasticby society.
governmenlexpenditures
Decreasing
on health,education
or socialsecuritymay be consideredsociallyunacceptable;
defenceexpenditures
are alsooften difficultto cut. On
the otherhand,increasing
taxationbeyonda pointwill
(seeLaffercurve,page92).
adversely
affectincentives
Expansionary
fiscalpolicymay leadto a widening trade
deficit; if a higherlevelof incomeresultsthen moreimports
will be absorbed,while if the averagepricelevelincreases
then exportswil shrinkasthey becomelesscompetitiveand
importswill riseasthey becomerelatively
moreattractive.
(HLOnly):Expansionary
fiscalpolicyand deficitspending
may end up crola/dngout privateinvestmentand thus
be lesseffective.The resultingbudget deficit must
somehowbe financed.Governmentborrowinqfrom
financlalmarketsmay driveinterestratesup and asa result
privateinvestmentwill decrease
(andso will consumption
expenditures).
lf this decreasein privatespendingmatches
government
the increased
spending,
the crowding-outs
saidto be completeand fiscalpolicyis totallyineffective.
77
The crowding-outeffect
Crowding-out
is a monetarist
criticism
of Keynesian
inspired
expansionary
f iscalpolicy.
lf the government
government
increases
spendingby
AG then,asa resultof the multipliereffect,AD will rise
from AD1 all the way to AD2.Fiscal
policythusseems,
accordjng
the Keynesian
School,likea verypowerful
tool to reflatean economyin recession.
Not so,claimthe
monetarists.
government
The increased
spendingand
resultinqgreaterbudget deficitneedsto be financed(e.g.
how cana government
spend€850mwhen it earnsfrom
taxesonly€700m?lt mustsomehowborrowthe missing
€150m).lf the government
borrows(bysellingbonds
to the non-bankprivatesector)then interestratesmay
rjse(asthereis goingto be greaterdemandfor loanable
f unds )ass howni n F i g .3 .1 9 .
lf interestratesincreasefrom 11to 12then private
(seel-ig.3.9).
sector;nvestment
spendingmaydecrease
Consumption
expenditures
mayalsodecrease.
Since
AD includes
not onlyG but alsoC and I it maynot after
all increase
to AD2 but only(if,at ail)to AD3 asshown
in Fig.3.18.Expansionary
fiscalpolicyis thus not as
oowerfulaswasthouoht.
Figure 3.18 The crowding-out effect
3
q
asa resultof
crowding out '
g
the mul ti pl i er
effect
Realoutput / Income(Yr)
Figure3.19 The loanablefunds market and the effect of
government borrowing on interest rates
Tip
The effectsof crowding out alsodependon the
typeof government
expenditures
financed.lf capital
(investment)
expenditures
arefinancedthen.given
that infrastructureinvestmentsmay createsubstantial
positiveexternalitiesto privatefirms, economicgrowth
mayevenaccelerate.
Thisis an especially
validargument
for developing
countries
whereimprovedinfrastructure
is muchneededand is considered
complementary
to
marketforces.AIso,if the budgetdeficitisfinancedby
foreignersthen domesticinterestratesmay not increase
(but otherproblemsmayresult).
Loanable Funds (per period)
Monetary policy
(easyor loose)monetary
Expansionary
policy
lf an economyis aboutto enterrecession
or if it already
is sufferingnegativegroMh ratesthen policymakers
(the centralbank or the government)may decrease
Interestrates(0 in an attemptto increaseaggregate
demandand thusoutputand employment.
How doesit
work? How are lower interestratesexpectedto reflate
a failingeconomy?lt is hopedthat aggregate
demand
will increase
asconsumption
expenditures,
investment
expendituresaswell as net exportswill tend to rise.
Consumption
expenditures
of households
will tend to
ncrease,
a5
(cars,
borrowingto financethe purchase
of durables
appiances,
etc.)becomescheaperso spendingon such
gOOdS
mayInCrease;
. reducedinterestratesmean lower monthlypayments
on variableratemortgageloansso households
will
havemoreavailable
to spendin general;
. the lower rate of returnwill makesavinglessattractive
so households
willtend to spendmore.
Investment
spendingby firmswill tendto increase
as
borrowingcoststo financepurchasesof capitalgoods
(equipment)
(newfactories)
and expansions
are lower
Also,lowerinterestratesimplythat the opportunitycost
to firmsof usingtheirown pastretainedprofitsto finance
inveslments
is alsolower
Lastly,as a resultof lower interestratesthe exchange
ratewill tend to depreciate
so exportswill become
more competitiveabroadand importslessattractive
domestically,
increasing
AD.
Monetary
(tight)monetary
policy
Contractionary
. Assume
economy
in whichinflationis
an overheating
(thecentralbankor
becoming
a problem.Polirymakers
interestratesin an attempt
the government)
mayincrease
to
to decrease
AD.Aggregate
demandisexpected
decrease
ashigherinterestrateswill work in the opposite
direction
above.Saving
will become
asthe onedescribed
moreattractive,
bonowingcostswill risefor households
andfirmsandthe exchange
ratewilltendto appreciate,
to
rendering
exportspricierandthuslessattractive
foreiqners.
Evaluationof
. Central
thetiming
banking
isbothanartanda science:
issuedbythe
of an interestratechange,the statements
centralbank.thesizeof the interestratechangeareall
crucialfor the success
of anypolicychange.Thereare
the extentto whicha
verymanyfactorsthat determine
poljcyresponse
ln general,
will or will not be successful.
policyisextensively
monetary
usedthroughoutthe world
on domestic
to regulate
thestrengthof totalspending
goodsandservices.
ratherflexibleas
lt is considered
centralbankscanalterinterestratesoften,theycanalter
anydecision.
andtheycanalsoreverse
themgradually
byseveral
on theotherhand,it isalsocharacterized
problems.
. lvlostimportantly,
andfirms
spending
by bothhouseholds
doesnot dependonlyon interestrates.Consumption
dependon a hostof other
expenditures
andinvestment
confidence
andbusiness
factors.Thedegreeof consumer
of
the response
importantin determining
isextremely
is
the
as
well
as
in
interest
rates
spending
to a change
Forexample,
andfirm indebtedness.
degreeof household
letthe centralbanklowerinterestratesin an attemptto
preventa recession.
and/or
lf businesses
arepessimistic
if households
burdened
by heavydebtsthere
arealready
is no guarantee
thattheywill betemptedby lower
interestratesto borrowandspendmore,andsothe
policymayfail.
Also,if the borrowingrateisalready
too low (closeto
zero)thenit cannotbe loweredanyfurtherasnegative
interestratesdo not makeanysense.
by potentially
Monetarypolicyis alsocharacterized
destabilizing
timelags.justlikefiscalpolicy.Thesetime
lagsmaybeshorterbuttheyarevariable,
creating
uncertainty
of anypolicychange.
asto the success
policyis
Undera fixedexchange
ratesystemmonetary
haveto be usedonlyto
ineffective.
Interestratechanges
fixedat the
ensure
rateremains
thatthe exchange
chosenlevel.
Today,
financialmarkets
arelargelyglobalsomost
firmsandevenhouseholds
cananddo borrowfrom
weakenthe
anyvvhere
in theworld.Thesedevelopments
policy.
effectiveness
of monetary
policies
Supply-side
the
policies
thataimat increasing
arepolicies
Supply-side
shiftingthe As curveto
aggregate
supplyof an economy,
in Fig.3.16.page75
therightasillustrated
. one maygroupsupply-side
policies
intoa setwhich
in
includes
measures
thatallwillagreearecrucial
capacity
of an economy
enhancing
the productive
morecontroversial
andintoanothersetthat includes
measures.
Commonlyaccepted
(especially
primary
lmproving
education
andsecondary . Lastly,
improvingthe institutional
frameworkwould
alsoserveto improveproductivity
wheretherateof returnisthehighest)
or making
and the supplyside
of an economy.
education
universalwill
improve
labourproductivity
and
thereis no uniquesetof
Unfortunately,
increase
laws,rulesand regulations
AS.
that canbe transplanted
to
Betterhealthservices
anyeconomyand proveoptimal.Russia's
madeavailable
to thegeneral
lostdecade
population
followingthe attemptin the early1990sto createa
wouldalsohavethesameeffed.
providing
A government
marketeconomycontrastedwith the recentChinese
betterinfrastructure
willalso
booslthesupply
experienceillustratethe ooint.
side.'Buildyourself
a roadto getrich'
isanoldsaying
andit expresses
a universal
truth.Roads,
harbours,
airports,
to lower
telecommunications,
allserve
production
costsof allfirmsin a country
More controversial
Overall,
thebenefits
expected
byimplementing
supply-side
policies
area result
of increased
levels
of competition
and
Thesecondand morecontroversial
set includes
the measures
the expected
enhanced
efficiency,
fewer
distortions
to
the
'supply-siders'
that the so-called
espouse.
Supply-siders
are
pricemechanism,
fewer
built-in
disincentives
and
increased
a group of economistswho are known for their extreme
flexibility
in labourmarkets.
pro-market
ideas.Thesemeasures
include:
policies
Ontheotherhand,pro-market
supply-side
canbe
. Labourmarket-related
policies:
theseincludepolicies
grounds:
criticized
on thefollowing
that try to makethe labourmarketmoreflexible.They
. Benefits
Theyare
usually
takea longtimeto materialize.
includeloweringor evenabolishing
the minimumwage;
policies
thus
long-run
with
incapable
of
dealing
short-run
decreasing
the powerof labourunionsand reducing
proorems.
(suchas national
non-wagelabourcoststo employers
. Taxcutsmayinstead
inducemoreleisure
andlesslabour
insurance
cheaper
contributions)
so that labourbecomes
proving
gift
and
investment,
more
of
a
the better-off
to
to firmsand morelabouris hired;makinghiringand firing
population.
segments
of
the
of workerseasierso that managersdo not hesitaleto hire
. Privatization
oftenhasled,at leastin the shortrun,to
morelabourwhen demandrises;makingpensionplans
increased
unemployment.
(sothat labourmobility
transferable
acrossoccupalions
. Deregulation
mayproveunsuccessful
in raising
increases);
reducingunemploymentbenefitsso that those
prices.
competition
and
lowering
The
1990senergy
crisis
out of work are more motivatedto find jobs, etc.
perhaps
good
in
California
is
a
example
of
the
dangers
. Productmarket-related
policies:
theseincludepolicies
that
thatderegulation
of utilitycompanies
maybrin9,as
aim to increasethe extentof competitionin marketsso
the
market
may
become
dominated
by
a singleprivate
that the economyreapsthe resultingefficiencybenefits.
prices
monopoly
which
has
no
incentive
to
keep
down.
(reducing
Deregulation
the amountof rulesand 'redtape'
. Thesmaller
safetynetthat results
from,say,lowerand
for firms)and privatization
aswell astradeliberalization
stricterunemployment
benefitsmayleadto increased
aretypicalcandidates.
income
inequality
maybe
and
segments
of thepopulation
. Decreasing
tax ratesto improvethe incentiveto work, to
marqinalized.
saveand to invest(seeLaffercurve,page92).
Pro-marketsupply-sidepolicies
Industrialpolicy
. Withinthissecond,rathercontroversial,
groupone may
policies'.'lndustrial
policies'
alsoinclude'industrial
are
government
championed
by polirymakers
who considered
interventionand guidancenecessary
for the productive
lhis groupconsiders
capacity
of an economyto increase.
marketforcesinadequate
10guidefinancialcapitaland
investmentsto their most productiveusesand thus
government
was necessary
to do the job and 'pick
80
winners',i.e,industries
and firmsto supportasthey
werethoughtto be the mostpromising
for groMh.
Subsidizedlow interestloans.lower ratesof taxationor
tax allowances,and protectionfrom foreign competition
aresomeof the measures
employed.
Somesuccessful
as
well as unsuccessful
developingcountrieshaveadopted
suchmeasures.
Many,if not all,advanced
economies
have
alsoemployedsuchpoliciesin varyingdegrees.
lnflation
Theinflation rate
increase
of the averagelevelof prices.
lnflationis definedasa sustained
as a price index,hasrisen
is the percentageby which the averageprice level,expressed
betweentwo periods.
throughtime
makescomparisons
A priceindex(a numberwithout unitsof measurement)
(or
'base'
reference)year
the
year
to
be
is
chosen
much easier.Usingstatisticalcriteriasome
price
for
the
baseyearwill
index
it.
The
percentage
of
years
as
a
are expressed
and all other
be equalto 100.
Measuringinflation
The averagelevelof pricesis measuredthrough a price
indexwhich is a weightedaverageof the pricesthat lhe
as an indexnumber.
typicalconsumerlacesexpressed
determinethrough surveysthe basketof
Statisticians
goodsand services
that the typlcalhouseholdbuys
The averageis a weightedaverageas goodsand services
to the typicalconsumerThe
are not of equalsignificance
weight tor eachgood are the expenditureson it expressed
as a proportionof total expendituresmade
. The cost of purchasingthe basketis recordedand then
as an lndexnurnber.
expressed
of measurement
Problems
The typicalconsumeris a fictitiousperson Thisperson
is bothyoungand old, livesboth in a cityand on a farm
and is both well off and relativelypoor.As a resultit is
problematicaltousethe inflationrate figure to determine,
for example,by how much a governmentshouldincrease
morehealthcare
pensions,
asan olderpersonconsumes
younger
individual.
than
a
and lessentertainment
The weightsusedto constructthe averagepricelevelare
fixed. As a resultthe effect on the inflationrate of an
increasein the priceof somegood is overestimatedEven
though consumerswill switchawayfrom it and purchase
other cheapersubstitutes,its significance(itsweight) in
will be ihe same The
of the average
the construction
true inflation.
thus
overestimate
officialinflationrate may
bias'.
as
the
'substitution
Thisis referredto
New productsare not immediatelytaken into account
of the averagepricelevel.lt took a
in the construction
to enter the
few yearsfor the prlceof cell phoneservices
typicalbasketof goodsand servicesin manycountries
This is referredto as the 'new productbias'.
Pricesfrom new retailoutletssuchasonline stores
(Amazon)or megaand discountstoresmay not be
sufficientlysampled.5incetheseretailoutletsusuallyhave
lower pricesthe officialinflationrate may overestimate
true inflation.Thisis referredto asthe 'new retail
outletbias'.
lmprovedqualityof goodsand servicesmay not be
propedyaccountedfor in the constructionof the average
pricelevel.A betterversionof a productmaybe 10%
but may last50% longerthan the older
moreexpensive
Again,the official
cheaper.
it effectively
version.rendering
true inflation.Thisis
inflationrate may overestimate
referredto asthe 'oualitv bias'.
Costsof inflation
national
redistributes
decision-making Inflation,in generaland on average,
in business
uncertainty
Inflationincreases
former
the
poor
well-off
since
to the
incomefrom the
so it makesit more difficull for firms to judge whether
to hedgeagainstinflationand,in
havefewerchoices
prospect
will orwill not be profitableAs
an investment
addition,they cannotborrow.The wealthycan borrow
and thus, in the
a resultinvestmentspendingdecreases
from
the bankingsystemand proceedto investin assets
long run, growth and employmentratesmay decrease.
whose
valueis expectedto risefasterthan inflation
As
markets
Exportsbecomelesscompetitivein foreign
lf
actual
inflationproveshigherthan expectedinflatjon,
imbalances
and
trade
a result,the exportsectorshrinks
gain at the expenseof lenders.The money
then
borrowers
may result.
theywill be payingbackwill be worth lessthan expected
on fixedmoneyincomes(suchaswage
Households
suffera declinein their
earnersand pensioners)
But mild inflation reducesthe realwage costsof firms and
mayworsen
power lncomedistribution
purchasing
mayihus helptheircompetitiveness.
The efficiencyof the pricemechanismis lost because
inflationdistortsthe signallingpower of relativeprice
i Tip
the priceof
or a firm witnessing
A consumer
changes.
i
good X risingcannot be surethat it is now relativelymore
asshecannotknowwhetherthe pricesof other
expensive
by the samepercentage
similargoodshaveincreased
and of firms.
of consumers
the decisions
Thisconfuses
r---------------
---------------i
i
Deflation
:
t
u
ts
D
E
D
B
D
1,
F
Deflationrefersto a process
of continuous
decreases
in
the averagepricelevel.lf the lnflationrateis negativethen
the economyis sufferingfrom deflation.In January
2006
priceschangedby -0.8% in Japan.Thismeans
consumer
that the averageconsumer
pricelevelhad decreased
by
0.8% compared
to January
2005.Japanwassufferingfrom
deflation.
Tip
Disinflation
refersto a decrease
of inflation.Prices
continueto risebut at a slowerrate.lf, for example,
inflationhasdecreased
from 8.7% to 5.5% annually
then pricescontinueto increase
but at a slowerrate.
E
l.
I
Costsof deflation
Consumers
delaypurchases
sincetheycometo expect
furtherpricedecreases.
Aggregatedemanddecreases
evenmore.pushingeveniowerthe averagepricelevel.
F rms are forcedto cut pricesto win overcustorners,
squeezing
theirprofitmarglnsand forcingthem to cut
down on costs.Wagesfall and layoffsfollowso AD shifts
furtherto the left.
The rea va ue of outstanding
debt increases.
Indebted
consumers
becomehesitantto makepurchases
and
indebtedfirms hesitateto make investmentsso AD
decreases
evenmoreand so doesthe averagepricelevel.
Sincethe realvalueof outstanding
debt increases,
some
households
and somefirmscannotservice
theirloans.
Banksaccumulate'bad'
loans(loansthat are not repaid)
and thusthe riskof a bankingcrisiswith repercussions
on
the realeconomyincreases.
. Sincenominalinterestratescannotdecrease
belowzero
the centralbankcannotuseeasymonetarypolicyto
reflatethe economy.Expansionary
fiscalpolicymayalso
proveineffective
as households
maypreferto saveand
postponespending.
Butexportsbecomemorecompetitive
abroadand AD may
increaseas a resultof a risein net exports.
Causes
of inflationand deflation
-^'ough the AD/Asdiagram
it is clearthat anyfactorthat
- -'eases
price
aggregare
denandw ll leadro an increasing
=.e, i.e.inflation,aswell asanyfactorcausingan adverse
:- 'i of aggregate
supply.Theformeris knownas
,:-and-pull inflationand the latlerascost-push
inflation,
:.:^ thoughoncean inflationary
process
beginsit is difficult
- :'actlceto distinguish
betweenthe two.
Figure3.20 Demand-pullinflation
T
g-
lernand-pullinflation
- :-: caseof demand-pull
inflationthe extentof the
--:: f,naryeffectresulting
from the increase
in aggregate
-- -:-rd dependson how steepthe AS curveis,ln other
how closeto full employment
the economyis
::--:: og.Thecloserto the ful/ employment
levelof output
'- = ::aeperAS is),the greaterthe effecton the average
: := :.'el of an increase
in aggregate
demand.
: :
:.20
illustrates
demand-pull
inflation
asthe average
-'=
: :: : . al s s hownt o i n c re a sfro
e m P1to P2 fo l l o w i nga
' :, :he r ght of aggregate
demandfrom AD1 to AD2.
RealOutput / Income (Yr)
Causesof inflation
causesof demand-pullintlation
Cost-pushinflation
. Rapidlncrease
Figure3.21 illustrates
and investment
cost-push
inflationasthe averaqeprice
in consumption
level
is
P1
causedby excessively
optimisticand
shownto increase
from to P2followinga shiftto
expenditures
the left of aggregate
supplyshock)from
confidentconsumers
andfirms.
supply(an adverse
. A surgein exports.Exportsmay increaseas a result
A51to AS2.
or depreciating
currency
especially
of an undervalued
Figure3.21 Cost-pu5h
inflation
if the priceelasticity
of supplyof exportsis low (i.e.if
bottlenecksexistin the productionof exports).Faster
groMh abroadmayalsosuddenlyincrease
foreign
demandfor our products.
t
government
Profligate
spendingis a typicalcauseof
.9
pressures.
Also,poorlydesigned
demand-pull
inflationary
.c
pressures
tax cutsmayfeeddemandand inflationary
qpt
insteadof increasing
the incentive
to work or to invest.
Inflationary
expectations
themselves
area commoncause
to continue
of continuinginflation.lf pricesareexpected
climblngthen all firmsandworkerswith pricingpower
will increase
theirpricesand wagesto keepup.
Perhaps
the singlemostimportantcauseof inflation
is'excessive
monetarygrowth'. The easiestway to
this is by quotingl\y'ilton
Friedman
s famous
understand
sayingthat inflationexistswhen 'too muchmoneyis
chasingaftertoo few goods'and thusthat inflationis a
RealOutput/ Income(Yr)
purelymonetaryphenomenon.
Tip
Bearin mindthat increases
in AD will affectnot only
the averagepricelevelbut alsorealoutput.Mild
inflationmaythusaccompany
a risein realoutputand
employment.
Causesof cost-pushinllation
. A risein the priceof oil (energycosts)is perhapsthe
mosicommoncauseof cost-push
inflation.Oil is stillthe
predominant
and
form of energyfor firmsso a sustained
production
sharpincrease
in the priceof oil will increase
costsacross
the boardandthus prices.
. Powerfullabourunions,asthey maybe in a positionto
for theirmembers
wage increases
higherthan any
achieve
productivity
9ains.
(or a sharpdepreciation)
of the currency
A devaluation
sinceit makesimportpriceshigher.Not onlywill the
averagepricelevelimmediatelyriseand leadworkersto
demandhigherwagesbut domesticproductioncostswill
and
alsoincrease
if firmsimporta lot of raw materials
i n ta rma r{i :ta
nr ^.1,,.t(
Risingcommodityprices(astheseare produclsusedas
inputsin manufacturing)
because
of risingworlddemand.
growth in china hasincreasedmanufacturing
The explosive
and constructioncostsin manyother countries.
An increase
in indirecttaxation.Thiswould be a 6neoff lncreasein the averagepricelevelso it would hardly
qualifyas a causeof inflation(a sustamedincreasein
prices)
unlessit leadsto demandsfor higherwagesand
an inflationary
spiralbegins.
A productivityslow-down.Productioncostswould rise
but sucha development
wouldtypicallyrequiresome
unfavorable
institutional
change.
Causesof inflation
Causesof deflation
Figure3,22 Deflation
Figure3.22 illustratesa caseof deflationsincethe average
price levelis shown to decreasefrom P'l to P2as a resultof
decreasing
aggregate
demandfrom ADl to AD2.
Deflationcan be causedby:
A decreasein aggregatedemand,often the resultof a
domesticcrisis,likea bankingcrisisor the collapse
of a
majorindustrybut possibly
a resultof an externalcrisis
that led to a suddencontractionof the exportsector.
Aggregatedemandrisingmoreslowlythan expected.
Extremelyoptimisticfirms may haveoverinvested
in new
capacity
leadingto a largeshiftto the rightof aggregate
supply.lf aggregate
demandfailsto riseasfastas
originally
anticipated,
a decreasing
averagepricelevel
may result.
RealOutpui/ Income(Yr)
Policies
to dealwith inflationat
Policiesto dealwith demand-oullinflation
, Policiesto dealwith cost-pushinflation
.
. Thepolicyresponse
In the caseof demand-pull
inflation,typically,
tight
is lessobviousin the caseof cost-push
policy
(increasing
monetary
is adopted
the interestrate)
inflation.lt mayseemthat supply-side
policiesare in order
oftenaccompanied
(meaninglowering
by fiscal'restraint'
but supply-side
policiesaredifficultto adoptand implement
government
spendingand raisingtaxes;loweringbudget
andtakea longtime to haveanyeffects.Of course,
deficits).Toshow how tighter monetarypolicy(andfiscal
appropriatesupply-side
policiesare alwayshelpfulto contain
restraint)
will hopefullyhelplowerinflationuseFig.3.23.
inflationsinceby shiftingASto the rightanyincrease
in AD
. GivenAD1 and A5. the averagepricelevelisatPl.Asa
will be absorbedwithout the averagepricelevelrising,
resultof demand-pull
inflationaggregate
demandwould
Non-inflationary
qroMh will be achieved(referto Fig.3.16).
. Thus,evenif inflationis'cost-push',
increase
to AD2 and the pricelevelto p2. lf the central
it is contractionary
bank increases
interestrates(tight moneiarypolicy)some
demandmanagement
policies
that areemployedby
households
maycut down theirspendingon durables
policymakers.
The typicalimmediateresponseto any
and somefirmsmaylowertheirinvestment
spendingso
inflationary
pressures
emergingin an economyis for
aggregate
demandwill not increase
policymakers
asfastall the way to
to tighten monetarypolicy,i.e.to increase
AD2 but will increase
onlyup to AD*. Prices
will risebut
interestratesand makeborrowingmore coslly.
. Figure
not as much.Inflationwill be lower.
3.24illustrates
thesituation.
Initially
realoutputisat
. Notethoughthat whereasrealoutputwould risetoY2 ii
Y1andtheaverage
pricelevelat pl. Assume
anadverse
will now as a resultof the contractionarypolicyemployed
supplyshockshiftingASfromA51to AS2(arrowa)and
nseonly up to Y*. Output increasedbut not as fast so
leading
to a higherpricelevelP2.Cost-push
inflationis
economicarowth sloweddown.
evenmorecostlythandemand-pull
inflationasrealoutput
Figure3.23 Dealing
with demand-pull
inflation
hasalsodecreased
fromYl to Y2 andunemployment
rises.
Figure 3,24 Dealing with cost-push inflation
.E
FP2
aP *
PI
84
g
gD'
4 ''
Policies
to deal,
. Letpolicymakers
policyby increasing
tightenmonetary
price
the average
interestratesin an attemptto maintain
andthe increased
levelat P1.lf the poliryissuccessful
and
byhouseholds
spending
borrowing
costsdecrease
(arrow
b)
maintaining
firms,thenADwillshiftto AD*
effect
pricesstableat P*. Notethoughthatthe negative
on economic
activity(onrealoutput)will be moresevere
will
to Y* andunemployment
asit willfurtherdecrease
a short-runcost
thisis considered
increase
more.Usually
groMh
worthsufferingaspricestabilityhelpsaccelerate
generation
in thelongrun.
andemployment
Dealingwith deflation
.
Deflationhasprovento be a most difficult problemto
suffered
economy,
dealwith..Japan,
a majoradvanced
the consequences
of deflationfor manyyears.Deflation
createsa viciouscircleof decreasingpricesleadingto
aggregate
demandleadingto decreasing
decreasing
pricesthat is extremely
difficultto break.Monetarypolicy
Tip
lncreasedexposureto internationalcompetitionalso
exertsa dampeningeffed on inflation.Not onlyare
domesticfirms forcedto becomemore efficientand
lower their pricesbut alsothey may benefitfrom
cheapersourcesof supply.
u,
3
o
at
o
|D
o
f
o
3
at
is ineffectiveand fiscalpolicyis weakened.Somehow
policymakers
the publicthat inflation
haveto convince
shouldbe expected.Governmentshaveresortedto
printing datedvouchersto force recipientsto spendthem
and not savethem. Deflationis often correctedthrough
the increasein aggregatedemandthat resultsfrom
cheaDerexDorts.
Unemployment
Who are the
to asthe workforceor the
of the labourforce(alsoreferred
An individualis consideredunemployedif sheis actively
the
population)
forceincludes
job
100.
The
labour
times
searching
for a
and cannotfind one.The unemployment working
employed
and
the
unemployed.
rate is the ratio of the numberof unemplovedoverthe size
Problemsin
distinction
to be a clearcut
Eventhoughthereseems
beconsidered
andwhoshouldn't
of whoshould
rate
measuring
theunemployment
unemployed,
rate
Theunemployment
isfraughtwith problems.
thetrue levelof
mayunderestimate
or overestimate
unemployment
in a countryHowdo governments
.
iseither
rate?Theanswer
arriveat theunemployment
(survey
method)or bycountingthe
throughsurveys
andreceiving
asunemployed
number
of thoseregistered
(claimant
method).
unemployment
benefits
rate
andtheunemployment
Thenumbers
of unemployed
surveys.
in thattheyarebasedon household
areestimates
unemployed
individual
to beconsidered
Fora surveyed
to startworkand
shemustbewithoutwork,available
at
soughtgainfulemployment
shemusthaveactively
fourweek.
sometime,usually
duringtheprevious
Surveyed
theirtruestatus.
individuals
maymisrepresent
the truelevel
Survey-based
statistics
oftenoverestimate
of unemployment.
ln additiontheymaysufferfrompoor
of
sample
design
andlimitedcoverage
andquestionnaire
theoooulation.
datacount
Ontheotherhandregistered
unemployment
and
thenumber
registered
asunemployed
of individuals
Thesenationalstatistics
receiving
benefits.
unemployment
conditions
aredependent
theeligibility
on whether
often
statistics
aresatisfied.
Claimantunemployment
have
asgovernments
underestimatdtrue
unemployment
to
eligibility
requirements
beenaccused
of manipulating
statistics.
underreport
the unemployment
85
Costsof
Privatecosts(coststhat the individualsuffers)
Taxrevenuescollectedare lower becauseof the lower
incomesandthe resulting
privatespending.
decreased
. Thesinglemostimportantcostan unemployed
individual
Government
spending
increases
because
of the
incursis hislostincome.
unemployment
benefitspaidand the increased
number
. Anothercostis the possible
lossof up-to-dateskills.
of trainingand retraining
programmes
that government
. Beingunemployedincreases
the chancesof remaining
often finances.
preferto hirean individualcurrently
unemployed.Employers
. lf unemployment
is highand prolonged,
societymay
employedelsewhere
to hiringan unemployed
worker.
experience
higherlevelsof drug and alcoholabuseand
Notonlywill herskilisbe up to datebut alsothe employer
hencehigherincidences
of crimeandviolenceand other
avoidsthe risk5createdby asymmetric
information(not
negativeexternalities.
knowingwhy the unemployedlost herjob in the first place).
. lf unemploymenlis concentrated
in regionsand/orin age
. The lossof self esteemthat often resultsand the
groupssuchproblemsmaybecomeevenmorepronounced.
probability
increased
that the personwill resortto alcohol
However,
theremaybe somebenefitsarisingfrom
privatecosts.
or drugsareotherpossible
'Freemarketeers'
unemployment.
believethat unionpower
weakensand thusthereis reducedcostinflationpressure
Socialcosts(coststhal societysuffers)
in
the economyand greaterlabourmarketflexibility.
Increased
. Giventhat the so-called'economicproblem'is scarcity,it
geographical
and occupational
mobilityis alsomentionedas
becomesevidentthat the greatestcost of unemployment
a possiblepositivesideeffect of unemploymentasworkers
is the lostoutputthat couldhavebeenproducedand
areforcedto moveor changeoccupation.
neverwill.Theeconomyoperatesinsideits production
possibilities
f rontier.
Typesof u
Seasonal
unemployment
Frictional
unemployment
. Construction
.
workersarelaidoff in the winterThistype
Frictional
unemployment
refers
to people
whoare
jobs.Thisisunemploymenl
of unemployment
isexpected
andthereisnothing
the
between
of a short-term
government
cando aboutit. Unemployment
natu'eandislargely
statistics
unavoidable
in aneconomy
since
('seasonally
thoughareoftencorrected
people
jobssearching
adjusted')
willalways
voluntarily
switch
for
sothatpolicymakers
candelermine
truechanges
in
betteronesor relocating.
unemployment,
notthosedueto thechanging
seasons. . Faster
andbetterlabourmarket-related
information
will
decrease
butnoteliminate
frictional
unemployment.
Governments
canthusminimize
frictional
unemployment
by
ensuring
thatjobvacancies
aswellastheprofiles
of those
available
for workbecome
knownfasterandmorewidely.
. In Fig.3.25aaggregatedemanddecreases
(Keynesian
Cyclical
or demand-deficient)
unemployment
for somereason
from ADI to AD2 resultingin a decrease
in economic
. Thistypeof unemployment
isdirectly
related
to the
adivityand a decrease
in realoutputfrom Y1 to Y2. The
business
cycle.
Higher
unemployment
willnecessarily
economyhasentereda recession
illustratedin the trade
accompany
a recession
because
of the lowerlevelof
cyclein Fig.3.25b.Thelowerlevelof economicactiviv
economlc
activity.
A decrease
in aggregate
demand
will
forcesfirmsto decrease
their demandfor labour.Somefirms
forcesomebusinesses
to shrinkandothers
to closedown.
Figure3.25 Cyclicalunemployment
(a)
(b)
E
(c)
of the
mayshrink,othersmayevenshutdown because
with
recession.
In Fig.3.25cthe labourmarketis illustrated
from DLl to DL2.[,4oney
demandfor labourdecreasing
(nominal)wagesareassumedto remainat wl asa result
of labourunionsand/orcontracts('stickywages') Excess
supplyof labourresults,equalto ab, reflectingthe resulting
cyclicalunemployment.
. Unemployment
isdealtwith
reasons
due to cyclical
policies.
the
Effectively
demand-side
by expansionary
governmentwill attempt to closethe deflationary
gap.Interestratesarecut in the hopethat households
to spendmoreandthe
andfirmswill be convinced
governmentmay evenlower taxesand Increase
on the stateof theirfinances
depending
expenditures
Structuralunemployment
. Structural
is perhaps
the mostserlous
unemployment
type of unemploymentsinceit is of a long-termnature
those remainingunemployedlong after
It represents
recoveryis underway in an economy.An economymay be
will not decrease
unemployment
boomingbut structural
. lt is the resultof the evolvingstructureof an economy
or shiftinq
advancement
because
of rapidtechnological
of
structure
The
changing
advantage.
comparative
an economyresultsin a mismatchbetweenthe skills
and the skillsrequiredby
by the unemployed
available
rendercertaln
the labourmarket.Newtechnologies
professions
obsoletebut at the sametime createnew
job opportunities.
Theinternetmayhave,for example,
decreased
the demandfor shop workersand postmen
but creatednew jobs for web designersand softn/are
But if the laid-offshopworkeror the employee
engrneers.
postal
serviceis not trainedin computersthen he
of the
or shemayfind it difficultto get a job.
. It is alsothe resultof labourmarketrigidities.
Minimum
bargaining
wage lawsandwagessetthroughcollective
of labour
and labourareexamples
betweenindustries
Theyboth resultin higher
rigidities.
market-related
aswageratesaresetabovetheir
unemployment
level.lf pensionplansin one
market-clearing
equilibrium,
to anotherinduslry
not
easily
transferred
industryare
a
Consider
mobilityis hampered.
then occupational
from
workerlosinghisjob in industryA but prevented
he cannotlransfer
takrnga job offer in industryB because
hispensionrightsso he will be unemployed.
. Lastly,
ascauses
areconsidered
institutional
disincentives
aswellas
LawsprevenLrng
firms+romfiringemployees
areexamples
benefils
highunemployment
Policies
to lower
butthe
is notpossible
unemployment
structural
Eliminating
i1:
help
decrease
to
followingareconsidered
. Training
permitslructurally
seminars
andretraining
workers
to findnewjobs.
unemployed
. Ensuring
to prepare
arecapable
curricula
thatschool
to
andwilling learn.
whoarecreative
individuals
. Reducing
power
of tradeunions
the
bargaining.
minimumwagelawsand collectlve
Eliminating
non-wagelabourcosts(suchasnational
Reducing
contributions).
insurance
. Reducing
benefitsand the
the levelof unemployment
length of time that benefitscan be collected
HOWEVET:
. Thereduction
thatsomeof
unemployment
in structural
maybringaboutmaycomeat a significant
thesemeasures
mayleadto
workerprotection
Decreasing
costto society.
may
earlier,
labourandsocialunrestwhich,asdiscussed
become
population
may
of the
hampergrowth.Segments
Realwage unemployment(or classicalunemployment)
.
a resultof labour
is considered
Realwage unemployment
the realwage rate(thepurchasing
unionsmaintaining
power of the moneywage rate)too high (abovethe
level)for the labourmarketto 'clear'.
eouilibrium
agaln
moreunequal,
marginalized
and incomedistribution
with adverseeffectson groMh and development
Finally:
. Expansionary
demand-sidepoliciesare ineffectiveto
In
asanydecrease
unemployment
dealwith structural
will be temporaryand at the costof
unemployment
hioherinflation.Thisoointwill becomeclearlater
Policies
that attemptto dealwith structural
naturebelonging
areof a microeconomic
unemployment
policies
discussed
supply-side
to the broaderclassof
a growing
Also,eventhoughiI soundscounterintuitive,
mayoverthelongrunsufferfromhigher
economy
thedifferent
Thisisbecause
structural
unemployment.
industries
of thedifferent
income
elasticities
of demand
unemployment
Equilibrium
anddisequilibrium
. Unemployment
whenthelabourmarketisin
thatexists
unemployment
as'equilibrium'
equilibrium
isconsidered
rateol
andismorewidelyknownaslhe'natural'
(NRU,
seebelow).
unemployment
. on theotherhand,cyclical
andrealwage
unemployment
of 'disequilibrium'
unemployment
arebothexamples
isnotthe
wageraTe
unemployment
astheprevaihng
eouilibrium
waoerate.
87
The naturalrate of unemployment
(NRU)is a term
The naturalrateof unemployment
introduced
by NobellaureateMillon Friedman,
the best
knownadvocateof monetarism.
Thebasicideaconveyed
isthat theremaystillbe
unemployment
in the labourmarketevenif participants
on both sidesof the marketsatisfytheirobjectives
and
prevails.
equilibrium
ln Fig.3.26the curveLDillustrates
the labourdemand
that firmsexpress
in the market.lt showshow many
workersfirmsarewillingto hireat eachrealwage rate.lt
is downwardslopingasat higherrealwage ratestheywi I
be willingto h re fewerworkers.ThecurveLFillustrates
the labourforceavailable
at eachwage rate.lt shows
the numberof individuals
workingor lookingfor a job at
eachwage rate.lt is slightlyupwardsiopingasat a higher
realwageratemorepeoplewi I be convinced
to enterthe
labourmarketand searchfor a lob.
It is the curveAJthat makesth s modelof the labour
marketdlfferent.lt isthe 'acceptjobs'curveand shows
at eachwageratethe numberof lndividuals
willingto
accepta job offerand work. lf you arelookingfor a job
you will not necessarily
acceptThefirstjob offeryou
get.Youmayhopeto obtaina betterjob and giventhe
levelof benefitscollected
it maybe worth continuing
the search.
AJ is alsoupwardslopingasthe LFis upward
slopingbut the horizontal
distance
at eachwagerate
betweenAJ and LFdecreases
because
the probability
of
accepting
a job offerwill be higherat a higherwage rate.
Thelabourmarkeiis in equilibrium
at Wr'. At W|" the
numberof peope firmsarewillingto hire]sequalto
the numberof peoplewillingto accepta job offer Note
thoughthat thereis stillunemployment
eventhoughthe
labourmarketis in equilibriurn
as'ef'workersarein the
Figure3.26 The natural rate of unemployment
E
3
t
tabour (L)
labourforcebut withouta job. Theunemployment
that
existswhenthe labourmarketis in equilibriums known
asthe natural rate of unemployment.
Sincethese'ef individuals
wou d not be willingto accept
a job offer evenif therewas one, the NRUis of a vo untary
nature.lf the wage ratesay,becauseof labourunionswas
higheraboveWr' thenpartof the resulting
unemployment
would be of an involuntarynatureand part of a vo untary
nature.Notethough that the voluntaryportionat that
higherthanequilibrium
wagerateis not the NRU.
TheNRUis alsoconsidered
to be of a structural
nature
as if the AJ curveshiftsto the rightbecause
of lower
unernployment
benefitsit would decrease.
ThePhillips
curve
TheoriginalPhillipscurve
Sincethe early1960sand untiithe mid 1970seconomists
re iedon an empirical
resultthat AlbanW Phillips.
a New
Zeaand economist
at the LondonSchoolof Economics,
madein 1958.Hiswork,the Phillips
curve,becameone of
the mostfamousrelationships
in macroeconomics.
lt showed
that there was a stabletrade-off betweenthe inflat on rate
andthe unemployment
rateof an economy.
,r.,
Hisoriginalempirical
(statistical)
work examinedUK data
on the annualpercentage
changein moneywagesand
the annualunemployment
rateovera periodof 96 years
(1861 1957).Figure3.27ashowswhat he found:that the
percentage
chan9eIn moneywagesand unemployment
were inversely
related.lf unemployment
was low ('tight'
abourmarket)then moneywagesrosea lot asemployers
Figu.e3.27 TheoriginalPhillips
curve
(a)
:e
qs
t5
88
(b)
TheoriginalPhillipscurve
Thisstableinverse
seemedto su99e5t['at
re aLronship
governments
couldexploitthistrade-offbetweeninflation
curvepresented
and unemployment.
lt wasas if the Phillips
policymakers
Theycouldachievea
with a menuof choices.
ratebut at the costof higherinflation
lowerunemployment
but at the costof higher
or
they
could
lower
inflation
lVovingfrom wage inflationto priceinflationwasthe nextstep.
unemployment.
Sincewagestypicallyform a big proportionof productioncosts
with
wascompatible
Thisstatistically
determined
relationship
and sincefirms in practiceoftensettheir priceas percentage
Keynesian
that
the
the
ruling
Keynesian
theory
Remember
(a
to explore
of their unit costs mark-up)it seemedsensible
perspective
rate
stressedthe importanceof aggregatedemand
how the annualinflationrateand the unemployment
income.lf AD rose
of equilibrium
what wasfound: inflation in the delermination
were related.Figure3.27billustrales
then realoutputwould increase
and thus unemployment
related.lf unemployrnent
were inversely
and unemployment
However,
thisrisein AD would alsoleadto
while if inflationdecreased would decrease.
then inflationincreased
decreased
pressures.
inflationary
Thus,asshownin Fig.3.27b,if using
slopedcurvein
The negatively
unemployment
would increase.
policies
unemployment
decreased
expansionary
demand-side
Fig.3.27bisthe originalPhillips
curve.
from n1 to n2.
from U1 to U2 then inflatlonwould increase
while if
wereforcedto bid up wagesto find employees,
unemployment
was high('sack' labourmarket)then money
(asfirmscould
wagesincreased
by a littleor evendecreased
less
even
by
offering
to
offer
more
or
hirewithout having
moneywage).
than lastyearl prevailing
-' ' j' . , -f l. -.
The long-runPhillipscurve
expectations
Phillips
aboutinflationadaptlvet(meaningthat
Thisis alsoknownasthe expectations-augmented
theyform theirexpectations
aboutnextyear'sinflationby
critique.
curveor the Phelps-Fredman
past
looking
at
inflation
rates)
so they ares/ow to realize
curverelationship
sincethe late1960sthe originalPhillips
result
of the expansionary
that
inflation
accelerates
as
a
setbacks.
Inflation
and theoretical
sufferedboth empirical
oolicles
oursued.
in the 1970s.
wereboth increasing
and unempioyment
. Fig.3.28blllustrates
with
a labourmarketin equilibrium
coined,implyingrecession
Theterm 'stagnation'was
(distance
'ef is
unemployment
its
natural
level
being
at
togetherwlth risinginflation.Theoriginalinverse
the NRU).Saythat this is at 5.2% and that the economy
hadcollapsed
and traditionalKeynesian
relationship
hasbeenexperiencing
infiationequalto 1.0%for some
round
it haroto explainwhat was9oin9on.
analysis
time
now
workers
againexpect1.0% inflation
so
that
Phlllips
of
the
original
this
empirical
refutatlon
But beyond
(point
g.
year
next
A1
in
F
3.28a).Assumenow that the
curvethere camea theoreticalattack.Ed Phelpsand
governmenl
policies
to try to lower
expansionary
adopts
(bothNobellaureates)
independently
lvliltonFriedman
('natural')
equilibrium
unemployment
to
4.5o/o
below
the
curvewasvertical
claimedthat in the long run the Phillips
/eve/.
2.0%.
As
a
result
the
lnflation
accelerates
now
to
(the naturalrate)
rateof unemployment
at the equilibrium
real
hire
more
workers.
wage
rate
decreases
and
firms
and anytrade-offbetweeninflationand unemployment
Unernployment
decreases
to 4.5yoand the economy
couldexistonlyin the shortrun.Thisbecameknown
point
has
are slow to realizethat
moved
to
42.
Workers
theory
as
the
critiqueand the
asthe Phelps-Friedman
nflation
is actuallyhigf,etal2.0o/oand thusthat the real
Phillips
curve.
expeclat'ons-augmented
wage
is
lower.
But when their expectationsadjustthey
. lf a government
belowthis
triedto lowerunemployment
the real
will
demand
higher
moneywages,increasing
policies
('natural')
rateusingexpansionary
equilibrium
levelWr'.
wage
to
its
original
equilibrium
for
firms
back
it would succeedonly temporarilyandat the cost of
returns
to its
Firms
so
unemploymenl
will
fire
workers
permanently
higherinflation.Theshort-runtrade-off
(point43).
equilibrium
rate
at
5.2%
wasonly because
betweeninflalionand unemployment
theyform their
workerssufferfrom 'moneyillusion':
critique)
Phillipscurveor the Phelps-Friedman
Figure3.28 The long-runPhillipscurve(the expectations-augmented
(a)
a
.t
3
(b)
6.s%
=
E
89
Thelong-runPhillipscurvecontinued
.v
E
o
o
l-l
o
m
.
lf the governmentinsistson tryingto decrease
unemployrnent
belowits naturalrate usingexpansionary
policies
demand-side
lt wouldneedto 'engineer'
higherand
higherinflationratesso that workerswould be temporarily
fooledandacceptjoboffers.In Fig.3.28a,infationwould
haveto accelerate
to 4.0% whileworkersexpectit to be
dt 2.0olo
for Jremploymeltto dropdgal and for tl'e
economyto moveto point44 beforeadjustingbackto A5.
. Thepolicylmplication
s clear:governments
shouldnoftry
(natural)
to lowerunemployment
belowitsequilibrium
rate
policres
usng expans
onarydemand-side
asit isfutile.Any
Thef ifth macroeconomic
goal
Thefifth macroeconomic
Aoalisto ensurethat income
distributlon
is equitable.
Equitable
doesnot meanequal.
decreasein unemploymentwill be temporaryand at the
costof higherinflation.
In the longrun,whenexpectations
haveadjusted
andthereis no moneyil usion,thereis no
trade-offbetweeninflationand unemployment.
There
s onlyone rateof unemployment
and it is compatible
with anyrateof inflationaslongasthisrateof inflation
(andthustemporarily
doesnot accelerate
leadto 'money
lllusion').
ln the longrunthe Phillips
curveisvearlcal
at
the NRU,whichis alsoknownfor thisreasonasthe
non-accelerating
inflation rate of unemployment
(NATRU).
..:,,
It meansfair.Butfairness
is an elusiveconceptand it means
differentthingsto differentpeople.
The Lorenzcurveand the Ginicoefficient
Incomedistributions illustrated
througha Lorenzcurve
Figure3.29 The Lorenzcurveand the Gini coefficient
and the degreeof incomenequaity is measured
through
^ 100%
the Gini coefficient.
In Fig.3.29populaton (incomerecipients)
is plottedon
E
percentages,
the l'orizonral
r.e.Iror
axisin cumulative
poorestto r chesthouseholds.
Thusat, say,the 20% po nt
E
we havethe poorest20% of the populationand at the
40% pointwe havethe poorest40% of the population.
'6
On the verlicalaxiswe measure
the percentage
of income
.E 40vo
received
by eachpercentage
of the populatlon.
z
TheLorenzcurveshowsthe proportionof national
200/0
incomeearnedby eachincomegroup.Forexample,
the
poorest20% in Fig.3.29 receives
only 5% of national
1Oo/o
income.Notethat T00% of the populationwill of course
5o/o
receive100% of nationalincome.Alsonotethat the
Oa/o
20%
4oo/o
aoo/o looo/o
diagonals the lineof equality(perfectly
equalincome
Population(cumulatively
ranked)
distribution).
Ii c he5t
^
Thefurtherawayfrom the diagonal,
the moreunequal
the sizedistfibution
of incomewhilethe closerto the
. TheG ni coefficient
canvaryfrom 0 (denotingperfect
diagonalthe moreequalthe distribution
of incomeis. f in
equality)to1 (denotingper{ectinequality).
Typically
highly
a countryincomedistribution
worsensit meansthat the
unequalincomedistributions
aredistrbutionswith a Gini
Lorenzcurvemovesfurtherawayfrom the diagonal.
coefficient
between0.50and 0.70.Somerepresentative
TheGini coefficientmeasures
the degreeof income
valuesof thiscoefficent are:Brazil0.60,Argentna 0.48,
inequality
in a population.
Jtis the ratioof the area
USA0.40,UK 0.36,Australia
0.35,Sweden0.25and
betweenthe Lorenzcurveandthe diagonaloverthe area
Austra 0.23.
of the halfsquaren whichthe curvelies.Focusing
on Fig. . Oftenwhat mattersis not the levelbut the directionof
3.29,the cini coefficient
isfound by dividingarea(A)by
change,i.e.whetherincomedistrbutionis becomng
area(A + B).
moreor tessunequat.
- :- :_ I.i
Possible
A moreequitabledistributionmay helpaccelerategrowth and . A proportional
tax systemis one in whichall individuals
paythe sameproportionof theirincomeindependently
promotehumanand economic
of
in manyways:
development
proportional
the
the
level
income.
In
a
tax
system
of
their
. Thepropensity
poor
is higherthan
to consumeof the
averagetax rateremainsconstantas incomerisesso the
that of the richso redistribution
will increase
aggregate
marginaltax rateis equalto the averagetax rate.A flatdemandespecially
for basicgoodsand services.
rate (proportional)incometax existsin severalcountries
. Socialtensionsare lower and thus governmentscan more
such
as Latvia,Russia
and Estonia
and is considered
easilyundertakeimportanteconomicreformswhich
presents
by
many
others.
lt
many
advantages
overthe
requirea highdegreeof consensus
withinthe population.
progressive
have.
income
tax
systems
that
most
countries
lf peoplefeel that they enjoythe fruits of economic
Disincentives
are lower,administrative
costsarelowet it
groMh then theywill be willingto work harderand
is simpleandthus moretransparent
and it is potentially
sacrifice
morenow in orderfor them or theirchildrento
evenfaireras loopholes
do not existwhichusuallyhigherenjoymoreat a laterdate.Theywill be willingand ableto
incomehouseholds
of.
takeadvantage
savemore,permittinghigherratesof investmentand thus
.
poorerindividuals
A
regressive
is
one
in
which
tax
system
growth. Fewersocialtensionsdecreaseuncertalntyand
pay
greater
proportion
a
of
income.
In a regressive
their
risksfor domesticand foreign investors.
tax systemthe averagetax rate decreases
as incomerises
. The very poor will be ableto afford accessto crucial
so
the
marginal
rate
is
less
than
the
average
tax rate.
tax
quality
of
resources
suchaseducationso the amountand
Indirect
proportional
taxes
are
with
respect
to
expenditure
productive
resources
available
to a countryincreases.
but regressive
with respectto income.Thisis why indirect
. Trustincreases
amongthe populationso the cost of
taxationon food and basicAoodsis lower or zero.
economictransactionsdecreases.
IVloreeconomicactivity
growth.
ln Fig.3.30the horizontal
will takeplacethusaccelerating
axismeasures
the tax base
(say,
income)
and
the
vertical
the
amount
of tax paid.A
However,an excessively
equalincomedistributioncould
proportional
tax
system
is
illustrated
by
any
straightline
lower economicefficiency.lt could lower the incentivesfor
progressive
through
the slope
the
origin.
ln
a
tax
system
hardwork andfor risktaking.Growthmaybe undermined.
of the ine is increasingwhile in a regressive
tax systemthe
slopeof the lineis decreasing.
Dired and indirecttaxes
Directtaxesare taxeson income,on profitsand on
wealth.The burdenof a directtax cannotbe shiftedonto
anotherentity.Indirecttaxesincludetaxeson goodsand
on expendituresand they havebeendiscussedearlier.The
burdenof an indirecttax can be shiftedonto a different
entity.
proportionaland regressive
Figure3,30 Progressive,
taxation
proportionaland regressivetaxation
Progressive,
To explainthe differencebetweenthe abovetypesof taxes
it is importantto definethe marginalandthe averagetax
takenby
rate.The marginaltax rate is the percentage
the government
on the lastkroneor dollarearned.lt is the
extratax paid as a resultof an extra kroneor dollar earned.
The average tax rate is the ratio of the tax collected
overincomeearnedor moregenerally
the ratioof the tax
collectedoverthe tax base.
Tax Base(lncome)
Thus:
. A progressive
tax systemis one in which higher-income
individualspayproportionatelymore so lhe averagetax
incometax
raterisesasincomerises.In a progressive
systemthe marginaltax rateis greaterthan the average
it follows
tax rate (rememberthat if the averageincreases
that the marginalis greaterthan the average).
91
How canincomebe rer
Short-runsolutions
Long-runsolutions
governments
Usually
resortto a mixtureof progressive
incometaxescoupledwith a systemof transferpayments.
paymentsincludepensions,
Transfer
unemployment
benefits,
dlsability
benefits,
subsidies,
etc.Bytaxinghigherincorne
households
moreheavily
than lowerincomehouseholds
and spendingmoreon trans{erpayments,
nationalincome
maybe redistrbutedin an attemptto satisfythe equitygoal.
Socialhealthinsurance
is usuallypaft of a packagethat aims
at effectively
increasing
the incomeof the lowerincome
strata.
In the longrun,the mosteffectiverouteto a moreequitable
incomedistribution
is by improvingthe qualityand access
to
educationand healthservices
for the mostdeprivedncome
groups.Jobcreationpolicies
arealsoof utmostsignifjcance.
Lastly,
lowercorruptionand a fairjudicialsystemarealso
important.
The Laffercurveand tax cuts
. In the early1980san Americaneconomist,
AathurLaffer, Figure 3.31 The Laffer curve
becamepopularlyknown because
of a diagramthat he
supposedly
sketchedon a napkinof a Washington
DC
restaurant
whilehavingdinnerThisdiagramshowedthe
obvious:that astax ratesrise,tax revenuesalso increase
but onlyup to a point,beyondwhichtax revenues
collected
will startto deciine.
. Focusing
on Fig.3.31,with a 07otax ratethe government
will collectzerotax revenuesso the Laffercurvestarts
from the origin.As the tax rateincreases,
tax revenues
wili alsoincrease
but onlyup to a certainpoint.There
is a tax rate(say,t* in Fig.3.31)suchthat jf the tax rate
rncreases
evenmorethenlax revenues
collected
will start
to decrease.
Thisdecrease
in tax revenues
is because
higherand highertax ratescreatedisincentives
for people
to work andto invest.At the limit,a l OO%tax ratewill
leadto zerotax revenuesfor the governrnentasthere is
no rewardto individualsfor any productiveeffort.
policyimplication
The
Tip
is that in countrjes
with hightax
'
ratesit mayverywell be the casethat by decreasingtax
ratesthe government
Tryto make surethat the maximurnof the Laffercurve
wiJlcollectrnoretax revenues
asa
you draw is not right abovethe mid-point50olotax rate
resultof the improvedincentive
to work and for firmsto
invest.
asthiscouldbe misleading.
We do not know the tax
(optiona, Whethera decreasein tax rateswill or \&illnot
rate after which the disincentives
createdare so stronq
inducemorelaboursupplydependson the substjtution
that tax revenuesstart to decrease.
and incomeeffects.lf the tax ratedecreases
then leisure
becomesmoreexpensive
so individuals
will tend to
work more.On the otherhand,if the tax ratedecreases
then disposable
incomeincreases
and sinceleisureis
considered
a normal'good' peoplewill tendto work less.
It followsthat the effectof a tax cut on laboursupply
dependson whichone of the two effectsdominates.
gaps:analternative
presentation
lnflationary
anddeflationary
The inflationary9ap
Figure 3.32 The inflationary gap: an alternative presentation
Assume
aneconomy
in long-run
lt is
equilibrium.
operating
at thefullemployment
levelo{ realoutput
whichcorresponds
to the naturalrateof unemployment.
Remember
thatthisimplies
thatthelabourmarket
is in
3
equilibrium,
i.e.thattherealwagerateissuchthatit
equates
thenumber
of workers
firmsarewillingto hirewith
the numberof workersthatarewillingto accepta job offer
(astheeconomy
It isalsoassumed
isin long-run
equilibrium)
thatexpectations
haveadjusted,
i.e.thattheanticipated
rate
of inflationisequalto the actualrateof inflation.
. An increase
in ADfromAD1to AD2in Fig.3.32will
foolworkerswhowill acceptjobsasinflationwill
accelerate,
exceeding
the anticipated
rate,andthusthere
YfeY'
will be a temporaryincrease
in realoutputto Y this
(Yr)
RealOutput/ Income
temporary
difference
betvveen
Y' andYfeis knownasthe
inflationarygap. Asmoneywagesareslowto respond, . When expectationsoi inflationadjustand moneywages
the realwageratedecreases
sofirmshiremoreworkers
rise,the realwage increases
backto its originallevel.
to producemoreoutputandworkersacceptastheydo
Productioncostsfor firms increaseand so the shortnot realize
thatinflationhasaccelerated.
Theincreased
run aggregatesupplyshiftsleft from SRASlto SRA52.
outputlevelY' corresponds
to the temporary
decrease
of
Outputwill returnto the full employment
leveland
unemployment
belowtheNRUthatmoneyillusion
creates. unemployment
backto its naturallevel.
Thedeflationarygap
Assume
aneconomy
in long+unequilibrium
operating
at the Figure3.33 Thedeflationarygap:an alternativepresentation
full employment
levelof outputYfe.
. lf nowAD in Fig.3.33dropsfromAD1to AD2then
theequilibrium
to Y'.The
levelof outputwilldecrease
(Yfe- Y') is knownasthe deflationary
gap.
difference
. Thisdiagramcanalsobe usedto showthatthe
equilibrium
levelof outputandthefullemployment
level
g
of outoutdo not necessarilv
coincide.
RealOutput/ lncome(Yr)
93
Schools
of economic
thought:
a briefoutline
It
E
o
c
o
(,
o
an
The Classical
School
. Giventhat scarcity
is the fundamental
economicproblem,
an economywill surelyalwaysfullyutilzeits scarce
resources.
An economywlll thus producewhateverits
permitlt to produce.
scarceresources
and its technology
. 'Supplycreatesits own demand':thisis knownassay's
law (a Frencheconomist)
and t meansthat production
createsincomeand this incomewill necessarily
be usedto
purchase
whateverwas produced.
. Overproduction
was ruledout, asoverproduction
implies
excess
supplywhichin competitive
marketsJeads
to lower
pricesandthusrnarketclearing.
. Prolonged
unemployment
alsowas ruledout as it implies
excess
supplyrn labourmarkets.Excess
supplyleadsto
lowerwagesforcingthe labourmarketto 'clear'(demand
for labourto equalsupplyof labour).
Flexibility
of pricesand wagesguaranteed
that the
productand labourmarketswould 'cleaf (thatdemand
wouldequalsupply).
Theeconomywouldthustendto operateat or nearthe
full employment
equilibrium.
Any deviation
from full
employment
would be temporary.
It followsthat therewould be no needfor the
governmentto intervene.Thisls known as /arssez
faire laissezpasser.
The KeynesianSchool
.
Demandfor outputcreatesthe supplyof output.lt is
ernployed.
(or reflationary)
Thisis knownasexpansionary
'effective'demandthat determines
fiscalpolicy.
equilibriumoutput and
. Theinherentinstabilityof a market(capitalist)
income.An economy's
tota output dependson the levelof
economy
'effective'demand,laterreferredto asaggregate demand.
ledto the observed
short-runfluctuations
of output
. Thereis thusno guarantee
aroundits long-runtrend.This nstabiity was a resut of
that an economywill find itself
(willbe in equiibriurn)at the 'ful employment'
consumption
leveiof
and investment
be ng unstabe aswell as
(a
output.Equilibrium
rnayoccurbelowfull employment
the existence
of the muhipliereffectand the interaction
deflationary
or recessionary
of the multiplierandthe accelerator.
9ap mayexist).
. lf the privatesector(whichlncludes
(thebusiness
households
and firms) . Instability
or tradecycle)required
just psychological)
government
for whateverreason(perhaps
is unable
intervention.
Counter-cyclical
demand-side
policies
to express
sufficent demandfor goodsand services
stablllzation
in an
were ntroduced
whichlncludeflscal
econorny
to leadto fu I employment
and monetarypolicies.
of resources
thenthe
. Fiscalpolicywas consideredmost effectivein timesof
government
couldraiseitsown spendingon goodsand
(aswell as lowertaxation)to increase
deeprecession.
services
the levelof
totaldemandto the levelat whichall resources
arefu ly
The Monetarists
Twomajordevelopments
in the 1970swereresponsible
for
the changen directionin Economics:
the greatlnflationof the
1970sand the deconstruction
of the Keynesian
interventionist
approach
by MiltonFriedman
andthe ChicagoSchool(or,
rnoregenerally,by the l\,4onetarists).
pro-market
Friedman's
ideasbeganto dominateeconomic
theoryandwith M.
Thatcher
in '1979in the UKand R.Reagan
in 1980in the Us
theyalsostartedto dominatepolirymaking.
In 1973,the firstoil crisiserupted,leadingto the
quadrupling
of the priceof a barrelof oil in one day.
Theeffectwas 'stagfiation',
the coexistence
of rising
!nemployment
and risinginflation.Thiswasa blow to
Keynesran
econornics
asthe two werethoughtto be
''. erselyrelatedthroughthe Phillips
curve.
. t,lonetarists
areconsidered
the intelectualhe rs of the
i asscalschoolof thought.
Friedman
and the Monetarist
schooltriedto showthat a
marketeconomyis inherently
stableand thusthereis no
needfor an activerolefor the government.
Consumption
expenditures
were not thoughtto dependon the current
levelof incomeandthe roleof expectatjons
on the
business
investment
spendingdecision
was diminished.
Thusprlvatespendingwas morestable.
[,4onetarists
firstpointedout the possibility
of 'crowdngout', thusweakeningdeflcitspendingasa tool to reflate
a flaggingeconomy.
Inflationfor Friedman
wasa 'purelymonetary
phenomenon'
with 'too muchmoneychasingaftertoo
few goods'.Theyevenconsidered
monetarypolicyas
potentially
destabilizing
and preferred
to relyon prornarketsupply-side
policies.
The Monetaristscontinued
t.J
whichpushedstablization,lberalization
and structural
adJustment
onto developlng
nationswith verydebatable
' esJL. Tr' etd) A ,i anC rs,,ol 1997-98n dy have
markeda turnaroundin economicth nk ng. Rsing
inequalties
betweenandwlthincountrles
suggestthat
rrdndgng l"lrondl econor a: a( well astl^eg obal
economymaybe necessary
afterall.Thequeston of
coursethat sti I remainsis:what kindof managng?
Theyd scredited
the Phillips
curveinflatlon
unemployment
trade-off,tryingto showthat in the long
run the Phlips curveis vefticalat the naturalrateof
unemployment,
a term that Fredmanhrmselfco ned.
Extreme[,4onetarists
cons]dered
that anythng
the government
cando the marketcando better.
Governrnent
fai urewasevenmorelikey than market
failur e.
Several
ideasrelatedto lvonetarisrfarethe basic
ingredentsof the so-called
WashingtonConsensus
o,
'-t
o
n
o
3
lBQuestions:
Section
3
SLLongEssays
HLLongEssays
1a Explain
Explain
the followingtypesof unemployment
why a government
mightfind it difficult
(a)frictional(b)structural
(c)cyclical/demand-deficient
to maintaina low rateof inflationasthe economy
(d)realwage/classical.
(10 marks)
('10marKs)
approaches
fuil employment.
1b Evaluatethe effectiveness
of the differentrneasures
1b Evaluate
the proposition
that the pr orityin economic
available
to governments
to dealwith the typesof
management
shouldbe the maintenance
of low
(15 marks)
unem ploy m en
int 1 a .(' 1 5ma rk s )
unemployment.
2a ldentifythe components
o{ aggregate
demandand
brieflyexplaintwo factorsthat mightdetermineeachof
(10 marks)
thesecomponenls.
2b Evaluate
the likeiyimpacton an economyof a
substantial
risein the levelof interestrates.(15 marks)
3a Explain
the costsof inflationand deflation.('i0 marks)
policies
3b Evaluate
demand-side
asa meansof reducing
inflation.(15 marks)
?h
Explain
the relatonshipbetweenthe Lorenzcurveand
(10 marks)
the Cinlcoefficient.
Evaluatethe effectiveness
of the variousmethodsthat
jncome.(15 marks)
governments
may useto redistribute
Explain
how interestratescanbe usedto bringaboutan
(10 marks)
Increase
in economicactivity.
3b Discuss
the strengths
andweaknesses
of demand-side
pollcies.
(15 rnarks)
4a Theworld economymaybe subjected
(10 marks)
to economic
4a What arethe possibe causesof unemployment?
shocks,
possible
policies
suchasa suddenincrease
in oll prlcesand
4b Evaluate
that maybe usedto lowerthe
terroristattacks.
With the helpof an aggregate
demand/
naturalrateof unemployment(15 rnarks)
aggregate
supplydiagramexplainthe possible
economic
5a Whatarethe macroeconomic
ob]ectvesof governrnent?
effectsof suchshocks.('10marks)
(10 marks)
4b Evaluate
the maineconomicpolicies
that governments
5D Assume
the government
chooses
to pursueone of these
might useto minimizetheseeffects.(15 marks)
objectives.
possible
Evaluate
the
consequences
for the
(10 marks)
5a Explain
(15 marks)
the variouscostsof unemployment.
otherobjectives.
policies
5b Evaluate
the alternative
almedat reducing
6a With the helpof d agramsdistinguish
betweendemand'
('l5 marks)
unemployment.
pulland cost-push
inflation.(10 marks)
6a Brleflyexplainthe mainpolicyobjectives
of governments. 6b Explain
whlch policeswouldbe appropriate
to dealwith
( 10 m ar k s )
thesetwo typesof inflation.(15 marks)
6b Discuss
the waysfiscalpolicymight be usedto achieve
Explain
the dlfference
betweendemand-side
and supply(15 marks)
theseobjectives.
(10 marks)
sideeconomlcpollcies.
7a With tl"erelp ol examples
explan the pJrposeo- the
7b 'Highereconomic
throughthe
Arowthcanonlybe achieved
policies.
(10 marks)
varioussupply-side
implementation
(15marks)
policies.'
of supply-side
Discuss.
7b Evaluate
the success
of thesemeasures
in countries
8a Expa n the economicproblems
that high unemployment
(15 marks)
wherethey havebeenimplemented.
maycausefor a country(10 marks)
8a What macroeconomic
policies
shoulda government
8b Discuss
the reasons
why governments
find the goalof
(15 marks)
adoptif it wishedto reduceaggregate
full employment
demandin an
difflcultto achieve.
(10 marks)
economy?
8b Shoulda government
attemptto managethe levelof
aggregate
demandto influence
and
unemployment
inflationrates?(15 marks)
-9::l
Grossdomestic
rn her moneywage but pricesof goodsand serviceshave
alsoincreased
by 5% then her realwage hasremained
constantas shecan buy on averageexactlythe sameas
before.
Measurement
of GDP
F
,
I
Thereare three conceptuallyequivalentwaysof arrivingat
the GDPfigurefor a country:
. the output method,wherewe add all domestically
producedfinalgoodsand services;
. the expendituremethod,wherewe add all expenditures
madeon domestically
producedfinalgoodsand services;
. the incomemethod, wherewe add all incomes
generated
in the domesticproductionprocess.
Conceptually
the threemethodsareequivalent
and,with
someminoradjustments,
the figuresarrivedat througheach
methodareequal.Thevalueof all outputproduceddid not
becomethin air but endedup in 'Dockets'
in the form of
wages,profits,interestor rent, i.e. as incometo the factors
of produclioninvolved.
Thisincomeis then spenton thjs
output.Eachmethodis usefulbecause
of the breakdownit
permits.Theoutputmethod,for example,
will giveusthe
shareof total output accountedfor by eachof the three
sectorsof an economyaswell asthe output of different
industries.
Theexpenditure
methodpermitsusto monitor
the levelof jnvestment
spendingthroughtime or the
proportionof governmentexpendituresin total economic
activity.The incomemethod providesinformationabout the
proportionof total incomeearnedby labourin contrastto
ownersof capital.
Problems
in GDPmeasurement
Twominoraccounting
compliGations
Domestic
outputor incomevs.nationaloutputor
income
Grossdomesticproductrefersto output produced
withinthe boundaries
of a countryindependently
of
the nationalityof the factorsof productioninvolved.
Grossnationalproductrefersto the valueof final output
producedby domesticallyowned factorsof production
independently
of whereproducLion
actuailytakesplace.
Forexample,UK GNPfigureswill includethe income
earnedby Britishmuliinational
corporations
abroad
but will not includethe incomeearnedbv foreion
multinalional
corporations
in the UK.
To convertGDPto GNP;
GNP= GDP+ Net FactorIncomefrom Abroad
whereNet FactorIncomefrom Abroad= (incomeearned
abroad- incomepaidabroad)
Grossvs. net
. Someportionof investment
spendingis aimedat
replacing
obsoletecapitalequipment(knownas
depreciation,
or capitalconsumption).
Thestockof capital
of an economyactuallyincreases
only by the difference
between(gross)investmentspendingand depreciation.
Net Investment= GrosslnvestmFnf- c:niiAI
Consumption
and
N N P = GN P -D epreci ati on
. Furthermore,
'do it yourself'activities
arenot included.
lf
Joey
repairs
hiscarhimselfinsteadof takingit to the
. GDPmeasurement
is fraughtwith problems.
mechanic
the valueof the servicehe produces
will not
. OfficialGDPfiguresin manycountriesunderstate
the
show
up
in
official
statistics.
true levelof economicactivitybecauseof the existenceof
. Thisbecomesan importantissuein the caseof many
(or black,shadow)economy.
a largeparallel
lndividuals
developing
countriesbecause
subsistence
farming
ln manycountries
underreport
theirincomesto avoid
(definedasfarmingto feedone'sfamily)is not included
taxation.A heavytax burden,especially
high marginal
in GDPmeasurements,
thustendingto underestimate
per
(r.e.top)taxratesmay be responsible
for thistax-evading
capita
incomelevels.
behaviour.Someproductiveactivitymay alsobe illegalper
. Lastly,
datacollection
in manycountriesis poorand
se (drugs,prostitution,etc.).
unreliable.
lB Questions:
Section
3 continued
HLShortEssays
I
I
tt
I
I 'Macroeconomic
equilibrium
doesnot necessarily
occur
at full empioyment.'
Explain
thisstatementusingthe
concepts
of inflationary
and defiationary
gaps.
!a
2 Explainhow a progressive
tax systemmay be usedto
redistribute
income.
:
I
3 Explainhow an increasein governmentspendingcan
Jeadto crowdingout.
I
5€ctio
10 Usean AD/ASdiagrarnto analysethe likelyeffectsof an
increase
in incometax.
1'l Examine
two reasons
why a government
mjghtwishto
control increases
in its expenditures.
'12 Explain
why the goalof full employment
mightconflict
with the goalof economjcArowth.
'13 What is demand-pull
jnflationand what can
governmentsdo about jtZ
4 Explain
the mulriplier
effectof an increase
in government 14 Usean AD/ASdiagramto explainhow cost-push
spendtng.
inflationmay occur and outlinetwo waysin which jt
mightbe controlled.
5 Explain
how the multiplierandthe accelerator
might be
linkedto eachother
15 Whatarethe likelyconsequences
of deflation?
6 Explainhow doublecountingcanoccurin calculating
nationalincomeand how measuring
valueaddedcan
overcomethis problem.
7 Keynesians
and l,4onetarists
havedifferentviewsof
the likelyshapeof a countrySaggregatesupplycurve.
Usingdiagrams
showhow theseshapescanaffect
macroeconomic
policy.
8 Whatarethe mainproblemsinvolvedin measuring
inflation?
9 Usean AD/ASdiagramto analysethe likelyeffectsof an
increasein interestrates.
16 Usea Phillips
curveto explainthe conceptof the natural
rateof unemployment.
Whymightknowledge
of the shapeof a country,s
Phillips
curvebeuseful
to policymakers?
18 Explain
two policies
thata government
mightuseto
dealwiththeproblem
(cyclical)
of demand-deficient
unemployment,
19 Whatisstructural
unemployment
andwhatmeasures
mr9ht9overnments
taketo combatit?
Ti
Fr
S
iA
;
i.