nationaleconomy

1. Week 7: The
National Economy

2. Key terms
macroeconomic issues
macroeconomic objectives
economic growth
employment / unemployment
inflation
Balance of Payments
exchange rate
policy conflict
circular flow of income
withdrawals
 savings, taxation, imports
injections
 Investment, government
spending, exports
aggregate demand

3. 4 Key Macroeconomic Issues
1. Economic growth
2. Employment
3. Inflation
4. Balance of Payments and the exchange rate

4. Macroeconomic issues
1.Economic growth
‘the growing ability of the economy to produce goods
and services’
government objective
 Achieve high but stable growth rates over a sustained period
of time
[UK = up from -0.4% to 1% but mostly due to the 2012
Olympics]

5. Macroeconomic Issues
2. Employment
employment is the
total number of people currently employed
unemployment is the total number of people
actively looking for work but who are not
currently employed
government objective:
 full employment (reducing unemployment) such that there is
no waste of human resources
[UK = down from 8.1% to 7.9%]

6. Macroeconomic Issues
3. Inflation
the general rise in prices
the rate of inflation measures the annual percentage
increase in prices
government objective:
 control inflation such that it is low and stable
[UK CPI = down from 2.5% to 2.2% - target is 2%]

7. Macroeconomic Issues
4. Balance of Payments
all payments made to other countries (import
purchases, outward spending, interest paid)
all payments received from other countries (export
sales, inward investment, interest earned)
if a country spends more foreign currency than it earns,
there will be a BofP deficit (currency surplus, exchange
rate falls)
government objective:
 achieve balance of country’s trade and capital flows over a
period of years – BofP equilibrium [UK = deficit £49b]

8. Macroeconomic Issues
Key problem: policy conflict
eg goal of high economic growth may conflict
with goal of low inflation
Solution: trade-offs
(opportunity costs, rational choices, and cost-
benefit analyses)

9. Economic Aggregates
Aggregate Demand (AD) =
* total spending on goods and services made within the
country over a given period of time (planned spending)

10. Aggregate Demand
4 components
1. Consumption (C)
2. Investment (I)
3. Government Spending (G)
4. Net Exports (X-M)
AD = C + I + G + X-M
Relationship between 4 macro objectives and AD – see
circular flow of income

11. The Circular Flow of Income
The inner flow
Firms and Households

12. Factor
payments
Consumption of
domestically
produced goods
and services (Cd)
The circular flow of income
Firms
Households

13. Beyond the inner flow
Withdrawals (W)
net saving (S)
net taxes (T)
import expenditure (M)
Total withdrawals are the total of net saving, net
taxes and expenditure on imports
W = S + T + M

14. Factor
payments
Consumption of
domestically
produced goods
and services (Cd)
BANKS, etcBANKS, etc
Net
saving (S)
GOV.GOV.
NetNet
taxes (taxes (TT))
ABROAD
ImportImport
expenditure (expenditure (MM))
The circular flow of income
WITHDRAWALS

15. Beyond the inner flow
Injections (J)
Investment (I)
Government expenditure (G)
Export expenditure (X)
Total injections are the sum of investment,
government expenditure, and exports
J = I + G + X
Aggregate demand (total spending on output) is Cd + J

16. Factor
payments
Consumption of
domestically
produced goods
and services (Cd)
Investment (Investment (II))
GovernmentGovernment
expenditure (expenditure (GG))
ExportExport
expenditure (expenditure (XX))
BANKS, etcBANKS, etc
Net
saving (S)
GOV.GOV.
NetNet
taxes (taxes (TT))
ABROAD
ImportImport
expenditure (expenditure (MM))
The circular flow of income
WITHDRAWALS
INJECTIONS

17. The Circular Flow of Income
The relationship between injections and withdrawals
the links between them are complex due to many
different decisions made by many different people
planned injections may not equal planned withdrawals
eg
S ≠ I, T ≠ G, X ≠ M

18. The Circular Flow of Income
The relationship between injections and withdrawals
 Disequilibrium when J ≠ W
This will set in motion a process to bring economy
back to state of equilibrium where J = W

19. Relationship between W and J
If J > W then the level of expenditure will rise; a rise
in AD
Extra spending will increase firms’ sales, encourage
them to produce more
Total output in the economy will rise
Firms pay out more in wages, profits, rents, interest
National income will rise

20. Effect of rise in AD on 4 macro objectives
1. Economic growth
The greater the excess of J over W, the bigger the rise in
national income
2. Unemployment
Will fall as firms take on more workers to meet the
extra demand in output
continued

21. Effect of rise in aggregate demand on 4
macroeconomic objections - continued
3. Inflation
Will tend to rise. The greater rise in AD relative to
capacity of firms to produce, the more firms struggle to
meet demand so likely to raise prices
4. Balance of Payments
Will tend to deteriorate. Higher demand means more
M and higher inflation means X less competitive and
imports relatively cheaper. So M tend to rise and X tend
to fall

22. Disequilibrium and a chain reaction
‘automatic stabilisers’
J W˃ As national income rises:
Households will spend more [Cd]
Households will save more [S]
Households will pay more taxes [T] [and government
will spend less on welfare benefits]
Households will buy more imports [M]
So withdrawals increase
Eventually, equilibrium: J = W
[ie automatic stabilisers can avoid unsustainable growth,
high inflation]

23. Question
This time: J < W
Step 1: What will be the effect on each of the four objectives if
planned injections are less than planned withdrawals?
Step 2: Explain how the chain reaction returns the economy
to equilibrium [J = W] [ie how the automatic stabilisers
work to limit the fall in growth to avoid high inflation]

24.  If planned injections are less than withdrawals, national income will fall.
Other things being equal, this will have the following effects on the four
objectives:
 Growth will be negative.
 Unemployment will rise.
 The rate of inflation will fall.
 Exports will tend to rise (as their relative prices fall) and imports will tend to
fall (as they become less competitive with home-produced goods and as
incomes at home fall and thus people cannot afford to buy so many imports).
These effects are collectively known as the international substitution effect
 As national income falls
 Households will spend less (Cd)
 Households will save less (S)
 Households will pay less taxes (T)[government will pay more welfare benefits]
 Households will buy fewer imports (M)
 Demand from abroad for X tends to increase. So withdrawals decrease

25. If J < W
 National income will rise / fall
 Ceteris paribus, this will have the following effects on the four macro-
economic objectives:
 Growth will be negative / positive
 Unemployment will rise / fall
 The rate of inflation will rise / fall
 Exports will tend to rise / fall
 Imports will tend to rise / fall
 So the balance of payments will improve / deteroriate
Automatic stabilisers can limit fall in growth by:

26. Aggregate Demand – components
1. Consumption (C)
The amount of consumer spending on goods and
services produced in the country (the largest part of
AD)
It is influenced by:
 Disposable income (the largest part of C)
 Expected future incomes/consumer confidence
 Household wealth
 The financial system/interest rates
 New technology

27. Aggregate Demand – components
2. Investment (I)
Expenditure by firms in the country on ‘capital goods’
(eg buildings, equipment NOT stocks, bonds)
It is influenced by:
 Increased consumer demand
 Expectations and business confidence
 Financial system/interest rates
 Technological advances
 Cost of capital goods
 Level of company profits

28. Aggregate Demand – components
3. Government spending (G)
on goods and services (eg defence, education, health,
housing etc)
it is influenced by:
 Government policy (political issue)
 National income – short-term
 National income – long-term (includes issue of tax revenue)
 Demographic changes
 Demand for merit and public goods

29. Aggregate Demand – components
3. Government spending (G) - continued
G directly increases/decreases AD
eg consider wartime spending
T indirectly increases/decreases AD
eg lower tax rate = consumers keep more of what they earn
thereby increasing their disposable income

30. Aggregate Demand – components
3. Government Spending (G) - continued
Budget deficit (G > T):
expansionary fiscal policy = increase AD
Budget Surplus (G < T):
contractionary fiscal policy + decrease AD
Balanced Budget (G = T):
neutral effect on AD

31. Aggregate Demand – components
4. Net Exports [X - M)
Net exports is the difference between the value of
exports and the value of imports
[M subtracted from X because M not part of the country’s
production]
Export sales lead to flow of funds into country so AD
increases
Import purchases lead to flow of funds out of country
so AD is reduced

32. Aggregate Demand – components
4. Net exports (X -M) continued
Spending on X depends on
 Level of income in other countries
 Exchange rate
Spending on M depends on
 Level of income in own country
 Exchange rate