National income, and the effects of economic growth rates and prices on business

1 Introduction to macroeconomics

The term ‘macroeconomics’ refers to the branch of economics that deals with national and international economics. ‘Microeconomics’, which will be dealt with later, deals with the study of specific markets for products and services.

Macroeconomics therefore covers topics such as:

• How can the size of a country’s economy be measured?

• How could the economy be made to grow?

• What is the unemployment rate and what affects this?

• What causes inflation and how can inflation be controlled?

• What determines currency exchange rates?

• How do imports compare to exports?

2 National income

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National income can be defined as:

the total value of a country’s final output of all new goods and services produced in a year.

The word ‘final’ is important. If Company A sold goods to consumers, then the value of those sales would be part of national income. However, if Company A sold to Company B and Company B sold to the public for the same price, then the sales revenue would appear in both companies’ accounts and there would be double-counting if both amounts were included in national income. To avoid this, only Company B’s sales would be included in national income.

The higher the national income, the more income is available for a country’s population

There are two main measures of national income:

• Gross domestic product (GDP)
  

• Gross national product (GNP)
  

A country’s gross domestic product refers to the total value of income or production taking place in that country. It is calculated as:

GDP = Household spending + Capital investment spending + Government spending + Exports of goods and services – Imports of goods and services

A country’s gross national product takes into account income earned from abroad and also profits earned in a country being sent to foreign investors. The difference between income being earned abroad and profits being remitted to overseas investors is called the net property income from abroad. So

GNP = GDP + Net property income from abroad

Net property income from abroad is a net figure: income earned abroad by this country’s residents, less the profits and interest earned here and remitted to overseas investors. It can be negative, in which case GNP is smaller than GDP.

3 The circular flow of income

If an item is sold for €50, then that amount appears in two places:

• The amount spent by the consumer (consumption or expenditure)
  

• The amount received by the seller (income)
  

The consumption (expenditure) and income must be equal.

Of course, there is another set of flows. Companies employ people and pay wages whilst employees can use their wages to buy goods from companies. Recognition of these two sets of flows (wages/labour, sales of goods/purchases of goods) gives rise to the circular flow of income.

• Households provide: labour, land, capital (together known as factors of production)
  

• Firm provides: wages, rent, interest
  

• Firms: produce goods or provide services
  

• Households: pay for the goods and services
  

As well as money, goods, services and factors of production moving between firms and households, there are injections and withdrawals (or leakages) from the system.

Injections:

• Government spending
  

• Exports (money comes from abroad)
  

• Investment (this is expenditure on goods in addition to household spending).
  

Withdrawals:

• Taxation
  

• Savings (for example, money is earned, but simply kept and accumulated)
  

• Imports (money goes abroad)
  

Injections will increase the circular flow of income (for example, money flowing into the country from the sale of exports). Similarly, withdrawals will decrease the circular flow (for example, more people deciding to save).

If an economy is in equilibrium (meaning that the circular flows are constant) then injections into the economy must stimulate the economy. For example, if the government suddenly printed more money and injected it into the economy by giving each person €10 to spend, then that additional money could be spent on goods and services, increasing both consumption and the supply of goods. To supply more goods, more factors of production would be bought, increasing the population’s income until a new equilibrium point is reached.

4 Aggregate supply and demand

Although money spend by consumers (consumption or expenditure) must equal the value of goods sold by suppliers (income) this does not mean that the demand for goods will always equate to the supply of goods. A product could be very popular but suppliers are not able to keep up with that demand. The imbalance between supply and demand can occur at the macro-economic level also:

• Aggregate demand: the total demand in the economy for goods and services; it is the total desired demand.
  

• Aggregate supply: the total supply of goods and services in the economy.
  

Aggregate demand would increase as prices decrease: lower prices stimulates demand. Aggregate supply increases as prices increase: higher prices will encourage firms to produce more.

An equilibrium (or balance) is reached when aggregate demand and aggregate supply are equal: enough is produced to exactly meet demand.

Let’s see what happens if these are not equal. Assume that because the economic situation had been a little uncertain, consumers had decided to save some of their income in case of redundancy. Then the economy picks up and consumers have more confidence to spend their savings. Suddenly aggregate demand would have increased, but the supply of goods might lag behind this sudden increase in demand. The likely effect is that there will be price rises as consumers are willing to pay more to satisfy their increased demand; production will be increased so that, once again supply will satisfy demand – but at a slightly higher price

The graph below shows what happens. Output — real national income — is on the horizontal axis and the general price level is on the vertical axis.

We start where aggregate demand line 1 crosses aggregate supply. At that point the quantity supplied exactly matches the quantity demanded, at output Y1 and price level P1.

When confidence in the economy rises and people are willing to spend more money, the aggregate demand line shifts to the right, from AD1 to AD2. This means that more goods are demanded at any given price.

The extra demand will stimulate producers to supply more and the equilibrium point moves from A to B. Prices are slightly higher. Of course, as production increases, employment will increase, so governments can increase employment by stimulating aggregate demand. Demand can be stimulated by measures such as:

• Decreasing tax so that consumers are left with more to spend
  

• Increasing government expenditure (eg the government borrows and spends)
  

• Decreasing interest rates so that it is cheaper for consumers to borrow and spend
  

Aggregate supply has limits, though. As output rises the economy runs short of spare factories, spare materials and, in the end, spare labour: once everyone is in employment no more goods can be made, however much is demanded. That is why the aggregate supply line becomes steeper and finally vertical.

The vertical part of the aggregate supply line is the economy’s capacity. At AD1 the economy settles well inside it, at output Y1, so there is spare productive capacity and there will be unemployment. At AD2 it has reached the capacity ceiling: output cannot rise any further, so the whole of the extra demand comes out in the price level, which rises from P1 to P2. Unmet demand is also likely to suck in imports.

Economists give the two shortfalls names. AD(FE) on the graph below is the level of aggregate demand that would deliver exactly full-employment output, YFE.

The deflationary gap is the amount by which aggregate demand would have to rise — from AD1 to AD(FE) — to reach full employment. While the gap is open, output sits at Y1, below capacity, and there is unemployment.

The inflationary gap is the amount by which aggregate demand would have to fall — from AD2 to AD(FE) — to stop bidding prices up. Output cannot go beyond YFE, so demand above AD(FE) buys nothing extra; it only raises the price level.

5 Shifts in the aggregate demand curve

This section is not talking about movement along an aggregate demand curve. Such movements are caused by changes in prices that will increase or decrease demand. We are looking at what causes demand curves to shift to the right (eg Demand line 1 moving to Demand line 2) or to the left.

Shifts to the right increase aggregate demand and is equivalent to an economy growing. Similarly, shifts to the left imply the economy is contracting. Controlling economic growth or contraction will be a key concern of all governments: fast growth can lead to inflation and can suck in imports to meet demand; fast decline can lead to mass unemployment.

Rightward shifts are caused by:

• An increase in disposable income. This can be caused by, for example, lower taxes, lower interest rates, increased welfare payments.
  

• Consumers deciding to save less (known as a lower marginal propensity to save).
  

• Increased government spending
  

• A more relaxed monetary policy (for example, the government simply printing more money
  

• A change in net exports. When a country’s exchange rate weakens, its exports become cheaper to foreign buyers and this stimulates demand in the economy as more goods are demanded by overseas buyers.
  

Leftward shifts are caused by:

• The opposite of each of the above influences
  

6 Inflation

Inflation is a general increase in prices in an economy and a consequential fall in the purchasing power of money: what can be bought for $1 now cannot be purchased by $1 in one year.

Inflation (in particular high rates of inflation) are undesirable. For example:

• It hurts people who rely on fixed incomes.
  

• It hurts savers (the purchasing power of savings declines).
  

• It is very distracting and confusing (for example, employees spend huge effort negotiating pay increases to cover inflation).
  

The causes of inflation are:

• Demand pull. Aggregate demand is higher than the aggregate supply.

• Cost push. An example of cost push inflation is where people in the manufacturing industry, let’s say coal mining, have a large wage rise. Inevitably that wage rise is passed on and will find itself reflected in the cost, say, of electricity. The cost of electricity goes up and that’s an example of cost push inflation.

• Import cost inflation. A good example is a sharp rise in the price of an imported essential such as oil or gas. When European wholesale gas prices rose several-fold during 2021 and 2022 after supplies from Russia were disrupted, every European economy that imports gas imported that price rise with it, and it appeared in domestic electricity bills, transport costs and food prices within months.

• Expectation. This is where people expect there to be inflation and because they expect inflation, they make higher wage demands and the higher wage demands inevitably push up the price of goods that are going to be sold.

• Increase in the money supply. An increase in the money supply will stimulate demand. More people have money to buy goods and this will cause demand pull inflation.

Governments attempt to reduce high inflation by means such as:

• Increasing interest rates so that it is harder to borrow to buy goods. Additionally, mortgage payers will have less disposable income after paying their monthly instalments.
  

• Legislation to limit wage rises
  

• Cutting back government expenditure to lower aggregate demand

7 Measures of inflation

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7.1 Introduction

Inflation is measured using indices. So, if a product cost $210 in 20X1 and $231 in 20X2, the inflation index would be calculated as:

Inflation price index = Price in 20X2 / Price in 20X1 = $231/$210 x 100 = 110.

20X1 is the base year, and an index of 110 implies an inflation rate of 10%.

7.2 Weighted indices: Laspeyres and Paasche

There is no problem calculating inflation indices for individual products, but it gets more interesting when trying to work out how inflation affects consumers as they purchase a wide range of products. The solution is to construct an index which takes into account typical patterns of consumption. For example, in the UK, the Government maintains a Consumer Price Index (CPI) based on a representative ‘basket’ of goods, including items such as food, heating, travel, clothing and entertainment.

Of course, over time, the contents of the ‘basket’ will change as spending habits change. For example, mobile phone costs will be included now whereas 30 years ago, they wouldn’t have been. Similarly, different foods will have increased and decreased in popularity and cigarettes have become less important for many populations.

So, both prices and quantities of goods and services can change and this means that there are different types of index:

• Base-year quantities as the weights — a Laspeyres index

• Current-year quantities as the weights — a Paasche index

7.3 Chain indices

Instead of relating prices back to a constant base year, it is also possible to create chain indices where each index is an update on the previous year’s prices.

7.4 Using indices to remove inflation from a series

When comparing one year’s national income to another’s (or even sales made by a company to sales made by the company in a previous year) inflation can distort the true measure of growth because inflation does not represent true growth.

Indices can be used to rebase each year’s figures to remove the effect of inflation. This can be done either by converting all figures to present-day amounts or by removing inflation from the later figures. For example:

Either method of adjustment shows that real growth in sales was illusory: after taking inflation into account, sales values have fallen markedly.

8 Trade cycles

8.1 The components

A trade cycle is composed of periods of good trade characterised by rising prices and low unemployment percentages alternating with periods of bad trade characterised by falling prices and high unemployment percentages (Keynes).

The dashed line is the trend — the economy’s underlying long-run growth. Actual output swings above and below it. A stretch of rising output is an expansion; the turning point at the top is the peak or boom; falling output is a recession; and the turning point at the bottom is the trough. The cycle then repeats.

During expansion, manufacturing and spending are increasing. There is a danger of high inflation as demand exceeds supply and the prices of materials and labour are bid up. Imports are likely to increase. Public finances are good because increased profits and employment yields increased tax.

During recessions, economies shrink. Businesses are likely to fail and unemployment will increase. Inflation might fall – though there is a phenomenon known as ‘stagflation’ which is characterised by high inflation together with high unemployment and stagnant demand in a country’s economy. Imports are likely to fall.

In boom periods economies are likely to ‘overheat’ with asset prices (shares, property etc) becoming overvalued, only to cause large losses when a recession sets in.

8.2 What each stage means for unemployment, inflation and the trade balance

The examiner’s interest is not in the shape of the curve but in what each stage does to three variables, because those three are what a government is trying to manage.

Read the table down a column rather than across a row and the government’s problem is obvious: the stage that is best for unemployment is the worst for inflation and for the trade balance, and the stage that is best for inflation and the trade balance is the worst for unemployment. There is no stage at which everything is comfortable.

8.3 Government responses to stages in the trade cycle

Trough

The economy is at its weakest and the priority is to get demand moving at all. The measures are those for a recession, applied harder — interest rates at their lowest, tax cuts, and direct government spending financed by borrowing. Quantitative easing (section 9.6) belongs here.

Expansion and boom

Attempt to prevent the economy overheating and inflation and prices roaring away. For example:

• Increase interest rates to make borrowing (and hence the spending of borrowed money) less attractive.
  

• Increase taxation
  

• Reduce government spending
  

• Decrease the money supply by tightening bank lending rules.
  

Recession

Attempt to stimulate the economy so that employment and incomes increase. For example:

• Decrease interest rates.

• Decrease tax.

• The government can borrow money to increase its expenditure.

• Increase the money supply by relaxing bank lending rules.

8.4 Unemployment: types and causes

Unemployment is one of the macroeconomic phenomena the syllabus asks you to explain the determination of, and ‘the economy is in recession’ explains only one of its kinds. Economists classify unemployment by its cause, because the cause decides the cure.

Two consequences follow, and both are examinable. First, some unemployment is unavoidable: frictional and seasonal unemployment exist even in a fully employed economy, which is why ‘full employment’ never means a rate of zero. Second, stimulating demand only cures the cyclical kind. Pumping demand into an economy whose unemployment is structural raises inflation without creating the jobs, because the people who are out of work do not have the skills the vacancies require; the answer there is retraining, relocation assistance and regional policy, not lower interest rates.

The costs of unemployment fall in three places:

• On the individual: lost income, lost skills the longer it lasts, and the well-documented effects on health.

• On the state: benefits paid out at the same time as income tax and sales tax receipts fall — a double hit on the public finances just when the trade cycle is already weakening them.

• On business: a smaller market for consumer goods, and, on the other side, a larger pool of available labour and less upward pressure on wages.

9 Public finance

9.1 Introduction

Public finance refers to how the government raises money and spends it.

The plan that sets out both sides of it for the year ahead is the CENTRAL GOVERNMENT BUDGET. A budget that plans to spend more than it raises runs a BUDGET DEFICIT; one that plans to raise more than it spends runs a surplus. Paying for a deficit is what the syllabus calls deficit financing, and in practice it means borrowing — §9.4.

9.2 Raising money

Governments can obtain money by:

• Taxation
  

• Borrowing
  

• Selling state assets (privatisation)
  

• Printing more money/quantitative easing
  

9.3 Taxation

Taxes can be described as:

• Regressive.
  

• Proportional.
  

• Progressive.
  

A regressive tax takes a higher proportion of a poor person’s salary than it does for a rich person. A simple example is VAT. If the VAT rate is 20% it doesn’t matter whether you are rich or poor you still pay 20% on a purchase and that is proportionally more taken from a poor person’s pay than it is from a rich person’s income.

A proportional tax takes exactly the same proportion of income tax from all levels of income. So you could have a flat rate tax which taxes everyone at say 10% from the very first dollar earned, up to millions of dollars.

A progressive tax takes a higher proportion of income as income rises. So maybe for the first $1,000 of income the tax rate is zero, for the next $4,000 of income the tax rate is 20%, and anything beyond that is taxed at say 40%. A progressive tax would obviously be more effective at redistributing wealth and income than either a regressive or a proportional tax.

Taxes can also be described as direct or indirect:

• A direct tax is paid directly by a person to the revenue authority. A good example is income tax. A certain proportion of your income goes directly to the revenue authority.
  

• An indirect tax is collected by the revenue authority from an intermediary, normally a supplier of some sort. A good example of an indirect tax is VAT. You buy something, you pay over the total purchase price, and then the seller passes some of that on to the government.
  

Some taxes are charged as a fixed sum per unit sold. So if you were to buy a bottle of wine it doesn’t matter whether it costs $5, $10 or $25; a fixed sum will go to the government.

An ad valorem tax is charged as a fixed percentage of the price of the good. A good example of an ad valorem tax is VAT.

9.4 Borrowing

Borrowing is how a budget deficit is financed. Governments raise funds by selling government bonds and treasury bills to investors. Government has to pay interest on its borrowings and this can become a very significant expense when borrowing is high. Governments with very high borrowing can find it difficult to raise more money in this way because investors fear government default. This puts up the interest rate that must be offered.

Most borrowing is repayable after a number of years but some bonds are irredeemable.

Borrowing is used if the government feels that taxes cannot be raised. For example, the government might fear for its popularity. In addition, if the government takes money from consumers through taxes then this will reduce consumer spending. Of course, the government can spend the money raised by taxation, but the economy is unlikely to be stimulated. Borrowing allows the government to spend more while not taking more from consumers and this will stimulate the economy.

9.5 Selling state assets

Over the last several decades it has become common for many countries to privatise businesses which had been owned and run by the government (nationalised industries). The assumption is that governments are not particularly good at running businesses (perhaps because of over-bureaucratic, slow decision-making or through political interference) and that privatised undertakings will be better run and will offer consumers more choice, better service and lower prices. Governments therefore went through a phase of selling off the state gas company, electricity company, water company etc. and this raised substantial revenue. In many economies there now isn’t much left to sell off so this source of funds is negligible.

Note the second motive. Privatisation and deregulation raise money, but they are also intended to make the economy produce more efficiently — they work on the supply side rather than on demand. That is why they are usually described as supply-side measures, and why a government may pursue them at a stage of the cycle when it is simultaneously trying to restrain demand.

9.6 Printing money

Governments can, through their central banks, ‘print money’ and spend it so introducing it to the economy so that the economy is stimulated. Nowadays this process is called quantitative easing and the extra money is created electronically.

Quantitative easing is used when economies are in a poor shape and need stimulating. If an economy was doing well releasing more money through quantitative easing will cause inflation and will reduce the purchasing power of money, penalising, in particular, savers and those on fixed incomes.

10 Government approaches to controlling the economy

10.1 Fiscal policy

The word “fisc” is an old word which referred to the king’s purse.

• Where does the state get the money from?
  

• Where does it spend it?
  

If the state wants to spend money it either has to raise income through taxes or borrow money. If it wants to reduce taxes it either has to reduce expenditure or borrow money.

The three have to be in balance and how this is achieved is the government’s fiscal policy

When an economy is in recession, governments seek to spend more money and therefore to put money into the economy to try to stimulate it. However, if they spend more by raising taxes they may actually not end up putting very much more money into the economy. They are taking with one hand and giving away with the other. So what most governments do in a recession is increase government borrowing: keep taxes the same; borrow money, spend it, and once it is spent it will be earned by people who will spend it again. And that is the way in which governments hope the recession will be brought to an end.

10.2 Monetary policy

The second way in which governments attempt to control their economies is by their monetary policy: managing the supply of money in the economy. The more money in the economy the more economies are likely to be stimulated.

There are two main weapons.

• Interest rates. If interest rates are very high people will tend not to want to borrow money. If you don’t borrow money you can’t spend it, and if you can’t spend it then demand pull inflation will be relatively low. If, however, you greatly reduce the interest rates more people will be encouraged to borrow. They spend that borrowed money on televisions, cars, houses, whatever. Once it’s spent the money is in the economy, other people earn it, demand goes up, and the economy is stimulated.
  

• Credit controls. This is a control over institutions, typically banks, on how much they are allowed to lend. So, for example, if you put $1,000 into a bank and the reserve requirement was only 10%, that means that the bank could lend $900 out of the $1,000 deposited. That $900 could be deposited again and the bank could lend on $810 and so on. Therefore, the initial deposit of $1,000 can create a much higher amount of money in the economy. Say however that the reserve requirement was 50% - $1,000 in the bank; the bank only lend on $500. That $500 is put into another account, the bank can lend on only $250 and so on. You can see that at the end of the cycles a much smaller amount of money will be created in the economy.
  

11 The multiplier

Let’s say that a government introduces $100m into the economy by employing additional doctors in a state health service. The extra doctors will receive salaries from the government and will spend some and save some of their earnings.

Let’s say they spend 75% and save 25% (25% is known as the marginal propensity to save).

So, $75m is spent by doctors and earned by other people or firms. If they also had a marginal propensity to save of 25%, they would spend 75% x $75m = $56.25m, and so on. The total additional expenditure will therefore be:

It can be shown that the sum of these amounts is:

Initial expenditure x 1/Marginal propensity to save = $100m/0.25 = $400m

So, the effect of the initial $100m is multiplied. This effect can make government intervention – or any other way in which the economy is stimulated - very effective. Success breeds success and once the economy starts to grow it can therefore grow rapidly until the factors of production run out.

Of course, the effect works the other way. If a government reduces expenditure, this is not felt just once but affects a whole chain of consumption, and the economy can quickly decline.

12 The effects on business

Everything so far has been described from the government’s side. The syllabus also asks you to describe the effects on a business of changes in the economic growth rate, in interest rates, in government expenditure and in taxation — the four levers this chapter has been pulling. This section states them in that order.

Two of these interact in a way worth stating separately. A government trying to restrain a boom will usually raise interest rates and raise taxes and cut its own spending at the same time. A business therefore does not meet these three one at a time; it meets them together, at the stage of the cycle when its own costs are already rising fastest. That is why the practical response — building cash reserves and holding back discretionary investment during the boom — runs against what the boom feels like at the time.

13 Tests

The nine tests below are the chapter’s own. Work each one before you open its answer.

14 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.