Macroeconomics Chamberlin, G. and Yueh , L. (2006)

1. MacroeconomicsChamberlin, G. and Yueh, L. (2006) Chapter 1

2. Macroeconomics & the Circular Flow of Income • The Circular Flow of Income • National Income Accounting and the Circular Flow of Income • Macroeconomic Modelling and the Circular Flow of Income

3. Learning Objectives • To understand what macroeconomics is about • Representing the macroeconomy by the circular flow of income • Using the circular flow of income to measure national income/output • Understanding the usefulness of macroeconomic models in analysing the economy & forming economic policy

4. (a) The Circular Flow of Income • The economy can be viewed as a system where there are actions & interactions between households, firms, the government, financial institutions & the foreign sector. This system has come to be known as the circular flow of income. • Eg. Consumption income employment hiring & investment decisions by firm projected sales consumption.

5. Government Policy • An important aspect of macroeconomics is the role of government policies. As the government is part of thecircular flow of income, it is in a position to take measures to try & influence parts of it to achieve certain goals. • These objectives are usually the promotion of economic growth, low unemployment, the control of inflation & trade balance.

6. The analogy of a hot water system • If we think of the economy as a central heating system that pumps hot water around a house, then the use of government policy can be viewed as the thermostat. If it is too cold, then action must be taken to make things warmer, more hot water must circulate. • Likewise, if it is too warm action must be taken to cool things down. Policy making at the macro level is mainly about influencing the circular flow of income.

7. Circular Flow of Income

8. Five main players:- • Households • Firms • Financial sector • Government • External (foreign) sector

9. Households • Savers (financial institution), workers (labour), consumers, investors, taxpayers Firms • Producers depend on labour (households sector) & capital (borrowing by bank loans / sell equity) Financial sector • Intermediary between borrowers & savers • Reinvesting saving of household in firms [loans @ purchase equity] • Eg. Banks, pension funds, insurance company, stock markets ect. Government • Increase funds by taxes to provide subsidies / buy output • FP @ MP External (foreign) sector • Import, export • Deregulation & liberalization of financial market

10. Injections & Leakages Factors determine size of income flows in an economy:- • Injections are items which add to the circular flow of income. These are investment (I), government spending (G) & exports (X). • Leakages from the circular flow are those items which lead to lower income flows; these are saving (S), taxes (T) & imports (M).

11. Equilibrium in the Economy • When injections exceed leakages the circular flow of income will increase, & likewise will fall when leakages exceed injections. • The economy will be in equilibrium when leakages are equal to injections. • I + G + X = S + T + M The level of national income determined by factors account for injections & leakages.

12. (b) National Income Accounting & the Circular Flow of Income • Gross Domestic Product (GDP) is a measure of the total output produced by an economy. There are 3 different ways of calculating the level of national output; these are the expenditure method, income method & output method. • National income accounting has a direct relationship to the circular flow of income. First of all, the level of GDP is an indicator of the strength of the circular flow of income. Secondly, due to the circular flow, the 3 methods of calculating GDP should all produce the same measure.

13. Three measures of GDP (1) Expenditure Method • Y = C + G + I + (X – M) • Adjustment: GDP (factor cost) = GDP (market prices) – Taxes + Subsidies • Example: Expenditure method for the UK • Net export = overall effect on total domestic expenditure • Market prices include taxes & subsidies, hence may overestimate the national income.

14. Components of Expenditure in UK GDP Export-Import 65% 15% 20%

15. UK GDP, adjusted from market prices to factor cost Note: The gaps  taxes & subsidies

16. (2) Income Method: • Total income earned by all domestic households & firms • Y = Other Income + Corporate Profits + Wages & Salaries where other income may refer to rental & interest income • Example: Income measure for the UK

17. Components of Income in UK GDP Largest proportion of income

18. (3) Output method • The output method avoids double-counting by totalling the value-added by each firm at each state of the production process.

19. Three measures of UK GDP -Clear that 3 methods produce fairly consistent estimates of national income, a bit violate circular flow of income. -differences statistical discrepancies

20. GDP and GDP per capita • Gross Domestic Product basically refers to the income generated by an economy in a year. • GDP per capita is the level of GDP divided by the country’s population, & is a widely used indicator of the material standard of living in a country. • High GDP a nation has more resources available  higher welfare/well-being.

21. Economic Growth • Economic growth is the change in GDP & is the main concern for governments & policy makers. • High & sustained economic growth means that a nation’s economy is generating more & more income, which allows the continual improvement of living standards. • EG in short run & long-run is key target for macro policy making.

22. UK Output & Trend GDP (EG in UK economy) • GDP grows consistently over time  people become increasingly richer & enjoy improving living standards. • GDP does not grow steadily. [Output fluctuation]

23. Output & Trend Growth of GDP • First, in the UK, GDP grows consistently over time, implying that people become increasingly richer & enjoy improving living standards. • Second, GDP does not grow steadily. In fact, the actual level of GDP fluctuates quite considerably around the trend path, which is a sign that the rate of economic growth is not constant in the short run. There is output fluctuation (booms & recessions).

24. Output fluctuation Maximum long-run growth to maintain continual improvement in living standards; whilst, stabilize in short-run to avoid painful consequences of business cycles (high unemployment).

25. Annual UK GDP growth rate

26. 2009e =-4 -5% [source: EPU] Sources: WDI, 2008

27. Open Economies • Closed Economy = One entity self-sufficient & no economic links with any others. • Openness can be seen in two ways: (a) Trade of goods & services. Exports are injections, & imports are leakages from the circular flow. (b) Capital flows to and from the financial sector, which reflects the globalisation of financial markets, e.g., FDI & portfolio capital (machinery & factories), which represents purchases of financial assets (bonds & equities).

28. Exports & imports as a percentage of GDP, UK -Proportion has risen continuously. -Trade increases in line with decreases in tariffs & improvement in transport technology. -Financial flows increase in line with liberalization of financial markets.

29. External assets and liabilities as a percentage of GDP, UK Values of overseas investment made by domestic residents Values of overseas investment held by foreign residents

30. Increase openness linkages between economies become stronger (no longer independent). Policy maker needs to take into account these issues. Sources: WDI, 2008

31. (c) Macroeconomic Modelling & the Circular Flow of Income • General equilibrium type models, which are designed to find equilibrium for the economy as a whole, & takes into account the actions and interactions among sectors of the economy. • Comparative statics analyses how equilibrium of economy Δ in responses to a policy Δ. • E.g., The Phillips machine, Bank of England Quarterly Model (BEQM used for forecast movement in economy & played as particular important role in setting MP)

32. Summary • The workings of the macroeconomy can be neatly summarised by the circular flow of income (simplification of how macroeconomy works), which describes how the various players (households, firms, financial, gov, foreign sectoretc) in an economy are linked together. These linkages & interactions suggest that the economy can be considered to be more than the sum of its parts. • The relevance of the circular flow is demonstrated in national income accounting where the expenditure, income & output methods should each produce the same measure of national income/output. [differences may due to statistical discrepancies]

33. Continue… • Macroeconomic policy making has largely focussed on promoting high & stable economic growth. High growth over the long run produces sustained improvements in material living standards. [LR perspective] • In the short run, the goal of policy makers is to smooth out cyclical movements in the economy to avoid episodes of high unemployment or inflation. To this end, the government through its central position in the circular flow of income can use monetary & fiscal policies to influence the economy.

34. Continue… • Over the last four decades economies have become increasingly open to each other through international trade & capital flows. This has meant that the study of open economies is increasingly relevant. • The formulation of policy is greatly aided by the use of macroeconomic models. These are heavily based on the circular flow of income & can be used to analyse the effects of policies or shocks on the economy. • Circular flows of income affected by overseas events in open economies.

35. Continue… • consumption not counted as injection because counterpart to savings (increase consumption, reduce savings)will double counting if include consumption.