A2 Economics

Chapter 9:
Macroeconomics
Economic Growth SR/LR

– Short run economic growth simply refers to an increase in output from an

increase in AD or SRAS within a discrete time period (“the short run”)
– Long run economic growth refers specifically to growth in output potential,
which we had previously (and will continue to) referred to as LRAS.
Economic Growth vs Economic
Development
– We could get into a lengthy philosophical discussion about whether or not an
increase in material possessions truly represents an increase in “well being”
beyond a certain point…
– Whether we assume it does or does not, we can still distinguish between an
increase in material well being on a macroeconomic level and other factors that
might influence wellbeing. For instance, we may examine the average life
expectancy, infant mortality, average # of years of education, prevalence of
mental or physical illnesses, social cohesion and a sense of belonging, birth
rates, inequality, or a multitude of other indicators (maybe even simply self
reported happiness)
Economic Growth vs Economic
Development
– The important idea then is simply that an increase in economic growth may not
actually make a country better off (it probably will, but not always), and
measuring economic development will provide a more precise picture.
– What indicators can and should be measured in constructing a measurement of
economic development is fundamentally subjective/normative, however.
– We will look more closely at measurements of economic development (human
development index,
Sustainable Economic Development

– While this naturally includes sustainable from the environmental perspective,

we also mean in a more general sense that resources are allocated with
“intergenerational equity”; we do not disproportionately allocate things like
natural resources or tax dollars disproportionately on one generation in a
manner that requires measurable reductions for other generations.
– The example I will constantly refer to is that the American generation born
shortly after World War II (1946-64), which has consumed and continues to
consume far more than the generations that preceded it and generations
following.
Bellwork 01/14/21

– What is the difference between economic growth and economic development?

– What is meant by sustainable economic development?
Actual vs Potential Economic Growth

– “Actual Growth”, in this context means simply more efficient utilization of

resources. On a PPC, we show this simply by moving closer toward the
boundary of the PPC from some arbitrary interior point.
– “Potential Growth”, is what we normally mean when we simply say ‘economic
growth’; this is where the ppc shifts outward and can also be demonstrated by
the LRAS curve shifting to the right. “An increase in an economy’s productive
capacity”
Output Gaps

– Any deviation from actual and potential output could be referred to as an output
gap. We demonstrated this last year, and will continue to do so this year, with a
divergence between short and long run macroeconomic equilibrium using an
AD/AS model. Recall that generally the AD curve will be the one responsible for
output gaps due to its increased volatility relative to the SRAS curve.
– Positive or inflationary gap: The macroeconomic equilibrium is higher than the long
run equilibrium. This is NOT sustainable in the long run; it would involve workers
working overtime, machines and capital equipment being used more than they are
designed to. In the long run, workers will reduce their hours back to “only” full time
and equipment/machinery/capital will need to be serviced and repaired.
– Negative output gap (deflationary gap): We have spare capacity and incomplete
usage of productive resources, and thus our short run equilibrium output, as a
result of low aggregate demand, occurs at an output level lower than potential
output.
Costs and benefits of Economic
Growth
– We must consider that in order for our macroeconomy to grow, it requires investment spending
on capital goods and infrastructure. This necessitates a reduction of spending on consumption
goods.
– Essentially then, growth is the deferment of consumption from the current time period to
future time periods; we consume less in year 1 in order to have the potential to consume more
in year 1+x.
– Large increases in stress and anxiety, social dissolution from urbanization, workers may have to
re-train or move away from their homes to match with appropriate jobs.
– More labor hours (book has an interesting example, annual work hours 2193 for south Koreans,
1408 for germans)
– Depletion of natural resources+creation of negative externalities
Benefits

– Obviously more goods and services available for consumers to enjoy

– Economic growth can make a massive positive difference for people in poverty
in a multitude of other ways; it can raise their life expectancy, increase literacy,
reduce death and disease, etc.
– Typically less unemployment
National Income Statistics

– We briefly studied GDP last year, we will expand on this metric and different
approaches to calculating it
– Gross National Income (GNI): The total output produced by a country’s citizens
wherever they produce it
– This differs from GDP which only measures what is produced by people living
within the home country.
– Some countries (China) might have a very large overseas population along with
a very low immigrant population, so the difference between GDP vs GNI might
be more substantial.
01/15/2021 Bellwork

– What is the difference between GNI and GDP?

– What are 2 weaknesses of GDP?
– What are 3 ways of computing GDP?
Ways of Measuring GDP

– Output measure: in this measure of GDP, we take the value added at each stage
of production for each good or service produced and sum them up. If a TV
manufacturing firm buys components costing 280,000 and uses them to make
TV that it sells for 350,000, only the resulting 70,000 is counted as a measure of
output in GDP
– (haven’t seen it on an a2 exam ever)
Income Method

– The value of an output produced is based on the costs in producing that point.
These costs include wages, rents, interest, and profits. All of these payments are
payments to factors of production. By summing all of these, we can also get a
good estimate for GDP. It is important that only payments made to factors in
exchange for productive economic activity are counted in GDP.
Expenditure method

– What is produced in a year will be either sold or added to “stocks” (reserves,

back stock, inventory). Therefore if we add together all of the money spent on
goods and services in addition to the value of all goods and services that are
produced and not sold, we also have an estimate of GDP.
Output method (value added)

– For each market transaction, take the difference between the cost of raw
materials used and the price of whatever is being sold. Whatever results must
be the economic value added to that good or service, and summing all this
together than results in the total economic value added for a macroeconomy.
– If a firm buys semi-conductors and parts for motherboards used in cellphones
for $100,000 and then sells the finished motherboards to a cell phone
manufacturer for $150,000, then the total amount added to GDP is $50,000.
Money (Nominal) GDP and Real
GDP
– Money GDP or nominal GDP is simply GDP measured in todays dollars without
any adjustment at all for inflation
– Real GDP presents a more accurate picture and tells us something about total
output after adjusting for inflation
– We adjust for GDP via the following formula: nominal GDP *( price index in the
base year/price index in the current year) Text book formula is wrong
– Since we must have more than one year for real GDP to be a meaningful
comparison, we can also simply say that the growth in real GDP is equal to the
growth in nominal GDP MINUS the rate of inflation
Examples

– GDP grows from $300bn in year 1 to $330bn year 2, but the inflation rate is 4%.
What is real GDP in year 2? 330/300 = 10% GDP growth – 4% inflation = 6% real
GDP growth = 300*1.06 = $318bn
Problems with GDP

– 1. Shadow Economy not included

– 2. Doesn’t consider other metrics of living standards (as discussed before)
– 3. measurement errors
Comparisons of GDP per capita
between country
– Ceteris paribus, higher GDP per capita countries tend to be nicer places to live
and have better standards of living.
– In order to really compare this, however, we need to account for the fact that
prices are much cheaper in lower GDP per capita countries.
– We do this through what is called purchasing power parity.
– Purchasing power parity takes a common basket of goods and compares how
much this basket of goods would cost in different countries.
– You can view it as a “theoretical exchange rate” that uses the real exchange rate
but takes into account differences in cost of living.
Purchasing Power Parity (PPP)

– Example: Vietnam has a GDP per capita of $2500 (approximately) and China has
about $18,000. Without further analysis, it would appear that Chinese people
have a standard of living which is 7.2 times higher than Vietnamese.
– But the equivalent of $1 can buy WAY more in Vietnam than it can in China, so
we calculate our PPP and use this to quantify the difference in living standard.
– What does $1 even buy in China?
PPP Formula

– PPP = Price of the basket of goods in country 1 / Price of the same basket of
goods in country 2
– We can then multiply the GDP per capita by the PPP to get a more realistic
comparison of the relative cost of living difference
PPP Example

– Let take the example of purchasing power parity between India and the US.
Suppose an American visits a particular market in India. The visitor bought 25
cupcakes for Rs.250 and remarked that cupcakes are quite cheaper in India.
The visitor claimed that on an average 25 such cupcakes cost $6. Based on the
given information calculate the purchasing power parity between the two
countries.
– Given, Cost of 25 cupcakes in INR = Rs.250
– Cost of 25 cupcakes in USD = $6
– Therefore, the purchasing power parity of India w.r.t US can be calculated as,
– Purchasing power parity = Cost of 25 cupcakes in INR / Cost of 25 cupcakes in
USD
– = Rs.250 / $6
– Calculation of Purchasing Power Parity of India w.r.t US will be Rs.41.67 per $

– This is a hypothetical exchange rate which might significantly deviate from the
actual exchange rate, but also might be much more useful to look at compared
to the actual exchange rate or compared to the comparison of GDP per capita.
Bellwork 01/18/21

– What is meant by Purchasing Power Parity?

– What are some disadvantages of high national debt?
– Why is it more useful to examine real GDP per capita growth than simply GDP
growth? Real GDP per capita is more accurate than GDP because real gdp per
capita is including population changes and inflation rates. For instance, we
cannot say that a country experiencing 10% GDP growth is making more
progress than a country experiencing 3% real gdp per capita growth.
– What is meant by an inflationary gap? What about a deflationary gap?
National Debt

– We will typically express national debt as a ratio of debt to GDP. This is much
more relevant than just stating the amount of debt
– Why is having a large national debt a big problem?
National Debt

– National debt means that future generations will need to pay interest on that
debt; essentially we are trading off less consumption in the future for more
consumption now.
– Is this really sustainable or fair to future generations?
– That money used to pay interest on debt could be being used to benefit future
generations instead….
National Debt

– National Debt interest payments will be financed how?

– How does this impact future generations?
– Fair/Sustainable?
National Debt vs Budget

– Note that national debt is not the same as a budget deficit and vice versa. It is
possible for a country to have high national debt but still have a budget surplus
or have no national debt (negative national debt, which would mean that other
countries owe our government more money than we owe them, is also
possible) along with a budget deficit.
– This is because the budget only describes the financial position for one
individual year for a country.
National Debt Disadvantages

– 1. Opportunity cost of paying interest on debt disadvantages future

generations. This is unfair and may lower living standards for future
generations.
– 2. It’s harder to attract people to lend money to your government if you already
owe a lot of unpaid debt, so if there is any need to borrow further amounts of
money it’ll be done at a higher interest rate.
Other Metrics for the standard of
living
– 1. Measurable Economic Welfare: A composite measure of the living standards
that adjusts GDP for factors that reduce living standards and factors that
improve living standards. This one in particular takes into account extra leisure
time.
– In practice, it’s very difficult/impossible to derive market prices and to quantify
the value of these non-marketed goods and services like leisure time.
► Perhaps the best-known measure of economic development is the
United Nation’s Human Development Index (HDI).
► This takes into account GNI per head, education (as measured by
mean years of schooling and expected years of schooling) and health
care (as measured by life expectancy).
► These are included as it is thought that people’s welfare is influenced
not only by the goods and services available to them but also their
ability to lead a long and healthy life and to acquire knowledge.
► The HDI value for a country shows the distance a country has to cover to
reach the maximum value of 1. Countries are divided into very high
human development, high human development, medium human
development and low human development.
► A country’s ranking by HDI does not always match its ranking in terms of
real GDP per head. Indeed, in some cases there are marked differences.
► For example, in 2012 Cuba’s HDI ranking was significantly higher than its
GNI per head ranking while Qatar’s GNI per head ranking was significantly
higher than its HDI ranking.
09.4 – Other Indicators of Living Standards
Page
231
–Other indicators of living standards

► Table 9.2 shows details on the ten countries with the highest HDI
rankings and the ten with the lowest HDI rankings in 2012.
► A more recent composite measure is the Multidimensional
Poverty Index (MPI). This was developed in 2010 by the Oxford
Poverty and Human Development Initiative and the United
Nations Development Program.
► It measures indicators of living standards (cooking fuel, sanitation, safe drinking
water, floor space and assets), education (years of schooling and school
attendance) and health (child mortality and nourishment).
► The six indicators of living standards are given a total weighting of 33%, the two
indicators of education a total weighting of 33% and similarly the two indicators
of health have a weighting of 33%.
► A household is considered to be multi-dimensionally poor if they are deprived in
at least 33% of the weighted indicators. This means a family would be regarded
as poor if it has lost a child and has another child who is not attending school.
2012 Ranking of HDI
Bellwork 01/19/2021

–2. Explain how a country can have a large budget surplus

2.

but also have a very large amount of government debt.

Budget surplus refers to government revenue being larger
than government spending for one year, but they can still
have negative debt at the same time. This is because the
amount of debt is accumulated over the course of several
decades, whereas the budgets refers to a single year.
– 1. What is the human development index? What is at least one weakness you can
identify with HDI as a measurement of economic development?
– 1. Shadow/Informal Economy not included (just liked in real gdp per capita)
– 2. Doesn’t take into account short run changes, overweighs prior long run changes
that may not represent modernity.
– 3. Doesn’t take into account inflation, real gdp per capita does.
– 4. Subject to the same data collection and sampling errors as GDP.
– 5. Doesn’t calculate gender disparity, social cohesion, human rights, inequality etc.
Bellwork 02/22/2021

– As an country’s national income, as measured by GDP per capita, grows, what is

likely to happen to the level of income inequality in that country? Why?

Do not use your book; try to authentically speculate (you are probably
circumstantially correct, but I don’t care about correctness)
Kuznets Curve
Kuznets Curve

– This plots the amount of income inequality as measured by gini coefficient as a function of
a country’s GDP per capita. As GDP per capita grows, income inequality initially becomes
worse, but once a country grows even further, income inequality improves.
– The Kuznets curve has been largely refuted since 2001 (more failure by your exam
designers…). Kuznets original data set included many Latin American countries that
historically had a very high level of inequality. Once removing these from the data set, the
inverted U shape of the curve completely vanished.
– Examining fast growing areas in Asia between 1965-1980, (japan, korea, Singapore,
Taiwan, Indonesia, Thailand, Malaysia), we observe rises in incomes similar to those in
Latin America, yet patterns in inequality were the opposite of what the Kuznets curve
would predict.
Characteristics of Developing vs
Developed Economies
– Developed Economies: Lower birth rates, higher levels of education, higher investment, more
secondary+tertiary sector employment, net immigration (more people coming in than leaving),
often more importation than exportation (not always), higher average age, smaller dependency
ratio.
– Developing economies have lower productivity, more uneven distributions of income, lower
education levels, more employment in primary sector, net migration (more people leaving than
coming in), more reliance on exportation of primary sector goods, younger average age, and
higher dependency ratio
– Dependency ratio: The ratio of “working age” people to non working age. This is often defined as
people between the age of 0-14 and over the age of 65 as being ‘dependents’ and everyone else
being non dependent. People from 14-18 are not technically working age but are also not solely
dependent on caretakers.
Bellwork 02/23/21 (3 minutes)

– What are some characteristics of emerging economics?

Emerging Economies

– These are economies that are between developed and developing. As such, they
still have some features of both developing and developed economies.
– These countries tend to attract a lot of foreign direct investment, have rapid rates
of economic growth, and have economies undergoing urbanization and
industrialization.
– China is now counted here, as are countries like Mexico, Russia, South Africa,
Turkey, and Indonesia. Your book author’s “stuck in 1983 mindset” is revealed as
they put South Korea among these countries as well, which is obviously now an
advanced first world economy, but if you’re an old British person who is out of
touch with any modern developments you may have missed this transformation.
Labor Productivity

– Labour productivity can be measured in a number of ways, but it generally

refers to how much output a worker is able to produce in a certain amount of
time.
– What factors influence productivity? Education, training, intelligence, talent, but
also the quality of the capital they have to work with. Arguably the last one may
be the most important in certain jobs.
Labour Force vs Population

– As we discussed last year, not every person in the country is in “the labor force”,
and the labor force is what is used to compute unemployment statistics, not the
population.
– The size of the labour force is influenced by demographics as discussed in chapter
8, chiefly the age distribution of the population since people from 0-18 are rarely
in or seeking employment and neither are those over 65 years old.
– To be in the labor force, a person must be 1. Of the standard age to leave school
for that country 2. Actively looking for a job 3. Not in prison 4. not in the military
5. not older than the standard retirement age in that country. 6. Not in full time
education
Full Employment and Natural rate of
unemployment
– Full employment means that we are at the lowest possible rate of
unemployment. This is NOT 0%, and we will see why as we decompose different
causes of unemployment. Economists estimate this to be around 3%
– Natural rate of unemployment is the amount of unemployment that exists
when labor markets are all in equilibrium and, by implication, so is the
macroeconomy. The natural rate will vary by country, subject to individual
characteristics of that country.
Bellwork 01/20/21

– 1. Explain the expenditure method and the income method of calculating GDP

– 2. What are 3 types of unemployment? Which do you think is the most severe?
Unemployment

– To be considered as unemployed, one must be both in the labor force but also
not employed. If one is outside of the labor force and without a job, this is NOT
counted in unemployment statistics
– When somebody was looking for a job for a long time and then gives up after
not finding one, we call this person a ‘discouraged worker’. If the amount of
discouraged workers is fairly high, unemployment statistics are understating the
problem of unemployment in that country.
Three Types of Unemployment

– 1. Frictional Unemployment
– 2. Cyclical Unemployment
– 3. Structural Unemployment
Frictional Unemployment

– Do markets for anything instantly reach equilibrium? For labour? No, definitely
not. The whole process takes time.
– When a worker exits one job and goes to another job, it is rarely instant. The
worker will often take weeks or months to search and sort for the correct job.
–  Similarly, graduates just entering the workforce add to frictional unemployment.
Usually, this type of unemployment is short-lived. It is also the least problematic
from an economic standpoint. Frictional unemployment is a natural result of the
fact that market processes take time and information can be costly. Searching for a
new job, recruiting new workers, and matching the right workers to the right jobs
all take time and effort, resulting in frictional unemployment.
Types of Frictional Unemployment

– Search, Voluntary, Casual, and Seasonal.

– Search unemployment is exactly what it sounds like. A worker may not take the
first job offered to them after quitting another.
– Voluntary unemployment is when a worker does not take up offers at all for a
period of time
– Casual and seasonal are basically interchangeable and refer to workers who
work during certain parts of the year then take a break during other parts of the
year (high school teachers, movie actors, professional musicians who make
money by touring, certain types of accountants)
Cyclical Unemployment

– There’s a great deal of variance in AD as we already know. Unemployment will

naturally vary with the short run equilibrium GDP; during economic downturns
from short run variation we’ll see higher unemployment. When we see upturns
and higher than long run equilibrium GDP, unemployment will be lower.
Structural Unemployment

– Structural Unemployment comes about through technological change in the structure

of the economy in which labor markets operate. Technological changes—such as the
replacement of horse-drawn transport by automobiles or the automation of
manufacturing—lead to unemployment among workers displaced from jobs that are
no longer needed. Retraining these workers can be difficult, costly, and time
consuming, and displaced workers often end up either unemployed for extended
periods or leaving the labor force entirely.
– Structural unemployment is the unemployment that results from a change in the
structure of an economy (if you add that this is because of a change in technology or
patterns of international trade, then this is okay, but without those supporting details
this is not a sufficient description of structural unemployment)_
Difficulties of measuring
unemployment
– It is not a precise number… given that we may have trouble even figuring out the exact
number of people in the labour force and our fairly narrow definition of unemployment,
how do governments measure unemployment?
– 1. Claimant count: Count the number of people filing for unemployment related benefits.
This has an obvious weakness in that not every single unemployed person will file for
benefits at all. Furthermore, some people seeking unemployment benefits may not have
any plans of looking for jobs, and still some more may attempt to collect benefits illegally.
– 2. Labour Force Survey: Take a sample of people in the labour force and extrapolate the
unemployment rate based on this sample. Obviously, sampling error may occur here. This
method, while more accurate, is also costly.
Correcting for unemployment

– Expansionary(reflationary) fiscal and monetary policy

– Reduce taxes, increase government spending, cut corporate taxes, etc will all
potentially lower unemployment
Bellwork 02/24/21

– 1. Describe the 3 types of unemployment

– 2. What are the 2 primary methods of measuring unemployment? What are the
respective weaknesses of these two methods?
A2 Economics version of
Expansionary Policy
– We already know how expansionary monetary/fiscal policy works and how to
demonstrate it graphically on a diagram from last year. What changes happen
for us going into A2 econ?
– We introduce the idea of a multiplier.
– We make the claim that an increase in government spending or an increase in
private sector spending actually results in MORE than a dollar’s worth of growth
in AD.
Multiplier Explained

– How could one dollar being spent by a government result in a larger than one dollar increase in
AD (and thus gdp)?
– Lets say a government spends $40,000 in a year on the salary for a nurse at a publically owned
hospital.
– That nurse spends $30,000 per year of that salary on goods and services.
– Those $30,000 are used to pay salaries for other workers at the places where she bought these
goods and services.
– Of this $30,000, we could say $22,500 is spent on goods and services, and this is used to pay
salaries for workers at the places where these goods and services were purchased.
–
We represent this chain of spending through what is called an EXPENDITURE MULTIPLIER
Multiplier Effects Definitions

– MPC = Marginal Propensity to consume. What portion of the increased income

from a tax cut or an increase in government spending results in extra
consumption spending?
– MPS = Marginal Propensity to Save. What portion of increased income is saved?
– The expenditure multiplier is calculated directly FROM the MPC and MPS. Since
MPC = 1 – MPS, which implies that MPS = 1 – MPC, as soon as we know one of
them, we know the other one and we also then can compute exactly how much
extra GDP we’ll get from an increase in government spending or a reduction in
tax burden.
Formula for Multiplier Effects

– Expenditure Multiplier =

– MPC = 1 – MPS
– MPS = 1 – MPC
– In the above example, we are not even done, but already from the initial $100
of expenditure, there has been an increase of about $343 dollars.
– If we did finish this long calculation, we’d find the amount of additional
spending is approximately equal to $1000 from the initial $100.
– And if we compute this with our formula above, we’ll get a multiplier of 10 =
1/(1 – 0.9)
– I guess you could try this out on a calculator to verify if you are bored…
Numerical Example

– The Marginal Propensity to Consume is 0.5. A government increases spending

by 1 million dollars. By how much does GDP increase?
– MPS = 1 – 0.5 = 0.5
– Multiplier Effect = 1/ (1 – 0.5) = 2
– Total increase in GDP = 2 million
Numerical Example 2

– A government increases spending by 2.3 million dollars and the MPS is 0.12.
What is the change in GDP?
– MPC = 1 – 0.12 = 0.88.
– Multiplier = 1/(1-MPC) = 1/0.12 = 8.3333
– 2.3 *8.3333 = 19.1666 million dollars.
Average Propensities to
Save/Consume
– The marginal propensities to save and consume consider a change in income
and how this results in a change in savings of consumption
– The AVERAGE propensities would instead deal with absolute values rather than
changes.
– APC = Total Consumption / Total Income
– APS = Total Saving / Total Income
Adjusting the Multiplier for taxes and
imports
– We have to consider that some portion of extra spending will be subject to
taxation OR used to purchase imports. Both of these represent “withdrawals”
from the circular flow of income
– Multiplier = 1/ MPS+MRT+MPM
– MRT = marginal rate of taxation
– MPM = marginal propensity to import = Change in import spending/change in
income
Example

– Assume we have an MPS of 0.2 in a closed economy with NO taxes. What is the
multiplier?

– Now assume that we still have an MPS of 0.2 but we have an open economy
with a marginal tax rate of 10% and the marginal propensity to import is 10%.
What is my multiplier now?
Poverty Cycles/Development Traps

– These terms are interchangeable. They refer to “self reinforcing poverty”.

– If a country’s citizens are poor, they need to spend a large part of their income
maintaining their basic necessities. This results in low savings.
– Low savings results in less economic growth, and thus low/no growth in citizen’s
incomes, resulting in low savings, and repeating the spiral
– Recall back to AS Economics, why does low savings result in low/no growth in
the macroeconomy?
World Bank Income Classifications

– Low income countries: $1035 GNI per capita

– Low-Middle: $1035-$4045
– High-Middle: $4046 – $12,535
– High: $12536 and above
Malthusian Theory

– This is the view that population grows geometrically whereas the quantity of
food grows only arithmetically. Population grows faster than the amount of
food available.
– This was put forward by a reverend in 1798 and was a popular school of
thought around the 1960s/1970s where it seemed this predictions were likely
to come to fruition.
– In modern times, this is very obviously not happening and we are in fact
struggling with the exact opposite problem of stagnant and often shrinking
population growth as a result of economic development.
Dependency Ratio

– Since the opposite of a Malthusian catastrophe seems to be happening right now, we

observe the problem of high dependency ratios once countries become sufficiently
developed.
– A country has a high dependency ratio if the number of people who are too young to
work (young age dependents) and the number of people who are too old to work (elderly
dependents) becomes large as a share of the population. This results in undue stress on
workers and various types of social and psychological dysfunction.
– A high dependency ratio because of many young people is not really a big problem; it
solves itself right away. A high dependency ratio because of a large elderly problem does
not similarly solve itself; young people eventually become working age, old people do
not!
Bellwork 02/25/21

– Government increases expenditure by 2 million dollars. Of this 2 million dollars,

1.8 million is spent and .2 million is saved. Assuming subsequent income is
saved at the same rate, by how much does the initial 2 million dollars boost
GDP?
– 2. Now assume that instead of 1.8 million being spent from the initial 2 million,
1.5 million is spent. The MRT is given as 0.05 and MPM is 0.1. Calculate both
the new multiplier and the new increase in GDP from this new multiplier.
– 3. Describe what is meant by the circular flow of income.
Optimum Population

– In each country during some discrete time period, there exists a population size
that maximizes GDP per capita.
– A population size that is too low results in to little specialization and division of
labor, but once the population is large enough too fully capitalize on
specialization and division of labor, adding one additional person results in the
average being lowered.
– The optimum population size and accompanying growth rate may not be
sustainable in terms of population age demographics/dependency ratio.
Open vs closed economies

– This refers to countries that engage or do not engage in international trade.

Closed economies do not.
– No economies are closed economies in the world anymore besides a few
isolated primitive tribes.
GDP components for open vs closed
economies
The circular flow of income

– The circular flow of income shows how income and spending move
around an economy.
– We have separate ones for open vs closed economies
Domestic (closed) model
Open Economy Circular Flow
Aggregate Expenditure Model

– Aggregate Expenditure differs from Aggregate Demand in 2 really important

ways: 1. AD plots GDP as a function of price levels, whereas AE plots GDP as a
function of INCOME levels. We will label the y-axis as “aggregate expenditure”,
which by definition must be equal to income anyway. GDP=AE= C+I+G+NX still
holds.
– 2. AE’s GDP axis will be nominal rather than real GDP.
AE model

– This might also be referred to as the “Keynesian 45 degree model” because we

start by simply labeling our axes and then drawing a 45 degree upward sloping
line from the origin.
– From there, we draw another upward sloping line originating at some point
above the origin on the income axis.
– The point where these two lines meet is our equilibrium point
Bellwork 03/02/21

– 1. Explain and diagram what is meant by both a recessionary gap and an

inflationary gap using the AE model.
– 2. How do we adjust the multiplier formula for a “four-sector” economy?
Injections and Withdrawals in the
circular flow
– Injections: Additions into the circular flow. These are export revenue,
government spending, and investment
– Withdrawals: Removal of income from the circular flow. This will come from
import spending, savings, and taxation
Injections and Withdrawals

– When injections are equal to withdrawals, the line plotting GDP on the AE
model stays the same. When withdrawals>injections, the line shifts downward
(the slop does not change). When, injections>withdrawals the line shifts
upward.
Inflationary and Deflationary Gaps in
AE model
Inflationary and Recessionary Gaps

– Inflationary gaps in the AE model occur when expenditure is significantly higher

than output. This leads to higher price levels as firms inventories deplete. There
is excess (aggregate) demand and not enough resources to meet it, thus driving
up price levels.
– Recessionary/Deflationary gaps in the AE model occur when expenditure is
lower than output. This leads to a reduction in output and a lower price level as
firms accumulate inventories.
Bellwork 03/08/21

– 1. Explain fully how the paradox of thrift works. (not a definition, an

explanation). What must happen with saved earnings in order to prevent a
paradox of thrift?
– 2. Explain the difference between autonomous and induced investment.
Autonomous vs Induced Investment

– Autonomous Investment is investment which occurs independently of changes

in income. Technological progress, government direct investment in things like
infrastructure, or FDI. There does not need to be a change in income for
autonomous investment.
– Induced investment: This is investment that happens in response to an increase
in income. Observing higher incomes and earning higher profits directed causes
(induces) firms to expand via investment spending
Accelerator Theory

– The accelerator theory focuses on induced investment and emphasises the

volatility of investment. It states that investment depends on the rate of
changes in income (and hence consumer demand), and that a change in GDP
will cause a greater proportionate change in investment.
– If a $1m increase in GDP causes induced investment to rise by $3m, the
accelerator coefficient is said to be 3.
– If GDP is rising, but at a constant rate, induced investment will not change. This
is because firms can continue to buy the same number of
machines each year to expand capacity
► However, a change in the rate of growth of income can have a very significant
influence on investment.
► Table 9.9 provides an example. It is assumed that the firm starts the period with
eight machines, that one machine wears out each year and that each machine
can produce 100 units of output per year.
► The table shows that when demand for consumer goods rises by 25% (from 800 to 1,000) in the second year,
demand for capital goods rises by 200% (from 1 to 3).
► When the rate of growth of demand for consumer goods slows in year 4, demand for capital goods falls,
investment falls to zero with the worn-out machine not being replaced, and hence production capacity is reduced.
► However, an increase in demand for consumer goods does not
always result in a greater percentage change in demand for
capital goods.
► For instance, firms will not buy more capital goods if they have
spare capacity or if they do not expect the rise in consumer
demand to last.
► It may also not be possible for firms to buy many capital goods if
the capital goods industries are working close to capacity.
The Quantity Theory of Money

– Aggregate expenditure is influenced by the money supply and, in turn, can

influence the money supply.
– One theory which seeks to explain how changes in the money supply can have
an impact on the economy is the Quantity Theory of Money. This theory is
based on what is called the Fisher equation, which is MV = PT. This is now more
commonly written as MV = PY. M is the money supply, V is the velocity of
circulation (i.e., the number of times money changes hands), P is the price level
and T or Y is the transactions or output of the economy.
► Both sides of the equation have to
equal each other since both sides
represent total expenditure in the
economy.
► To turn the equation into a theory,
monetarists assume that V and Y
are constant, not being affected by
changes in the money supply, so
that a change in the money supply
causes an equal percentage
change in the price level.
–The Quantity Theory of Money

► For example, the money supply may initially be US$80bn, the velocity of circulation 5,
price level 100 and output is 4bn. If V and Y are unchanged, an increase in the money
supply by 50% to 120 would cause the price level to also rise by 50% to 150.
► The monetarist view is that inflation is a monetary phenomenon. Keynesians, however,
argue that the equation cannot be turned into a
theory since V and Y can change with
a change in the money supply and so
no predictions can be made about
what effect a change in M will have
on P.
Broad and Narrow Money, M1, M2,
M3.
► The money supply is the total amount of money in an economy. It
consists of currency in circulation plus relevant deposits.
► Governments measure the money supply to gain information
about trends in aggregate demand, the state of financial markets
and to help them in determining the direction of monetary policy.
► In practice, measuring the money supply is not straightforward.
This is because it is difficult to decide what to include in any
measure of the money supply.
–Broad and narrow money

► There are two main measures of the money supply:

1. Narrow money: This is money that is used as a medium of exchange and
consists of notes in circulation and cash held in banks and in balances
held by commercial banks at the central bank. This is sometimes referred
to as the monetary base.
2. Broad money: This consists of the items in narrow money plus a range of
items that are concerned with money’s functions as a store of value. An
example is money in savings accounts.
► There are five main causes of an increase in the money supply:
1. an increase in commercial bank lending
2. an increase in government spending financed by borrowing from commercial banks
3. an increase in government spending financed by borrowing from the central bank
4. the sale of government
bonds to private sector
financial institutions
5. more money entering
than leaving the country.
–Commercial banks

► Commercial banks, also called high street banks and retail banks, make most of their
profits by lending to customers, and when they lend they create money. This is because
when a bank gives a loan (also called an advance by bankers), the borrower’s account is
credited with the amount borrowed.
► Banks are in a powerful position to create money because they can create more
deposits than they have
cash and other liquid
assets (items that can be
quickly converted into
cash).
––The credit multiplier
 
► By estimating what liquidity ratio to keep, a bank will be able to calculate its credit multiplier.
This is also referred to as a bank or credit creation multiplier, and shows by how much
additional liquid assets will enable banks to increase their liabilities. It is given by the formula:

► For example, if total deposits rise by $600 million as a result of a new cash deposit of $100m,
the credit multiplier is $600m/$100m = 6. It is also possible to calculate the credit multiplier,
in advance, by
using the formula:
Bellwork 03/10/21

– 1. What is meant by a bank’s “liquidity ratio”? The ratio of a bank’s liquid assets to
liabilities; in simpler terms, what portion of it’s depositors’ money must be held in
the form of liquid assets. What assets do banks hold? They hold cash and loans
(the income stream from a loan that they give to a consumer IS an asset). They
also hold government debt (typically in the form of bonds).
– 2. What are some important differences between Keynesian and monetarist
macroeconomic schools of thought? (start here after quiz)
– 3. What is meant by quantitative easing? A monetary policy where the central
bank buys government bonds from the private sector as a way to increase the
money supply.
How does a commercial bank make
money?
– They make investments and loans and collect interest on these. They get the
money for these investments and loans from the money that is deposited at the
bank.
– They incentivize people to deposit their money at the bank through a
combination of offering various financial services as well as giving interest
payments to depositors.
–Liquidity ratio

► If a bank keeps a liquidity ratio of 5%, the credit multiplier will be 100/5 = 20. Knowing this enables
a bank to calculate how much it can lend. It first works out the possible increase in its total
liabilities, found by multiplying the change in liquid assets by the credit multiplier.
► So, if the credit multiplier is 20 and liquid assets rise by $40m, total deposits can rise by $40m × 2 =
$800m.
► To work out the change in loans (advances), the change in liquid assets is deducted from the change
in liabilities. This is because the change in liabilities will include deposits given to those putting in
the
liquid assets. In the example,
the change in loans can be
$800m − $40m = $760m.
Bellwork (full on in class assignment, not
really bellwork!) 03/11/2021

– 1. What is meant by excess reserves?

– 2. What is the traditional monetary policy tool for increasing aggregate
demand? How does it work and what variable does the central bank
manipulate?
– 3. How does quantitative easing differ from the “conventional” monetary policy
tool above?
– 4. Assume a central bank initiates a quantitative easing program and this results
in commercial banks excess reserves increasing. Does this indicate that no new
lending happens? Why or why not?
– #2: “The central bank increases the money supply to lower interest rates in
order to make people borrow more and save less. This results in more
consumption and more investment spending, thus raising AD.” Central banks
set liquidity ratio requirements (also known as reserve ratio requirements) for
commercial banks. If the ratio goes down, interest rates fall as well. A fall in the
liquidty ratio means that bank doesn’t have to hold as much in reserves and can
thus lend more in order to make more profit, even if they lower the interest
rate they lend at.
– 4. Assume a central bank initiates a quantitative easing program and this results
in commercial banks excess reserves increasing. Does this indicate that no new
lending happens? Why or why not?
– This does NOT indicate that no new lending occurred. We need to know how
much revenue the commercial banks and financial institutions actually got from
the quantitative easing (how much revenue did they earn from selling the
government securities?). If there was a creation of excess reserves but it was
smaller than the amount of revenue that the banks gained, then some portion
of that difference was probably taking the form of new lending (continued on
next slide)
– Furthermore, just because it resulted in the creation of excess
reserves in that time period does NOT indicate that these excess
reserves were not LATER used for more lending. The bank may
take time to match with credit worthy borrowers. The bank may
also end up with more lending only BECAUSE of the presence of
excess reserves; in any sort of recession that would necessitate
quantitative easing, banks confidence is fairly low and they may
seek to remain considerably over their reserve requirement ratios.
–Commercial banks

► The lower they keep the ratio, the more they can lend. However,
they have to be able to meet their customers’ demands for cash.
If they miscalculate and keep too low a ratio, or if people
suddenly start to cash more of their deposits, there is a risk of a
run on the banking system.
–Liquidity ratio
► In practice, however, a bank may not lend as much as the credit multiplier implies it
can. This is because there may be a lack of households and firms wanting to borrow
or a lack of credit-worthy borrowers.
► If banks persist in lending to borrowers with poor credit ratings, as was the case in
the US sub-prime market, the risk of default is high
and can have serious
consequences on a
bank’s liquidity.
–Quantitative easing

► When the rate of interest is very low, a central bank may decide to try to increase aggregate
demand by engaging in quantitative easing.
► This involves a central bank buying government bonds from financial institutions, including
commercial banks, in order to increase the money
supply.
► With more liquid assets, it is
hoped that the commercial
banks will lend more which will
increase investment and
consumer expenditure and so
aggregate demand and
economic activity.
Quantitative Easing

– Why use quantitative instead of conventional monetary policy?

– To answer this question, ask yourself this: What can the central bank do in order to
stimulate AD if interest rates (specifically those offered by commercial banks to
depositors) are already at or near 0?

In order to circumvent this conundrum, the central bank engages in quantitative

easing. Buying government bonds bids down their interest rates, so they become a less
attractive investment for consumers who were already less willing to save their money
in commercial banks but may have been willing to buy government bonds. This results
in more spending from consumers as more liquidity for commercial banks, which
should hypothetically result in more lending and spending.
Quantitative Easing

– In practice however, at least in the US, this resulted in a lot of money being held
by banks in excess of their liquidity ratios.
– Most macroeconomists claim that quantitative easing did help the US (and the
world) out of the 2008 financial crisis. In practice however, it’s impacrt, whether
positive or negative, is impossible to really quantify due to its coupling with
expansionary fiscal policy happening at the same time.
– Other countries have tried Quantitative Easing strategies. Since it is overall quite
new and not well understood even today, nobody really knows if this strategy is
helpful or not. As such, it’s attracted plenty of criticism, see the classic
“Quantitative Easing Explained” video.
Summary of QE

– Quantitative easing is a type of monetary policy in which a nation’s central bank

tries to increase the liquidity in its financial system, typically by purchasing long-
dated government bonds from that nation’s largest banks. Quantitative easing
was first developed by the Bank of Japan (BoJ), but has since been adopted by
the United States and several other countries. By purchasing these securities
from banks, the central bank hopes to stimulate economic growth by
empowering the banks to lend or invest more freely.
Monetary Transmission Mechanism

– The process by which monetary policy influences the macroeconomy.

– Essentially this is just a formal name for a concept we’ve discussed since IGCSE:
Central banks increase the money supply or lower interest rates, which causes
an increase in AD and thus an increase in PL and output.
Bellwork 03/15/2021

– 1. Why do Keynesians think that unemployment is a more serious problem than

inflation?
– 2. How do Keynesians and Monetarists differ with regard to the causes of
inflation?
Keynesian vs Monetarist Views

– The central tenant of Keynesianism (named after John Maynard Keynes) is that
absent any intervention, macroeconomies will NOT necessarily gravitate toward
long run equilibrium and full employment.
– Government intervention in the form of fiscal policy and active monetary policy
from the central bank are therefore justified; without them, the macroeconomy
can and will deviate from long run macroeconomic equilibrium for long periods
of time without any self correction.
Monetarists

– Monetarism posits that the macroeconomy is ultimately self correcting and that most
macroeconomic instability is itself a correction from irresponsible growth in the
money supply resulting from previous time periods monetary policy.
– The top priority is to actively control the money supply and make sure it grows only
by the amount that productivity grows.
– Why not just leave the money supply static? Because under the monetarist view, this
would result in deflation.
– “Inflation is fundamentally a monetary phenomenon”. There can’t be inflation unless
the central bank/govt prints too much money. Cost push/demand pull are not really
“inflation”, just short run deviations in market price that will self correct eventually.
Bellwork 03/16/21

– 1. Explain what is meant by “crowding out” and why

monetarists believe in this concept.

– 2. Explain why Keynesians say that unemployment is a

worse problem than inflation. (again…)
Monetarists vs Keynesians

– Monetarists think that inflation is directly CAUSED by an increase in the money

supply, whereas Keynsians say that inflation can cause an increase in the money
supply. Demand Pull or Cost Push factors increase price levels, resulting in firms
and households borrowing more money to keep pace with price changes, thus
causing increase in the money supply.
Monetarists vs Keynesians

– Monetarists think that government borrowing results in “crowding out”.

Essentially, if governments borrow a lot of money, this is manifest with an
increase in the interest rate. The interest rate is the “price” of a loan. This then
results in less private sector borrowing and investment.
– Keynesians, however, argue that government borrowing, and thus more
government spending, actually results in MORE private sector investment. This,
they argue, is because more government spending raises peoples’ incomes and
then they engage in more investment spending.
Bellwork 03/17/21

– Explain the Keynesian idea of crowding in.

– Crowding in is what happens when an increase in government spending results
in an increase in private sector investment. This happens because higher
government spending leads to higher economic growth (and higher incomes for
consumers and firms), leading to better investment opportunities for firms and
individuals. We mean the capital I investment, not financial investment. Does
depend on the existence of a multiplier effect.
Keynesian AD/AS model and
Wage/Price Stickiness
– Keynesians argue that both wages and prices are inflexible downward (until the
economy is at full employment, anyway). This is because even in times of recession,
workers will not be willing to accept lower wages. This is exactly why price levels do
NOT fall when we have lower AD along the horizontal portion of the AS curve.
– Firms are similarly unwilling to cut prices; they would lose less money by simply
reducing output when compared to cutting prices+wages and producing the same
quantity (This would be especially true for goods with inelastic demand)
– This horizontal portion, then, is “elastic” with respect to a change in output; given a
change in output, there is no change in price level. Firms only sell at one price level
for a given range of GDP values.
Liquidity Preference Theory

– In the Keynesian view, interest rates are a function of the demand for and
supply of money itself.
– The supply of money is fixed and determined by that country’s central bank
– The demand for money is explained by preference for liquidity
– Liquidity: the property of an asset or belonging describing its ability to make
purchases quickly
Why the preference for liquidity?

– 3 reasons: Transaction motive, precautionary motive, and speculative motive

– Transaction motive: We want to hold liquid assets for the very simple purpose
of needing it for our every-day transactions
Precautionary Motive

– We want to hold assets in liquid form in the event of unforeseen or unexpected

negative events. These are not planned purchases, but rather “emergencies”.
– Speculative motive: A reason for holding money with a view to make future
gains from buying financial assets (stocks, bonds, mutual funds,
cryptocurrencies, housing, land)
– We might hold money as an ‘idle balance’ because we believe that the currently
available financial assets have too low of returns, so we keep it as money and
wait until something with a potentially higher return comes along.
Liquidity Preference Theory

– The diagram essentially plots the quantity demanded of money as a downwards

sloping function of the interest rate. If the interest rate is relatively high, we
demand less money; there is more opportunity cost for holding money and we
instead want to save money and earn interest.
– The money supply curve is a fixed vertical line
The Liquidity Trap

– This is essentially what results in something like quantitative easing being

devised.
– The liquidity trap is Keynes idea that if interest rates are low enough, increasing
the money supply does not really increase demand for money (and thus does
not increase spending or borrowing).
International Trade and Aid

– International trade’s impact on a developing country is somewhat ambiguous.

While it is overall positive, they can experience a number of disadvantages as
well.
– Chiefly, developing countries are reliant on exports of primary sector outputs
which have relatively income inelastic demand compared to manufactured
goods. Because of insufficient capital, they import lots of manufactured
goods.This means as its trading partners incomes rise, their demand for the
exports of the developing country don’t rise very much.
International Trade and Aid: Prebisch-
Singer Hypothesis
– Meanwhile, manufactured goods are somewhat income elastic, so when the
developing country’s income rises, they demand much more manufactured
goods imports.
– All of this ultimately leads to a fall in the terms of trade for developing
countries; over time they need to export more of their outputs to receive the
same amount of imports.
– Is this really a “loss” or “disadvantage” of international trade? No, but it does
mean that the benefits of international trade are relatively higher for the
developed country and lower for the developing countries.
International Trade and Aid: Prebisch-
Singer Hypothesis
– Additionally, developed countries often erect trade barriers on developing
countries and pressure developing countries to remove theirs.
– This worsens the problem of developed countries disproportionately benefitting
from international trade.
– Like many things in AS/A2, this hypothesis is not really relevant in 2021, or even
in 1990. It was more of an observation than a hypothesis and was only really
empirically true a very long time ago before any of us were born.
Foreign Aid

– Occasionally, developed countries will grant donations or provide goods and

services directly to people in developing countries.
– They have several motivations for this, including altruistic, political, and
economic ones.
– Aid may compensate for the lack of savings in developing countries and result in
higher economic growth; this is good for trading partners in the long run, even
if it costs the trading partner in the short run.
MNCs and FDI

– This is essentially unchanged from IGCSE material.

– MNCs (Multinational Companies) are companies that produce in more than one
country. An MNC setting up in a developing country may be beneficial or
harmful.
– It depends on the wages/working conditions relative to domestic producers
AND whether or not their presence drives local competitors out of business.
– They may set up in industries that are undeveloped or simply do not exist in the
developing country, in which case driving out local businesses is not a concern
at all.
The role of the IMF, World Bank, and
WTO.
– The International Monetary Fund (IMF) aims to promote world trade, promote
economic stability, and offer assistance to countries with balance of payments
difficulties
– The World Bank provides credit to predominantly developing countries to
finance their investment projects so that they can develop and grow more
quickly.
– World Trade Organization also promotes free trade and encourages the removal
of trade barriers. It also mediates any trade disputes between different
countries.
Foreign Aid

– Assistance to poor countries in the form of direct provision of goods or services,

low-interest loans, grants, or technical assistance can all be classified as foreign
aid.
Bellwork 03-04-21

– What are 3 of metrics that indicate the quality of life/level of economic

development in a country?
– Which is more harmful to an economy? Structural or cyclical unemployment?
Why or why not?