Section 2:

Macroeconomics
Section 2: Macroeconomics
2.1 The level of overall economic
activity
2.2 AD and AS
2.3 Macroeconomic objectives
2.4 Fiscal policy
2.5 Monetary policy
2.6 Supply-side policies
2.1 The level of overall
economic activity
 Unit Goals
Students should be able to define, diagram,
give examples of, and evaluate:
2.1.1 Economic activity
 The circular flow of income model
 Measures of economic activity:
- Gross domestic product (GDP)
- Gross national product (GNP)
- Gross national income (GNI)
2.1.2 The business cycle
 Short-term fluctuations & long-term trend
2.1 The level of overall e
conomic activity

2.1.1 Economic activity

(Quantitative questions)
2.1.2 The business cycle
 A Big Picture Of Economics
Classical • An economy will rest at FE.
economics: • Laissez-faire (don’t intervene).
Free market

Keynesian • An economy may not rest at FE.

school: • Govt can stabilize economy &
achieve FE.
An active • D-side policies (fiscal &
government role monetary)

Neo-classical school: • An economy will always

move towards FE.
Free market • Minimum GI
&
minimum • S-side policies (mkt-based
intervention & interventionist)
 A timeline of economics: who rules?
 Pre-1929 (150 years): The classical school
Free market. Adam Smith
 1930s/After WWII - 1970s: The Keynesian school
An active government role. John M. Keynes
(First regular use of expansionary fiscal policy: Roosevelt in US i
n Great Depression of 1930s.)
 1970s – 1990s: New classical school
Free market and minimum intervention. Followers of classical
• 1970s: Monetarism: Milton Friedman. Deconstructed Keynesia
n interventionist approach. Markets “rule”.
(Economic crisis: stagflation, 1973 1st oil crisis/great inflation)
• 1980s: Supply-sider: market forces are further emphasized.
(Thatcher in 1979 in UK and Reagan in 1980 in US)
 Late 1990s - Debate continues...
• 1997-8 East Asian crisis and 2007-9 Great Recession: a revival
of Keynesian policies: doubts on extreme pro-market policies
and “Washington Consensus”.
• Rising inequalities within/between countries: necessity to ma
nage globalization.
 2.1 The level of overall
economic activity
2.1.1 Economic activity
 The circular flow of income model
 Measures of economic activity:
- Gross domestic product (GDP)
- Gross national product (GNP)
- Gross national income (GNI)
Syllabus content
2.1.1 Economic activity
 The circular flow of income model
 Describe, using a diagram, the circular flow of income between households and firms
in a closed economy with no government.
 Identify the four factors of production and their respective payments (rent, wages, in
terest and profit) and explain that these constitute the income flow in the model.
 Outline that the income flow is numerically equivalent to the expenditure flow and t
he value of output flow.
 Describe, using a diagram, the circular flow of income in an open economy with gove
rnment and financial markets, referring to leakages/withdrawals (savings, taxes and i
mport expenditure) and injections (investment, government expenditure and export
revenue).
 Explain how the size of the circular flow will change depending on the relative size of
injections and leakages.
 Measures of economic activity
 Examine the output approach, the income approach and the expenditure approach
when measuring national income.
 Distinguish between GDP and GNP/GNI as measures of economic activity.
 Distinguish between the nominal value of GDP and GNP/GNI and the real value of G
DP and GNP/GNI.
 Distinguish between total GDP and GNP/GNI and per capita GDP and GNP/GNI.
 Explain the meaning and significance of “green GDP”, a measure of GDP that account
s for environmental destruction.
 Evaluate the use of national income statistics, including their use for making compari
sons over time, their use for making comparisons between countries and their use fo
r making conclusions about standards of living.
Quantitative questions:
 Calculate nominal GDP from sets of national income data, using the expenditure app
roach. (HL only)
 Calculate GNP/GNI from data. (HL only)
 Calculate real GDP, using a price deflator. (HL only)
 2.1 The level of overall
economic activity
 The circular flow of income model
 2.1 The level of overall
economic activity
The circular flow of income model
Definition
The circular flow of income model is a simplified
model of the economy that shows the flow of
money through the economy.
The circular flow of income model is a simple model
of the economy showing flows of goods and
services and factors of production between firms
and households.
• Two sector model
• Four sector model
A closed economy with two sectors (household
s & firms)

Income:
Rent
Wages
Output: Interest
Expenditure Goods & services Factors of production: Profits
on goods & service (3) Land (2)
(4) Labor
Capital
Management
(1)
• The four factors of production (land, labour, capital & e
ntrepreneurship) and their respective payments (rent,
wages, interest and profit) constitute the income flow i
n the model.
Income circulates throughout economy:Households provid
e FoP (1) and receive income (2); they buy the g&s (3) prod
uced by the firms by using the income received (4).
(Households provide FoP for firms who produce g&s. In ret
urn FoP receive factor payments, which in turn become ex
penditure on g&s produced by firms.)
• The income flow is numerically equivalent to the expe
nditure flow and the value of output flow.
income flow (2) = expenditure flow (4) = output flow (3)
- income flow: wages, rent, interest, profits
- expenditure flow: expenditure on g&s
- output flow: goods & services
An open economy with four sectors & financial markets
(households, firms, the gov’t & foreign sector)
The size of the circular flow will change depending on the re
lative size of injections & leakages. (link to AD/AS diagram)
- e is in equilibrium where leakages = injections.
- if leakages rise, without a corresponding increase in injec
tions, national output will fall to a new E, as there will be l
ess income circulating.
when leakages > injections, size of circular flow will diminish
and e will tend towards recession and unemployment.
- if injections rise with no corresponding rise in leakages, th
e economy will rise to a new E.
when injections > leakages, size of circular flow will increa
se and e will tend towards expansion and inflation.
- eg a rise in saving and a fall in I will decrease the value of
the circular flow of income.
Leakages (Withdrawals): income not passed on by households to domes
tic firms in circular flow of income
• Savings(S): hds do not spend all income on g&s but save some of it in banks
• Taxes(T): payments made to gov’t
• Import expenditure(M): buying g&s from other countries
Injections: addition to income of domestic firms besides expenditure of households
• Investment(I): addition of capital stock to an economy
• Gov’t spending(G): except transfer payments
• Export revenue(X): selling g&s to other countries
Circular flow of income in an open economy:
- savings → banking sector → investment
- taxes → gov’t → gov’t spending
- import expenditure → foreign sector → export revenue
 2.1 The level of overall
economic activity
 Measures of economic activity:
- Gross domestic product (GDP)
- Gross national product (GNP)
- Gross national income (GNI)
 2.1 The level of overall
economic activity
THREE approaches to measure
national income:
1. Output approach
2. Income approach
3. Expenditure approach
 Two-sector circular flow of income model

Household
s
Expenditure Output: FOP: Income:
on goods Goods Land Wages
and and Labor Rent
services services Capital Interest
(4) (3) Management Profits
(1) (2)

Firms
Examine THREE approaches to measure national
income:
1. Output approach (3): measures the actual value of final
g&s produced domestically.
2. Income approach (2): measures the value of all the
incomes earned in the economy
3. Expenditure approach (4): measures the value of all
spending on g&s in the economy; includes spending by
households (Consumption), spending by firms
(Investment), by gov’t (Gov’t spending), and spending by
foreigners on exports minus spending on imports (X-M,
net exports): GDP = C + I + G + (X–M)
● In theory, 3 methods are equivalent: each measures the same
national income by different sets of data, accounting will result
in the same equal final figure: National income = national
output = national expenditure
● In practice, imbalance among final values b/o inaccuracy of
data collection. Figures have to be revised at later times when
full information is collected.
● Each method is useful for its data analysis, e.g.:
- output method gives the share of total output by each sector
& output of different industries.
- income method provides information about proportion of
total income earned by labor in contrast to capital owners.
- expenditure method permits to monitor I spending level
through time or G proportion in total economic activity.
 2.1 The level of overall
economic activity

National income statistics:

1. GDP and GNP/GNI
2. Nominal GDP & real GDP
- GDP deflator
3. Per capita GDP & GNP/GNI
4. Green GDP
 1. GDP and GNP/GNI
• Gross domestic product (GDP) is the total value of
all final goods and services produced in an econom
y in a year.
GDP: total output produced within the boundary of a c, re
gardless of who owns the assets or FoP nationality.
• Gross national product/income (GNP/GNI) is the t
otal value of all final goods and services produced
by a country’s nationals in a year (total income ear
ned by a country’s factors of production).
GNP/GNI: total output produced/income earned by a cou
ntry’s FoP, regardless of where assets are located or where
production actually takes place.
• E.g. the UK GNP include income earned by British MN
Cs abroad, but not include the income earned by forei
gn companies operating in the UK.
• GNP/GNI ==GDP
GDP + net property income from abroad
+ (income earned abroad – income paid abroad)
Example:
2010 (billion yuan)
Household consumption expenditure 13,329
Government consumption expenditure 5,361
Gross capital formation 19,169 Net exports
of goods & services 1,571
Gross domestic product (current prices) 39,430
Net property income from abroad 896
Gross national product/income 40,326
2. Nominal GDP & real GDP
When comparing GDP over time, inflation distort/overstate GDP
value.
An increase in GDP may not be due to an increase in output but
due to an increase in Ps (GDP will rise even if no increases in
output). So in order to get a true picture of changes in economy,
it is necessary to use the real value.
• Nominal GDP (GDP at current prices, money GDP) is the
value, in current prices, of all final goods and services
produced in a country within a given time period.
- A measure of output of a certain period valued at the Ps
prevailing in that same period.
- Change reflects both Ps & Qs
• Real GDP (GDP at constant prices) is the value, in
constant prices, of all final goods and services produced
in a country within a given time period, usually
measured against prices of predetermined base year.
Real GDP = GDP adjusted for inflation
- A measure of output of a certain period valued at the Ps
prevailing at some base period.
- Change reflects the amount that GDP would change if Ps
GDP deflator
 

To calculate real GDP, a P index is used to factor out

P changes hidden by nominal GDP. Usually it is GDP
price deflator or consumer price index (CPI).
• GDP deflator is a general P index that includes all
kinds of goods (measures Ps across all goods.)
• CPI covers only consumer good by urban hhds.
Real GDP = x 100
GDP deflator = x 100
3. Per capita GDP & GNP/GNI
GDP per capita (GDP per head/person) is the total
GDP divided by population size in a country.
Per capita GDP = GDP/population
Usually used for comparing countries in terms of
raising living standards
Eg in 2005, China’s GDP (US$1,417 bn) is 65% higher
than Canada’s (US$857 bn). However, Canada’s GDP per
capita (US$27,079) is 26 times China’s (US$1,100)
• Nominal per capita GDP = nominal GDP/population
Usually used for comparison across countries
• Real per capita GDP = real GDP/population
Usually used for measuring real per capita GDP
growth in a certain country
4. Green GDP
Green GDP is a measure of GDP that takes into
account environmental costs incurred from the
production of the goods and services included in the
GDP figures.
Green GDP = GDP - environmental costs of production
“Green GDP” is a measure of GDP that accounts for
environmental destruction.
• Environmental costs of production include:
health, agricultural & industrial costs caused by air &
water pollution, costs of waste disposal & clearing up
environmental damage (eg BP oil spills off US coast in 2010)
• It estimates a country’s aggregate output while factoring
in any output losses created by environmental
degradation (eg soil erosion, pollution, loss of bio-
diversity & contributions to climate change)
 2.1 The level of overall
economic activity

Quantitative questions
• Calculate nominal GDP from sets of national
income data, using the expenditure
approach. (HL only)
• Calculate GNP/GNI from data. (HL only)
• Calculate real GDP, using a price deflator.
(HL only)
Formula:
 

1. GDP = C+I+G+(X-M)
GNP/GNI = GDP + net property income from
abroad
= GDP + (income earned abroad - income paid
abroad)

2. Real GDP = x 100

GDP deflator = x 100

1. Use the expenditure approach, calculate the
GDP of Canada in 2009:
(million CAD$)
Consumer expenditure 1 527 258
on goods and services
Business investment 269 394
Government expenditure 333 942
Exports 438 553
Imports 464 722

• GDP = ?
• GDP = CAD$ 2,104,425 million
2. The table shows national income statistics of a country.
Category US$ billion
Government spending 900
Transfer payments 320
Gross private domestic investment 410
Taxation 340
Consumption 950
Imports 330
Exports 150
Net property income from abroad -270
Saving 60

a. Calculate GDP using the expenditure approach.

GDP = 950+410+900+(150-330) = US$ 2,080 billion
b. Calculate GNP/GNI.
GNP/GNI = 2,080 + (-270) = US$ 1,810 billion
3. Calculate the GDP deflator and real GDP for
the following examples:
Nominal GDP Real GDP
Year (billion yuan) (billion GDP deflator
yuan)
2005 18,494 18,494 100
2006 21,631 20,838 103.8

2007 26,581 23,789 111.7

2008 31,405 26,084 120.4

2009 34,090 28,480 119.7
4. Using 2008 as the base year, calculate the
real GDP for the following examples:
Year Nominal GDP Price index Real GDP
($ billion) (GDP (2008 prices)
deflator)
46.91
2007 45.5 97.0
2008 49.3 100 49.30
2009 54.3 104.3 52.06
2010 60.4 107.4 56.24
2011 62.1 110.1 56.40
5. The table shows national income statistics of a country.
Year Nominal Nominal GDP Real Real
GDP GDP deflator GDP GDP
($ growth ($ growth
billion) (%) billion) (%)
2009 586 N.A. 97 604 N.A.
2010 620 5.8 100 620 2.6
2011 625 0.8 102 613 -1.1
2012 624 -0.2 99 630 2.8
a. Using 2010 as the base year, calculate the nominal GDP
growth rates, real GDP & real GDP growth rates.
b. Briefly explain the differences b/t nominal & real GDP
growth rates in 2011 & 2012.
2011: mild inflation, so real GDP g.rate lower than nominal
2012: mild deflation, although negative nominal g.rate,
there was actually still some growth in real terms
c. Which phase of the business cycle was this economy
most likely going through in 2011?
In the phase of recession.
 2.1 The level of overall
economic activity

 Evaluate the use of national

income statistics
Use of national income statistics
1. to make comparisons over time
for performance of an economy
2. to make comparisons between countries
3. to make conclusions about standards of living
used as a basis for evaluating quality of life of a country
4. to develop policies eg
gov’ts use to decide whether expansionary or
contractionary D-side policies should be used
5. to evaluate success of a govt’s economic policies
eg people use as “report card” to judge if a govt has been
successful in achieving its main goal - increased growth
6. businesses use to make forecasts about future D
7. economists use to develop models of economy &
make forecasts about future
Limitations of national income statistics
When we use n.i. data to compare b/t c or measure l. stds, i
t is important to be aware of many limitations of the data:
While there is a positive correlation b/t GDP & social welfare,
growth in GDP does not necessarily mean improved l.stds
& may mask many significant differences & inequality b/t c.
1. Inaccuracies & inconsistencies (data:measurementproblems)
2. Unrecorded/under-recorded economic activity -
informal markets
3. A widening wealth gap is not reflected
- income distribution
4. External costs
5. Other indicators of living standards should be c
onsidered
6. Composition of output
PB P.247-250, CC P.163-4
1. Inaccuracies & inconsistencies
Measurement problems distort comparisons b/t countries.
• Statistics may be inaccurate (from a wide range of sources: tax claim
s by households & firms, output & sales data)
• Accuracy degree will vary from c to c (many developing c have poor
/unreliable data collection)
• Different countries have different conventions of calculations.
2. Unrecorded/under-recorded e. activity - informal markets
Informal markets (parallel markets) are markets in which activity is
not officially registered (recorded).
GDP data do not include unrecorded/under-recorded e.activity:
• Street vendors: typically part of informal sector
• Work at home (Do-it-yourself work) & subsistence farming
(S.f. output may be very significant in many low-income developing c.)
• Hidden economy (shadow/parallel/black/underground e.):
- Illegal activity: drug trafficking, prostitution
- Legal activity but people do it illegally: foreign workers with no wo
rk permits do cleaning/work in restaurants
- Tax-evading behavior: self-employed ppl under-report income to a
void income taxes, smokers buy cigarettes illegally to avoid indirec
t taxes, employers hire workers unofficially. (Gen. c with heavy tax
burden have a bigger size of hidden e.)
• Extent of ‘black’ or informal economy may differ, leading to varying
levels of underestimation in different c.
3. A widening wealth gap is not reflected: income distribution
• The data do not indicate income distribution in the economy:
does not tell whether income is equitably or unequally distri
buted
• An increase in GDP may not necessarily lead to an improvement i
n livelihood for population majority
4. External costs
• The data do not value costs of pollution, environmental degradati
on & resource depletion
Eg agriculture is responsible for soil erosion & forest burning; ind
ustrialization for heavy air/water pollution, traffic congestion in c
ities, emissions & increased energy requirements
• External costs compromise life quality, even as GDP increases
5. Other indicators of living standards should be considered
• Other important concerns on life quality: eg life expectancy, infan
t mortality, literacy rates, access to safe water, daily calorie suppl
y, number of doctors per 1000 people, the amount of leisure tim
e, free activities
Value of leisure: GDP may grow as ppl work longer hrs/take fewer holidays
. While earn higher income, may not actually enjoy higher l. stds.
Free activities: volunteer work or caring for the elderly & children at home
. Can lead to a better society, but discouraged in pursuit of e. growth.
6. Composition of output is not reflected
A country may have a large proportion of output in goods that do
 2.1 The level of overall
economic activity
2.1.2 The business cycle
 Short-term fluctuations & long-term
trend

Syllabus content
2.1.2 The business cycle
 Short-term fluctuations and long-term trend
 Explain, using a business cycle diagram, that economies typically tend
to go through a cyclical pattern characterized by the phases of the
business cycle.
 Explain the long-term growth trend in the business cycle diagram as
the potential output of the economy.
 Distinguish between a decrease in GDP and a decrease in GDP
growth.
 2.1 The level of overall
economic activity
Short-term fluctuations & long-term trend
Business cycle =
SR fluctuations in real GDP around its LR trend

Definition
Business cycle (trade cycle) is the short-run
fluctuations of real GDP around its long-run trend.
Business cycle is the periodic or cyclical fluctuations
in economic activity (real GDP) around its long-term
growth trend. It shows that economies typically
move through a pattern of economic growth with
the phases: boom, recession, trough & recovery.
Economies typically tend to go through a cyclical pattern
characterized by the phases of the business cycle.
4 phases: boom (peak), recession (contraction),
trough, recovery (expansion)
• Recovery (expansion): GDP increa
ses at a rising rate.
AD↑ → unempt↓, PL↑(inflation)
• Boom: as e. nears potential output:
inflationary pressure↑, GDP growth↓
: policymakers will slow down growt
h → AD↓(beginning of recession)
• Recession (contraction): two cons
ecutive quarters of negative GDP
growth, i.e. falling GDP.
AD↓ → unempt ↑
PL↓(low inflation/deflation
• Trough: contraction comes to an end,
output cannot continue to fall. AD w
ill pick up & e. will enter recovery: th
e cycle will repeat itself.
• Economies tend to go through cyclical fluctuations in
real GDP around their long-term growth trend.
• LT growth trend in the business cycle represents the
potential output of the economy (its PPC).
• 2nd recovery at a higher real GDP l
evel than 1st & each boom higher t
han the last
• Actual output line: ST cyclical fluct
uations in growth
LT trend line: a steady ↑in output
(represents growth rate that e. ca
n sustain over time)
• Output gap: difference b/t actual
& potential output
− At point A: negative output gap:
e. producing below potential & u
nemployment*
− At point B: positive output gap: e
. producing above capacity & infl
ation*
*“Trade-off” b/t inflation & unempt
will address in detail later
 Distinction:
A decrease in GDP
A decrease in GDP growth
• A decrease in GDP = t
he economy actually gets sm
aller, i.e. a recession.
During a recession, there is a dec
rease in GDP (i.e. negative GDP gr
owth)
• A decrease in GDP growth =
the economy continues to gr
ow, but at a slower rate.
In approaching its boom, an econ
omy often experiences a decreas
e in GDP growth (i.e. falling GDP
growth)
 Assessment advice: interpreting data
Result:
In all years the GDP of Lu
xembourg was rising.
• 2002-03 (3.5%-2%):
GDP grew, but at a slower r
ate than it had the previous
year.
• 2003-04- 05: (2%-4.2%-4%):
Growth rate increased shar
ply to 4.2% and then slowe
d slightly in the next year to
4%.

CC P. 169
 Exercise
Match each term or concept with the appropriate
definition or explanation.
1 Long-term trend a The maximum GDP
recorded immediately
before a downturn star
ts
2 Recession b When real GDP increases
3 Expansion c The real GDP recorded i
mmediately before recov
ery begins
4 Trough d Potential GDP
5 Boom (Peak) e When real GDP falls for
at least two consecutive
quarters
How does the world see
China’s GDP growth?
Where do
you live?