Macroeconomics Chamberlin and Yueh Chapter 1 Lecture slides

Macroeconomics and 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 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1 -84480 -042 -1 © 2006 Cengage Learning

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 and forming economic policy Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1 -84480 -042 -1 © 2006 Cengage Learning

The Circular Flow of Income • The economy can be viewed as a system where there actions and interactions between households, firms, the government, financial institutions and the foreign sector. This system has come to be known as the circular flow of income. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1 -84480 -042 -1 © 2006 Cengage Learning

Government policy • An important aspect of macroeconomics is the role of government policies. As the government is part of the circular flow of income, it is in a position to take measures to try and influence parts of it to achieve certain goals. These objectives are usually the promotion of economic growth, low unemployment, the control of inflation and trade balance. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1 -84480 -042 -1 © 2006 Cengage Learning

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 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. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1 -84480 -042 -1 © 2006 Cengage Learning

Circular Flow of Income Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN

Five main players • • • Households Firms Financial sector Government External (foreign) sector

Injections and Leakages • Injections are items which add to the circular flow of income. These are investment (I), government spending (G) and exports (X). • Leakages from the circular flow are those items which lead to lower income flows; these are saving (S), taxes (T) and imports (M). Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1 -84480 -042 -1 © 2006 Cengage Learning

Equilibrium in the Economy • When injections exceed leakages the circular flow of income will increase, and 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 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1 -84480 -042 -1 © 2006 Cengage Learning

National Income Accounting and the Circular Flow of Income • Gross Domestic Product (GDP) is a measure of the total output produced by an economy. There are three different ways of calculating the level of national output; these are the expenditure method, income method and 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 three methods of calculating GDP should all produce the same measure. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1 -84480 -042 -1 © 2006 Cengage Learning

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 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1 -84480 -042 -1 © 2006 Cengage Learning

Components of Expenditure in UK GDP Use with Macroeconomics by Graeme Chamberlin and Linda

UK GDP, adjusted from market prices to factor cost Use with Macroeconomics by Graeme

Three measures of GDP • (2) Income Method: • Y = Other Income + Corporate Profits + Wages and Salaries • Example: Income measure for the UK Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1 -84480 -042 -1 © 2006 Cengage Learning

Components of Income in UK GDP Use with Macroeconomics by Graeme Chamberlin and Linda

Three measures of GDP • (3) Output method • The output method avoids double-counting by totalling the value-added by each firm at each state of the production process. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1 -84480 -042 -1 © 2006 Cengage Learning

Three measures of UK GDP: Figure Use with Macroeconomics by Graeme Chamberlin and Linda

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, and is a widely used indicator of the material standard of living in a country. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1 -84480 -042 -1 © 2006 Cengage Learning

Economic Growth • Economic growth is the change in GDP and is the main concern for governments and policy makers. High and sustained economic growth means that a nation’s economy is generating more and more income, which allows the continual improvement of living standards. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1 -84480 -042 -1 © 2006 Cengage Learning

UK Output and Trend GDP Use with Macroeconomics by Graeme Chamberlin and Linda Yueh

Output and Trend Growth of GDP • First, in the UK, GDP grows consistently over time, implying that people become increasingly richer and enjoy improving living standards. There is a positive trend. • 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, such as booms and recessions. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1 -84480 -042 -1 © 2006 Cengage Learning

Annual UK GDP growth rate Use with Macroeconomics by Graeme Chamberlin and Linda Yueh

Open Economies • Openness can be seen in two ways: • Trade of goods and services. Exports are injections, and imports are leakages from the circular flow. • The second is capital flows to and from the financial sector, which reflects the globalisation of financial markets, e. g. , foreign direct investment and portfolio capital, which represents purchases of financial assets, such as bonds and equities. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1 -84480 -042 -1 © 2006 Cengage Learning

Exports and imports as a percentage of GDP, UK Use with Macroeconomics by Graeme

External assets and liabilities as a percentage of GDP, UK Use with Macroeconomics by

Macroeconomic Modelling and the Circular Flow of Income • General equilibrium type models, which are designed to find equilibrium for the economy as a whole, and takes into account the actions and interactions among sectors of the economy. • E. g. , The Phillips machine, Bank of England Quarterly Model Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1 -84480 -042 -1 © 2006 Cengage Learning

Summary • The workings of the macroeconomy can be neatly summarised by the circular flow of income, which describes how the various players in an economy such as households, firms etc. are linked together. These linkages and 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 and output methods should each produce the same measure of national income/output. • Macroeconomic policy making has largely focussed on promoting high and stable economic growth. High growth over the long run produces sustained improvements in material living standards. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1 -84480 -042 -1 © 2006 Cengage Learning

Summary • 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 and fiscal policies to influence the economy. • Over the last four decades economies have become increasingly open to each other through international trade and 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 and can be used to analyse the effects of policies or shocks on the economy. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1 -84480 -042 -1 © 2006 Cengage Learning