Chapter 8: The Level of Overall Economic Activity

8.1: Economic Activity

- Households own the factors of production, which they sell to the firm.
- The firm uses these to produce goods and services, which they sell to households.
Land – rent
Labor – wages
Capital – interest
Entrepreneurship – profit
Income flow (firms to households) = expenditure flow (households to firms)
Value of output = expenditure on them = income
Injections = investment, govt spending, exports. (INCOME SPENT ON GOODS AND SERVICES0
Leakages/withdrawals = saving, taxes, imports. (INCOME NOT SPENT ON GOODS AND
SERVICES)
1. Savings – consumer income that is not spent but saved. (leakage, because it is not spent
buying goods or services.)
2. Investment = spending by firms for the production of capital goods.
These two are linked, because consumers save their money by putting it in financial markets such as
bank accounts or stocks, and firms get their money through these financial markets, thus money lost
as leakages is regained as an injection.
1. Taxes = paid to the govt. leakage b/c it is not spent on goods and services.
2. Govt spending = use taxes to fund govt expenditure = injection.
Money goes out as taxes and comes back as govt spending.
1. Imports = leakage because it goes out as expenditure to other countries.
2. Exports = injection because it is money spent by foreigners on goods and services.
Real world – leakages are not equal to injections.
When leakages are more, circular flow size becomes smaller.
WHEN leakage > injection, the money that flows out doesn’t return, so expenditure decreases = firms
downsize = unemployment = household income decreases.
WHEN injection > leakage, circular flow becomes larger. Firms produce more, unemployment falls,
households have greater income.
EQUILIBRIUM = when leakages = injections.
- National income = value of output = aggregate output helps us measure growth in comparison
to the past, provides a basis for policymaking, and allows comparison with other economies.
COMPUTING AGGREGATE OUTPUT
 1. Expenditure method – sum of all the spending required to buy all final goods and services
produced by the country in a given time period.
2. Output approach – sum of the value of final goods and services produced in a country in a
given time period. Done by sector, and then all sectors are added up. This allows for
comparison of sector growth.
3. Income approach – adds up income earned by the factors of production that produce all goods
and services produced in a country in a given time period.
Final goods = goods ready for final use. Intermediate goods = goods to be used as inputs for other
goods.
C + I + G + (X – M) = GDP
C = consumer spending (expenditure by households on final goods) (housing is not in this, it is
investing)
I = investment spending (spending by firms on capital goods – machinery, equipment, etc.)
G = govt spending
X – M = net exports = exports – imports.
Intermediate goods are not included because of double-counting.
GDP – Gross Domestic Product – output produced within the country, regardless of who owns them.
Total value of output produced in a country.
GNI – Gross National Income – income of the country’s residents, regardless of where it comes from.
Total income received by residents of a country = value of final goods produced by country’s
residents regardless of where they are.
Nominal value = money value of prices at the moment.
Real value = measure that takes into account changes in price over time.
PER CAPITA MEASUREMENT = per person measurement = important because of differing
populations in countries, and population growth over time.
GROSS measurement = depreciation + net investment.
Net investment = Gross investment – depreciation.
EVALUATION OF national income statistics = cannot accurately be used to draw conclusions about
standards of living, and does not measure true value of output. Why?
Because it does not take into account quality improvements over time, non-market products, parallel
market products, negative externality costs, natural resource depletion, or differing domestic price
levels.
It cannot draw conclusions about standards of living. Health and education aren’t considered, quality
of life factors such as low crime rate or increased life expectancy aren’t counted, economic growth
and not economic development is measured. Leisure hours increased = GDP and GNI falls but
standards of living rise. Wealth distribution not accounted for.
Cleaning up oil spills or treating bad health is shown as expenditure = greater GDP but these are bad
for standards of living.
GREEN GDP = GDP – the value of environmental degradation
Or GREEN GDP = GDP – the value of environmental degradation – p6
World Bank – genuine saving – to see how much is saved for future generations and estimate that
value.
BUSINESS CYCLE = fluctuations in the growth of real output.
Expansion = growth of real GDP.
Peak = a cycle’s maximum real GDP, end of expansion. At peak, unemployment has fallen and
inflation is likely being experienced.
Contraction = falling real GDP. If it lasts six months or more, recession.
Trough = a cycle’s minimum level of GDP, end of contraction. Widespread unemployment.
Unemployment can never be zero due to natural rate of unemployment.
Full employment is when unemployment = natural rate of unemployment.

Chapter 9: Aggregate Demand and Aggregate Supply

Aggregate demand = total quantity of aggregate out (real GDP) that all buyers in an economy want to
buy at different possible price levels. It contains consumer demand (C), firm demand (I), govt demand
(G), and demand by foreigners for exports (X – M).
Wealth = value of assets that people own.
DOWNWARD SLOPE OF THE AD CURVE =
1. Wealth effect. Prices increases, real value of wealth falls, and people feel worse off and cut
back spending, and vice versa.
2. Interest rate. Changes in price = more money needed for purchases. As demand for money
increases, interest rates increase, disposable income decreases, people have lesser to spend
and thus demand less.
3. International trade effect. If domestic price level increases, exports fall, and imports increase.
Net exports fall. Real GDP falls.
Difference between demand and AD – AD has no marginal benefits involved. AD is about all goods,
not just one good, and about ALL buyers, not just consumers.
SHIFTS IN THE AD CURVE
1. Consumer confidence (measure of how confident consumers are in the future of the economy)
if they are expecting good things, they will spend more, and curve shifts right. M –
questionnaires.
2. Interest rates – interest rates increase, purchasing power falls, curve shifts left.
3. Wealth – value increases = spend more = curve shifts right.
4. Personal income tax or business tax – (taxes paid by households on their incomes) – if it
increases, disposable income decreases, AD shifts left.
5. Indebtedness (personal and corporate) – high levels of debt means AD shifts left bc they have
to pay that back.
6. Business confidence – if firms are confident about future sales, they invest, AD shifts right.
7. Improvements in technology – stimulate investment spending = AD shifts right.
8. Legal changes.
9. GOVT – changes in political/economic priorities – to stimulate or not?
 10. Changes in national income abroad – if foreigners have more income, they buy more =
exports increase, AD curve shifts right.
11. Changes in exchange rates. If domestic exchange rates rise, then exports fall and imports rise,
so net exports fall, and AD shifts left.
12. Trade and tariff – if Country A has tariffs placed, then exports fall, net exports fall, AD shifts
left.
Slopes upward because as price levels increase, production becomes more profitable. Resources
prices don’t change because it is short run, and thus profits increase.
SHIFTS IN SRAS
Caused by changes in cost of production. Labor costs, non-labor costs, business taxes rise, subsidies
offered change. When COP rises, AS shifts left. Supply shocks = capital often destroyed = AS shifts
left.
RECESSIONARY GAP – at the price level, the four components want to buy less than the potential.
The AD is not worth firms producing at potential, and firms cut down. Unemployment rises, so it is
higher than the rate of natural unemployment.
INFLATIONARY GAP – at the price level, the four components want to buy more than the potential.
There is too much demand in the economy, and the firms try to produce more. Unemployment falls
below the rate of natural unemployment.
FULL EMPLOYMENT LEVEL OF REAL GDP – unemployment = natural rate of unemployment.
In the long run, economies cannot experience inflation or recession and move into full employment
equilibrium. NEOCLASSICAL MODEL
SHORT RUN = prices don’t change much. LONG RUN = prices of all resources are flexible.
AS = total quantity of goods and services produced in an economy over a time period at different
price levels.
Keynesian counter – New classical theory depends on the idea that resource and product prices are
flexible. Wages don’t fall even in unemployment because of things like minimum wage legislation,
trade unions, labor contracts, etc. Also, product prices will not fall because firms don’t want a loss.
Oligopolistic firms will either collude and not lower the prices, because then they might get into a
price war.
ECONOMY DOES NOT AUTOMATICALLY TEND TOWARDS FULL EMPLOYMENT
EQUILIBRIUM.
If prices don’t change, economy is stuck in the short run. If wages don’t fall, SRAS can’t fall –
demand just keeps decreasing and the problem is not fixed.
KEYNESIAN AS CURVE
Section 1 – low real GDP. PL remains constant as this increases. Unemployed capital that the firm can
use. (Spare capacity)
Section 2 – real GDP increases and price increases. Output increase = resources used = no more spare
capacity. Wages and resource prices rise. COP increases.
Section 3 – Real GDP cannot increase anymore. Any efforts on the part of the firm = rise in price
level.
Recessionary gaps can persist for long periods of time.
Rightwards shifts of the AD do not always cause increases in price level. That always happens in the
new classical model.
SHIFTS IN THE LRAS TO THE RIGHT
1. Increase in quantity of factors of production.
2. Improvements in quality of factors of production.
3. Increased efficiency.
4. Technological improvements.
5. Institutional changes – how to allocate resources?*
6. Reduction in natural rates of unemployment.
SHIFTING THE SRAS CURVE WITHOUT IMPACTING LRAS – temporary conditions, example
inclement weather, that impact output for a short time only.
Definitions
1. Aggregate demand
2. Aggregate supply
3. Unemployment – When an able-bodied person of the working age group who is willing to
work or seeking work at the prevailing wage rate but is unable to find a job. (involuntary)
4. Underemployed – When a person is working below his skillset / when a person is working
less than the required number of hours which he can work. (eg: part-time and not full-time /
can be voluntary)
5. Inflation – sustained rise in the average price levels over a period of time.
6. Stagflation – stagnation + inflation – fall in real GDP, increase in UET.
7. Hyperinflation – Deficit financing – printing more notes as a last resort measure.
8. Disinflation – a fall in the rate of inflation – prices are still rising, but slower than before.
9. Inflationary gap – when the real GDP is more than the potential GDP, leading to inflation in
the economy.
10. Deflationary/recessionary gap – when the potential GDP is more than the real GDP, leading
to deflation in the economy. (Only because of AD shifts)
11. Deflation – sustained decrease in average price levels over a period of time.
12. Hysteresis – when employees lose their skills after being unemployed for a long time.
13. Consumer goods – bought by a household for direct satisfaction of wants.
14. Intermediate goods – goods that help with the further production of goods and services and
are either completely used up or resold within the year.
15. Capital goods – help in further production of goods and services and are not completely used
up, eg. machinery.
16. End-use classification – classifying goods by the group that is purchasing them (capital,
intermediate, consumer)
17. Purchasing power – Quantity of goods that an individual can purchase with his money (Y) at
a given price level.
18. Menu cost – cost of reprinting menus when prices change / burden on retail business.
19. Shoe leather cost – Time / effort / energy spent searching for the best deal (opportunity cost of
time spent).

Chapter 10: Macroeconomic Objectives I – Low

Unemployment, Low and Stable Rate of Inflation
UNEMPLOYMENT
 1. Labor force = unemployed + employed people.
2. The labor force does not include children, retired people, adult students, disabled people.
3. Difficulties in measuring unemployment:
a. Underestimation – does not include discouraged workers – people who have stopped
looking due to repeated rejections.
b. Underestimation – does not make a distinction between full-time and part-time workers –
so people may be underemployed.
c. Does not include people who leave their jobs to be retrained.
d. Unemployment figures do not account for the type of work done by the individual
(underemployment?)
4. Economic consequences of UET:
a. Government has to support the unemployed via unemployment benefit = opportunity cost
= other welfare projects given up.
b. Loss in real GDP / output, since lesser people employed and contributing.
c. Loss in taxes – lesser income tax = budget deficit = loans and deficits in the future
because of the borrowing.
d. Unemployment benefits mean that people will be dependent and thus reluctant to find
jobs.
e. Government will have to spend more on controlling crime rates (LT)
f. Long term unemployment = hysteresis = falling productivity if they return to work.
g. Some people are not earning, others are = income distribution changes, gap between rich
and poor increases.
5. Social / personal causes of unemployment:
a. Hysteresis = fall in self-confidence and self-esteem.
b. Low standards of living.
c. Homelessness, crime rates increase.
d. Consumption of demerit goods increases.
e. Psychological effects: depression, anxiety, suicidal tendencies increase.
f. Family tensions rise, divorce rates, etc.
6. Causes of UET:
a. Cyclical UET: Caused by a fall in AD. AD falls, producers produce less, downsizing and
workers fired.
b. Structural UET: arises due to the mismatch in supply and demand of labor skills, OR
labor market rigidities, OR change in the geographical location of industries. Derived
demand – derived from the demand for goods they produce. Technical development may
cause it (eg: computers came and typists were fired).
c. Labor market rigidities:
I. Minimum wage legislation (role of trade unions to negotiate)
II. Employment contracts – harder for employers to fire workers (so they are more
reluctant to hire)
III. Generous UET benefits – thus reluctant to be employed.
IV. Seasonal UET – not employed throughout the year, eg: umbrellas, etc.
d. Frictional UET: moving between jobs. (also due to lack of information)

INFLATION
1. Measuring UET:
a. CPI (Consumer Price Index) – shows the cost of living for a typical household –
compares the value of the basket of goods and services for a particular class of consumer
in the current year as compared to the value of the same basket of goods and services in
the base year. (Cost of living index)
2. Problems of using CPI
a. Different rates of inflation for different consumers (depending on the different quantities
consumed by different types of consumers (economic levels))
b. Different rates of inflation depending on cultural / regional difference: eg: South Indians
buy more rice than North Indians – inflation affects them differently.
c. Consumption patterns change due to change in relative prices. (substitute goods)
d. Consumers using ‘sales’ / discount times due to which consumption time is affected.
e. Consumption changes due to new products introduced – the base year basket does not
have that or take it into account.
f. Can’t be used to compare countries.
g. Comparability is not possible over a long period of time – goods go in and out of the
‘basket.’
3. Core rate of inflation: calculating inflation by ignoring certain goods like food and energy
(oil) which are highly volatile in nature (Then CPI)
4. Producer Price Index: several indices of prices which are received by the producer at different
stages of the production process. (PPI for inputs, intermediate goods, and final goods).
5. Consequences of Inflation:
a. Redistribution effects:
Better off Worse off
Savers if the rate of interest is greater People who receive a fixed income (PP
than the rate of inflation. falls, RV of money falls)
Lenders if the rate of interest is greater Savers if the rate of inflation is greater than
than the rate of inflation. the rate of interest.
Borrowers if rate of inflation is lesser Lenders if the rate of inflation is greater
than rate of inflation. than the rate of interest.
Payers of fixed incomes, because the real - Holders of cash, since PP has
value of money falls, purchasing power fallen.
falls. - People who receive incomes that
increase less rapidly than inflation.
- Borrowers when rate of interest is
greater than rate of inflation.

b. Uncertainty – investors, consumers, producers are all uncertain due to the rising prices.
Consumers and investors postpone their expenditure, demand falls, producers produce
less.
c. Menu cost and shoe leather cost.
d. Money illusion – some people feel better off after receiving incomes not realizing that the
PP has fallen – fail to realize that the prices have also risen, and start behaving
irrationally.
e. Reduces international competitiveness – prices in Country X rise faster than Country Y,
so exports for Country X fall and imports rise, so the balance between net exports
becomes unfavorable.
6. Types of inflation:
a. Demand pull – Excess of AD over AS at the full employment level which leads to
inflation in the economy.
b. Cost pull inflation – increase in cost of production due to supply-side shocks. (increase
can be because of rise in wages, rise in material prices, natural calamities, and rising oil
prices.)
7. Demand pull inflation
a. UET is lesser than NRU
b. No cyclical UET
 8. Cost pull inflation
a. UET is greater than NRU
b. No cyclical unemployment.
c. Stagflation.
d. Demand deficient UET.
e. Stagflation – (UET rises, APL rises)
9. Deflation – rarely seen in real-life situations.
10. Why not in real life?
a. The wages of the workers do not fall (trade unions) and since the wages do not fall,
sellers find it difficult to cut costs, hence prices don’t usually fall.
b. Falling prices might lead to price wars, especially in oligopolistic firms since the rival’s
reaction is unknown – so prices don’t usually fall to avoid price wars.
c. Firms avoid price drops due to menu cost as well.
11. Types of deflation – good deflation and bad deflation.
12. Good deflation – due to increase in AS.
13. Bad deflation – due to fall in AD
a. AD falls = consumers postpone consumption, so prices fall further, and UET rises. As
UET rises, AD goes further down (people go on postponing).
b. SRAS shifts to the right since the cost of production falls (because workers are insecure
and accept lower wages. Spiral begins after second AD push.
14. Consequences of deflation:
a. Redistribution effects
Better off Worse off
Borrowers, if rate of interest is lesser than Borrowers when rate of interest is greater
rate of deflation. than rate of deflation.
Holder of cash (purchasing power and RV
of money has risen)
Savers if rate of interest is greater than Savers when rate of interest is lesser than
rate of deflation. rate of deflation.
Lenders when rate of interest is greater Lenders when rate of interest is lesser
than rate of deflation. than rate of deflation.
Receivers of fixed incomes since RV of Payers of fixed income since RV of
money has risen. money has risen.

b. Uncertainty – consumers are postponing consumption, so producers are postponing

production.
c. Menu cost / shoe leather cost.
d. Deflationary spiral (may go from recession to depression).
e. Bankruptcies increase (as the real value of money increases, so does the value of debt).

Chapter 11: Macroeconomic Objectives II – Economic

Growth and Equity in the Distribution of Income
1. Economic growth – sustained increase in real per capita GDP over a period of time (1
financial year) or growth in real GDP.
2. GDP – Money value of all financial goods and services produced during the year.
3. Final goods – consumer goods (CG) + capital goods (KG)
4. Real GDP – GDP measured at base year prices
5. RGDP is a better indicator of economic growth than NGDP (since it nullifies the impact of
price changes), and real per capita GDP is a better indicator than RGDP (since it measures
real GDP per person).
6. If there is a positive growth rate of RGDP, then relate it to GDP per capita using the
population growth. If the population growth rate is higher than GDP growth rate, then GDP
per capita growth rate is usually negative, and vice versa.
7. Rates of growth impact RGDP, which is why policies focus on it.
8. A PPC shows combinations of maximum output that can be produced by an economy with
fixed resources and technology, provided that there is full or maximum use of resources and
productive efficiency.
9. Most economies produce within the PPC because being on the PPC means no unemployment,
which is hard. The further away from the point, the greater the productive inefficiency and
resources wastage.
10. Reduction in unemployment and better use of resources means more actual output produced.
11. Factors that lead to shifts in the PPC: increase in the quantity of resources, and improvements
in the quality of resources, such as more skilled workers or improvements in physical capital
through technological change.
12. The ET levels must be kept high as well as productive efficiency because if not then the shifts
don’t mean anything. (eg: having more skilled workers but if UET is high then they are just
unable to work)
13. Inward shifts of the PPC – decrease in quantity or quality.
14. Non-parallel shifts of the PPC – when improvements are made that favour one good –
example an influx of unskilled workers means more quantity of resources to produce a good
that requires unskilled workers – or technological improvements that help with Good X and
not Good Y.
15. Human capital – the knowledge, skills, health, and ability of the labour.
16. Physical capital – capital goods like machines that help with the production process. (future
stream of benefits).
17. Natural capital – land or resources found in nature. (eg: biodiversity, environment, oil in the
land, minerals, metals, etc.) Can be depleted (cutting, mining, etc.) or replenished.
Maintenance of natural capital helps the quality and quantity of resources.
18. Improved capital goods mean capital goods that embody new and improved technology that
allow workers to increase output. (result of investment)
19. Investment in human capital is things like education and hospitals (sanitation, unpolluted
environment, clean water, access to healthcare, etc.) that allow workers to improve their skills
and health, so that they can produce greater output.
20. Natural capital:
a. Marketable commodities – (timber, metal, etc.) – can contribute to growth but are not
essential.
b. Ecological goods and common-access resources – crucial to long term growth (eg: soil
quality, air quality, etc.) Sustainable development – leaving enough good quality
resources for future generations. (inward shifts of PPC if not).
21. Productivity – output produced per hour by each member of the working population. More
productivity = economic growth b/c more output. Results in outward shifts of the PPC.
22. Causes of increases in productivity –
a. Increase in the quality and quantity of physical capital through investment in technology.
b. Increase in the quality and quantity of human capital through investment in education and
healthcare.
c. Improvements in / maintenance of natural capital through investments.
23. PPC: illustrates how present choices affect future PPC. In order for greater economic growth
via shifts in the PPC, consumption has to be sacrificed for investment in capital goods.
24. Consumption here refers to instant consumer goods.
25. Investments require saving – so they can borrow from other countries or accept foreign
investment.
26. LRAS curve, unlike the PPC, shifts to the right for the same reasons except it’s fall in NRU
(where PPC its all UET) and institutional changes, which are not seen in PPC.
27. Consequences of economic growth – unemployment falls since output increases, so consumer
income increases, so UET falls, standards of living rise, inflation increases due to AD rising,
etc.
28. Equity – the idea of being fair or just and Equality – the idea of being equal with respect to
something.
29. The problem of income inequality rises because the ownership of factors of production is
unequal and their prices vary enormously, and income depends on how individuals can sell
the factors of production they own.
30. Market-determined income distribution is usually highly unequal because some people have
additional advantages like land that they give for rent – or the economy is simply not big
enough to ensure that everyone is employed.
31. Redistribution – governments changing the market determined distribution of income and
output to a more socially desirable outcome.
32. Quintile – 20% population of a country (example: poorest 20%, richest 20%)
33. A Lorenz curve is sued to show the degree of income inequality in a country.
34. Perfect equality line – 20% of the income for 20% of the population, etc. (x = y)
35. The Lorenz curve plots the actual relationship between the income and the population. The
closer the curve is to the perfect equality line, the lesser the income inequality.
36. The Gini coefficient has a value from 0 to 1 – the larger the coefficient, the higher the income
inequality. Perfect income equality means the Gini coefficient would be zero.
37. If a single household receives all the income in an economy, Gini coefficient = 1.
38. Poverty – an inability to satisfy minimum consumption needs.
39. Poverty line – an income level considered minimally sufficient to sustain a family in terms of
food, clothing, housing, and other basic needs.
40. Extreme poverty – less than $ 1.25. Moderate poverty – less than $ 2.
41. Absolute poverty – below the poverty line.
42. Relative poverty – comparing incomes to median incomes. If income were equally
distributed, there would be no relative poverty, because no one would earn more than anyone
else. The greater the degree of income inequality, the greater the relative poverty.
43. Causes of poverty –
a. UET – receiving no income, and UET benefits, if given, are usually very less and for
limited time periods.
b. Lack of human capital – less skills and poorer health means less productivity and
generally lesser income.
c. Low levels of capital or land ownership – gives them an income advantage. Without this,
they have to pay rent (added cost).
d. Discrimination – leads to lower income for same work.
e. Geography – remote areas with lower employment possibilities.
f. Age – cannot be employed + pensions are usually not in the informal sector.
g. Limited social services – reliance on government prerogatives that may or may not
happen (merit goods).
h. Poverty (vicious cycle)
44. Consequences of poverty –
a. Low living standards
b. Lack of access to education of healthcare
c. Greater chances of infant or maternal mortality
d. More preventable diseases
e. More social problems (drug use, crime rates, divorce rates, family breakdowns)
 f. Inability to realize full potential (means they remain unskilled and impact the economy
and the PPC)
45. Methods to promote equity –
a. Transfer payments – payments made by the government to individuals for the specific
purpose of redistributing incomes away from certain groups and towards others. (from
taxes, fines, etc.) Types of transfer payments are UET benefits, housing benefits, student
grants, maternity benefits, etc. made to vulnerable people – the sick, the old, the poor, etc.
b. Subsidized or direct provision of merit goods – merit goods beneficial for society and if
they were left up to market forces, they would be underproduced and underconsumed, so
governments have to make it affordable to vulnerable groups. Eg: education, healthcare.
c. Government intervention: minimum wage legislation, food price ceilings, price floors for
farmers.
46. Taxation – source of funds for such policies (transfer payments, etc.)
47. Direct taxes – these are unavoidable taxes paid directly to the government authorities by the
taxpayer, such as:
a. Personal income taxes – paid by households and individuals on income (wages, salaries,
rental income, income from dividends on shares, interest income).
b. Corporate profit tax – separate legal entities, so tax on their profits / income.
c. Wealth taxes – tax on ownership of assets (property taxes and inheritance taxes)
d. Payroll taxes / social insurance (security) contributions – paid by workers and their
employers not to the government but into specific funds used to finance specific
expenditures, such as pensions. (Earmarked taxation)
48. Indirect taxes – taxes on expenditure on goods and services. Consumers pay for part or all of
the taxes but it is indirect because they do so through the supplier.
a. General expenditure / sales tax – tax on expenditure. Also called VAT (value-added tax)
for the value added at each stage of production. Paid by the consumer.
b. Excise taxes – indirect taxes paid on specific goods and services, such as cigarettes or
gasoline, and split between the firm and the consumer. Size of tax burden determined by
PED and PES.
c. Customs duties / tariffs – tax on imports of foreign goods (don’t to either reduce Mts or
increase government revenue).
49. Proportional taxation – as income increases, the fraction of income paid as taxes remains
constant. (constant tax rate)
50. Progressive taxation – as income increases, the fraction of income paid as taxes increases.
(increasing tax rate).
51. Regressive taxation – as income increases, the fraction of income paid as taxes decreases.
(decreasing tax rate). Makes income distribution less equal.
52. Exclusions – a certain level of income that is not taxed, usually in proportional systems,
where the taxable income = income – exclusion, making it in effect progressive. So, the
systems usually vary in terms of how progressive they are.
53. Indirect taxes are regressive because they are the same for everybody, meaning that they are a
greater percentage of a poor man’s income than a rich man’s income. However, some goods,
depending on necessity, are exempt from indirect taxation, making it somewhat progressive.
54. Average tax rate – tax paid divided by total income, expressed as a percentage.
55. Marginal tax rate – tax rate paid on additional income.
56. In the absence of market failure, everything is run by prices. Taxation alters the relative after-
tax prices of goods, and some economists argue that this leads to allocative inefficiency –
since taxes are put to move the market towards socially desirable goods, technically, the
economy is producing what should be produced and not what the consumers want.
57. Income equality requires progressive taxes. Progressive taxes will discourage higher earners,
reduce savings and thus reduce investment, and also ensure that high earners (hence good
 workers) will be demotivated and less productive, leading to lower efficiency. (high marginal
tax rates).
58. Indirect taxes – (VAT is fine because it remains constant) but excise taxes mess with prices
and thus lead to allocative inefficiency.
59. Counterarguments:
a. These are all only theoretical, not practical.
b. Make business cycle fluctuations lesser (fewer recessions and inflations) meaning lesser
impact on resources and investment (I).
c. Greater equality could promote economic growth because people lifted from poverty can
then work and become skilled and benefit everyone = more efficient use of resources.
60. Transfer payments and allocative efficiency –
a. On one hand, benefits mean that they will be reluctant to find work, and continue
depending on the government, causing a strain on resources and opportunity cost.
b. However, it is necessary for vulnerable groups and can act to decrease chances of
recession or inflation.
61. Government expenditures and allocative efficiency –
a. On one hand, opportunity cost.
b. However, spending on merit goods is actually correcting a misallocation of resources
since merit goods are underprovided, underconsumed, and underallocated.
62. Government intervention in markets and allocative efficiency – often leads to resource
misallocation and the loss of social surplus.

Chapter 12: Demand-Side and Supply-Side Policies

1. Demand-side / demand management policies – required to stabilize the fluctuations in the
business cycle by influencing the AD in the economy. (Any change in consumer behavior
leads to change in AD and RGDP which affects the business cycle).
2. Discretionary policies (dd side)
a. Fiscal Policy (expansionary FP and contractionary FP) – focuses on short term
stabilization, but can affect the long term by providing the stable macroeconomic
environment that firms needs to pursue economic growth. Direct effects on growth –
encourage government expenditure and investment in capital that improves technology or
infrastructure and increases productivity).
b. Monetary Policy (expansionary MP and contractionary MP)
3. Non-discretionary Policies / automatic stabilizers (dd side)
a. Progressive income tax – prevents high-earning workers from spending too much so C is
regulated and AD doesn’t rise too much (inflation)
b. Unemployment benefits – even as workers are unemployed, their consumption is
maintained, so AD isn’t too hard-hit.
c. Disinvestment (sale of shares to private sector)
Fiscal Policy
1. Government Budget

Receipts (Revenue) Expenditure

Revenue Receipt (RR)
- Does not increase the liability of the
government, and does not decrease the
assets
- Tax receipts – income earned from
direct and indirect taxes
Revenue / current expenditure (RE)
- Recurring expenditure on day-to-day
activities. Neither decreases liability not
increases assets.
- Employee salary
- Expenditure on asset maintenance
- UET benefits (transfer payments)
 - Non-tax receipts – Fines, dividends
from shares, fees, etc.
Capital Receipt (KR)
- Either increases liability of the
government or decreases the assets.
- Borrowing
- Disinvestment
- Recovery of loans (when a loan is
given, an asset is created – so when a
loan is recovered, the asset goes)
- Repayment of interest (only interest is
repaid, not the loan, so the liability is
still there)
Capital expenditure (KE)
- Either decreases liability or increases
assets
- Repayment of loans (liability goes)
- Construction of dam or road (asset)
- Investment grant
- Transfer payment (war damages, etc.)

Balanced budget à total revenue = total expenditure (RR + KR = RE + KE)

Surplus budget à TR is greater than TE
Deficit budget à TR is lesser than TE
Public / government debt = deficits – surpluses
2. Fiscal Policy – a policy that deals with government or public revenue, public expenditure, and
public debt / borrowing.
a. Expansionary FP – used when economy is in a deflationary gap (objective is rise in AD)
Expansionary Contractionary Negative effects Positive effects
Government increases Government reduces Time lags – Can limit recession.
government expenditure. government implementation takes
Multiplier effect leads to expenditure. time due to political Can limit inflation.
government expenditure AD falls. (Multiplier constraints (various
+ induced expenditure. effect). parties mean Can target particular
Indirect effect – UET indecisiveness). sectors of the
decreases, consumer Y economy.
increases, consumer Crowding out –
expenditure increases, increase in spending Direct impact of
and AD increases. without increase in government exp on
Government reduces Government increases revenue, leading to AD (G) – helps with
taxes. taxes. excessive borrowing. certainty – but taxes
Reduce in Y tax means Increase in income tax Govt borrowing leads may not have such
higher disposable means decreased to an increase in the an effect all the
income, higher disposable income and demand for money, time.
consumer expenditure, lesser consumer leading to an increase
and an increase in AD. expenditure = fall in in roi, meaning lower Ability to affect
Reduce in corporate AD. investment spending output directly and
profit tax means Increase in corporate of private firms, or the indirectly.
company profits profit tax means lesser crowding out of
increases, investment profits and lesser private investment.
increases, and AD investment = fall in
increases. AD. Cannot address
Reduce in indirect taxes Increasing indirect stagflation, where both
= fall in inequalities = taxes = rise in prices and UET are
rise in AD. inequalities = fall in rising.
AD.
Government increases Government reduces Tax cuts don’t work in
borrowing. borrowing. recession because
pessimism means that
 Government then Government MPS increases and
invests, employment expenditure and spending doesn’t.
increases, income investment fall,
increases, consumer unemployment rises, Cannot fine tune to a
expenditure increases, income falls, specific level because
AD increases. consumer expenditure there are too many
falls, AD falls. factors controlling AD
Ratchet effect. that the government
cannot control.

Real life example – Greece (expansionary policy)

Crisis hit Greece after the worldwide Great Recession of 2007 – 2008, where aftershocks were felt
in 2010 after the government increased taxation and austerity measures. The confidence in the
economy fell and so led to recession in the economy. The government increased its borrowing from
the IMF and other European banks to invest in the economy to increase the AD.

3. Monetary Policies – the policy that deals with the supply of money and credit in the economy.
a. Central banks – banks for the government, and deals with commercial banks.
b. Commercial banks – deals with the common public.
Functions of the Central Bank
1. Banker to the government – provides guidance on loans, rate of interest, et cetera.
2. Banker to the commercial banks – commercial banks have to keep a certain percentage of
their deposits with the central banks as reserves (cash reserve rates (CRR))
3. Regulates the commercial banks:
a. Gives guidance on who to lend to, when to lend, which sector, etc.
b. Commercial banks have to submit their books to the central bank.
c. Central bank has to approve mergers between commercial banks.
4. Lender of last resort – if commercial banks cannot pay, they borrow from the central bank.
5. Controller of monetary policy.
*Bank rate – the rate at which CB loans to commercial banks.
*Statutory liquidity deposits - % of total deposits that commercial banks have to keep with themselves
as reserves.
*Open market operations are the buying and selling of bonds in the open market.
- Expansionary MP (when the objective is to increase the AD)
- Contractionary MP (when the objective is to decrease the AD)
Policy Negative effects Positive effects
CB reduces the bank rate. Time lag – for problem to be CB independence – no political
Bank rate reduces so recognized, for policy to take constraints, so quick
commercial banks borrow effect. implementation.
more, then lend more, so
investments and consumer Might be ineffective in No crowding out.
expenditure increases = rise in recession, because monetary
AD. policy presupposes that No political constraints
Reduce the legal reserve ratio. commercial banks are willing because no changes made in
Less CRR and less statutory to adjust their lending rates – in government budget or merit
liquidity deposits. inflation, they will decrease,
 = More disposable funds for
commercial banks, I and C
increase = rise in AD.
Open market operations.
CB buys bonds from
commercial banks so they have
more cash in hand, lending
increases, C and I increase =
rise in AD.
Moral suasion.
Verbal order to do it.
but in recession they may be
reluctant to increase lending
because they fear the
consumers may be unable to
pay them back.
Affects government objectives
+ domestic and foreign market
variables + exchange rates,
creating confusion and conflict.
Demand side policy, so cannot
deal with supply side shocks.
goods provision or taxation
revenues.
Independence from
government – CB can make
decisions that are for the long-
term benefit of the economy
regardless of how politically
unpopular the policies are.
Can do fine-tuning, because
interest rates can be adjusted
incrementally.

Contractionary / tight monetary policies – to decrease aggregate demand by increasing the rate of
interest or decreasing the money supply so that consumers choose to decrease consumption,
investments fall due to high rates of interest, and AD falls.
Inflation targeting monetary policy – where the central bank makes a commitment to a certain level of
inflation in the economy.
1. Advantages of inflation targeting:
a. Low rate of inflation
b. Stable rate of inflation
c. Improved ability to speculate on future rates of inflation – since the CB has opened
communications with the public about the objectives
d. Better coordination between monetary and fiscal policy – govt can complement CB
e. More transparency and accountability for CB
2. Disadvantages of inflation targeting:
a. Reduced ability of CB to pursue other macroeconomic objectives.
b. Reduced ability to respond to supply side shocks – eg if oil prices suddenly rise leading to
stagflation and cost-push inflation, then the CB may need expansionary policy to pull
through which means higher rate of inflation than what they planned
c. Can’t deal w financial crisis – expansionary policy will mean higher inflation rate than
planned
d. Finding the right target – can’t be too high or too low
e. Inflation targeting relies heavily on forecasting, which can be unreliable.
3. Automatic stabilizers – factors that reduce fluctuations in the business cycle without any
interference from government authorities.
a. Progressive taxes
b. UET benefits
Supply-side policies focus on the production side of the economy by increasing production capacity
and institutional framework, and focusing on improving the quantity and quality of factors of
production.
Interventionist supply-side policies:
Presupposes that a free market cannot achieve the desired results of production on its own and
requires government intervention (favored by Keynesian economists).
1. Investment in human capital – training and education (retraining programs for structurally
unemployed workers, skills training to reduce NRU, assistance with relocation for
 geographically unemployed workers, training to make workers more skilled and
productive + education is a merit good so justified). And improvement in and access to
healthcare services (merit good + improves employee productivity = economic growth.
2. Investment in new technology – helps with improvement in physical capital = economic
growth. LRAS to the right in the long run, AD increases in the short run + added
incentives such as tax incentives by govt to private firms to do R & D. Positive
externalities of R & D too.
3. Investment in infrastructure - helps with improvement in physical capital = economic
growth. LRAS to the right in the long run, AD increases in the short run + better
productivity and efficiency.
4. Industrial policies – support for small or medium sized firms, and infant industries, which
receive grants, subsidies, tax exemptions, and tariffs (protection against imports).
Market-based supply side policies:
Presupposes that market automatically tends towards potential GDP and full employment level, and
that the focus of governments should be on creating optimal conditions for that rather than
stabilization.
1. Encouraging competition – forces firms to reduce costs, become more efficient, and
potentially increase the quality of their products. The need to be competitive will ensure that
resources are allocated effectively + LRAS shifts to the right.
a. Privatization – transfer of ownership of a firm from the public to the private sector, on the
premises that government firms are usually more inefficient due to bureaucratic
limitations, high administrative costs, and inefficient workers.
b. Deregulation – elimination or reduction of government regulations on private sectors (on
the assumption that these regulations decrease competition and encourage inefficiency)
(Regulations often control prices and output, which protects firms from competition).
(Social regulations such as worker and public safety from private sector activities are
strengthened though).
c. Private financing of public sector projects – private firms compete to be chosen = increase
in efficiency.
d. Contracting out to the private sector – competition to get the contract.
e. Restricting monopolies – preventing certain mergers, anti-monopoly legislation, etc.
f. Trade liberalization – forcing domestic producers to compete with international ones.
2. Labor market reforms – Reducing labor market rigidities and making the labor market more
competitive to reduce the NRU and lower labor costs.
a. Abolishing minimum wage legislation – more workers can be hired, firms can make
greater profits = investment = economic growth.
b. Weakening the power of trade unions – worker bargaining power falls, they accept lower
wages, more workers hired, firm profits rise = investment = economic growth.
c. Reducing UET benefits – UET people won’t be dependent, forced to look for a job = ET
rises.
d. Reducing job security – firms are more likely to hire if they can fire. Reduced job security
means a worker is forced to be productive if he wants to keep his job. Easy fire means
firms don’t have to pay high compensation to workers when fired = high profits,
economic growth.
3. Incentive related policies
a. Reducing personal income tax – lead to higher after-tax income, leading to an incentive
for people to provide work. Affects the aggregate supply, LRAS shifts right in the long
run.
 b. Lowering taxes on capital gains – higher income, higher savings = investment and
economic growth.
c. Lowering corporate profit tax = investment and R & D expenditure = greater output and
economic growth.
Supply side policies
Advantages Disadvantages
Helpful in a recession by working on the AD Time lags – the supply side stuff needs time to
side and closing the recessionary gap. materialize, such as the R & D and the
investment.
Play important roles in increasing potential
output. In an inflation, it may contribute to inflationary
pressure.
Reduce inflationary pressures – LRAS shifts
right and if AS can keep up with AD then
average price levels face little to no upward
pressures. (COP low)

Arguments favoring:
Interventionist
Investment allows the targeting of sectors to
boost growth.
Industrial policies have allowed the Asian
Tigers to emerge by investment in human
capital = productivity.
Lowering tax rates impacts the demand side too
much, more than supply side, so interventionist
is better.
Market-based
Intervention could lead to allocative inefficiency
while reliance on the market can lead to long
term growth.
Possibility of government failure – due to
political constraints, lack of information, or
unintended consequences of actions.
Intervention requires government spending =
opportunity cost.

Incentive market-based policies lead to deficit in Govt spending also requires high taxes, which
budget. are demotivators for work and thus impact
productivity.
Market-based policies that encourage
competition in the short run could cause Interventionist could lead to budget deficits.
unemployment. Easy firing means firms often
fire workers to keep costs low. Job losses in the
public sector could happen if the contracts are
given to private sector + overall job loss if
contracted to another country.

MB policies also increase the poverty in

individuals by abolishing minimum wage.

Interventionist human capital expenditure

improves equity, MB reduces equity.

Privatization can lead to the private sector

exploiting vulnerable groups with higher prices
than the government would have kept due to
profit-making motives.
Deregulation could adversely impact the
environment.