Transcript 3.1 Measuring national income (GNP/GDP, circular flow)

2.1 THE LEVEL OF OVERALL ECONOMIC
ACTIVITY
2.3 MACROECONOMIC OBJECTIVES
(LOW UNEMPLOYMENT, LOW AND STABLE RATE
OF INFLATION, ECONOMIC GROWTH)
2.1 The level of overall economic
The five main macroeconomic goals:
 Economic
Growth –a steady rate of increase of
national output
 Employment- a low level of unemployment
 Price Stability- a low and stable rate of inflation
 External Stability- a favorable balance of payments
position
 Income Distribution- an equitable distribution on
income
2.1 The level of overall economic

Economic growth
An increase in real GDP or an increase in the quantity of
resources
Gross Domestic Product (GDP) is often used to measure
economic growth

Economic development
A qualitative measure of a country's standard of living
which takes into account numerous factors such as
education
and health
The Human Development Index is normally used to measure
a country's economic development

Sustainable development
The rate at which a country can develop without
compromising the needs of future generations
1.Explain, using a diagram, the circular flow of income between
households and firms in a closed economy with no government.
National income, output and expenditures are
generated by the activities of the two most vital parts of
an economy, its households and firms, as the engage in
mutually beneficial exchange.
The primary economic function of households is to
supply domestic firms with needed factors of production
– land, human capital, real capital, and enterprise.
The function of firms is to supply private goods and
services to domestic households and firms, and to
households and firms abroad.
1.Explain, using a diagram, the circular flow of income between
households and firms in a closed economy with no government.
2. Identify the four factors of production and their respective
payments (rent, wages, interest and profit) and explain that these
constitute the income flow in the model.
Factors of production:

Basic components or inputs which are required in the production of goods and services
Land:
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Gifts of nature, this includes everything on the land, under the land, above the land, or in the
sea (e.g., oil, water)
Labor:
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Interest
Any man-made aid to production. It is physical plant, machinery, equipment and buildings; it
is not the money that you invest in the stock market
Entrepreneurship:

Wages
The human component hired to assist in producing a good or service. Simply the number of
hours of work put in by a person
Capital:

Rent
Profit
Combines the other factors and takes risks recognizing the possibility of gain from
employing these factors in a specific way. An entrepreneur is the one who sees an economic
opportunity and mixes land, labor and capital together to produce a product with economic
value.
3. Outline that the income flow is numerically equivalent
to the expenditure flow and the value of output flow.
Three equivalent measures of national income:
Income: takes into account wages and salaries, rent, interest, selfemployed income and adds up to make total domestic income.
Wages for labor, Interest for capital, Rent for land and Profits for
entrepreneurship.
National Income = W+I+R+P
Expenditure: Takes into account all spending in an economy.
National Expenditures = C+I+G+[N-X]
Output: Takes into account everything which is produced in an
economy.
National output = Outputs of the primary sector + the secondary sector
+ the tertiary sector
3. Outline that the income flow is numerically equivalent
to the expenditure flow and the value of output flow.
The circular flow model illustrates the essential idea
that all spending in the economy will roughly equal all
the income received.
Thus we can say that spending on output must, at the
same time, represent income to the factor of
production.
Economist have three main methods of counting national
income:
 The spending (expenditure) approach
 The income approach
 The output approach
4. Explain, using a diagram, the circular flow of income in an open economy with
government and financial markets, referring to leakages/ withdrawals (savings, taxes and
import expenditure) and injections (investment, government expenditure and export revenue).
Injections and Leakages Model:
One half of the injections-leakages model is injections, which are nonconsumption expenditures on aggregate production. The three injections are
investment expenditures, government purchases, and exports. These are
termed injections because they are "injected" into the core circular flow of
consumption, production, and income.
The other half of the injections-leakages model is leakages, which are nonconsumption uses of the income generated from production. The three
leakages are saving, taxes, and imports. These are termed leakages
because they are "leaked" out of the core circular flow of consumption,
production, and income.
Equilibrium in the injections-leakages model relies on a balance between
the injections into the core circular flow and leakages out of the flow.
If leakages match injections, then the volume of the core circular flow does not
change.
4. Explain, using a diagram, the circular flow of income in an open economy with government and
financial markets, referring to leakages/ withdrawals (savings, taxes and import expenditure) and
injections (investment, government expenditure and export revenue).
5. Explain how the size of the circular flow will change
depending on the relative size of injections and leakages.
The critical implication from the circular flow is that a
balance between injections and leakages maintains a
constant flow of income, consumption, production, and factor
payments moving between the household and business
sectors.
This is the essence of macroeconomic equilibrium -- the level
of aggregate production remains unchanged.
However, if injections exceed leakages, then the volume of
the basic flow expands and aggregate production
increases.
Alternatively, if leakages exceed injections, then the volume
of the basic flow contracts and aggregate production
decreases.
6. Distinguish between GDP and GNP/GNI as
measures of economic activity.
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Gross domestic product (GDP) is the market value of
all officially recognized final goods and services
produced within a country in a given period.
GDP per capita is often considered an indicator of a
country's standard of living; GDP per capita is not a
measure of personal income.
GDP can be determined in three ways, all of which
should, in principle, give the same result. They are
the product (or output) approach, the income
approach, and the expenditure approach.
6. Distinguish between GDP and GNP/GNI as
measures of economic activity.
Gross National Product (GNP)
A measure of citizen's activities all over the world. The
difference between GNP and GDP is the value of any
net property income from abroad.
Gross National Income (GNI)
The total value of goods and services produced by a
country per year plus net income earned abroad by its
nationals; formerly called "gross national product."
6. Distinguish between GDP and GNP/GNI as
measures of economic activity.
GDP can be contrasted with gross national product (GNP) or gross
national income (GNI). The difference is that GDP defines its scope
according to location, while GNP/ GNI defines its scope according to
ownership.
GDP is product produced within a country's borders; GNP/ GNI is
product produced by enterprises owned by a country's citizens. The
two would be the same if all of the productive enterprises in a country
were owned by its own citizens, but foreign ownership makes GDP and
GNP/ GNI non-identical.
Production within a country's borders, but by an enterprise owned by
somebody outside the country, counts as part of its GDP but not its
GNP/GNI; on the other hand, production by an enterprise located
outside the country, but owned by one of its citizens, counts as part of its
GNP/GNI but not its GDP.
2.1 The level of overall economic
Criticisms of GNP/ GDP:
1. Real national income excludes price changes. A short period
rise in national income during an upswing of an economic
cycle does not constitute economic development.
2. GNP does not factor in a change in the population of a
given nation.
3. GNP does not reveal or factor in the negative externalities
such as pollution.
4. GNP tells nothing about the distribution of a societies
income.
5. Does not factor in other forms of measurement such as
illegal markets, services, etc.
7. Distinguish between the nominal value of GDP and GNP/GNI
and the real value of GDP and GNP/GNI
Real gross domestic product (GDP) is a macroeconomic measure
of the value of output economy adjusted for price changes (that
is, inflation or deflation). The adjustment transforms the moneyvalue measure, called nominal GDP into an index for quantity of
total output.
Nominal gross domestic product is defined as the market value
of all final goods and services produced in a geographical region,
usually a country. That market value depends on two things: the
actual quantities of goods and services produced and their
respective prices .
 The relation between the nominal and real values is given the
following definitional relation:
 Nominal GDP = Real GDP x Price Levels where GPD stands for
nominal GDP and Price stands for the price index of GDP.
7. Distinguish between the nominal value of GDP and
GNP/GNI and the real value of GDP and GNP/GNI
Real GDP the value of a nation’s output in a particular year
adjusted for changes in the price level from a base year..
Real GDP Offers a more accurate measure of actual quantity
of goods and services a nation’s produces because it adjusts
for price changes
Nominal GDP is nation’s output produced in a year. (Base
year)
Real GDP is nation’s output produced in a year minus
inflation
8. Distinguish between total GDP and GNP/GNI and
per capita GDP and GNP/GNI.
GDP Per capita measures the total GDP of a nation divided
by the total population.
Gives a more realistic measure of how rich a nation is.
Total GDP is intended to be a measure of total national
economic activity—a separate concept from standard of
living
8. Distinguish between total GDP and GNP/GNI and
per capita GDP and GNP/GNI.
List of countries by GDP (nominal)
List of countries by GDP (nominal) per capita
List of countries by real GDP growth rate
9. Examine the output approach, the income approach and the
expenditure approach when measuring national income.
There are three ways of calculating GDP - all of which
should sum to the same amount:
National Output = National Expenditure (Aggregate
Demand) = National Income
The Expenditure Method = aggregate demand (AD)
The full equation for GDP using this approach is
GDP = C + I + G + (X-M) where
C: Household spending
I: Capital Investment spending
G: Government spending
X: Exports of Goods and Services
M: Imports of Goods and Services
9. Examine the output approach, the income approach and the
expenditure approach when measuring national income.
The Income Method – adding together factor incomes
GDP is the sum of the incomes earned through the production of goods and services.
This is:
Income from people in jobs and in self-employment (+) Profits of private sector
businesses
(+) Rent income from the ownership of land (=) Gross Domestic product (by factor
incomes)
Only those incomes that are come from the production of goods and services are
included in the calculation of GDP by the income approach. We exclude:
 Transfer payments e.g. the state pension; income support for families on low
incomes; the Jobseekers’ Allowance for the unemployed and other welfare assistance
such housing benefit
 Private transfers of money from one individual to another
 Income not registered with the tax authorities Every year, billions of pounds worth
of activity is not declared to the tax authorities. This is known as the shadow
economy.
 Published figures for GDP by factor incomes will be inaccurate because much activity
is not officially recorded – including subsistence farming and barter transactions
9. Examine the output approach, the income approach and the
expenditure approach when measuring national income.
Value Added and Contributions to a nation’s GDP:
There are three main wealth-generating sectors of the economy –
manufacturing and construction, primary (including oil& gas,
farming, forestry & fishing) and a wide range of service-sector
industries.
This measure of GDP adds together the value of output
produced by each of the productive sectors in the economy using
the concept of value added.
Value added is the increase in the value of goods or services as a
result of the production process
Value added = value of production - value of intermediate
goods
10. Calculate nominal GDP from sets of national
income data, using the expenditure approach.
HOW TO:
Nominal GDP is the quantity of output in a particular year
multiplied by the prices in that year.
Nominal GDP = C + I + G + NX
11. Calculate GNP/GNI from data
HOW TO:
The difference between GDP and GNP is that you must
SUBTRACT the value of output produced in a nation by
companies based in other nations, but you must ADD the
value of output produced in other nations by companies
based in the nation you are calculating GNP for.
12. Calculate real GDP, using a price deflator.
HOW TO:
Real GDP is the value of a nation’s output in a particular year measured
using the prices from a base year. So you must multiply the quantity from the
year in question by the prices from the base year (which should be
provided).
If you are not given price and quantity data, rather you are given the GDP
deflator price index, you can divide the nominal GDP for a particular by the
GDP deflator for that year, and multiply by 100 to get the real GDP.
If you know the nominal GDP and the real GDP and are asked to calculate
the GDP deflator, you simply divide the nominal by the real and multiply by
100.
If you have two years’ GDP deflators, and are asked to calculate the
inflation between those years, you simply find the percentage change in the
GDP deflator price indexes between the years given.
13. Evaluate the use of national income statistics, including their use for making
comparisons over time, their use for making comparisons between countries and
their use for making conclusions about standards of living.
GDP Overestimates well-being:
 Adding clearly negative social behaviors and transactions
as net positives for GDP.
 Under-reporting the loss of natural resources.
GDP Underestimates well-being:
 The fact that people are living longer is not included.
 Black and underground market activity is not included.
 GDP does not measure many aspects of quality of life.
 GDP provides no information about the distribution of
income.
 GDP, as commonly reported in the news, does not account
for purchasing power.
13. Evaluate the use of national income statistics, including their use for making comparisons
over time, their use for making comparisons between countries and their use for making
conclusions about standards of living.
The limitations of using national income statistics
 Inaccuracies:
Various measures of national income come
from a vastly wide range of sources
 Unrecorded or under-recorded economic activityinformal markets:
 External costs: GDP figures do not take into account the
cost of resource depletion.
 Quality of life concerns: GDP may grow because people
are working longer hours, or taking fewer holidays.
 Composition of output: a countries output may not benefit
consumers, such as defense and capital goods
13. Evaluate the use of national income statistics, including their use for making comparisons
over time, their use for making comparisons between countries and their use for making
conclusions about standards of living.
The limitations of using national income statistics
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Composition of Output : Does not show what this income is spent on for example Soviet Russia spent
significant amounts on armaments in the cold war, however this does not improve the standard of
living.
Composition of Expenditure: National income figures do not take into account what the incomes are
spent on. For example heating in cooler countries adds nothing to standards of living; however, does
contribute to national incomes.
Exchange Rate Distortions: Exchange rate conversions may not create an accurate representation of
a populations relative purchasing power. Purchasing power parity may take this into account.
Unaccounted for Activity : Parallel markets, such as subsistence living and black market activity are
not taken in GDP.
Distribution of Income: Doesn't take into account how this income is distributed.
Intangible additions to welfare: Doesn't take into account the ability to enjoy fresh air and have
leisure time.
Externalities and environmental damage: Damage to the environment and pollution are not taken
into account.
13. Evaluate the use of national income statistics, including their use for making
comparisons over time, their use for making comparisons between countries and their
use for making conclusions about standards of living.
Using GDP as a measure of a nation's economy makes sense
because it's essentially a measure of how much buying power a
nation has over a given time period.
GDP is also used as an indicator of a nation's overall standard of
living because, generally, a nation's standard of living increases as
GDP increases.
GDP is probably the most widely used indicator.
It implies a lot about the country. If the figure is high it suggests
they have a large number of productive industries producing goods.
It also suggests that the service industry is well developed. (Services
include things such as hospital and schools.
If the figure is low it suggests that the country has few industries and
few services so therefore a poor standard of living.)
GDP is fairly easy to calculate from official government figures.
14. Explain the meaning and significance of “green GDP”, a
measure of GDP that accounts for environmental destruction.
Green GDP is an attempt by economists to measure the growth of an economy
compared to the harm production does to the environment.
This is done by subtracting the costs of environmental and ecological damage done in
a specific period of time from the gross domestic product, or GDP, from that some
time.
As a result, the damage done to the environment as a whole is factored into the
equation to give a clearer picture of the consequences of growing an economy.
Unfortunately, green GDP can be difficult to measure because of the problems
inherent in trying to quantify the costs of ecological and environmental damage.
Environmental concerns have come to the forefront of nearly every aspect of life, as
people become increasingly concerned with depleted natural resources and polluted
environments.
These concerns are often not taken into consideration when measuring the strength of
an economy.
The gross domestic product, which is a measurement of both the consumption and
production within a country, isn't meant to encompass these environmental issues.
As a result, green GDP has been at the forefront of efforts to marry economic and
environmental concerns.
15. Explain, using a business cycle diagram, that economies
typically tend to go through a cyclical pattern characterized by the
phases of the business cycle.
15. Explain, using a business cycle diagram, that economies typically
tend to go through a cyclical pattern characterized by the phases of
the business cycle.
The Stages of the Business Cycle:
 There are four stages that describe the business cycle.
At any point in time you are in one of these stages:
 Contraction - When the economy starts slowing down.
 Trough - When the economy hits bottom, usually in a
recession.
 Expansion - When the economy starts growing again.
 Peak - When the economy is in a state of "irrational
exuberance."
15. Explain, using a business cycle diagram, that economies typically
tend to go through a cyclical pattern characterized by the phases of the
business cycle.
A business cycle is characterized by fluctuations in the overall
economic activity of an economy.
Real GDP does not go up in a straight line. Real GDP growth is
followed by a period of economic slowdown or decline.
So the business cycle is a period of growth followed by contraction –
the cycle then repeats.
Periods of declining (but not necessarily negative) real GDP and rising
unemployment are referred to as recessions.
A widely accepted definition of a recession is two or more consecutive
quarters of a decline in real GDP.
A depression is a very severe recession characterized by negative real
GDP (a very sharp decline in economic activity) and unusually high
unemployment.
Business cycles tend to be irregular in duration and magnitude.
15. Explain, using a business cycle diagram, that economies typically
tend to go through a cyclical pattern characterized by the phases of
the business cycle.
What Causes the Business Cycle?
The business cycle is affected by all the forces of supply
and demand.
When consumers are confident, they buy now knowing
there will be income in the future from better jobs, higher
homes values and increasing stock prices.
Even a little healthy inflation can trigger demand by
spurring shoppers to buy now before prices go up.
As demand increases, businesses hire new workers, which
further stimulates more demand.
This is the Expansion phase.
15. Explain, using a business cycle diagram, that economies typically
tend to go through a cyclical pattern characterized by the phases of
the business cycle.
What Causes the Business Cycle?
In the Contraction phase, confidence is replaced by
fear or even panic.
Consumers sell their homes, and stop buying. Businesses
lay off workers, and hoard cash.
Confidence must be restored to before the Trough can
be hit, and the economy re-enters a new Expansion
phase.
16. Explain the long-term growth trend in the business
cycle diagram as the potential output of the economy.
POTENTIAL REAL GROSS DOMESTIC PRODUCT:
The total real output (real gross domestic product) that the
economy can produce if resources are fully employed.
In theory this means that the economy is operating ON the
production possibilities frontier.
Full employment is generally indicated by achieving what
is termed the natural unemployment rate.
If the economy is at full employment then actual real gross
domestic product is equal to potential real gross domestic
product and the actual unemployment rate is equal to the
natural unemployment rate.
The macro economy is thus living up to its potential.
16. Explain the long-term growth trend in the business
cycle diagram as the potential output of the economy.
Potential output (also
referred to as "natural
gross domestic product")
refers to the highest level
of real Gross Domestic
Product output that can
be sustained over the
long term.
OKUN'S LAW:
A relationship that says that the gap between actual
and full employment output level of gross domestic
product widens by 3.0% for each percentage point
increase in the unemployment rate.
When Arthur Okun discovered this empirical
relationship he was on President Kennedy's Council of
Economic Advisers (CEA).
Okun cautioned that the relationship was valid only
within unemployment rates of 3% and 7.5%.
OKUN'S LAW:
Is an empirically
observed relationship
relating unemployment to
losses in a country's
production.
The "gap version" states
that for every 1%
increase in the
unemployment rate, a
country's GDP will be
roughly an additional
2% lower than its
potential GDP.
17. Distinguish between a decrease in GDP and
a decrease in GDP growth.
The growth rate is the percentage increase or decrease of
GDP from the previous measurement cycle.
The GDP growth rate is the most important indicator of
economic health.
If GDP is growing, so will business, jobs and personal income.
If GDP is slowing down, then businesses will hold off investing
in new purchases and hiring new employees, waiting to see if
the economy will improve.
This, in turn, can easily further depress GDP and consumers
have less money to spend on purchases.
If the GDP growth rate actually turns negative, then the U.S.
economy is heading towards a recession.
17. Distinguish between a decrease in GDP
and a decrease in GDP growth.
GDP growth (annual %)
List of countries by real GDP growth rate
List of countries by GDP (real) per capita growth rate
2.3 Macroeconomic Objectives: Low unemployment
18. Define the term unemployment.
Unemployment (or joblessness) occurs when people are without
work and actively seeking work.
Full employment and Underemployment: A society is almost never
fully employed, but one of the goals is to reach full employment.
Full employment has two conditions: Everyone who wants to work is
working, and the rate of inflation is stable. When the economy is at
full employment, there is no cyclical unemployment but still frictional
and structural unemployment. This is defined as natural
unemployment.
You are only classified as unemployed if you go and register with
the government as available for work.
The labor force is defined as those of 16 years of age or older who
are employed plus all those who are unemployed seeking work.
Unemployment rate : the number of people with no work
expressed as % of the labor force
19. Explain how the unemployment rate is calculated.
The unemployment rate is the number of people
looking for work divided by the total number of people
in the labor force.
Calculating the Unemployment Rate:
(Number of unemployed)/(Labor force) X 100 =
unemployment rate
20. Calculate the unemployment rate from a
set of data.
HOW TO:
The unemployment rate is the proportion of the labor force that is
unemployed. This means they are actively seeking work but unable to
find it.
You may be given a table showing the number of people in different
groups, like college students, retirees, people looking for jobs, people
who have given up looking for jobs, part time workers, full time
workers, etc… You will have to calculate the unemployment rate from
this information.
NOTE: People who are working part time but want to work full time
ARE EMPLOYED.
People who have given up looking for jobs are DISCOURAGED
WORKERS and are no longer considered unemployed, rather, they
have dropped out of the labor force.
Discouraged workers are not accounted for in unemployment data.
20. Calculate the unemployment rate from
a set of data.
The country of Altinima has a population of 150,000. According to the latest
data, there are 20,000 people under the age of 16, and 30,000 people who
are over the age of 16, but not looking for work.
Currently, there are 5,000 people who are 16 or older and actively looking for
work.
The president of Altimina has asked you what the size of the labor force is, what
the number of unemployed is and what the unemployment rate for Altimina is.
The labor force in Altimina is ?
The number of unemployed is ?
The unemployment rate is ?
Not in labor force In labor force ?
21. Explain the difficulties in measuring unemployment, including the existence
of hidden unemployment, the existence of underemployment, and the fact that it is
an average and therefore ignores regional, ethnic, age and gender disparities.
Unemployment data may be based on people who
are registered as unemployed.
Alternatively, it may be calculated as the number of
people who are claiming unemployment benefits.
There may be problems measuring the true numbers of
people unemployed.
For example, the incentive to register as unemployed is
likely to depend on the availability of unemployment
benefits.
A person who is not entitled to any benefits is not likely
to register as unemployed.
21. Explain the difficulties in measuring unemployment, including the existence of hidden
unemployment, the existence of underemployment, and the fact that it is an average and
therefore ignores regional, ethnic, age and gender disparities.
There is also discouraged workers. These people are long-term
unemployed who have given up the search for work and are
no longer eligible for benefits. As soon as they give up the
search, they are no longer part of the unemployed.
Distribution of unemployment:
A national unemployment rate establishes an average for a
whole country, and this is very likely to mask inequalities
among different groups within an economy.
Typical disparities:
 Geographical disparities
 Age disparities
 Ethnic differences
 Gender disparities
22. Discuss possible economic consequences of unemployment, including a loss
of GDP, loss of tax revenue, increased cost of unemployment benefits, loss of
income for individuals, and greater disparities in the distribution of income.
Economic consequences of unemployment:
 Lower level of Aggregate Demand
 Under-utilization of the nation’s resources
 Brain-drain
 A turn toward protectionism and isolationist policies
 Increased budget deficits
 diminished
tax base
 increased transfer payments
 increased
difficulty for labor market entrants - employers
have more choices, they favor experienced workers
 unemployed workers lose their skills
23. Discuss possible personal and social consequences of
unemployment, including increased crime rates, increased stress
levels, increased indebtedness, homelessness and family breakdown.
Individual consequences of unemployment:
Decreased household income and purchasing power
 Increased levels of psychological and physical illness, including
stress and depression
 lower quality of life
 lower self-esteem
Social consequences of unemployment:
 Downward pressure on wages for the employed
 Increased poverty and crime
 Transformation of traditional societies
Psychological Effects of Unemployment and
Underemployment
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24. Describe, using examples, the meaning of frictional, structural,
seasonal and cyclical (demand-deficient) unemployment.
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Classical Unemployment: (Real-Wage ) your wage is too high, the price of
the good goes up and no one buys it so the firm moves to a cheaper country
Structural: Unemployment caused by the demand for your product falling e.g.
coalmining, we use oil now. Some skills are no longer needed e.g. you are a
trained draughtsman but we use computers now
Frictional: This is the desirable process of finding work, employers looking for
the right worker. In order to help accelerate this process, governments assist
people looking for jobs with programs and qualification surveys.
Seasonal: Unemployment caused by changes in season’s. e.g Santa Clause
only works a few weeks a year
Cyclical/Demand-deficient: Unemployment resulting from business recessions
that occur when total demand is insufficient to create full employment.
Regional Unemployment: if there is a coalmining area which closes down
there will be large unemployment in that area
Voluntary Unemployment: you are unemployed by choice, you get money
from the government anyway
25. Distinguish between the causes of frictional, structural, seasonal
and cyclical (demand-deficient) unemployment.
Unemployment types and causes
Types of unemployment
causes of unemployment
26. Explain, using a diagram, that cyclical unemployment
is caused by a fall in aggregate demand.
27. Explain, using a diagram, that structural unemployment is caused by changes
in the demand for particular labor skills, changes in the geographical location of
industries, and labor market rigidities.
Structural unemployment is a
more permanent level of
unemployment that's caused
by forces other than the
business cycle.
It can be the result of an
underlying shift in the
economy that makes it difficult
for certain segments of the
population to find jobs.
It's typically when there is a
mis-match between the jobs
available and the skill levels
of the unemployed.
Equilibrium Unemployment
If the labor market is in
equilibrium and there is
still unemployment, then
there must be a gap
between the actual
supply of labor and the
potential supply of labor
as this diagram shows.
Equilibrium Unemployment
The labor supply curve shows the number of people
who are willing and able to supply their labor at
each given wage rate.
If there is equilibrium in the labor market then that
implies that everybody who is willing to work at the
equilibrium wage rate is working, so any remaining
unemployment must be people who could work
(potential supply - Spot) but are not willing to work at
the equilibrium wage.
This is called equilibrium unemployment.
28. Evaluate government policies to deal
with the different types of unemployment.
Policies to deal with different types of unemployment:
Classical Unemployment: (Real-Wage )
 Reduce Union labor power and/or reduce or eliminate
national minimum wages laws.
Structural:
 Enhance occupational mobility of people, so that they are
more able to take available jobs.
 Re-trains programs, subsidies to firms that train workers,
tax breaks to move to where the jobs are, support more
apprenticeships programs.
28. Evaluate government policies to deal with
the different types of unemployment.
Policies to deal with different types of unemployment:
Frictional:
 The government should lower unemployment benefits to
encourage unemployed workers to take the jobs that are
available rather than allow them to wait for a better one
to come along.
 Also, by improving the flow of information from potential
employers to people looking for jobs.
Seasonal:
 Reduce unemployment benefits and a greater flow of
information of jobs available in the off season.
28. Evaluate government policies to deal with the
different types of unemployment.
Policies to deal with different types of unemployment:
Cyclical/Demand-deficient:
 Increase in aggregate demand through the use of fiscal
or monetary policies
Regional Unemployment:
 Reduce unemployment benefits and a greater flow of
information of jobs available in the off season.
Voluntary Unemployment:
 Reduce unemployment benefits and a greater flow of
information of jobs available in the off season.
28. Evaluate government policies to deal with the
different types of unemployment.
Policies for Reducing Unemployment:
There are two main strategies for reducing
unemployment  Demand side policies to reduce demand-deficient
unemployment (unemployment caused by recession)
 Supply side policies to reduce structural
unemployment / (the natural rate of unemployment)
2.3 Macroeconomic Objectives:
Low and stable rate of inflation
29. Distinguish between inflation,
disinflation and deflation. (Stagflation)
Inflation is defined as a sustained rise in the
average price level and a fall in the value of
money.
Deflation is defined as a sustained fall in the
average price level and a rise in the value of
money.
29. Distinguish between inflation,
disinflation and deflation. (Stagflation)
Disinflation is a decrease in the rate of inflation
– a slowdown in the rate of increase of the
general price level of goods and services in a
nation's gross domestic product over time.
 For example if the annual inflation rate one
month is 5% and it is 4% the following month,
prices disinflated by 1% but are still increasing
at a 4% annual rate.
29. Distinguish between inflation,
disinflation and deflation. (Stagflation)
Stagflation
In economics, the term stagflation refers to
the situation when both the inflation rate and
the unemployment rate are high.
It is a difficult economic condition for a
country, as both inflation and economic
stagnation occur simultaneously and no
macroeconomic policy can address both of
these problems at the same time.
30. Explain that inflation and deflation are typically measured by calculating a
consumer price index (CPI), which measures the change in prices of a basket of
goods and services consumed by the average household.





The Consumer price index (CPI) / retail price index (RPI) measures changes
in the average prices of goods and services that the average consumer sees.
The GDP deflator is measured as the ratio of the value of total domestic
output at current prices divided by the same quantity of output valued at the
constant prices of a selected base year
The tax and price index (TPI) attempts to measure the changes in income
before tax that the average consumer would need to maintain their purchasing
power
The producer price index (PPI) measures changes in the average prices of
goods sold in primary markets by producers of commodities in all stages of
processing
All price indices suffer from certain inaccuracies. For example, they have a
hard time taking into account quality changes, and the “basket” may not
always be entirely representative of the purchases actually made.
31. Construct a weighted price index, using a set
of data provided.
To establish a weighed price index, we first determine the
weighted price of a basket of goods by adding together
the average price (P) of each category multiplied by the
category weight expressed in hundredths.
Assuming a price index has three categories, A, B and C, the
weighted price of the basket of good is:
(Pa x weighted in hundredths) + (Pb x weighted in
hundreds) + (Pc x weighted in hundreds)
Calculate the inflation rate from a set of data.
32. Calculate the inflation rate from a
set of data.
HOW TO:
The inflation rate = (CPI year 2 – CPI year 1)/CPI year 1.
It is the rate of change in the CPI between two years.
You do NOT always simply take the CPI and calculate the
rate of change since it was 100.
This would tell you how much inflation there was since the
base year, but inflation is usually measured between two
years.
IR = CPI2 – CPI1/CPI1 x 100
33. Explain that different income earners may experience a
different rate of inflation when their pattern of consumption is not
accurately reflected by the CPI.
Not all of a nation’s household are typical in that the income
of a nation is not evenly distributed across all households.
Some consumers will typically purchase a very different
basket of goods than is measured to determine the CPI
and inflation.
If a large percentage of a consumer’s income goes towards
a small selection of the goods measured by the CPI, then the
CPI as a whole may over or understate inflation depending
on how the prices of those particular goods have changed
relative to the rest of the goods measured.
34. Explain that inflation figures may not accurately reflect changes
in consumption patterns and the quality of the products
purchased.
The CPI only looks at one characteristic of the consumer
goods it records: the price.
What is not accounted for is the quality or the
technology behind the products.
What is not captured by this measure, however, is the
improvement in consumer happiness resulting from
improved quality and technology of newer and better
products that increase in both price and quantity.
35. Explain that economists measure a core/underlying rate of
inflation to eliminate the effect of sudden swings in the prices of
food and oil, for example.
In many countries, what is reported most often to households
by the government is what’s known as the core CPI.
This price index does not include changes in the price of
food and fuel, which economists ignore because of the
frequent dramatic swings in price from one period to the
next.
However, for many households food and fuel make up a
significant proportion of their expenditures.
A CPI that does not account for these goods may not
accurately reflect the effect that inflation is having on the
typical household.
Core CPI
36. Explain that a producer price index measuring changes in the
prices of factors of production may be useful in predicting future
inflation.
The Producer Price Index is a family of indexes that
measures the average change over time in the selling
prices received by domestic producers of goods and
services.
Producer Price Index PPIs measure price change from
the perspective of the seller. This contrasts with other
measures, such as the Consumer Price Index (CPI), that
measure price change from the purchaser's perspective.
37. Discuss the possible consequences of a high inflation rate,
including greater uncertainty, redistributive effects, less saving, and
the damage to export competitiveness.
Costs of Inflation Include:
International competitiveness:

A relatively higher inflation rate will make British goods less competitive, leading to a fall in
exports. However this may be offset by a decline in the exchange rate. But, if a country is in
the Euro (e.g. Greece, Ireland and Spain) they can’t devalue. Therefore, high inflation can be
very damaging as it leads to a decline in competitiveness.
Confusion and Uncertainty:

When inflation is high people are uncertain what to spend their money on. Also, when inflation
is high firms may be less willing to invest because they are uncertain about future profits and
costs. This uncertainty and confusion can lead to lower rates of economic growth over the long
term.
Menu Costs.

This is the cost of changing price lists. When inflation is high, prices need changing frequently
which incurs a cost. However, modern technology has helped to reduce this cost.
Shoe leather costs.

To save on losing interest in a bank people will hold less cash and make more trips to the bank.
37. Discuss the possible consequences of a high inflation rate, including
greater uncertainty, redistributive effects, less saving, and the damage to
export competitiveness.
Income redistribution.

Inflation will typically make borrowers better off and lenders worse off. Inflation reduces the
value of savings, especially if the saving is not index linked. However it does depends on the real
rate of interest. e.g. if a saver gets a higher rate of interest than the inflation rate he will not lose
out.
Boom and Bust Economic Cycles.

High inflationary growth is unsustainable and is usually followed by a recession. By keeping
inflation low it enables a long period of economic growth. E.g. in the UK, low inflation helped
economic growth to be more stable in the period 1992-2007. Sustainable, low inflationary,
economic growth is highly desirable.
Cost of Reducing Inflation:

High inflation is deemed unacceptable therefore governments feel it is best to reduce it. This will
involve higher interest rates to reduce spending and investment. This reduction in Aggregate
Demand will lead to a decline in economic growth and unemployment.
Fiscal Drag.

The amount of tax we pay will increase if there is inflation. This is because with rising wages more
people will slip into the top income tax brackets. See: Fiscal Drag

low inflation is often seen as harmless or even beneficial because it allows prices to adjust more
easily
38. Discuss the possible consequences of deflation, including high
levels of cyclical unemployment and bankruptcies.
Deflation is a period when the general price level falls i.e. the cost of a basket of goods and services is
becoming less expensive


It is normally associated with falling AD causing a negative output gap (actual GDP < potential GDP)
Deflation can be caused by an increase in productive potential, which leads to an excess of
aggregate supply over demand
Benign Deflation

If falling prices are caused by higher productivity, as happened in the late 19th century, then it can
go hand in hand with robust growth. On the other hand, if deflation reflects a slump in demand and
persistent excess capacity, it can be dangerous, as it was in the 1930s, triggering a downward spiral
of demand and prices. If the falling prices are simply the result of improving technology or better
managerial practices, that is fine.
Malign Deflation

Malign deflation occurs when prices fall because of a structural lack of demand which creates huge
excess capacity in an economic system. If there is a slump in demand, companies go out of business
and sack people, and hence demand falls again – the negative multiplier effect starts to have its
effect.
Problems of Deflation
38. Discuss the possible consequences of deflation, including high
levels of cyclical unemployment and bankruptcies.
Possible Economic Costs of Deflation:
 Holding back on spending: Consumers may opt to postpone demand if they
expect prices to fall further in the future. If they do, they might find prices are
5 or 10% cheaper in 6 months.
 Debts increase: The real value of debt rises when the general price level is
falling and a higher real debt mountain can be a drag on consumer
confidence and people’s willingness to spend.
 The real cost of borrowing increases: Real interest rates will rise if nominal
rates of interest do not fall in line with prices. For example UK policy interest
rates were slashed to 0.5% in 2009 but realistically they cannot go any lower.
If inflation is negative, the real cost of borrowing increases.
 Lower profit margins: Lower prices can mean reduced revenues and profits
for businesses - this can lead to higher unemployment as firms seek to reduce
their costs by shedding labor.
 Confidence and saving: Falling asset prices such as price deflation in the
housing market hit personal sector wealth and confidence – leading to further
declines in aggregate demand.
39. Explain, using a diagram, that demand-pull inflation is caused
by changes in the determinants of AD, resulting in an increase in AD.
Demand-Pull Inflation:
results from an increase in
aggregate demand when
the economy is at or near
full-employment.
Demand-pull inflation is inflation demanding?
40. Explain, using a diagram, that cost-push inflation is caused by
an increase in the costs of factors of production, resulting in a
decrease in SRAS.
Cost-Push Inflation:
results from an increase
in the cost of production.
(energy or labor mostly)
Seen by an inward shift
of the aggregate
supply.
Cost-push inflation - is
inflation pushy?
excess monetary growth
Inflation due to excess
monetary growth: With more
money in the system there is
more demand and spending
which increases aggregate
demand.
Monetary inflation is a
sustained increase in the money
supply of a country. It usually
results in price inflation, which
is a rise in the general level of
prices of goods and services.
Originally the term "inflation"
was used to refer only to
monetary inflation, whereas in
present usage it usually refers
to price inflation.
41. Evaluate government policies to
deal with the different types of inflation.
For Demand-pull inflation, the approach would be to
either:
 reduce aggregate demand with either deflationary
fiscal policy and/ or deflationary monetary policy.
 Policies to increase aggregate supply would also be
used to increase real output and lower price levels.
Cost-Push Inflation:

By addressing Input prices, productivity & governmental
involvement in the business sector cost push inflation can be
addressed
Excess Monetary Growth:

By addressing monetary policy that inflates the money supply
above money demand.