IB Economics The Level of Overall Economic Activity

IB Economics The Level of Overall Economic Activity Chapter 13

What do you know? ØIn groups write down what you know about macroeconomics ØThink about these things (but don’t limit your thoughts to these) ØWhat is the difference/link between micro and macro ØWho are the main players in the macro economy? ØWhat does a good economy look like? ØWhat is happening in the world economy at the moment? ØEven if you know words but don’t know their meaning write them down!

Learning Objectives ØUnderstand the five main macroeconomic objectives (goals) ØUnderstand, describe and illustrate the circular flow of income ØUnderstand the different measures of national income ØCalculate national income ØExplain the meaning and significance of ‘green GDP’ ØEvaluate the uses of national statistics ØExplain and illustrate the business cycle

What is Macro economics? ØBefore we looked at micro economics ØWe looked at what happened within the firm and within the market ØNow add all of those markets together and we get the macro economy ØWe looked at allocation of resources in a market ØMacroeconomics is concerned with the allocation of a nation’s resources ØThere are five main variables ØEconomic growth ØEmployment ØPrice stability ØExternal stability ØIncome distribution

Macro objectives ØThere are five objectives that most economies have ØA steady increase of national output (growth) ØA low level of unemployment ØA low and stable rate of inflation ØA favourable balance of payments (Trade - Exports minus Imports) ØAn equitable (fair) distribution of income

The circular flow game ØTo understand how an economy works we need to understand the flows ØTo do this we will use a really simple model ØThere are four households (families) who have been shipwrecked on a desert island ØDivide into 4 groups ØThe supply of money in the economy is £ 5 and we assume that all the money will be used to buy good and services ØHousehold A spends £ 5 and received from household B goods and services in exchange. ØHousehold B then spends £ 5 on goods sold by household C and the process is repeated until all households have participated. ØKeep count of how much your household spends ØKeep count of how much you earn

The circular flow game ØIf these 4 families are the entire economy ØWhat is the value of national output = ? Ø£ 20 ØWhat is national income = ? Ø£ 20 ØWhat is national expenditure = ? Ø£ 20

The circular flow game summary ØIn a simplified model GDP = National Output = National Income = National Expenditure ØNot only is this true in a simplified model it is also true (with a few statistical adjustments) for any economy ØIn a more sophisticated economy households do not trade with each other and we need to add firms GDP = National Output = national income = national expenditure

Check your understanding Ø National Income, National Output and National Expenditure should always be equal. Why is this? Ø If a newspaper headline says ‘UK National Income increased last year by 2%’, what does this mean in terms of Ø output and expenditure? Ø Changes in flow? Ø Same amount of growth in national output and national expenditure Ø Flow has increased Ø More flowing in than out

What circular flows do we have in this 2 sector model?

Leakages and Injections ØThis model is very simplified ØWhat is it not taking into consideration? ØDo people spend all of their income? ØNo, they save some in the bank or other financial institutions ØThis is known as a leakage from the circular flow ØIf households don’t buy all the output that is produced by the firms will have unsold stock ØThey will reduce their output ØThey will use less factors of production and pay less income ØThe amount of income in the economy will fall Saving: foregoing current consumption to allow for consumption in the future

Leakages and Injections ØThe good thing about savings is that firms will have access to them by borrowing money from banks ØThey can use the money to increase their stock of capital and expand their output ØThis is known as investment ØIt is an injection into the circular flow of income ØInvestment allows the amount of income circulating in the economy to rise

Leakages and Injections ØWhy is this model still too simple? ØAn economy is not closed ØHouseholds can buy goods and services from other countries ØWould this be an injection or a leakage? ØImports are a leakage – this is income that is being spent and not being returned to firms ØPeople buy the countries exports of goods and services ØAre exports leakages or injections ØExports are an Injection because they represent a source of income not coming directly from the households

Leakages and Injections ØWhy is this model still too simple? ØThere are more than two sectors ØWe now need to introduce the government sector ØWhat injection and leakage can be added to this diagram due to the introduction of the government sector?

Leakages and Injections ØSome of the income earned by the households must be paid to the government in the form of taxes ØTaxes are a leakage ØGovernments spend money in the economy on schools, roads, campaigns, hospitals etc ØGovernment spending is an injection ØDon’t assume that government spending = revenue from taxes

Leakages and Injections ØYou will see later that governments can spend more than they earn to deliberately influence the level of leakages and injections to affect the level of national income

How is national income measured? ØThere are three ways (which we saw before when we played the desert island game) of measuring income ØCan you remember? ØOutput – the value of goods and services produced (less the costs of inputs) ØIncome – the value of all incomes earned in the economy ØExpenditure – the value of all spending in the economy ØSpending by households known as consumption (C) ØSpending by firms known as investment (I) ØSpending by government (G) ØSpending by foreigners on exports minus spending on imports or net exports (X-M) ØThere is an identity that you will need to learn GDP = C + I + G + (X-M)

How is national income measured? ØIn practice, the data collected to calculate GDP comes from many different and varied sources ØThere are often inaccuracies ØThis can be due to timing ØOften figures have to be revised at later date when full information is collected

Different measures of income GDP – the total of all economic activity in a country regardless of who owns the productive assets GNI = Green GDP – GDP minus environmental costs GDP Gross National Product (GNP) or Gross National Income (GNI) – the total income that is earned by a country’s factors of production regardless of where the assets are located + income earned from assets abroad - Over time capital gets used up – it’s value depreciates GDP does not take this into consideration. NNI does. NNI = GNI minus depreciation income paid to foreign assets operating domestically

Real GDP or nominal GDP ØTo make a comparison of GDP year on year you need to take into consideration the rise in prices ØYou are measuring by the total value of goods and services ØThe goods and services may not have changed ØInflation may mean that the prices of the same goods and services have gone up ØWe use a GDP deflator to do this ØGDP x 100/(100 + inflation rate) = real GDP ØIf the inflation rate was 4% ØReal GDP = GDP x 100/104 Real GDP – GDP which has been adjusted for inflation Nominal GDP – GDP which has not been adjusted for inflation

GDP per capita ØTo make a judgement about the progress of a country in comparison with other countries in terms of raising living standards the GDP per capita figure is much more appropriate GDP per capita – GDP divided by the size of the population

Limitations of the data ØInaccuracies – figures tend to become more accurate after time as they are revised ØUnrecorded or under-recorded economic activity (informal markets) ØDIY in developed countries ØCare for elderly or children ØSubsistence farming in developing countries ØIllegal activities (alien workers, drug trafficking etc) ØWork done for cash (and no tax is paid) ØCountries with higher tax burdens tend to have a larger hidden economy ØExternal costs ØGDP does not take into account resource depletion or negative externalities ØQuality of life concerns ØGDP may grow because people are working longer hours ØComposition of output ØOutput could be defence that does not benefit consumers

The Business Cycle ØThe business cycle fluctuations in economic activity measured by changes in real GDP ØFluctuations in practice are highly irregular Recovery: economic expansion largely driven by increase in aggregate demand as households and consumers are encouraged to spend more. Firms increase their output in response to the increase in demand. Newly employed workers spend their income on goods and services

The Business Cycle Trough: at some point the contraction will come to an end. Aggregate demand will pick up and enter the recovery phase Recession: defined as two consecutive quarters of negative GDP growth. Falling aggregate demand will lead firms to lay off workers so unemployment rises. This means less spending leading to lower rates of inflation or deflation Boom: increased demand for goods and services pushes up average prices (inflation). The rate of growth of GDP will fall as the economy nears its potential output. Policy makers may try to slow growth (to reduce inflation) causing a fall in total demand recession could begin.

Long term trend and output gaps Economies fluctuate but tend to have positive long term growth trends Negative output gap (A): the economy is producing below its trend and unemployment is likely to be a problem Positive output gap (B): the economy is producing above its trend and inflation is likely to be a problem