Macroeconomics

ABHISHEK MAITY
2013
MACROECONOMICS
Abhishek Maity, KIS, 2012
1

 Chapter 1: Introduction to Macroeconomics
 Chapter 2: Aggregate Demand
 Chapter 3: Aggregate Supply
 Chapter 4: Macroeconomic Equilibrium
 Chapter 5: Unemployment
 Chapter 6: Inflation
 Chapter 7: Economic Growth
 Chapter 8: Equitable Distribution of Income
2

ABHISHEK MAITY
SEMESTER 2, 2013
UNEMPLOYMENT
3

 Low Unemployment
 Low inflation or Price Stability
 Stable economic growth
 Equitable distribution of income
 TOK – Is there an order of priority for these objectives? Are such a
criteria external to economic theory, that is normative?
4

Define unemployment:
“Unemployment is the condition of someone of working
age who is able and willing to work, actively seeking
employment, but unable to work.”
How unemployment rate is calculated:
UR = # of unemployed/labor force * 100
Practice question:
In country X there are 60 million people, 70% are
available for work, while 39 million are currently
employed.
Calculate the UR in X.
5

 Geographical disparities
 Age disparities
 Ethnic differences
 Gender disparities
6

Recent college or school graduate looking for employment
Immigrants
People who have lost their jobs
People who have resigned
People trying to return to work
Medical leave
Stay at home parents
7

People who lost their jobs and are seeking new ones
Emigrants
Retirees
The deceased
People returning to higher education
Medical leave
People who have simply given up – “Hidden
unemployment”
8

Underemployment vs. Unemployment
Part-time workers
Over qualified workers
People who have “given up”
This decreases the Labor Force Participation Rate (LFPR)
9

It is the ratio of the number of people in the labor force to
the entire working age population in the economy.
LFPR has been increasing in most countries in recent years.
Impact on the PPC
What can the government do to promote LFPR?
Reduce benefits
Access to education and job training
Help minority groups
Other policies?
10

Changes in the LFPR can distort the unemployment figures.
“Hidden unemployment”
11

 Individual :
 Decreased household income and purchasing power
 Increased levels of psychological and physical illness, stress, and depression
 Social:
 Downward pressure on wages of the employed
 Increased poverty and crime
 Transformation of traditional societies
 Economic:
 Lower AD
 Under-utilization of economy’s resources
 Brain drain
 Protectionism and isolationism policies
 Increased budge deficits
12

Remove minimum wages
Abolish trade unions
Flaws of solutions?
Harm poor workers
Hard to get rid of unions
14

Frictional and Seasonal
Structural
Cyclical (Demand deficient)
15

Frictional:
Short – three months or less
Usually between jobs and voluntary
Prospect for new employment is generally positive.
Solutions – reduce unemployment benefits
Seasonal:
Employment on requirement
Also a kind of voluntary unemployment
Might have off-setting seasonal employment
Solutions – information, reduce benefits, encouragement
16

Structural:
Making workers redundant
Change in preferences
Transition in economic nature
Foreign labor
Technology
It is a natural outcome of the evolution of an economy
“Creative destruction” ~ Joseph Schumpter
Innovation and progress destroys old methods
Longer in term than frictional or seasonal unemployment
Solutions? – Retraining, education, awareness campaigns
17

The natural rate of unemployment (NRU) comprises:
Seasonal
Frictional
Structural
18

Moves with the machinations of the business cycle.
Caused by a fall in AD
Demand for labor falls pushing down wages and prices
Graphical interpretation.
19

In 2009 in the US, there were 13 million people who lost
their jobs, however, there were 3 million job vacancies
that opened up that could not easily be filled. Why do you
think this was the case? What could be the potential long
term outcome of this scenario?
Structural unemployment – mismatch of jobs
Fall in housing prices reduce mobility of labor
Even in recovery there could be continued mismatch
Wage wars may lead to inflation
Unemployment benefits might increase
20

21
Type of
Unemployment
Description Causes Possible Solutions
Frictional
People who are in between
jobs or looking for their first
job. Generally very short
term. Part of NRU
Young workers entering
the market. Workers
who voluntarily quit for a
better job
Reduce unemployment
benefits. Improve information
symmetry between supply and
demand of labor.
Seasonal
Structural
Cyclical (Demand-
Deficient)
Natural (NRU)

Goal is occupational flexibility
Long term solution – education.
Retraining programs
Subsidies to companies with training for their workers.
Tax breaks to companies who hire.
Relocation tax credit to increase labor mobility.
Support of apprenticeship programs.
PROBLEMS?
High opportunity cost.
Only effective in the long run.
22

Reduce unemployment benefits.
Reduce regulations (deregulate) for hiring and firing.
PROBLEMS?
Lower benefits increases inequity and fairness.
Loss in guarantees of working conditions.
23

Demand-Side Policies: Shifts AD (reduce deflationary gap)
Expansionary fiscal policy – lower taxes and spending
Looser monetary policy – increasing money supply or
lowering interest rates
PROBLEMS?
Opportunity cost and no guarantee of success if CC is low.
Time lag
Inflation – especially at full-employment levels
NOTE:
Discretionary Fiscal Policy verses Automatic Stabilizers
24

Supply-Side Policies: Shifts LRAS
Useful for reducing natural rate of unemployment.
Quality of labor force and flexibility and adaptability.
PROBLEMS?
Opportunity cost.
Large time lag
NOTE:
Ideally, the best course of action is a mix of supply and
demand side policies.
25

How does the government get money for a budget deficit?
Selling government or treasury bonds/bills
It is a form of savings
This increases demand for savings or real loanable funds in
the economy.
The consequence of this is called “crowding out”.
[Diagram] – loanable funds verses Investments
Interest rates ↑ causing Investments ↓
The extent of “Crowding Out” is debatable – Keynesians say
it won’t occur at below full employment. Neo Classical
believe it is a significant problem.
26

Discuss the economic consequences of unemployment.
Discuss the social and personal consequences of
unemployment.
With the help of a diagram, explain two possible causes of
structural unemployment.
Explain the difficulty in obtaining accurate unemployment
rate data.
Evaluate the policies that are available to a government
that wishes to reduce its country’s unemployment.
Using diagrams and examples distinguish between the
different types of unemployment.
Explain using relevant diagrams “crowding out” theory.
27

ABHISHEK MAITY
SEMESTER 2, 2013
INFLATION
28

“Inflation is a sustained increase of the average level of
prices. The inflation rate is the percentage by which the
price index has risen between two periods.”
Example:
If a bottle of Coke costs Rs. 10 in 2009, and there is 10.9%
inflation in 2009, how much will the bottle cost in 2010?
The opposite of inflation is “deflation”
NOTE: “Disinflation” –the rate of inflation is decreasing.
29

The average price level is measured through a “price
index”.
Weighted average price of goods and services a typical
consumer faces.
It is called the Consumer Price Index (CPI)
Some year is chosen as a “base” or “reference” year for
this basket of goods and services and the cost is indexed.
Price index of base year will always be 100.
By creating an index we get rid of units to make
comparisons more easily.
30

Core or Fundamental Inflation
Food and energy prices can fluctuate based on a variety of
reasons, so items that are typically unrelated to the
fundamentals of the economy are isolated, permitting a
more accurate interpretation of the workings of an
economy.
31


32

Calculating load weighted averages and CPI from data.
[Data Response Questions]
33

 What is a “typical” person?
 Errors in data collection.
 Patterns of consumption differ from different demographics so prices
faced by them will differ.
 Weights are usually fixed – so the price of one particular good
changing can have a skewing effect on CPI even if people substitute.
Substitution Bias
 New goods are not taken into account. New Product Bias
 Improvement in quality of goods are not accounted for. Quality Bias.
 Different countries have different ways of measuring inflation.
 Sometimes prices may fluctuate resulting in “unclean” data.
 CPI does not take into consideration intermediate goods needed by
manufacturers.
34

An alternative price index to the CPI.
PPI includes prices that producer’s receive for goods (not
services), at all stages of production process, including
semi finished and intermediate goods and raw materials.
Changes in PPI are considered as “leading indicators” of
future consumer inflation rates because PPI picks up price
changes that a typical consumer will face before those
changes actually materialize.
35

Loss of purchasing power in the event of sticky wages.
Effect on savings
Value of savings might decrease if savings interest rate is
lower than the inflation rate
Effects on interest rates – increases with inflation
Decrease in international competitiveness
Uncertainty – consumer and business confidence
decreases
Labor unrest
36

There is “good” deflation and “bad” deflation
GOOD:
Supply side increases – better productivity – LRAS
increase will mean prices decrease and real output
increases.
BAD:
Demand side decrease – if AD decreases, real output
decreases and prices decrease.
37

… of “bad” deflation
Unemployment increases
Business profits decrease – investments reduce
Cost to debtors increase.
38

Demand Pull Inflation
When aggregate demand increases
[DIAGRAM]
Cost Push Inflation
When the cost of production increases causing the SRAS
to shift left
[DIAGRAM]
39

Combination of Demand-Pull and Cost-Push Inflation.
Known as the Inflationary Spiral.
AD ↑  (if economy is near full employment) then
Inflation ↑  cost of production ↑ and SRAS moves left.
Higher wages can lead to an “illusion” of more money
causing AD ↑ again…
[DIAGRAM]
40

Milton Friedman and the Monetarists
Loose Monetary Policy causes the AD ↑ causing a form of
Demand Pull inflation.
[DIGRAM]
41

Yes, it gives the Central Banks maneuverability to
counteract “liquidity traps”.
There are other positives like the Mudell-Tobin effect of
investments.
42

Contractionary Policies for Demand Pull Inflation:
Monetary
Fiscal
Supply-Side Policies for Cost Push Inflation:
Trying to increase the LRAS
What kind of inflation is it, anyway?
We don’t usually know for sure
Combination of both types of policies
Governments are generally short-sighted – and the
public is generally gullible, uneducated and non-thinking.
43

The Spanish Price Revolution – 16th to 17th Century
The Chinese Perfumed Paper Money Problem – 11th
Century
Shaving coins in the Medieval times in Europe.
Germany in the Second World War
Argentina
Zimbabwe
44

Named after William Phillips
Work on unemployment in the 50s at LSE
MONIAC computer.
The relationship between rate of inflation or rate of
change in real wages and unemployment.
Inflation and Unemployment are inversely related.
45

The original Phillips Curve was “Rate of Change of Wages”
against “Unemployment”
At low unemployment levels, wages will be higher as there
is competition for labor
At high unemployment, people are willing to work for less.
Inflation replaced “rate of change of wages” as wages is
the primary cost in the firm – wages feed the change in
price levels.
46

Data after the 1970s showed that Inflation and
Unemployment may both simultaneously rise!
Stagflation
Also using supply-side economics, there can be deflation
and decrease in unemployment as well
Caused the Phillips Curve to be rejected.
48

Milton Friedman and The Monetarists adapted the Phillips
Curve to the Neo Classical LRAS.
A change from the SRPC to the LRPC.
[DIAGRAM]
LRPC shows the natural rate of unemployment at a given
inflation rate.
Supply-side policies can reduce the LRPC.
Natural Rate of Unemployment (NRU) is very difficult to
calculate.
49

Explain the main consequences of inflation.
Evaluate the methods that might be used to reduce
inflation.
Using an appropriate diagram, explain why there might be
a trade-off between unemployment and inflation in the
short run.
Evaluate the extent to which demand-side policies are
effective in reducing inflation.
With the help of a diagram explain the concept of
Inflationary Spiral.
Data Response Questions (DRQ)
50

ABHISHEK MAITY
SEMESTER 2, 2013
ECONOMIC
GROWTH
51

Difference between Real and Nominal GDP
Real GDP growth rate and Real GDP
Even if GDP growth rate is decreasing, as long as it is
positive, the economy is growing.
Negative real GDP growth rate in two consecutive
quarters means recession.
Growth rate of developed versus developing economies.
Deflationary gap and PPC. [DIAGRAM]
Growth and PPC [DIAGRAM]
52

Positive Consequences:
Non-inflationary growth [DIAGRAM]
Quality of life
Higher tax revenue for the government
Repayment of debts
Low unemployment
Negative Consequences?
Inflation
Stress and deterioration in family life
Environmental damage - China
53

Discuss the possible consequences of economic growth.
Using an appropriate diagram, explain how economic
growth may bring about an increase in potential output.
Using an appropriate diagram, explain how investment
may result in economic growth.
54

ABHISHEK MAITY
SEMESTER 2, 2013
EQUITY
DISTRIBUTION IN INCOME
55

“Fairness” of income and wealth in the economy. It is not
equality.
The goal is to bridge the gap between the rich and the
poor.
Presently, globally, the top 300 wealthy own the same
wealth as the bottom 3 billion.
And that is just for declared wealth!
56

They may be born into low income households.
They may have received poor, or no education.
They may suffer from poor nutrition and healthcare.
They may have found it necessary to find work before
completing their education.
57

Low living standards
Lack of access to sufficient health care
Low levels of education
Poor quality of human capital – resulting in long term
consequences.
Societal unrest!
58

Unequal incomes lead to people working harder to earn
more money.
If all kinds of jobs and transfer payments equated then the
economy would collapse as no one would have an
incentive to work harder.
59

In the turn of the 20th Century Max Lorenz came up with
studying income inequalities.
Plot of cumulative percentage of total income and
cumulative percentage of total population.
A good representation of understanding not just income
inequalities but also which deciles have the largest
discrepancies.
[DIAGRAM]
Please note that the Lorenz curve only takes into account
present income, not wealth.
60


61

Please be wary that even country’s with high HDI can have
a high Gini Index.
There is no strict correlation between level of
development in a country and income equality.
For example:
US (HDI Rank 13) – 40.8 Gini Index
Ethiopia (HDI Rank 171) – 29.8 Gini Index
Income equality is not necessary to raise the standard of
living.
62

Please be wary that even country’s with high HDI can have
a high Gini Index.
There is no strict correlation between level of
development in a country and income equality.
For example:
US (HDI Rank 13) – 40.8 Gini Index
Ethiopia (HDI Rank 171) – 29.8 Gini Index
Income equality is not necessary to raise the standard of
living.
63

Taxation – The Laffer Curve
Direct – income tax
Indirect – VAT, sales tax
Progressive (tax slabs/brackets)
Regressive – might worsen income inequality
Proportional
Transfer Payments
Government Spending for Essential Goods and Services
64

Consider the following tax brackets and calculate the
average tax rate for:
Person 1 (low income) - $15,000
Person 2 (middle income) - $38,000
Person 3 (high income) - $90,000
65
Income ($) %
0 - 5,000 0
5,001 - 20,000 20
20,001 - 40,000 40
40,000+ 50


66

As a supply side policy to incentivize higher earnings, risk,
entrepreneurship.
To reduce the complexity of progressive systems.
Might actually help increase tax revenue.
67

It is a controversial idea – redistributing income.
What constitutes a “reasonable condition”?
Consider the poverty line issue.
Neo Classical Economists argue against any form of
government interference stating that government
intervention leads to inefficiencies in the system.
68

Corporate paid insurance and benefits might lead to lower
unemployment.
High taxes might result in lower entrepreneurial activities.
Movement of money to “tax havens”
Lower taxes help economic growth.
Free market theorists argue that rather than redistribution
of income, the government should promote long run
actions:
Ensure rights
Better judicial system
Promote competition
Better infrastructure
69

 Person A (low income) – earns $20,000 per year and spends
$14,000 on goods and services.
 Person B (middle income) – earns $45,000 per year and spends
$30,000 on consumer items.
 Person C (high income) – earns $120,000 per year and spends
$80,000 on stuff.
 Calculate each of their average rate of total tax (direct +
indirect) based on the data.
70
Income ($) %
10,001 - 30,000 20
30,001 - 50,000 40
50,000+ 50
Sales Tax 20

Absolute poverty is the minimum income necessary to
satisfy basic needs.
The 2008 World Bank Global Poverty Level is set at $1.25
(PPP) per day.
Relative poverty is how much a household’s income falls
below the national average.
Poverty is a vicious cycle.
71

It might help accelerate growth:
Access to resources – education, healthcare
Labor force improves as a result
AD will increase as the MPC for poor people is higher.
Social tensions will be lower – reduces uncertainty and risk
for investors.
72

Transfer payments
Social health insurance
Public education
Improving the quality and access to education and
healthcare service is the most effective route to equity.
Access to better roads, infrastructure, and sanitation.
A healthier population with better education, training and
skills will increase labor productivity.
A better judicial system and lower corruptions are also
important.
73

ABHISHEK MAITY
SEMESTER 2, 2013
MONETARY AND
FISCAL POLICY
74

The Government Budget
Sources of Revenue
Taxation
Types of Expenditures
Current – Day to day expenses
Capital – public investment spending
Redistribution policies
75

G > T – Budget deficit – National debt grows
G < T – Budget surplus – National debt shrinks
G = T – Balanced budget – National debt remains same
National/Public debt vs. External Debt
76

Increase government spending (G)
Reduce taxes
Causes an increase in aggregate demand
Keynesian vs. Neo Classical impact of increasing AD
Deficit – Budget and Trade
High inflation
Crowding out
77

Decrease government spending (G)
Increase taxes
Causes a decrease in aggregate demand
Keynesian vs. Neo Classical impact of decreasing AD
Slow down in growth or even a recession
Increased unemployment
78


79

Crowding Out Effect
Automatic Stabilizers
Mitigating a downturn [DIAGRAM]
Cooling off an over-heating economy [DIAGRAM]
80

Spending on transfer payments and current spending is
unlikely to have an impact on LRAS.
Capital spending increases LRAS
Consider positive externalities.
Lower tax rate might unleash more work and investments
but tax revenue is also important.
Prudent fiscal policy might be more useful at economic
booms or at full employment levels.
81

Relationship between
tax rates and
government revenue.
“Arithmetic effect” vs.
“Economic effect”
It need not be single
peak though, nor
perfectly symmetrical.
82

Fiscal policy has a direct impact on the AD.
A decrease in taxes might help supply side effects.
Monetary policy might be ineffective in a deep recession.
Unemployment benefits and progressive taxes work as
automatic stabilizers.
Positive externality of capital spending.
Maybe even green technologies.
If the multiplier is greater than one, increase in
government spending can be very powerful.
83

There is a time lag
Detection lag
Administrative lag
Execution or impact lag
Large deficit spending may increase national debt
Inflationary pressures from fiscal spending
Crowding out private investments
“Expansionary Bias”
Widening trade deficit
Contractionary fiscal policy is hard to implement.
It is not easily reversible!
Some argue against the multiplier effect as well.
84

It is a link – a proxy, and a store of value.
The Banking System: “the two-tier system”
The Central Bank
Commercial Banks
85

Role of the Central Bank?
Banker to the government and other commercial banks
Sole note-issuing authority.
Issues and redeems government bonds
Manages government banking account
Monetary policy to manage inflation and growth
Exchange rate policy management
“Credit Crunch” and “Bailouts” – institute of last resorts
Regulates and supervises commercial banks and sets cash
reserve ratio.
86

These are financial intermediaries
Brings borrowers and lenders together
They are profit oriented – depends on the “spread”
Charge of different rates, based on circumstances
Cash reserve ratio – what can be lent out is much more
than the actual cash deposits.
87

Demand for money refers to the want for liquidity
Opportunity cost of holding cash
Liquidity Preference (Keynes):
Transactions motive: Need money to buy goods and
services
Precautionary motive: To meet unexpected expenses.
Speculative motive: This demand is inversely proportional
to the interest rates.
88

Money Demand for various levels of income.
[DIAGRAM]
Note: if interest rates are too low, money demand
becomes perfectly elastic.
89

Exogenous – not affected by AD
[DIAGRAM]
Includes all cash and coins and current accounts – i.e.
money available for transactions.
Central Bank can change money supply using the following
tools:
Change cash reserve ratio
Discount rate
Open market operations – bond transactions –
“quantitative easing”
90

[Money Supply and Money Demand Diagram]
Remember MS is perfectly inelastic
Interest rate is the MS and MD equilibrium
91

Demand Side Policy – increase AD
Easy or Loose Monetary Policy – expansionary
Reasons?
Tight Monetary Policy – contractionary
Reasons?
92

It is an art and a science
Advantages:
Flexible
Size and Speed can vary
Reversible
93

Disadvantages:
Might fail – liquidity trap
Consumption depends on many things and not just
interest rates
Time lags
Ineffective in fixed exchange rate systems [more later]
Effectiveness is reduced by increased borrowable markets
94

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