The Short-run Macroeconomic Equilibrium

A very simplified Keynesian model is used to show the short-run macroeconomic equilibrium. For example, the rate of interest is fixed to simplify the model by keeping constant money in the economy. It is also assumed that production and employment depend on the amount of spending. In that we mean that if people buy more then firms will produce more, providing that they have the spare capacity available. The basic formula we use is that the level of National Income is equal to the domestic consumption plus the three withdrawals from the circular flow of income. Or, in shortened terms: Y = Cd + W. In this model, aggregate demand is actually known as aggregate expenditure (E) and relies on the amount of domestic consumption and the injections into the circular flow of income (J). Also written as AD = E = Cd + J. We reach a point of equilibrium when withdrawals equal injections and at this same point National Income will equal aggregate expenditure. If injections were to be higher than withdrawals then National Income would rise and the withdrawals would rise until withdrawals is once again equal to injections. Now enter the 45 degree line.

The 45 degree line shows the relationship between National Income and consumption, withdrawals and injections. Consumption and withdrawals are endogenous - their value is determined by the model. However injections are exogenous, meaning their value is determined independently of the model.

At ever point on the 45 degree line (Y), the items on each axis equal each other. The C line is consumption. It differs from Cd because it doesn't contain taxes and export spending. Consumption is a function of National Income: C = f(Y). As National Income rises, so does consumption - hence the upwards slope. It crosses the 45 degree line because poorer people may be required to spending above their earnings to survive where as richer people spend less than they earn, therefore at the end of the line it is below the Y line. The slope is given by the marginal propensity to consume - the proportion of any increase in National Income that goes on consumption. It is the change in consumption divided by the change in National Income. 

Consumption is determined by a whole bunch of different things: 

• Taxes
• Expected future incomes
• Expected future prices
• Consumer confidence
• Household wealth 
• Attitudes of the lenders
• Age of 'durables'
• Distribution of income

Any changes in these cause a shift in the consumption function whereas a change in National Income causes a movement along the consumption function. 

Now onto the withdrawals. The amount saved depends on the marginal propensity to save (mps). The proportion of an increase in National Income that is saved. Mps = Change in savings / Change in N.I. Taxes is pretty much the same - it depends on the marginal propensity to tax (mpt), or changes in tax / changes in N.I. It tends to rise as National Income rises because income tax is progressive. Finally imports - depending on the marginal propensity to import. Or, mpm = change in imports / change in National Income. 

Total withdrawals will look something like this: 

Injections now and we'll start with investment. It is determined by the following things: Consumer demand, expectations, interest rate, availability of finance and cost/efficiency of capital equipment. Replacing new equipment will rely on National Income. Government spending is independent of National Income in the short term, Exports is also classed as independent on National Income to keep the model simpler.  

That's it for the background on the theory. Next we'll be moving on to how National Income is determined from all of this. Stay tuned.

Sam. 

Causes of Long-Run Economic Growth (Macroeconomics)

I'm fully aware that there is already about a post about economic growth, however i want to use this one to focus in specifically on economic growth in the long run. Long run economic growth isn't so dependent on aggregate demand changes, but a lot more dependent on changes to the long run aggregate supply curve. A shift the the right of the LRAS curve is a sign of long run economic growth.

Increases in LRAS on a diagram resemble an increase in the economies capacity to supply goods and services, and for this increase to happen there needs to be there needs to be either an increase in the quantity of the factors of production or an increase in the quality of them. The most important factor of production is undoubtedly the labor force, so therefore these are what i'll focus on.

There are few ways to increase the quantity of the labor force. First, increasing the size of the population. This is difficult to achieve artificially as it is influenced a lot by social and cultural factors. The second way is to increase the labor force participation rate. This is a measure of the proportion of the population able to work and either in employment or actively seeking it. Changes to the taxation and benefit system can influence this by making it more appealing for people to actually start seeking work and get into employment. The final way is to increase the flow of migrant workers, better known as immigration. Joining groups such as the EU allows free-er movement of labor among countries which can increase the population. However, immigration may only be temporary and therefore there may be no long-term increase in the productive capacity.  

It is also possible to improve the quality of the labor force. The first method is through education and training. It improves each workers productive potential allowing each worker to make more due to the better knowledge and skills gained through the education. As economic growth occurs, economies tend to move away from primary and secondary industries and onto tertiary industries. It is important to equip the population with the skills to take part in the tertiary sector so the economy can complete the transition away from primary and secondary sector industries.

There we go.. to summarize: The quantity or the quality of the factors of production are required to increase for the economies productive capacity to increase which then causes economic growth in the long run. Thanks for reading.

Fiscal Policy (Macroeconomics)

Right, this post will discuss the basics of fiscal policy. Basically, fiscal policies are any policies that relate to government spending and government taxation - the government uses these two tools to manage the economy and redistribute resources.

The budget plays a big part in fiscal policies. Depending on what fiscal policies have been employed by the government depend on the position of the budget. If the government spends more than it receives through tax receipts then it will have a budget deficit. If it receives more than it spends then there will be a budget surplus.Two other terms that come about when talking about the budget are the following:

• Public Sector Net Cash Requirement (or PSBR) - This is an account of how much the government has to borrow in order to balance the budget.
• Public Sector Debt Repayment (or PSDR) - This is when the budget is in surplus and the government can pay back some loans.

When using taxation as a fiscal policy, the government can change the rates of direct taxation or indirect taxation. Direct is tax paid straight from the income, wealth or profit of individuals or firms (income tax or corporation tax). Indirect is tax paid on goods and services (VAT or council tax).

The effects of fiscal policies are as follows, generally:

• A rise in taxes / a cut in government spending leads to a fall in aggregate demand.
• A cut in taxes / a rise in government spending leads to a rise in aggregate demand.

Now for the rules. "The Golden Rule" is a rule relating to the Labour parties thoughts that fiscal policy should be stable and consistent. This rule states that tax receipts should cover all government spending and that borrowing by the government should only be done for investment purposes. This rule applies over an economic cycle, not on an annual basis.

Another rule is the "Sustainable Rule". This states that government debt should be kept at a stale level. This means that debt shouldn't rise above 40% of GDP, this target is to be met every year.

Fiscal policy basics complete. Thanks. 

Inflation (Macroeconomics)

Inflation is a term that is thrown around a lot, so therefore it's a well known term. However, i'll still write this post to add some details and other information.

Inflation is defined as a rise in the general level of prices over a period of time. It is measured using The Harmonized Index of Consumer Prices (HICP). It measures the average weighted increase in the prices of a typical basket of goods. Inflation was previously measured using the Retail Price Index (RPI).

Inflation can be caused by either demand-pull or cost-push factors. Demand-pull inflation occurs when there has been an increase in the level of demand in an economy - basically there are too many people chasing too few goods. This is illustrated by a rightward shift of the AD curve on an aggregate demand/supply graph.

The other type of inflation, cost-push inflation, is caused by firms raising their prices because of increased wage costs, cost of raw materials or components. Basically, anything that makes production more expensive and causes the firms to raise prices. This type of inflation may be down to imported inflation, which is when we import from abroad a good that's price has risen because of inflation in the country it came from.

To summarize: Inflation is when prices of goods rise over time, caused by either demand-pull or cost-push factors. That is all, in brief.

Thanks for reading.

Economic Growth (Macroeconomics)

Economic growth is when an economies Real GDP increases, so a sustained increase in real output and income in a period of time. It can be shown by an outward shift on a PPF curve or a rightward shift of AD on an AD/AS diagram, providing there's enough spare capacity in the economy.

Economic growth is caused by anything that increases AD, providing there is enough spare capacity available. What also causes it is increases in the efficiency in using factors of production. What can cause this is improvement in education and training, improving labour mobility, increasing competition and obtaining more factors of production.

The benefits of economic growth include:

• Increased output, employment and income.
• Improved standard of living.
• Improved health, education and public services.

However, there also costs of economic growth. These are:

• Degrading of the environment by using up resources and creating waste.
• Increased stress and a faster pace of life.
• Increased inequality, difference between rich and poor.

That's the basics of economic growth, you can come to your own conclusion about whether it is desirable in large quantities etc. Thanks.

Aggregate Demand & Supply (Macroeconomics)

A classic AD/AS diagram has two axis. On the y axis (vertical one) we have price levels. Reading of this axis we will be able to see if the price levels in the economy have increased or decreased, thus seeing if there's been inflation or deflation in the economy. On the x axis (horizontal one) we have real GDP. The real part just means the figure has been adjusted slightly so it's in line with inflation. From the axis we will be able to read off the GDP of the economy so we can determine whether the economy has grown or shrunk. Also, we can determine from this axis whether unemployment has risen or fallen.

When we bring both aggregate demand and aggregate supply together and model them on the same diagram the two curves cross. This point is know as the macroeconomic equilibrium. This means both aggregate demand and aggregate supply are equal. 3 of the Governments's main objectives are to achieve full employment, low and stable inflation and to achieve steady economic growth. All of these can be viewed on an AD/AS diagram. Here is a standard AD/AS diagram:

As you can see, the AD curve hits the LRAS curve at the point where the LRAS curve begins to become vertical. This means that full employment has been achieved, or thereabouts. If AD was to shift to the left, it would mean unemployment has increased and the government would have to attempt to stimulate aggregate demand again to increase employment. It would do this by increasing any of the factors... (AD = C+I+G+(X-M)).

The government set the Bank of England the objective of stable prices (a target of 2% inflation). For this to be achieved, aggregate demand must not exceed the point of full employment on the diagram. If this would happen, you can see that price levels would increase dramatically and price levels rising is inflation.

To achieve economic growth, the AD curve would need to shift to the right - meaning Real GDP will have increased. To achieve this growth without inflation, the LRAS curve would need to shift to the right as well as the AD curve if the economy was operating at full employment. This would create some extra capacity for the economy to expand into.

There you have the three government objectives displayed and explained on a diagram. That's it for AD/AS diagrams.. Refer back to the individual posts about aggregate demand or aggregate supply if you're confused. Next up will be a short introduction to the multiplier effect. Thanks.

Aggregate Supply (Macroeconomics)

So, what is aggregate supply?
Well, aggregate supply is the total output of goods and services that producers in an economy are willing and able to supply at different price levels in a given time period. Aggregate supply can be modeled on a diagram in two ways: the long run and the short run.

In this diagram we have a long run aggregate supply curve, sometimes shortened to just 'LRAS'. We can see that initially supply increases as the price level increases as businesses stand to make more profit. The curve then hits at vertical point. This point is know as full employment. What this means is that all factors of production are fully employed so there can be no more growing. So, after this point the only change that occurs is the increase in price levels. The point of full employment is similar to operating on the edge of the PPC which was described in a previous post. The next post will go into further detail about the long run diagrams. 

Another way aggregate supply can be modeled is in the short run. 

Here we have aggregate supply in the short run, sometimes referred to as just 'AS'. In this the curve is simply sloping upwards as factors of production ca easily be increased or improved in the short run. The AS may increase (shift to the right on the diagram) if there are falls in production costs or a fall in wages. It may decrease (shift to the left on the diagram) if production costs increase or something like the price of oil increase. 

Going back to the long run aggregate supply curve now. It has the potential to shift if aggregate supply changes. 

The causes of changes in the LRAS curve are:

• A fall in interest rates. This will encourage businesses to invest therefore allowing them to expand and increase supply. This will shift LRAS to LRAS 1 on the diagram. If interest rates rose the opposite would happen and we could end up at curve LRAS 2 on the diagram.
• Unemployment related benefits could be reduced. This would encourage more to try and get back into work, thus giving more potential labour for firms. This will increase LRAS to LRAS 1. The opposite would happen if unemployment related benefits were increased.
• Education and training will improve the productivity of the workforce.. pushing LRAS out to LRAS 1. If funding for education and training was cut then LRAS may fall to curve LRAS 2.

That's pretty much it for a brief overview of aggregate supply. In the next post i'll be looking at aggregate supply and aggregate demand together and how these can be modeled on one diagram. Thanks for reading!

Aggregate Demand - Net Exports (Macroeconomics)

Right, the last component of aggregate demand: net exports. Net exports is the result of subtracting the value of imports from the value of exports. Imports is the value of goods bought from abroad by a country, exports is the value of goods sold abroad.

Both exports and imports are influenced by the same things, so therefore they can be grouped together into net exports. These are the influencing factors:

• Disposable income abroad. This refers to how much money people in other countries have available to spend. Therefore, if people have more money then they are likely to purchase more goods - potentially ones from our country, thus exports will rise and the value of net exports will increase. If disposable income abroad is low then exports will fall and the value of net exports will fall. 
• Disposable income at home. This refers to how much money people at home have available to spend on luxuries. The more money people have at home, the likelier they are to spend - which can result in a rise in imports. Rising imports will have a negative effect on net exports on the overall aggregate demand. Vice versa.
• Protectionism. Protectionism will be explained in depth in a later post, but i'll briefly mention it here as it's relevant. This is measures taken by a government to restrict trade. Normally these limit imports, so lots of protectionism at home may have a positive impact on net exports as imports will fall. However, lots of protectionism in countries abroad may limit exports and thus net exports will fall. 
• Exchange rates. These play a large part in the value of net exports. A fall in a countries exchange rate will reduce the price of exports and raise the price of imports, thus exports should rise and imports fall - resulting in an increase in net exports. A rise in a countries exchange rate will raise the price of exports and make imports cheaper, therefore making exports fall and imports rise. The overall effect will be a fall in net exports. 

These are the main influencing factors on net exports. And with that comes the end of the posts about the components of aggregate demand. Next up i'll move on to aggregate supply. Thanks. :-)

Aggregate Demand - Government Spending (Macroeconomics)

Government spending, another component that makes up aggregate demand. It is often referred to as just (g). As with the other components of aggregate demand, there are a lot of factors which influence it, these factors will be discussed in this blog post.

So, the influencing factors are:

• The type of government. This is key to how much government spending there is. If the government is a 'high tax, high spend' government, such as Labour in the UK then we can expect government spending to be generally quite high. If the government is the opposite and doesn't interfere with the market as much we can expect government spending to be lower.
• Time of year/Time in power. Governments seem to spend a lot more in the run up to elections as an attempt to please the public and boost the chances of re-election. So, around these times government spending may be higher, and lower in times away from elections.
• War or threat of war. The government will look to spend if the country is in war or is threatened by war. Defence spending will rise in an attempt to prepare. This is the same for crime as well. If the crime rate is high, or there is a threat that crime may rise then the government may increase spending to solve the issue. 
• Current economic situation. Unemployment is probably the biggest factor here. If unemployment is high then the government need to attempt to create jobs. To create jobs, they increase spending which will boost aggregate demand and hopefully expand the economy - creating jobs. This theory will be explained in greater detail in a later post. If there is high inflation, the government may reduce spending to try and dampen down the rising price levels. 

Government spending is the least influenced of the components of aggregate demand, it generally stays fairly constant and doesn't vary that much. That is all. Next up is the influences on net exports... Stay tuned. 

Aggregate Demand - Investment (Macroeconomics)

Right, investment is another of the components that makes up aggregate demand as a whole. It is often referred to as just (I). It basically takes into account firms investing money into their business, which normally occurs when they expect that return of their investment to be larger than the investment itself - or more basically put if there is profit available to be made.

There are many influences on this factor, it is also the most volatile component and therefore fluctuates a lot depending on the economic climate and other factors. Here are the influences:

• Corporation Tax - This plays a major part in how much investment is made. Corporation tax is a tax on business' profits. So, the lower the tax the more likely firms are to invest as they will be likely to keep a larger percentage of the profit created from the investment. 
• Interest Rates - This is also a large influencing factor. Interest rates generally dictate the amount paid back on loans. So if the interest rates are low then firms can expect to take out a loan without having to pay as much back in comparison to if interest rates were high. This would be an incentive for firms to increase their investment. Obviously, if interest rates were higher then firms would be discouraged from investing as much.
• Price of Capital Equipment - Investment is all about firms spending money on capital equipment to expand their output. If the capital equipment is cheap, then firms are more likely to invest in it knowing that they will be able to increase profits potentially at a lower cost. 
• Profit Levels - This may influence a firms willingness to invest. If a firm has a high profit level already, they will feel more comfortable investing as they have more money to throw around. However if profit levels are very low then the firm will be taking more of a risk investing money and may be discouraged from doing so.

These are the main factors that influence the level of investment in an economy. Other minor factors include changes in real disposable income, expectations and advances in technology. 

That's the lowdown on investment.. Next up will be government spending. Thanks for reading. 

Aggregate Demand - Consumer Expenditure (Macroeconomics)

As stated in the previous post, consumer expenditure makes up part of aggregate demand. It is also referred to as consumption. There are many factors that affect the size of consumer expenditure in an economy:

• Disposable income. This makes up the largest part of consumption. If people's real disposable income is high then you'd likely see high consumption, if real disposable income is low then you'd expect to see low consumption. 
• Wealth. The wealthier people are, in the form of things such as their home and cars, the more likely people are to buy and consume goods - thus increasing consumption.
• Confidence. The confidence of consumers also plays a big part in consumption. If consumers are confident with spending and have high expectations for the future - maybe they feel safe in their job, then they are likely to purchase  more, boosting consumption. If consumers aren't confident then they are more likely to save their money than spend and consumption will fall.
• Interest rates. Generally, a lower interest rate will mean more consumption. This is because it is cheaper for consumers to take out loans to pay for expensive items such as houses or cars and also because they won't be earning much money on savings so it is beneficial to spend. 
• Inflation. High inflation, means higher prices and thus lower consumption. Vice versa as well, of course.

Obviously, there are other factors that will have a minor effect on consumption other than these ive stated. Next up will be investment, stay tuned. Thanks!

Aggregate Demand (Macroeconomics)

Well, the first post on a macroeconomic topic. I'll start with the very basics - aggregate demand.

Aggregate demand, often shortened to just AD, is the total demand for goods and services in an economy at a given price level. No longer are we looking at just individual markets, but the demand in the economy as a whole. When we say price level, we are referring to the average price of products produced in the economy. Price levels go up and we have inflation, which will be explained in a later post.

Aggregate demand is made up of 5 components. These 5 components are consumer expenditure (C), investment (I), government spending (G) and net exports [exports (X) - imports (M)]. Therefore, aggregate demand equals C + I + G + (X - M). Each component will be detailed individually in later posts, but i'll give a brief description of each here.

• Consumer expenditure - This is often called consumption, it is spending by households on products and generally makes up the biggest proportion of aggregate demand. 
• Investment - This is spending on capital goods, such as machinery and delivery vehicles. It's the most volatile component. 
• Government spending - This is government injecting money into economy through spending on things such as the NHS. 
• Exports - Simply put, the value of goods we sell abroad.
• Imports - The opposite of above, the value of goods we buy from abroad.

So, each of these components make up the overall value of aggregate demand. The next post will look at consumer expenditure. Thanks.