UNIT 3.

3 MacroEconomic Objectives
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ECONOMIC GROWTH IN THE SHORT TERM AND LONG TERM

- Economic Growth: When a country produces more goods and services in one period than
in a previous one, measured in terms of GDP

Short-term growth
- Can be illustrated using the production possibility curve (PPC) and aggregate supply and
demand diagram
- PPC represents the size of the economy when all resources are fully employed. The
quality and quantity of the factors are what determines the full employment of output
Increase in actual output
- At point A, the economy is underutilizing its FOP. This
occurs when an economy is in recession and output is below full
employment.
- Once economic growth returns and resources are fully
utilized, the economy will experience an increase in actual
output, demonstrating short term growth

Role of AD/AS model

- Aggregate Demand is determined by changes in
consumption, investment, government spending, and/or
net exports and imports - can be influenced by
fiscal/monetary policy, trade policy, and customer
sentiments
- But, a shift in AD without a shift in LRAS will
result in inflation. Therefore, boosting AD is not
sustainable for long-term growth
- A reduction of unemployment through
government policies will also cause an increase in AD as
more people will have the income to spend on consumer goods and services

Long-term growth: increase in potential output

Shifts of the PPC model (growth in production possibilities)
- When there is an increase in the quantity and quality of the factors of production
- When this happens, the PPC model shifts outwards
 Role of LRAS in the AD/AS model
- Economic growth can be shown on the
aggregate supply and demand graph
- While Keynesian and neoclassical
have differing opinions about the time frame
and stick wages regarding short growth, both
agree that long term growth is centered on
increasing capacity for economic activity,
quantity, and quality of factors of production
(land, labor, capital)

Calculate economic growth

𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑦𝑒𝑎𝑟 2 − 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑦𝑒𝑎𝑟 1
Rate of economic growth = 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑦𝑒𝑎𝑟 1
x100

Consequences of economic growth

A. Impact on living standards
- Economic growth has the ability to increase people’s incomes with increases in output,
the extent varies per country
- Can be seen through the poverty rate and purchasing power parity
B. Impact on the environment
- Economic growth has often been blamed for the poor treatment of our environment
- Countries’ pursuit of higher incomes has sometimes been at the expense of the
sustainability of their resources
C. Impact on income distribution
- Income gains can be felt throughout the population, but the equality of this is not assured
- Economic growth may lead to a wider gap between the rich and the poor
- Lower-income households have less disposable income and higher income will be able to
save and invest in a higher income percentage
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UNEMPLOYMENT
- Unemployment = The status of people who are in the workforce, actively seeking
employment, but unable to find it
- Difficult to measure as we cannot survey every person in a country within a reasonable
time frame. Additionally, some people are voluntary not seeking employment and retired
early

Measures of unemployment
- Working Age: 18 to 65 years
 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
Formula: 𝑇𝑜𝑡𝑎𝑙 𝑙𝑎𝑏𝑜𝑢𝑟 𝑓𝑜𝑟𝑐𝑒
x100
The unemployment rate is the percentage of the labor force who are actively looking for work
but are without a job

Difficulties of measuring unemployment

A. Hidden unemployment
- Part-time workers are considered as employed although their skills are not fully utilized
B. Discouraged workers
- Discouraged workers won’t be included as they must be actively seeking employment
C. Regional, ethnic, age and gender disparities
- Data ignores regional, ethnic, age, and gender disparities. Since the unemployment rate is
published as a national employment rate (an average)
- Some age ranges may have much higher unemployment rates than others
D. Informal economy
- People employed in the underground or informal economies may be considered
unemployed, overestimating the employment rate

Causes of Unemployment
A. Cyclical/demand-deficient
unemployment
- Occurs during a recession = a
reduction in aggregate demand causing falling
national output, a fall in earnings for
businesses and individuals, increase
unemployment, fall in general price level
- Recessions can also originate from
supply shocks when SRAS falls, when FOP to
rises and leads to stagflation
- Stagflation refers to a state of the
economy when it experiences both high
unemployment and high inflation. This is caused
by a fall in short-run aggregate supply
- Total demand for labor falls from ADL to
ADL1. At the market wage rate W E, firms are not
willing to employ the entire supply of labor, so
there is disequilibrium. The number of
unemployed workers are represented in the gap
between point A and B/Qe and Q1
B. Real-Wage unemployment
- Refers to the gap between the number of jobs available and the number of people willing
and able to work at the prevailing wage rate.
- Because of a minimum wage, firms are only willing to supply at Qs, but the demand for
labor is at Qd, showing real wage unemployment

C. Natural Rate of Unemployment (Equilibrium Rate of Unemployment)

- These types are expected in any capitalist economic system as a result of competition and
innovation
- No economy desires a 0% unemployment rate
a. Frictional Unemployment
- Occurs when people are between jobs or between school and a job and are
therefore unemployed
b. Seasonal Unemployment
- Occurs for specific jobs types that are only required during certain times of years
c. Structural Unemployment
- Occurs when there is a mismatch between
the supply and demand for a particular set of labor skills
- Cause 1: industry relocates across a country
to another country so employees working will be
unemployed - fall in demand for labor
- Seen through the shift in demand
from D1 to D2 causing falling wage rate from W1 to W2.
Quantity of labor now at Q2 from Q1
- Cause 2: labor market rigidities/laws that
prevent the easy firing of ineffective workers or changing
of jobs - fall in supply for labor
- Seen through the shift in supply from
S1 to S2 causing increasing wage rate. Quantity of labor
now at Q2 from Q1, showing an increase in unemployment
Costs of Unemployment
Economic Costs
A. Loss of GDP
- People not engaged in work will not contribute to a nation’s GDP and will not earn
salaries/wages, which could’ve been used to contribute to the consumption factor of GDP
B. Loss of tax revenue
- People with no jobs will not be able to contribute taxes, reducing government funds.
- May force the government to run on deficits, where spending exceeds revenue. Because
of the demand for unemployment benefits and disability allowance
C. Increase cost of unemployment benefits
- Greater demand for unemployment services, particularly alarming when the government
is not earning revenues for taxes
D. Loss of income for individuals
- Neoclassical economists suggest that there will be lower wages for those employed as
firms would want to still produce but at a lower cost
- However, Keynesian economists disagree with this due to the stickiness of wages
E. Greater disparities for distribution of income
- People on lower incomes may be more susceptible to becoming unemployed during
recessions, widening the gap between rich and poor
Personal costs of unemployment
- Unemployment can damage an individual’s quality of life, both physically and mentally
- It is also difficult to find a job after being unemployed
A. Increasing indebtedness, homelessness, and family breakdown
- Struggle to pay personal bills, monthly payments, rent
B. Increased stress levels
- Stress can be manifested physically and mentally, putting extra pressure on the national
healthcare system
Social costs of unemployment
A. Increased crime rate
B. Increased risks to health

Solutions for unemployment

A. For Cyclical/Demand deficient
unemployment
- An economy would normally be at
Point A as it cannot be at Point C due to the
natural rate of unemployment. The gap
 between A and C is called equilibrium unemployment
- When there is a recession, AD will shift inwards from ADL1 to AD L2.
- According to Keynesians, wages are sticky, so the market ends up at point B. The gap
between A and B is called disequilibrium unemployment
- Should wages fall based on Neoclassical, the new equilibrium would be at point E
Solution: Stimulate AD through tax incentives, increased government spending, lowering interest
rates, and a greater supply of money - depends on consumer confidence and gravity of cyclical
unemployment
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INFLATION
- A sustained increase in the general price level over a period of time.
- A symptom rather than a problem itself
- This is because money depreciates in value, therefore more money is needed to
purchase the same goods and services.

Measurements of Inflation
- Governments use CPI (Consumer Price Index)
- CPI measures the value of a typical basket of goods and services consumed by typical
households
- Goods with high volatile prices are not included in the CPI
- When rate of inflation decreases, this is called disinflation

1. Calculate the cost of monthly basket

2017: (15x1) + (3x7) + (7x5) = BGN 71
2018: (15×1.5)+(3×9)+(7×4) = BGN 77.5 .
2019: (15×2)+(3×11)+(7×6) = BGN 105
2. Calculate the CPI using the formula
 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑦𝑒𝑎𝑟
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑏𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟
x100
77.5 105
2018: 71 x100 = 109.1 / 2019: 71 x100 = 147.88

Limitations of CPI in measuring inflation

- It is difficult to choose a particular set of goods that are universally used by all
households in a country
- Ignores disparities between goods and services bought by income groups
- A basket must be reviewed constantly to account for changes in consumer groups
- Inflation is only concerned with changes in price, but goods and services also change in
terms of quality; does not account for changes in quality
- Statisticians often leave out the core rate of inflation, typically consists of food and
energy as they experience the most fluctuations

Causes of Inflation

Demand-Pull Inflation
- Occurs when there is an increase in aggregate demand in the economy.
- In order to supply the increased number of goods and services, higher prices are needed

NeoClassical Economists
- Will not lead to economic growth as an
increase in AD is followed by upward pressure
in wages and a shift in SRAS
- So there is no increased output in the
long run

Keynesian Economist
- Not all increases in AD will cause price
increases as the economy may be operating
below full employment
- Only when resources are fully or
nearing full employment will price increase
 Cost-Push Inflation (Stagflation)
- Occurs when aggregate supply
(SRAS) falls, caused by an increase in the
cost of production or sharp disruption in
FOP
- War, natural disasters, changes to
minimum wage laws, increases in the cost
of imported raw materials, and business
regulations
- This causes a decrease in
unemployment and an increase in prices

Inflationary Wage-Price Spiral

- Occurs when demand-pull and cost-push
inflation act in unison
- A rise in AD causes an increase in the Real
GDP and price level. Workers will then
demand higher wages. Since wages are an
FOP, SRAS will shift inwards
- NeoClassical: Situation to be avoided and
any attempt to stimulate AD will result in
inflation without any increase in national
income
- Keynesian: Encourage stimulation of AD unless it is in the vertical portion of the AS
curve/when the economy is at the maximum output level

Cost of a high inflation rate

1. Greater uncertainty: A high rate of inflation makes it very difficult for businesses to plan
for the future and for individuals to plan for financial security
2. Redistributive effects: Inflation will affect lower-income households more as they spend
a greater proportion of their income on essential goods
3. Effects on savings: When inflation exceeds interest rates, the value of savings decreases
over time. Lower real interest rates may cause people to stop savings
4. Damage to export competitiveness: A high rate of inflation will reduce demand for
exports. Severe consequences for those reliant on trade balance
5. Impact on economic growth: Purchasing power of wages becomes eroded. Suppliers and
consumers will pull back on economic activity, decreasing GDP and growth
 6. Inefficient resource allocation: Producers will not know if increases in prices are caused
by increased demand or by inflationary pressures and will no longer have a clear idea of
which resources to procure and produce.

Economic growth does not always lead to

inflation. Using an AD/AS diagram, try to find
ways to show economic growth taking place
that causes prices to rise, fall and remain
unchanged.
- Inflationary growth will occur when
aggregate demand growth outstrips aggregate
supply growth in the economy.
- Non-inflationary growth will occur
when aggregate supply and aggregate demand
growth are keeping pace with each other. This
is an ideal situation, and confidence won't be
eroded by inflation.
- Deflationary growth will take place when aggregate supply growth is faster than growth
in aggregate demand. This is also positive and might be the result of improved
productivity within a country.
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DEFLATION
- A sustained decrease in general price level over time
- Note: Disinflation: decrease in inflation rate over time = inflation still rising but at a
slower rate

Causes of Deflation
A. Economic Growth

- Occurs when aggregate supply

grows faster than aggregate demand
- From innovation and/or
decreasing costs of FOP, economy is
making better use of the FOP
- AS shifts rightward to AS1 ;
falling price levels from PL to PL1
- Deflation increases export
competitiveness and causes a subsequent
increase in demand for exports,
increasing the GDP and shifting AD
 - If innovation (increase in quantity and quality of FOP), typically LRAS shifts rightwards.
If lowering cost of FOPs, SRAS shifts rightward
B. Falling Aggregate Demand
- When AD shifts inward (from AD to AD1),
resulting in falling prices (from PL to PL1)
- Resources are not employed fully, and there
is an excess supply of goods causing prices to fall,
in an attempt to restore balance and sell surpluses.
- This also causes workers to get redundant
(see Cyclical Unemployment)

Disinflation and Deflation

Deflation is not very common in the world as it is rare to see general prices falling
1. Wages do not normally fall and wages represent a bigger proportion of the costs of
production. Hence, firms will avoid lowering their prices as this will cut into their profits.
2. Large multinational firms in an oligopolistic market may fear a price war, where firms
continuously lower their prices. So, they will not lower prices as this will result in even
lower profits.
3. Frequent price changes are undesirable as firms will incur high ‘menu costs’
EU countries target 2% annual inflation rate. This is because continuous disinflation can quickly
lead to deflation as consumers will delay their spending, expecting the price will decrease even
further.

Costs of Deflation
1. Business uncertainty: A deflationary period can cause uncertainty in the business
community. Firms would be hesitant to expand due to falling prices as well as
anticipating lower costs for capital investments
2. Redistributive effects: People with fixed income will be able to afford more goods and
services. Lenders also benefit as the purchasing power of money has increased.
Borrowers and payers of fixed incomes lose as they must pay money that has increased in
value.
3. Deferred consumption: Consumers will delay consumption due to lower wages and
anticipation for lower prices, further exacerbating disinflation.
4. High levels of cyclical unemployment : Deflation indicates falling economic output as
firms try to lower prices to entice consumers to start spending money again. As a result,
income will fall, resulting in a downward-wage price spiral. Borrowing in the economy
also falls as the real value of debt has increased.
 5. Bankruptcies: Firms are forced to lower prices and it may be unsustainable in the long
run as the costs of debts have also increased. Many firms will go bankrupt
6. Increase in real value of debt: Public and private debt increase in real value. Individuals
and businesses will struggle to pay these loans and there will be hesitancy to borrow and
invest.
7. Inefficient resource allocation: Allocation of resources will begin to give market signals
that further encourage savings and discourage spending, resulting in an inefficient
resource allocation. Consumers expect prices to fall ; businesses will lower their
production
8. Policy ineffectiveness: Surrounding all of this is policy uncertainty for governments and
central banks. In deflationary periods, governments may decide to use expansionary
fiscal policy and central banks use monetary policies. But, it is difficult for governments
to convince firms and individuals to borrow money to consume and invest.
______________________________________________________________________________
RELATIVE COSTS OF UNEMPLOYMENT VERSUS INFLATION
- When AD shifts to the right, this will result in increased GDP and employment will be
maximized. However, this may result in an inflationary growth, where AD outstrips AS.
Low unemployment and low inflation
- Low unemployment is achieved when the economy experiences a period of boom, when
AD shifts rightwards causing firms to hire more workers and offer higher wages.
- But these costs are passed to consumers as wages are considered an FOP, resulting in
inflation.
- Governments must balance these two macroeconomic objectives
High economic growth and low inflation
- Economic growth occurs when total national output
increases and the quality and quantity of FOP increases.
- With a rightward shift of AD, the aggregate prices
and Real GDP rises. This is followed by upward pressure in
wages, therefore there is no economic growth, only
inflation. (demand pull inflation)
- If economic growth is a result of LRAS shifting,
then the government can achieve growth and low inflation.
High economic growth and environment sustainability
- Many developing countries will have to make a
trade-off between economic growth and environmental
sustainability.
- This is illustrated in the Environmental Kuznets
Curve (EKC), as income rises, environmental degradation
also rises, until a turning point where it starts to fall due to
the rise in green technology.
 - Some Economist argue with green technology becoming more available and affordable,
policies must be focused on sustainable development

Factors that determine successful resolution of economic growth-environmental sustainability

dilemma:
- Corruption: weaker enforcement of government environmental policies
- Foreign direct investment: current technologies and knowledge are brought in and can be
used
- International trade: trade increases growth and can bring new technologies, and increase
efficiency
High economic growth and equity in income distribution
- An increase in economic growth tends to lead to an decrease in the equity of income
distribution. There is no clear and definite reason as to why, but one theory is that it is
because of the unequal distribution of wealth. Because the rich possess more of the assets
in the economy, they will benefit more from the economic growth rather than the working
class. Additionally, those are more skilled and educational background benefit from this.
- However, there are also some studies that show economic growth can lead to a more
equitable distribution of income. This can happen if the lowest wages rise faster than the
average wage, meaning that the increase in the lowest wages is greater than the overall
increase in the general price of wages.
- Economic growth can also lead to a decrease in unemployment because the increase in
output will create more jobs which can then help distribute income throughout the
households in the economy.
- A more equitable income distribution reduces poverty and leads to higher human
development and educational attainment, which is a precondition for economic growth.
This is because the government would issue higher taxes for benefits to lower class,
social unrest, and criminal activities.
______________________________________________________________________________
 Calculating inflation with a weighted
index (HL)
Price Basket: (Price 1 x Weight) + (Price 2
x Weight)...
𝑃𝑟𝑖𝑐𝑒 𝑏𝑎𝑠𝑘𝑒𝑡 𝑜𝑓 𝑦𝑒𝑎𝑟 𝑥
Index Value: 𝑃𝑟𝑖𝑐𝑒 𝑏𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟
x100
Inflation Rate:
(𝑖𝑛𝑑𝑒𝑥 𝑣𝑎𝑙𝑢𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑥+1) − (𝑖𝑛𝑑𝑒𝑥 𝑣𝑎𝑙𝑢𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟𝑥)
𝑖𝑛𝑑𝑒𝑥 𝑣𝑎𝑙𝑢𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑥
x100
𝑛𝑒𝑤−𝑜𝑙𝑑
𝑜𝑙𝑑
x100
122.86−100
In 2019: 100
x100 = 22.86
134.60−122.86
In 2020: 122.86
x100 = 9.55

______________________________________________________________________________
DEFICITS AND DEBTS
- Governments will finance spending through income streams, sale of government-owned
property. But, the main source of income is taxing personal and business incomes
- During periods of economic growth, government revenues increased. However, during
low periods of economic growth, the government is pressured with unemployment
benefits, welfare, and other programs.

Measurement of government (national) debt as a percentage of GDP

- Government debt is measured as a percentage of GDP and is a key indicator for the
sustainability of government finance.
𝐷𝑒𝑏𝑡
- Debt to GDP Ratio: 𝐺𝐷𝑃
 - Debt is the cumulative liabilities of the government
- GDP is the total value of goods and services produced over a given period,
usually a year
- The higher the ratio, the less likely it is for a country to be able to repay its debt
- So, the country is more likely to default on (stop paying) its loans to international
financial institutions
- Government Bond: Central bank may issue bonds to raise funds to finance a range
of projects. After a predetermined period of time, the government must repay the
loan, including interest.

Relationship between a budget deficit and government (national) debt

- Budget Deficit: arises when government expenditure exceeds tax revenue ; spending
more than it is taking in during a given year
- This often happens in recessionary periods where governments are reluctant to raise taxes
and spend more on social safety nets.
- Government borrowing helps to finance programs that will make the nation more
economically healthy and productive in the future. Doing so would allow the debt to be
paid back.
- Interest on bonds is determined by the market's perception of the issuing government’s
ability to pay its debt. Credible countries will not need to pay high-interest rates. More
risky countries will need to offer higher interest rates.
- In the short term, governments can borrow money through bonds and spend it to support
citizens’ economic activity. If deficits continue year after year, national debt will grow.

Costs of a high government (national) debt

Debt servicing costs
- As the debt-to-GDP ratio increases, the government will have to spend more money of its
debt on servicing debt.
- Less money left for investment in areas that are important to the growth
Credit ratings
- Several agencies in the world determine the credit ratings of a country’s bonds.
- Credit ratings present an assessment of a government’s ability to repay its public debt
- Not being able to pay a debt will result in low credit ratings.
Impact on future taxation and government spending
- The opportunity cost of debt is the future spending that the money going towards paying
the debt and interest could have been used for by governments.
- Increases in debt will mean increased taxes in the future and less ability for the
government to spend on areas such as education and health care, which are important for
society.
Sustainable level of government debt as a percentage of GDP
Key Factors of Sustainable Debt
1. Political Stability
- Debts need to be paid back by governments. If the government looks unstable,
that would risk the repayment of the debt.
2. Composition of the debt
- Who is it owed to and for how long?
3. Is the country vulnerable to external shocks?
- For example, countries that rely on a trade surplus to generate large portions of
GDP might be considered vulnerable, while those that generate GDP through
consumption may not.
______________________________________________________________________________
THE PHILLIPS CURVE
Short-run Phillips Curve
- With economic growth, there is a fall in the unemployment rate, as more labor is needed
in the economy.
- As economic growth speeds up, inflation rate increases as wage rate and other FOPs cost
increases

- As the economy grows and aggregate demand shifts from AD1 to AD2, the new
equilibrium will be at point 2 and 3.
- The validity of this theory depends on the assumption that SRAS does not shift, rather it
remains constant.
Long-run Phillips Curve

- Fluctuations in economic activity caused by increases in aggregate demand will only

exist in the short run.
- As AD shifts, SRPC will move from position 1 to position 2, corresponding to the shift in
AD1 to AD2. Causing a temporary increase in output as well as lower unemployment
rates.
- However, workers will demand higher wages, shifting SRAS1 to SRAS2. Similarly, the
Phillips curve will shift to SPRC2. This is known as the wage-price spiral. Employment
also returns to NRU (Natural Rate of Unemployment). Economies end up at position 3,
which is why economists think demand-driven expansion results in inflation
- Evidence for why governments should not intervene with demand-side policies, instead
focus on reducing structural unemployment with long-term policies