l

1. 9
The Economy and
Business Activity

2. Macroeconomic Objectives
• Microeconomics and macroeconomics
• The major macroeconomic issues
– economic growth
– unemployment
– inflation
– balance of payments and exchange rates
• Government macroeconomic policy
– controlling various intermediate variables
• interest rates, money supply, taxes, government
expenditure, etc.

3. The Circular Flow of Income
• The inner flow

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

5. The Circular Flow of Income
• Withdrawals
– net saving (S)
– net taxes (T)
– import expenditure (M)
• Injections
– investment (I)
– government expenditure (G)
– export expenditure (X)

6. The circular flow of income
INJECTIONS
Export
expenditure (X)
Investment (I)
Government
Consumption of expenditure (G)
Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)
WITHDRAWALS

7. The Circular Flow of Income
• The relationship between withdrawals
and injections
– the links between them
– planned injections may not equal planned
withdrawals
• effect of J > W
• effect of W > J
– equilibrium in the circular flow

8. The circular flow of income
INJECTIONS
Export
expenditure (X)
Investment (I)
Government
Consumption of expenditure (G)
Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)
WITHDRAWALS

9. The Circular Flow of Income
• The relationship between withdrawals
and injections
– the links between them
– planned injections may not equal planned
withdrawals
• effect of J > W
• effect of W > J
– equilibrium in the circular flow
• The circular flow and the four
macroeconomic objectives

10. The Determination of Business Activity
• The importance of aggregate demand
– effects of J > W
– effects of W > J
• Identifying the equilibrium level of GDP
– the 45o line diagram

11. Equilibrium GDP
Cd, E, W, J (£bn)
GDP = Cd + W
45°
O GDP (£bn)

12. The Determination of Business Activity
• The importance of aggregate demand
– effects of J > W
– effects of W > J
• Identifying the equilibrium level of GDP
– the 45o line diagram
– the GDP and E lines

13. Equilibrium GDP
Cd, E, W, J (£bn)
GDP = Cd + W
E = Cd + J
Cd
J
45°
O GDP (£bn)

14. The Determination of Business Activity
• The importance of aggregate demand
– effects of J > W
– effects of W > J
• Identifying the equilibrium level of GDP
– the 45o line diagram
– the GDP and E lines
• effects of E > GDP
• effects of GDP > E

15. Equilibrium GDP
Cd, E, W, J (£bn)
GDP = Cd + W
c E = Cd + J
d
Cd
a
b
45°
O GDP1 GDP2 GDP (£bn)

16. The Determination of Business Activity
• The importance of aggregate demand
– effects of J > W
– effects of W > J
• Identifying the equilibrium level of GDP
– the 45o line diagram
– the GDP and E lines
• effects of GDP > E
• effects of E > GDP
– finding the equilibrium point

17. Equilibrium GDP
Cd, E, W, J (£bn)
GDP = Cd + W
c E = Cd + J
d
Cd
e
a
b
45°
O GDP1 GDPe GDP2 GDP (£bn)

18. The Determination of Business Activity
• The multiplier
– the multiplier process
– definition of the multiplier
∀ ∆GDP / ∆J
– the marginal propensity to consume
domestic goods and services
• mpcd = ∆Cd / ∆GDP

19. The multiplier: a rise in aggregate expenditure
Cd, E, W, J (£bn)
GDP
Multiplier = ∆GDP / ∆ J E2
= 60/20 = 3
E1
160
∆GDP Cd
120
∆J
100
∆Cd = 40
O 100 160 GDP (£bn)
∆GDP = 60

20. The Determination of Business Activity
• The multiplier
– the multiplier process
– definition of the multiplier
∀ ∆GDP / ∆J
– the marginal propensity to consume
domestic goods and services
• mpcd = ∆Cd / ∆GDP
– formula for the multiplier
• 1 / (1–mpcd)

21. The multiplier: a rise in aggregate expenditure
Cd, E, W, J (£bn)
GDP
Multiplier = ∆GDP / ∆ E E2
= 60/20 = 3
E1
160
∆GDP Cd
120
∆J
100
∆Cd = 40
O 100 160 GDP (£bn)
∆GDP = 60

22. The Business Cycle
• Growth in actual and potential output
• Economic growth & the business cycle
– fluctuations in actual growth
– the phases of the business cycle
• the upturn
• the expansion
• the peaking out
• the slowdown or recession

23. The business cycle
Potential output
National output
3
4
2 Actual
3
output
4
2 1
1
O
Time

24. The Business Cycle
• Growth in actual and potential output
• Economic growth & the business cycle
– fluctuations in actual growth
– the phases of the business cycle
• the upturn
• the expansion
• the peaking out
• the slowdown or recession
– long-term output trend

25. The business cycle
Potential output
Trend
National output
output
Actual
output
O
Time

26. The Business Cycle
• Growth in actual and potential output
• Economic growth & the business cycle
– fluctuations in actual growth
– the phases of the business cycle
• the upturn
• the expansion
• the peaking out
• the slowdown or recession
– long-term output trend
– the business cycle in practice

27. The Business Cycle
• Growth in actual and potential output
• Economic growth & the business cycle
– fluctuations in actual growth
– the phases of the business cycle
• the upturn
• the expansion
• the peaking out
• the slowdown or recession
– long-term output trend
– the business cycle in practice
• the length of the phases

28. The Business Cycle
• Growth in actual and potential output
• Economic growth & the business cycle
– fluctuations in actual growth
– the phases of the business cycle
• the upturn
• the expansion
• the peaking out
• the slowdown or recession
– long-term output trend
– the business cycle in practice
• the length of the phases
• the magnitude of the phases

29. Growth rates in selected industrial countries
10
9 UK
8
Annual growth rate (%)
7
6
5
4
3
2
1
0
-1
-2
-3
1970 1975 1980 1985 1990 1995 2000 2005

30. Growth rates in selected industrial countries
10
9 UK
8
Annual growth rate (%)
7
6
5
4
3
2
1
0
-1
-2
-3
1970 1975 1980 1985 1990 1995 2000 2005

31. Growth rates in selected industrial countries
10
9 UK
8 EU15
Annual growth rate (%)
7
6
5
4
3
2
1
0
-1
-2
-3
1970 1975 1980 1985 1990 1995 2000 2005

32. Growth rates in selected industrial countries
10
9 UK
8 EU15
Annual growth rate (%)
7
6
5
4
3
2
1
0
-1
-2
-3
1970 1975 1980 1985 1990 1995 2000 2005

33. Growth rates in selected industrial countries
10
9 UK USA
8 EU15
Annual growth rate (%)
7
6
5
4
3
2
1
0
-1
-2
-3
1970 1975 1980 1985 1990 1995 2000 2005

34. Growth rates in selected industrial countries
10
9 UK USA
8 EU15
Annual growth rate (%)
7
6
5
4
3
2
1
0
-1
-2
-3
1970 1975 1980 1985 1990 1995 2000 2005

35. Growth rates in selected industrial countries
10
9 UK USA
8 EU15 Japan
Annual growth rate (%)
7
6
5
4
3
2
1
0
-1
-2
-3
1970 1975 1980 1985 1990 1995 2000 2005

36. Growth rates in selected industrial countries
10
9 UK USA
8 EU15 Japan
Annual growth rate (%)
7
6
5
4
3
2
1
0
-1
-2
-3
1970 1975 1980 1985 1990 1995 2000 2005

37. The Business Cycle
• Causes of cyclical fluctuations
– Why does AD change in the first place?
– Why do booms and recessions persist?
• time lags
• bandwagon effects
– the accelerator
– Why do booms and recessions end?
• ceilings and floors
• echo effects
• the accelerator
• random shocks
• changes in government policy

38. Money, Interest Rates and Business Activity
• The meaning of money
– narrow definitions of money (M0 in the UK)
– broad definitions of money (M4 in the UK)
• The supply of money
– banks and the creation of credit
• simple illustration

39. Credit creation: Banks' original balance sheet

40. Credit creation: Effect of a new deposit of £10bn

41. Credit creation: Full effect of a new deposit of £10bn

42. Money, Interest Rates and Business Activity
• The meaning of money
– narrow definitions of money (M0 in the UK)
– broad definitions of money (M4 in the UK)
• The supply of money
– banks and the creation of credit
• simple illustration
• the deposits multiplier

43. Money, Interest Rates and Business Activity
• The meaning of money
– narrow definitions of money (M0 in the UK)
– broad definitions of money (M4 in the UK)
• The supply of money
– banks and the creation of credit
• simple illustration
• the deposits multiplier
– creation of credit: the real world

44. Money, Interest Rates and Business Activity
• The meaning of money
– narrow definitions of money (M0 in the UK)
– broad definitions of money (M4 in the UK)
• The supply of money
– banks and the creation of credit
• simple illustration
• the deposits multiplier
– creation of credit: the real world
• banks' liquidity ratio may vary

45. Money, Interest Rates and Business Activity
• The meaning of money
– narrow definitions of money (M0 in the UK)
– broad definitions of money (M4 in the UK)
• The supply of money
– banks and the creation of credit
• simple illustration
• the deposits multiplier
– creation of credit: the real world
• banks' liquidity ratio may vary
• banks respond to the demand for money

46. Money, Interest Rates and Business Activity
• Causes of increases in money supply
– increased demand for money
• banks reduce liquidity ratio
– inflow of funds from abroad
– a public-sector deficit (PSNCR)
• depends on how it is financed
– from banking sector: money supply expands
– from outside the banking sector: money supply does
not expand

47. Money, Interest Rates and Business Activity
• The demand for money
– reasons for holding money
• transactions and precautionary motive
• assets or speculative motive
– determinants of demand for money
• money national income
• speculation about future return on assets
• rate of interest

48. Money, Interest Rates and Business Activity
• Equilibrium rate of interest
– where demand for money equals supply

49. Equilibrium in the money market
MS
Rate of interest
re
Md
O
Money

50. Money, Interest Rates and Business Activity
• Equilibrium rate of interest
– where demand for money equals supply
– if supply of money rises or demand for money
falls, the rate of interest will fall

51. Equilibrium in the money market
MS
Rate of interest
re
Md
O
Money

52. Money, Interest Rates and Business Activity
• Effects of changes in money supply on
national income
– rise in money supply causes interest rate to fall
– fall in interest rate causes investment to rise
– rise in investment causes GDP to rise
• Determinants of the size of these effects

53. Unemployment
• Measuring unemployment
– defining the unemployment rate
– claimant unemployment
• do claimant statistics give a true picture of
unemployment?
– standardised unemployment (ILO/OECD)
• use of labour force surveys

54. Unemployment
• Unemployment and the labour market
– the aggregate demand and supply of labour

55. Aggregate demand and supply of labour
ASL
Average (real) wage rate
ADL
O
No. of workers

56. Unemployment
• Unemployment and the labour market
– the aggregate demand and supply of labour
• equilibrium in the model

57. Aggregate demand and supply of labour
ASL
Average (real) wage rate
We
ADL
O
Qe
No. of workers

58. Unemployment
• Unemployment and the labour market
– the aggregate demand and supply of labour
• equilibrium in the model
– disequilibrium unemployment

59. Disequilibrium unemployment
ASL
Average (real) wage rate
B A
W2
We
ADL
O Q2 Q1
No. of workers

60. Unemployment
• Unemployment and the labour market
– the aggregate demand and supply of labour
• equilibrium in the model
– disequilibrium unemployment
– equilibrium unemployment

61. Equilibrium unemployment
ASL
Average (real) wage rate
e
We
ADL
O
Qe
No. of workers

62. Equilibrium unemployment
ASL N
Average (real) wage rate
e d
We
ADL
O
Qe Q2
No. of workers

63. Equilibrium and disequilibrium unemployment
ASL
Average (real) wage rate
e
We
ADL
O
Qe
No. of workers

64. Equilibrium and disequilibrium unemployment
ASL
Average (real) wage rate
Disequilibrium
unemployment
b a
W2
e
We
ADL
O
No. of workers

65. Equilibrium and disequilibrium unemployment
ASL
N
Average (real) wage rate
Disequilibrium
unemployment
b a c
W2
e
We Equilibrium
unemployment
ADL
O
No. of workers

66. Unemployment
• Unemployment and the labour market
– the aggregate demand and supply of labour
• equilibrium in the model
– disequilibrium unemployment
– equilibrium unemployment
• Disequilibrium unemployment

67. Unemployment
• Unemployment and the labour market
– the aggregate demand and supply of labour
• equilibrium in the model
– disequilibrium unemployment
– equilibrium unemployment
• Disequilibrium unemployment
– real-wage unemployment

68. Unemployment
• Unemployment and the labour market
– the aggregate demand and supply of labour
• equilibrium in the model
– disequilibrium unemployment
– equilibrium unemployment
• Disequilibrium unemployment
– real-wage unemployment
– demand-deficient (cyclical) unemployment

69. Unemployment rates in selected industrial countries
14 UK
Annual growth rate (%)
12
10
8
6
4
2
0
1970 1975 1980 1985 1990 1995 2000 2005

70. Unemployment rates in selected industrial countries
14 UK
Annual growth rate (%)
12
10
8
6
4
2
0
1970 1975 1980 1985 1990 1995 2000 2005

71. Unemployment rates in selected industrial countries
14 UK
EU15
Annual growth rate (%)
12
10
8
6
4
2
0
1970 1975 1980 1985 1990 1995 2000 2005

72. Unemployment rates in selected industrial countries
14 UK
EU15
Annual growth rate (%)
12
10
8
6
4
2
0
1970 1975 1980 1985 1990 1995 2000 2005

73. Unemployment rates in selected industrial countries
14 UK USA
EU15
Annual growth rate (%)
12
10
8
6
4
2
0
1970 1975 1980 1985 1990 1995 2000 2005

74. Unemployment rates in selected industrial countries
14 UK USA
EU15
Annual growth rate (%)
12
10
8
6
4
2
0
1970 1975 1980 1985 1990 1995 2000 2005

75. Unemployment rates in selected industrial countries
14 UK USA
EU15 Japan
Annual growth rate (%)
12
10
8
6
4
2
0
1970 1975 1980 1985 1990 1995 2000 2005

76. Unemployment rates in selected industrial countries
14 UK USA
EU15 Japan
Annual growth rate (%)
12
10
8
6
4
2
0
1970 1975 1980 1985 1990 1995 2000 2005

77. Unemployment
• Equilibrium unemployment
– frictional (search) unemployment
– structural unemployment
• changing pattern of demand
• technological unemployment
• regional unemployment
– seasonal unemployment

78. Inflation
• Defining inflation
– consumer price inflation
– other categories of inflation
• Inflation in historical perspective
– low inflation in 1950s and 60s
– high inflation in 1970s and 80s
– low inflation since mid 1990s
• most developed countries gear monetary policy
to achieving a low target rate of inflation

79. Inflation rates in selected industrial countries
26
24 UK
22
Annual growth rate (%)
20
18
16
14
12
10
8
6
4
2
0
-2
1965 1970 1975 1980 1985 1990 1995 2000 2005

80. Inflation rates in selected industrial countries
26
24 UK
22
Annual growth rate (%)
20
18
16
14
12
10
8
6
4
2
0
-2
1965 1970 1975 1980 1985 1990 1995 2000 2005

81. Inflation rates in selected industrial countries
26
24 UK
22 EU15
Annual growth rate (%)
20
18
16
14
12
10
8
6
4
2
0
-2
1965 1970 1975 1980 1985 1990 1995 2000 2005

82. Inflation rates in selected industrial countries
26
24 UK
22 EU15
Annual growth rate (%)
20
18
16
14
12
10
8
6
4
2
0
-2
1965 1970 1975 1980 1985 1990 1995 2000 2005

83. Inflation rates in selected industrial countries
26
24 UK USA
22 EU15
Annual growth rate (%)
20
18
16
14
12
10
8
6
4
2
0
-2
1965 1970 1975 1980 1985 1990 1995 2000 2005

84. Inflation rates in selected industrial countries
26
24 UK USA
22 EU15
Annual growth rate (%)
20
18
16
14
12
10
8
6
4
2
0
-2
1965 1970 1975 1980 1985 1990 1995 2000 2005

85. Inflation rates in selected industrial countries
26
24 UK USA
22 EU15 Japan
Annual growth rate (%)
20
18
16
14
12
10
8
6
4
2
0
-2
1965 1970 1975 1980 1985 1990 1995 2000 2005

86. Inflation rates in selected industrial countries
26
24 UK USA
22 EU15 Japan
Annual growth rate (%)
20
18
16
14
12
10
8
6
4
2
0
-2
1965 1970 1975 1980 1985 1990 1995 2000 2005

87. Inflation
• Aggregate demand & supply and prices
– aggregate demand curve

88. Price level Aggregate demand and aggregate supply
AD
O
National output

89. Inflation
• Aggregate demand & supply and prices
– aggregate demand curve
• why AD curves slope downwards

90. Inflation
• Aggregate demand & supply and prices
– aggregate demand curve
• why AD curves slope downwards
– lower price level leads to fewer imports
– lower price level tends to cause interest rates to fall
– lower price level increases value of people's savings

91. Inflation
• Aggregate demand & supply and prices
– aggregate demand curve
• why AD curves slope downwards
– lower price level leads to fewer imports
– lower price level tends to cause interest rates to fall
– lower price level increases value of people's savings
– aggregate supply curve

92. Aggregate demand and aggregate supply
AS
Price level
AD
O
National output

93. Inflation
• Aggregate demand & supply and prices
– aggregate demand curve
• why AD curves slope downwards
– lower price level leads to fewer imports
– lower price level tends to cause interest rates to fall
– lower price level increases value of people's savings
– aggregate supply curve
• why AS curves generally slope upwards

94. Inflation
• Aggregate demand & supply and prices
– aggregate demand curve
• why AD curves slope downwards
– lower price level leads to fewer imports
– lower price level tends to cause interest rates to fall
– lower price level increases value of people's savings
– aggregate supply curve
• why AS curves generally slope upwards
– equilibrium

95. Aggregate demand and aggregate supply
AS
Price level
Pe
AD
O
National output

96. Aggregate demand and aggregate supply
AS
Price level
Pe
b a
P2
AD
O
National output

97. Inflation
• Aggregate demand & supply and prices
– aggregate demand curve
• why AD curves slope downwards
– lower price level leads to fewer imports
– lower price level tends to cause interest rates to fall
– lower price level increases value of people's savings
– aggregate supply curve
• why AS curves generally slope upwards
– equilibrium
– shifts in AD and AS curves

98. Inflation
• Causes of inflation
– demand pull

99. Demand-pull inflation
AS
Price level
P1
AD1
O Q1
National output

100. Demand-pull inflation
AS
Price level
P1
AD2
AD1
O Q1
National output

101. Demand-pull inflation
AS
Price level
P2
P1
AD2
AD1
O Q1 Q2
National output

102. Inflation
• Causes of inflation
– demand pull
– cost push
• wage push
• profit push
• import-price push

103. Cost-push inflation
AS1
Price level
P1
AD
O Q1
National output

104. Cost-push inflation
AS2
AS1
Price level
P1
AD
O Q1
National output

105. Cost-push inflation
AS2
AS1
Price level
P2
P1
AD
O Q2 Q1
National output

106. Inflation
• Causes of inflation
– demand pull
– cost push
• wage push
• profit push
• import-price push
– the interaction of demand-pull and cost-
push inflation

107. The interaction of demand-pull and cost-push inflation
AS1
Price level
P1
AD1
O
National output

108. The interaction of demand-pull and cost-push inflation
AS2
AS1
Price level
P2
P1
AD2
AD1
O
National output

109. The interaction of demand-pull and cost-push inflation
AS3 AS
2
AS1
P3
Price level
P2
P1 AD3
AD2
AD1
O
National output

110. Inflation
• Causes of inflation
– demand pull
– cost push
• wage push
• profit push
• import-price push
– expectations and inflation

111. Inflation
• Causes of inflation
– demand pull
– cost push
• wage push
• profit push
• import-price push
– expectations and inflation
• Policies to tackle inflation

112. Inflation
• Causes of inflation
– demand pull
– cost push
• wage push
• profit push
• import-price push
– expectations and inflation
• Policies to tackle inflation
– demand-side policies

113. Inflation
• Causes of inflation
– demand pull
– cost push
• wage push
• profit push
• import-price push
– expectations and inflation
• Policies to tackle inflation
– demand-side policies
– supply-side policies