Chapter 4

The macro-economic environment

Revision- PESTEL

P
Economic - Macro

E
L

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1 Definition
Macroeconomics is a branch of economics dealing with the performance,

structure, behavior and decision-making of an economy as a whole

rather than individual markets.
2 Objectives of government
macroeconomic policies
 2 Objectives of government macroeconomic policies

(a) To control price inflation. This means to achieve stable price.

(b) To achieve full employment. It implies a low unemployment level other than
everyone has a job.
(c) To achieve a balance between exports and imports. The balance refers to the
balance of country’s payments accounts.
(d) To achieve economic growth, and growth in national income per capita of the
population. The aim is to achieve a real growth, an increase in national income,
rather than the nominal one which may be caused by an inflation of price.
3 Inflation and its consequences
3.1 The definition of inflation
Inflation is the rise in the prices of goods and services within an economy over
time. It reduces the purchasing power of money, meaning that each unit of
currency (each pound or dollar, for example) buys fewer goods and services.
3.2 Why is inflation a problem?

1. Redistribution of income and wealth (wealth transfers

from trade receivables to trade payables)
2. Balance of payments effects ( in the short-term: input
output ; in the long-term: decrease in exchange rate:
1本币换更少外币)

3. Uncertainty of the value of money and prices

4. Economic growth and investment

3.3 How to measure inflation?
a. Retail Prices Index (RPI) 商品零售价格指数
b. Consumer Prices Index (CPI) 消费者物价指数
 3.4 Causes of inflation

Causes of inflation Possible solutions

Demand pull (too much money Reduces aggregate demand (AD) – e.g. tax rises, cut in
chasing too few goods) government spending, increase in interest rates
Cost push (labour costs and Get agreement from trade unions not to demand higher
raw materials price) wages ;
Take steps to strengthen domestic currency.
Imported – caused by heavy Encourage firms to use domestic products instead;
reliance on imports and weak Strengthen currency
national currency
Monetary – overexpansion in Restrict growth in money supply – e.g. issue fewer
money supply currency, increase interest rates
Expectation – e.g. anticipation Prices policy
of rising prices leads people to
demand higher wages
4 Unemployment
• Unemplement occurs when people are willing and able to work but can not find a job.
4 Unemployment
• The rate of unemployment in an economy can be calculated as:
4.1 Consequences of unemployment

• The government will suffer a loss of income from income tax and VAT, as well as increased
unemployment benefits payments.
• When there is high unemployment, people’s basic living standards may be affected, which
may lead to social turbulence.
• In the long-term, national economy will suffer.
4.2 Categories of unemployment

Real Wage
Frictional Seasonal

Structural Cyclical
Technological
4.2 Categories of unemployment
vReal wage

• Strong labor unions or minimum wages

Wage
S
Minimum price (Price floor)

D
0 Quantity of labor
4.2 Categories of unemployment
v Frictional
• Short-term delays in transferring from one job to another
• Information asymmetry in the labour market
• Difficulty in matching workers quickly with jobs
• There are job opportunities
4.2 Categories of unemployment
v Seasonal
• Short-term
• It occurs in certain industries (eg tourism, argriculture)
 4.2 Categories of unemployment

v Structural
• Long-term changes in industries
• Closing/scaling down of entire industries
• High regional unemployment rate in the location of industry affected
v Technological
• A form of structural unemployment
• Long-term changes due to new technologies
4.2 Categories of unemployment
v Cyclical
• Long-term
• business cycle
Summary

Category Term Key words

Real Wage Labor unions or minimum wages

Frictional Short Information asymmetry

Seasonal Short Tourism, argriculture

Structural Long Industries （mismatch of abilities)

Technological Long New technologies

Cyclical Long Business cycle

Example question 1
 Example question 2

Martin is an experienced and fully trained shipbuilder, based in a western European city. Due to significant economic
change in supply and demand conditions for shipbuilding in Martin’s own country, the shipyard he worked for has closed
and he was made redundant. There was no other local demand for his skills within his own region and he would have to
move to another country to obtain a similar employment and could only find similar work locally through undertaking at
least a year’s retraining in a related engineering field.
Which of the following describes the type of unemployment that Martin has been affected by?
A Structural unemployment
B Cyclical unemployment
C Frictional unemployment
D Marginal unemployment
4.3 Government employment policies
• Increasing capital spent on both of creating jobs directly by government itself and encouraging growth
of private sector, which can also create job vacancies;
• Providing training for people to increase their employability;
• Improving information flow to encourage labour mobility
• Lowering minimum wage to encourage employers to expand recruitment.
5 The balance of payment
 5 The balance of payment
A country's balance of payments records all financial transactions made between individuals, businesses and its
government with foreign consumers and organisations.

5.1 Current account and capital account

The balance of payments is split into two parts:

• Current account (import and export of goods and services)

• Capital account (net change in ownership of foreign assets, such as

loan between the government and other countries)

• Financial account

Often when people talk about the balance of payments, they are just referring
to the surplus or deficit on imports and exports – i.e. the current account.
 5.2 The equilibrium in the balance of payment

v Equilibrium

ü Eexchange rate remains stable

ü The annual trade of goods and services is in overall balance over a period of years

Equilibrium hardly happen because of government‘s measures which will cause unemployment,
inflation, reduced economic growth or trade barriers.
5.3 Surplus or deficit on the current account

Surplus
üExport>import
üCurrency will appreciate
Deficit

üExport<Import
ücurrency will depreciate
6 Economic growth
6.1 Aggregate supply and aggregate demand

ü Aggregate supply (AS) refers to the total amount of goods and services (real output) produced and
supplied by an economy’s firms over a period of time.
ü Aggregate demand (AD) is the total planned or desired consumption demand in the economy for
consumer goods and services and also for capital goods.

AD can be calculated as the sum of government spending (G), investment (I), consumption (C) and net
export (Nx). That is:
AD =� +� +� +� x
6.3 Measurement of economic growth
ü GDP - Gross domestic product
国内生产总值
ü GNP - Gross national product
国民生产总值
Example question 3
Which of the following statements not directly increase aggregate demand in the economy?
A. Investment in capital goods
B. Government spending
C. Consumption

D. Savings
6.3 Measurement of economic growth
Additionally, national income can also be used to evaluate economic growth.

• Equilibrium national income

AD = AS.
• Full-employment national income
This is an ideal equilibrium level of income. It will be reached if there is full employment where AD
equals AS.
6.3 Measurement of economic growth
Additionally, national income can also be used to evaluate economic growth.
The determination of national income

• Inflationary gap
It happens where there is full employment, and AD>AS.
• Deflationary gap
It happens where there is unemployment, prices are fairly constant and
AS changes as AD varies (AS >AD).
6.3 Measurement of economic growth
Additionally, national income can also be used to evaluate economic growth.

• Stagflation
It is a combination of unacceptable high unemployment, high inflation and low economic growth.

It is caused by a long-term major increase in costs.

6.3 Measurement of economic growth
Additionally, national income can also be used to evaluate economic growth.

Employment of
National income AD&AS Changes in price
resource
Equilibrium AD=AS

Full-employment AD=AS full employment

Inflationary gap AD>AS full employment price increase

AS changes as AD
Deflationary gap unemployment prices constant
varies
High
Stagflation price increase
unemployment
6.4 Business cycle

stagnation
6.4 Business cycle

Recession (A-B):
Decrease: demand; household consumption, companies output
Increase: unemployment
Depression (B-C):
Low: Business confidence; aggregate demand
High: Unemployment
Recovery (C-D):
Decrease: Unemployment
Increase: New technology; demand; firms invest; incomes
Boom (D onwards):
Nearly full capacity in economy.
Example question 4
7 The circular flow of income and expenditure
7 The circular flow of income and expenditure

If there are only firms and households in economy

system, then the households will spend the whole of
what they have earned on firms’ goods and service. This
is a circular flow between consumption and income.
7 The circular flow of income and expenditure

However, when taking other sectors into account,

such as financial sectors, government and
foreign sectors, the situation is different.
8 Fiscal policy
8 Fiscal policy
Fiscal policy is action by the government directly to spend money, or to collect money in taxes, with the purpose of
influencing the condition of the national economy.

public
Taxation
spending

Fiscal Policy
 8 Fiscal policy

The two key elements that governments must plan for each year are:

•Income – this is primarily the money the government raises from direct
and indirect taxes on individuals and businesses.

•Expenditure – this is the total amount the government will need to spend
to provide services for the population. These include the costs of the
police and army, road and rail building as well as the wages of civil servants.

In the medium-to-long term, most governments would prefer to run a

balanced budget. This occurs when government income and expenditure are
exactly matched.
 8.1 Budget surplus, budget deficit

Taxation Public Public

(Revenue) spending borrowing

< budget deficit Expansionary policy

> budget surplus Contractionary policy

The circular flow of income and expenditure
9 Fiscal policy
 9.1 Methods of monetary policy

Monetary policy refers to actions that the government undertakes indirectly through banks and financial
intermediaries.

Money Interest Exchange

supply rates rates

Monetary policy
9.1 Methods of monetary policy

9.1.1 The money supply

The price and income will increase along with more money supply, leading an increase in demand as a result.
Growth in the money supply, however, should therefore be a medium-term target of monetary policy.
The circular flow of income and expenditure
9.1 Methods of monetary policy

9.1.2 Interest rates

Higher interest rate will discourage people to invest and borrow which leads demand to reduce. Interest rates
influence the exchange rates and inflation etc.
The circular flow of income and expenditure
9.1 Methods of monetary policy

9.1.3 Exchange rates

The fall of exchanges rates will stimulate exports and reduce demand for imports. When a country is heavily
dependent on overseas trade, it might be appropriate to establish a target exchange rate. However, the
exchange rate is dependent on inflation and interest rates.
The circular flow of income and expenditure
9.2 Types of Monetary policy

Monetary policy can be described as expansionary or contractionary:

• An expansionary policy increases the money supply in the economy, decreases interest and exchange rate,
helping to increase aggregate demand and boost economy.
• A contractionary policy decreases the total money supply, increases interest rate and exchange rate, helping
to decrease aggregate demand and suppress economy.
Example question 5

Which of the following measures would enable the government of UK to reduce inflationary pressures in the economy?
A. An increase in welfare benefits paid to the unemployed
B. A decrease in the level of interested rates
C. The introduction of export subsidies to key industries
D. The withdrawal of local authority grants for installation of solar heating