Week 5

The Macroeconomic Environment

Sloman et al. (2023) – Chapter 26
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 Course Material
 Module 5 – Introduction to macroeconomic concepts

 Module 6 – The monetary economy

 Module 7 – Macroeconomic equilibrium and policy

 Module 8 – Productive capacity and the external economy

 The Macroeconomic Environment
Lecture Structure and Content
 Key macroeconomic issues – economic growth, unemployment, inflation, foreign trade and
global economic relationships, financial well-being
 Circular flow: national income and aggregate expenditure
 Income determination – calculating equilibrium national income
 Aggregate demand/aggregate supply analysis
 Role for government policy – stabilisation, full employment,
 Fiscal, monetary, supply side policy approaches; investment – growth
 Quantity theory of money: money supply and price level -- inflation
 So, what is macroeconomics about?

The Whole Economy

 A big role for government policy: managing unemployment and inflation

 Supporting economic growth – making sure that it’s sustainable

 Avoiding recession – keeping business confidence high

 We think about these by concentrating on

 National income – total value of transactions in the economy

 Payments made to households as owners of factors of production

 Price level – average price of all market transactions

 So aggregate demand – aggregate supply diagram important tool

 The Macroeconomic Environment
Key macroeconomic issues
 Economic Growth
 Unemployment
 Inflation
 The economic relationship with the rest of the world
 The financial well-being of individuals, businesses and other organisations, governments and
nations, and the relationship between the financial system and the economy.
 The Macroeconomic Environment
Key macroeconomic issues - Economic Growth
 To be able to measure how quickly an economy is growing, we need a means of measuring the value
of a nation’s output.
 Gross Domestic Product (GDP) - the value of output produced within a country (typically over a 12-
month period)
 To compare changes in output from one period to the next we must eliminate those changes in GDP
that result simply from changes in price.
 Nominal GDP - GDP measured at current prices (taking no account of inflation)
 Real GDP - GDP measured at constant prices that ruled in a chosen base year (e.g. 2018)
 Business cycle or trade cycle - the periodic fluctuations of national output around its long-term
trend. Economies suffer from inherent instability.
 Annual economic growth rates
10

8
Annual economic growth rate (%) 6

–2

–4

–6 Eurozone Germany
UK USA
–8
Japan Australia
–10
11111111111111111111111111111122222222222222222222222222
99999999999999999999999999999900000000000000000000000000
77777777778888888888999999999900000000001111111111222222
01234567890123456789012345678901234567890123456789012345
Notes: Data from 2022 based on forecasts; Eurozone = 19 countries using the euro (as of 2022); figures for Germany based on West
Germany only up to 1991.
Sources: Based on data in AMECO Database (EC) up to 1980; and World Economic Outlook (IMF, October 2022); various forecasts
 Output paths from 1965
Eurozone Germany
160 UK USA
Real GDP (2000 = 100) (log scale)
Japan Australia

80

40

20
11111111111111111111111111111111111222222222222222222222222222
99999999999999999999999999999999999000000000000000000000000000
66666777777777788888888889999999999000000000011111111112222222
56789012345678901234567890123456789012345678901234567890123456
Notes: Data from 2022 based on forecasts; Eurozone = 19 countries using the euro (as of 2022); figures for Germany based on West
Germany only up to 1991.
Sources: Based on data in AMECO Database (European Commission) up to 1980; and World Economic Outlook (IMF, October 2022)
 The Macroeconomic Environment
Key macroeconomic issues - Unemployment
 The inherent instability of economies has implications for the number of people in work, and so for the
number unable to find work.
 Higher levels of economic activity will tend to reduce unemployment, while reduced activity will tend to
increase them.
 Number unemployed - those of working age who are without work, but who are available for work at
current wage rates.
 Labour force - the number employed plus the number unemployed.
 Unemployment rate - the number unemployed expressed as a percentage of the labour force.
 Underemployment - when people work fewer hours that they would like at their current wage rate.
 If resources are not being used, they are unemployed (unused or underused, e.g. lecture theatre at 7am)
 Q If there are 3 million people unemployed and 24 million
people employed, the rate of unemployment will be:

A. 3%

B. 8%

C. 9%

D. 11.1%

E. 12.5%
 Unemployment
 Standardised unemployment rate - measure used by ILO and OECD. People of working age who
are without work, available for work and actively seeking employment.
 Claimant unemployment - those in receipt of unemployment-related benefits.
 Unemployment trends
 cyclical movements – variations across the business cycle
 longer-term trends – structural changes in the labour market
 The costs of unemployment
 costs to the unemployed – financial costs, self-esteem, stress-related illness
 wider costs
 to family and friends – strain on personal relations, families splitting up, domestic violence
 cost to taxpayers; impact on social services, health care, police; firms lose profit, impacts national output
Standardised unemployment rates by age and gender, average 2010–21
Less than 25 years 25 to 74 years All ages
Male Female Total Male Female Total Male Female Total
EU 27 20.6 20.5 20.6 7.8 8.3 8.0 9.0 9.4 9.2
Eurozone 20.9 20.6 20.8 8.4 9.0 8.7 9.6 10.0 9.8
Austria 11.0 10.0 10.5 5.2 4.7 5.0 6.0 5.3 5.6
Belgium 20.5 18.5 19.6 6.4 6.1 6.3 7.6 7.0 7.3
Denmark 14.2 11.9 13.1 5.0 5.5 5.2 6.3 6.5 6.4
France 22.3 25.6 23.8 7.9 7.6 7.8 9.4 9.3 9.3
Germany 8.6 7.1 7.9 4.2 3.6 3.9 4.7 4.0 4.4
Greece 40.7 50.5 45.2 16.3 23.3 19.3 17.7 25.1 20.9
Ireland 23.6 17.1 20.6 9.1 7.5 8.4 10.9 8.8 9.9
Italy 32.5 36.3 34.1 8.3 10.1 9.1 9.9 11.7 10.6
Netherlands 12.5 10.4 11.4 4.6 5.8 5.1 5.9 6.6 6.2
Poland 18.1 20.0 18.9 5.5 6.1 5.8 6.6 7.2 6.9
Portugal 26.8 29.8 28.2 9.7 10.1 9.9 11.1 11.5 11.3
Spain 43.7 43.0 43.4 16.6 19.2 17.8 18.5 20.9 19.6
Sweden 22.0 20.3 21.2 6.0 5.9 5.9 7.9 7.7 7.8

Source: Based on data from Employment and Unemployment (LFS) (Eurostat, European Commission)
 Definitions: Unemployment

 Average real wage rate – the average wage rate expressed in terms of its purchasing power (in other
words, after taking inflation into account)

 Aggregate supply of labour curve - shows the total number of people willing and able to work at different
average real wage rates.
 Relatively inelastic since the size of the workforce at any one time cannot change significantly.
 Not completely inelastic because (i) a higher wage rate will encourage some people to enter the labour market
(e.g. parents raising children) and (ii) the unemployed will be more willing to accept job offers rather than
continuing to search for a better-paid job.

 Aggregate demand for labour curve - shows the total demand for labour in the economy at different
average real wage rates.
 Slopes downwards – the higher the wage rate, the more firms will attempt to economise on labour and
substitute other factors of production.
 Definitions: Unemployment

 Disequilibrium unemployment - unemployment resulting from real wages in the economy being above the
equilibrium level.
 For disequilibrium unemployment to occur, two conditions must hold:

 the aggregate supply of labour must exceed the aggregate demand.

 there must be a stickiness in wages (in other words the wage rate must not immediately fall to the
equilibrium wage rate).

 Equilibrium (‘natural’) unemployment - the difference between those who would like employment at the
current wage rate and those willing and able to take a job.
 Even when the labour market is in equilibrium, however, not everyone looking for work will be
employed.
 Some people will hold out looking for a better job.
 Disequilibrium unemployment

ASL
Average (real) wage rate Disequilibrium
unemployment

b a
W2

We

ADL

O Q2 Q1
No. of workers
 Equilibrium unemployment

ASL N
Average (real) wage rate

e d
We
Equilibrium
unemployment

ADL

O
Qe Q2
No. of workers
 Equilibrium and disequilibrium unemployment

ASL
N
Average (real) wage rate Disequilibrium
unemployment

b a c
W2
e
We Equilibrium
unemployment

ADL

No. of workers
 Disequilibrium Unemployment
 Real-wage unemployment – caused by real wages being driven up above the market-clearing level.
 Union power not as strong now, labour markets more flexible, labour available in other countries due to
globalisation, UK evidence suggests minimum wage not high enough to have adverse effects on
employment.

 Demand-deficient (cyclical) unemployment - disequilibrium unemployment caused by a fall in aggregate

demand with no corresponding fall in the real wage rate.
 Associated with recessions – as the economy moves in recession, consumer demand falls, firms find that
they are unable to sell their current level of output, firms cut back on production, firms cut back on
labour.

 Growth in the labour supply – if labour supply rises with no corresponding increase in the demand for
labour, equilibrium wage rate will fall. If wages are ‘sticky’ unemployment will occur.
 Equilibrium Unemployment
Although there may be overall macroeconomic equilibrium, with aggregate demand for labour equal to the
aggregate supply (and thus no disequilibrium unemployment), at a microeconomic level supply and demand
may not match.
 Vacancies in some parts of the economy

 Excess labour (unemployment) in others.

 Frictional (search unemployment) – occurs when people leave their jobs, either voluntarily or because
they are sacked or made redundant, and they are unemployed for a period, while they look for a new job.
 They may not get the first job they apply for (the employer may continue looking for a better-qualified
person.
 They may not take the first job they are offered – maybe there will be a better one
 Imperfect information – workers are not fully informed about what jobs are available and what they entail,
employers are not fully informed about what labour is available
 Equilibrium Unemployment
 Structural unemployment – occurs where the structure of the economy changes. Employment in some
industries may expand while in others it contracts. Why?
 A change in the pattern of demand – some industries experience declining demand. This may be due to
changing consumer tastes or competition from other industries. For e.g., shift away from coal to other fuels.
 A change in the methods of production – new techniques of production often allow the same level of output to
be produced with fewer workers (labour-saving technological process).
 Unless output expands sufficiently to absorb the surplus labour, people will be made redundant.
 Creates technological unemployment. For e.g. job losses in the retail sector and banking
 Regional unemployment – most likely to occur when specific industries are concentrated in specific areas, for
e.g. the decline in the South Wales coal-mining industry.

 Seasonal unemployment - occurs when the demand for certain types of labour fluctuates with the seasons.
Q Which of the following defines real-wage unemployment?

A. Real wages being set above the equilibrium level by trade unions, or minimum wage
legislation.
B. Inflation causing an erosion of real wages and hence a rise in unemployment.
C. Increased aggregate demand in the economy driving up equilibrium real wages.
D. Increased aggregate demand in the economy causing money wages to rise faster than
real wages.
E. Real wages falling below the equilibrium level as a result of deficiency of demand.
 Q Frictional unemployment is the result of:

A. A shift in the pattern of consumer demand.

B. Workers and employers being ill-informed about the labour market.

C. The introduction of new technology.
D. The economy entering the recessionary phase of the business cycle.
E. Employers responding to the time of year and cutting back on their level of production.
 The Macroeconomic Environment
 Key macroeconomic
issues - Inflation
 The percentage increase
in the (general) level of
prices over a 12-month
period.
 Typically, inflation relates
to consumer prices.
 Inflation
 The Costs of Inflation
 Menu Costs
 Changing price labels, catalogues, menus

 Redistribution
 Inflation redistributes income away from those on fixed incomes (e.g. pensioners)

 Inflation redistributes wealth to those with assets (e.g. Property) and away from those with savings
(with interest rates that pay below the rate of inflation)
 Uncertainty and lack of investment
 Greater with higher inflation and inflation volatility

 Balance of payments
 Exports will become less competitive, imports become relatively cheaper

 Resources used to cope with inflation

 Firms need additional financial advice on how to cope with the effects of inflation.
 The Macroeconomic Environment
 Key macroeconomic issues - Financial well-being
 Importance of financial stability and the problem of financial distress
 2007-09 financial crisis
 Led to economic turmoil globally, due to the interconnectedness of financial institutions and market.
 Financially distressed governments, businesses and households who were burdened by unsustainable
levels of debt.
 Financial accounts – three key accounts compiled for the main sectors of the economy (the household,
corporate and government sectors), and the whole economy
 Income account – economic growth refers to the annual real growth in a country’s income flows
 Financial account – financial flows (new saving, borrowing or repayments) and balance sheet (record
of stocks of assets and liabilities of individuals and institutions)
 Capital account – flows and stocks of physical assets and liabilities
 The Macroeconomic Environment
 Macroeconomic policy objectives
 High and stable economic growth
 Low unemployment
 Low rates of inflation
 Avoidance of balance of payments deficits and excessive exchange rate fluctuations
 Stable financial system
 Avoidance of excessively financially distressed sectors of the economy, including government

 Conflicts between objectives

 For e.g., a policy designed to accelerate the rate of economic growth may result in higher inflation, a
balance of payments deficit and excessive borrowing.
 Economic Volatility and the Business Cycle
A fundamental characteristic of economies is their volatility – they experience both periods of
expansion and periods of negative growth (contraction in output levels).

Growth in actual and potential output

 Recession - period where national output falls for a few months or more. Officially, where real
GDP declines for two or more consecutive quarters.
 Actual growth - the percentage annual increase in national output actually produced, usually
measured over 3-month or 12-month periods.
 Potential growth - the speed at which the economy could grow. The percentage increase in the
economy’s capacity to produce over a period of time.
 Economic Volatility and the Business Cycle
 Potential output – the level of output when the economy is operating at ‘normal capacity utilisation’.

 Allows for firms having a planned degree of spare capacity to meet unexpected demand or for hold-ups in
supply.
 It is somewhat below full-capacity output, which is the absolute maximum that could be produced with firms
working flat-out.
 Output gap – the difference between actual output and potential output.

 If actual output exceeds potential output, the output gap is positive.

 If actual output is below potential output, the output gap is negative.
 If the actual growth rate is less than the potential growth rate, there will be an increase in spare capacity and
a likely increase in unemployment.
 Periods when actual growth exceeds potential growth can only be temporary. In the long run, the actual
growth rate will be limited to the potential growth rate.
 Economic Volatility and the Business Cycle
 The Hypothetical Business Cycle
 Fluctuations in actual growth
 The phases of the business cycle (a stylised representation)
 The upturn – a stagnant economy begins to recover and growth in output resumes.
 The expansion – rapid economic growth: the economy is booming.
 A fuller use is made of resources.
 The peaking out – growth slows down or even ceases.
 The slowdown or recession – there is little or no growth or even a decline in output.
 Increasing slack develops in the economy.
 A hypothetical business cycle

Full capacity
output
National output

3
4
2 Actual
3
output
4
2 1

O
Time
 A hypothetical business cycle

Full capacity
output
If, over time, firms
Trend on average operate
with a ‘normal’
National output
output degree of capacity
utilisation, the trend
output line will be
Actual the same as the
potential output
output
line.

O
Time
 Economic Volatility and the Business Cycle
 The business cycle in practice - business cycles are irregular

 Differences in the length of the phases – for e.g. some booms are short-lived
 Differences in the magnitude of the phases – for e.g. Covid-19

 Spending, output and the business cycle

 The fluctuations in economic activity that characterise the business cycle reflect, in one way or
another, fluctuations in total spending.
 Important to identify the sources of volatility.
 Cycles caused by changes in aggregate demand (aggregate demand = total spending on goods
and services made within a country)
 Economic Volatility and the Business Cycle
 AD = C + I + G + X − M
 Periods of rapid growth are associated with periods of rapid expansion of AD
 Periods of recession are associated with a decline in AD.
 Phases of the business cycle and trade-offs between macroeconomic objectives

Cycles caused by changes in aggregate supply

 Aggregate supply is the total amount firms plan to supply at any given level of prices.

 Sometimes changes in technology, the regulatory environment, a health emergency or political

shocks may cause cycles.
 Sudden sharp increases in input prices or reductions in input prices could affect firms’ output
decisions.
 The business cycle and macroeconomic variables

High output, low unemployment

but Full-capacity output
Real GDP high inflation, current account deficit

3
4
2 Actual
3
output
4
2 1

1 Low inflation, current account surplus

but
low output, high unemployment
O
Time
 Q Which of the following would represent a
rise in aggregate demand?

A. A rise in saving.

B. A fall in investment.

C. An increase in taxes.

D. A fall in consumption.

E. A rise in exports.
 The circular flow of income

Firms
• Households own factors of
production
• Firms use factors to produce
goods and services
• Households hire out factors to
firms
• Firms sell goods and services to
Consumption of
households
Factor domestically • National income: payments for
payments produced goods hiring factors
and services (Cd) • Aggregate expenditure: payments
for goods and services
• Equilibrium: income equals
expenditure

Does all my income or all your

income go back to domestic
firms as expenditure on goods
Households & services?
 The circular flow of income

Withdrawals from circular flow –

household income not allocated to
consumption

Consumption of
Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)

WITHDRAWALS
 Injections in circular flow –
expenditure outside household sector

INJECTIONS

Export
expenditure (Xd)
Investment (Id)
Government
Consumption of expenditure (Gd)

Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)

WITHDRAWALS
 Pause for Thought…
 How would a rise in government benefit payments, all other things being equal, affect
the flow of withdrawals?
 Pause for Thought…
 How would a rise in government benefit payments, all other things being equal, affect
the flow of withdrawals?

 Withdrawals would fall. Benefit payments are captured in the circular flow model by net
taxation. Benefits are equivalent to a ‘negative tax’. Hence, an increase in benefit
payment reduces net taxation and therefore withdrawals.
 Aggregate expenditure
 Sum of four elements
 Consumption – C
 Investment – I
 Government expenditure – G
 Net exports X – M (exports less imports)
 All involve the purchase of goods and services
 First three – demand within our own economy
 Last one – demand for our goods and services in the rest of the world
 Less our demand for goods and service produced in rest of the world
 AE = C + I + G + X – M

 Equilibrium occurs in this circular flow model

 Require national income equal to aggregate expenditure: Y = AE = C + I + G + X - M
 Another way of thinking about equilibrium
 Suppose no injections and withdrawals
 Aggregate expenditure is just consumption
 In equilibrium, national income equals consumption (Y = C)

 With injections and withdrawals

 Income must be allocated by households: Y = C + S + T + M
 Firms receive payments for goods and services equal to value of national income: Y = C +
I+G+X
 Total value of withdrawals: S + T + M; total value of injections: I + G + X
 Both amount to Y – C; so, must be equal
 In equilibrium, injections and withdrawals are equal:

S+T+M=I+G+X
 The relationship between with withdrawals and injections
 There are indirect links between:
 Savings and investments via financial institutions
 Taxation and government expenditure via the government (central and local)
 Imports and exports via foreign countries

 These links, however, do not guarantee that S = Id or T = Gd or M = Xd

 Take investment and saving – the decisions to save and invest are made by different people.

 Planned injections (J) may not equal planned withdrawals (W)

 Disequilibrium triggers a chain of events that leads us back to J = W.
 For e.g. when J > W (perhaps due to increased business confidence and a rise in I or perhaps a fall in T),
the level of expenditure will rise (AD will rise) and firms will be encouraged to produce more and will
therefore have to pay out more in wages, etc. But as national income rises, W increase too.
 About income determination
 Assumptions
 Every time household income increases by a pound, there will be a set amount added to
consumption, savings and imports
 Marginal propensity to consume
– proportion of additional income which is spent on goods and services

 Either national income equals aggregate expenditure; or injections equal withdrawals

 Y = AE = C + I + G + X - M or S+T+M=I+G+X
 Measuring National Income and Output
To assess how fast the economy has grown we
must have a means of measuring the value of
the nation’s output. The measure we use is
called gross domestic product (GDP).
GDP can be calculated in three different ways

 Product method – add up the value of all

the goods and services produced in the
country, industry by industry.
 Income method – focus on the incomes
generated from the production of goods
and services.
 Expenditure method – add up all
expenditure on final output (which will be
at market prices).
 C+I+G+X-M
 Aggregate demand and aggregate supply
 Aggregate demand: relationship between equilibrium national income and price level

 Require aggregate expenditure equal to national income

 Downward sloping - as prices increase, GDP (national income) falls (due to a switch to
alternatives – either imports or savings)
 International substitution effect - expect greater proportion of imports (falling exports)
 Inter-temporal substitution effect – people need more money to pay for purchases. Saving may
fall, and borrowing may increase, leading to higher interest rates. Higher interest rates will
discourage borrowing and encourage saving, which will reduce AD
 Real balance effect – if prices rise, the real value of people’s savings will be eroded and so, they
may spend less and save more to compensate.
 There may also be an income effect – consumers cut down on spending (C)
 Aggregate demand and aggregate supply
 Aggregate supply: relationship between national income prices
 The AS curve slopes upwards – at least in the short run.
 The higher the level of prices, the more will be produced (profitability incentive)
 Assume wage rates and other input prices, technology and the total supply of factors of production remain
constant.
 In long run, expect fixed capacity at all prices

 Equilibrium price level will be where AD = AS.

 If there is a change in the price level, there will be a movement along the AD and AS curves.
 The AD curve will shift if there is a change in any of its components (C, I, G, X, M)
 SRAS shifts if costs of production change
 LRAS will shift to the right if there is an increase in potential output (due to technology, labour force and
stock of capital)
 AD – AS diagram
Price level
AD LRAS

SRAS

P*

National income (Y)

Y*
 Government policy: demand side
 Fiscal policy
 Change government expenditure on goods, services
 Increased spending shifts AD to the right
 Change taxation
 Reduced taxation shifts AD to the right

 Monetary policy
 Change money supply - instruct central bank to trade bank assets (e.g. gilts), cost of holding
money (interest rate) falls
 Change money demand - instruct central bank to change interest rate
 Higher interest rates reduce demand for borrowing and investment, but increase saving; so
aggregate expenditure falls
 Supply-side policy - education, investment, growth

 Investment – expenditure on goods, services

 Used in future production of goods, services
 Investment will shift long run AS curve to right – economic growth
 Treat education as form of investment
 Development of skills, knowledge, attributes increasing productivity
 Suggests government spending on education can shift both AS, AD to right
 Increases national income; may not even cause increase in price level

 Aim – to shift aggregate supply curve to the right

 Increase national income, while reducing price level
 Associated with measure to improve efficient operation of economy
 Inflation
 Demand-pull inflation

 Caused by persistent rises in aggregate demand

 associated with a booming economy
 rightward shifts in AD curve
 Cost-push inflation

 Caused by persistent rises in costs of production (independent of demand)

 effect of ‘one-off’ cost shocks
 effect of continuous upward shifts in AS curve
 Demand-pull inflation

AS
Price level

P2

P1
AD2

AD1

O Q1 Q2
Real national income (GDP)
 Cost-push inflation

AS2
AS1
Price level

P2
P1

AD

O Q2 Q1
Real national income (GDP)
 Q Which one of the following would be the cause of
cost-push inflation?

A. A cut in the rate of income tax

B. A cut in the rate of VAT

C. A cut in interest rates

D. A rise in the exchange rate

E. A rise in the price of oil

 What is money?
 Do not confuse money and income
 Money is a stock concept. At any given time, there is a certain quantity of money in the economy (e.g. £1
trillion), but that does not tell us the level of national income.
 Income is a flow concept (as is expenditure). It is measured per period of time.
 The relationship between money and income depends on how rapidly the money circulates: it’s velocity of
circulation. MV = PY (Money stock * velocity of circulation = price level * national income)

 Money is any item with these properties

 A store of value – household savings in bank can be used for future consumption
 A medium of exchange – we can value every good and service in terms of its monetary value
 A unit of account – accounting values are expressed in terms of value
 A means of payment – universally accepted in full settlement of purchase of goods and services
 Could be shells, or commodities such as tea, or metals, or paper, or entry in a digital ledger (money in your
bank account)
 How do we create money?
 Banks create money whenever they make a loan
 Credit money into one account as a deposit
 Debit the loan account into which repayments will be made in future
 Money is a liability of banks; loans are assets

 Central bank (bank to the government) creates money too

 Government decides to spend money, bank provides it
 Supply of money - mixture of public money (central bank issued) and private money (commercial
bank created)