The macroeconomy (AS)

Macroeconomics studies the economy as a whole: output, employment, prices and the balance of payments.

4.1 National income statistics

Gross domestic product (GDP) is the total value of goods and services produced within a country in a period. Gross national income (GNI) is GDP plus net income from abroad (profits, interest and wages earned abroad minus those paid to foreigners).

Purchasing power parity (PPP) adjusts for differences in the cost of living so that incomes in different countries can be compared more fairly than at market exchange rates.

Limitations of GDP as a measure of welfare: ignores the informal economy and unpaid work, distribution of income, environmental damage, leisure, quality of life and what is produced. Other measures include the Human Development Index (HDI), which combines income, education and health.

4.2 Introduction to the circular flow of income

The circular flow shows money moving between households and firms: households supply factors and receive income; firms produce and receive spending.

• Injections add to the flow: investment (I), government spending (G) and exports (X).
• Withdrawals (leakages) remove: saving (S), taxation (T) and imports (M).

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The circular flow of income with injections and withdrawals

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Three ways to measure national income: output, income and expenditure, all giving the same total.

4.3 Aggregate demand and aggregate supply analysis

Aggregate demand (AD)

AD is total planned spending on the economy's output at each price level.

The AD curve slopes down because of the wealth effect, the interest rate effect (lower prices lower rates, raising investment and consumption) and the international trade effect (lower prices raise exports).

Shifts in AD (right = increase): consumer confidence and wealth, interest rates, taxes and benefits, government spending, exchange rates, world growth, business confidence and expectations.

Aggregate supply (AS)

Short-run aggregate supply (SRAS) is the total output firms are willing to supply at each price level, given costs of production. It slopes up because higher prices raise profit while input costs are fixed in the short run. Shifts: costs of raw materials and wages, taxes, exchange rates, energy prices.

Long-run aggregate supply (LRAS) shows the economy's productive capacity. The Keynesian view has LRAS horizontal at low output (spare capacity) then rising, then vertical at full employment; the classical (monetarist) view has LRAS vertical at the full-employment level of output. Shifts of LRAS come from more or better resources, productivity, technology, education and institutions.

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Aggregate demand and Keynesian aggregate supply with spare capacity and full employment

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Equilibrium

Macroeconomic equilibrium is where AD meets AS. An increase in AD raises real output and the price level (more output if there is spare capacity, mostly price rises near full employment). A rise in costs (SRAS left) causes stagflation: higher prices and lower output. A rise in LRAS brings growth with lower inflationary pressure.

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Aggregate demand and a vertical long-run aggregate supply: more demand raises prices only, more supply raises output

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4.4 Economic growth

Economic growth is an increase in an economy's output over time: the percentage change in real GDP.

Causes: more and better resources, investment, technology, education and training, institutions, trade and stable policy.

Benefits: higher living standards, more jobs, more government revenue, options to improve services. Costs: environmental damage, resource depletion, inequality, congestion, inflation if growth is too fast, and structural change.

The business cycle: boom → slowdown → recession (two quarters of falling output) → recovery. Output gaps: the difference between actual and potential output: a negative gap means spare capacity; a positive gap signals overheating and inflation.

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The business cycle around a rising trend

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Nominal GDP growth includes the effect of rising prices; real GDP growth shows the change in output only. Nominal growth of 7% with 4% inflation means real growth of about 3%.

4.5 Unemployment

The claimant count (people receiving benefits) and the labour force survey (ILO definition) measure it. Problems: hidden unemployment (discouraged workers, underemployment).

Costs: lost output (below the PPC), lost income and tax, higher benefit spending, hardship and social problems, and wasted skills. Benefits (a little): flexibility and search for better matches.

Measures of unemployment: the claimant count (people claiming unemployment benefit, easy to measure but excludes those not claiming) and the labour force survey (an ILO survey of people without work, available and looking, more consistent internationally). Difficulties: hidden unemployment (discouraged workers who stop looking), underemployment (part-time workers wanting more hours), informal work and people claiming who are working.

Consequences of unemployment: for individuals, lost income, poverty, stress and loss of skills; for the economy, lost output (below the PPC), lower tax revenue, higher benefit spending and wasted resources; for society, crime, inequality and social tension. A little unemployment allows labour to move to better jobs.

4.6 Price stability

Inflation is a sustained rise in the general price level; deflation is a sustained fall; disinflation is a fall in the rate of inflation.

Measuring inflation

The consumer price index (CPI) tracks the cost of a typical basket of goods and services using weights based on spending. Inflation is the % change in the index. Limitations: weights differ across people, the basket changes over time, quality changes, new products, regional differences.

Causes of inflation

• Demand-pull: AD rises faster than AS (excess demand).
• Cost-push: higher costs (wages, raw materials, imports, taxes) shift SRAS left.
• Imported inflation and expectations; a wage-price spiral.

Effects

Deflation can delay spending, raise real debt and cause a spiral of falling output. Price stability is a key aim (a target of about 2% in many countries).

Nominal (money) values are measured at current prices; real values are adjusted for inflation, so only real data show changes in purchasing power. Difficulties in measuring prices: the basket and weights differ from person to person, quality improves, new goods appear, shopping habits change and prices vary across regions.

Consequences of inflation: falling real incomes for those on fixed incomes, a fall in the real value of savings and debt, uncertainty that discourages investment, menu and shoe-leather costs, loss of competitiveness (exports dearer) and a wage–price spiral. Deflation can lead to postponed spending and rising real debt.