Unit 7 Macroeconomics & National Income PDF

Unit 7. Macroeconomics and National Income Week 8 Prepared by DRIZ Moving on to Macroeconomics! Macroeconomics is concerned with the We will learn the following economy as a whole. It looks subtopics: at five major issues – national...

Unit 7. Macroeconomics and National Income Week 8 Prepared by DRIZ Moving on to Macroeconomics! Macroeconomics is concerned with the We will learn the following economy as a whole. It looks subtopics: at five major issues – national Gross domestic product Circular flow of income output, unemployment, Keynesian model of national inflation, financial system income and economic relationships The multiplier with other countries. Prepared by DRIZ 2 Why Study Macroeconomics? To understand events that occur in our daily lives. Key macroeconomic goals For e.g., the Asian financial crisis in 1997 or the Economic growth more recent COVID-19 recession, reasons for Low unemployment government debt, high property prices, possible Low rates of inflation reasons for unemployment, etc Stable financial system To formulate better economic policies Avoid balance of payment To have a feel of what’s going on in the economy – deficits and excessive exchange will give you a better idea of the factors that are rate fluctuations driving your business. The government plays an important role in realising these macroeconomic goals. It manages the economy by implementing two kinds of government policies: 1. Fiscal policy – concerned with government expenditure and taxation. 2. Monetary policy – primarily concerned with the management of the money supply and interest rates. Macroeconomics focuses on households, firms, the government and the rest of the world. Prepared by DRIZ 3 Gross Domestic Product (GDP) GDP is the market value of all final goods and services produced within a country in a given time period. A Monetary Measure GNS are valued at their market prices – enables comparison of different goods and services in different years. Money acts as the common denominator (or price tag). Avoids Double Counting GDP only counts the final GNS produced for final use – NOT for resale, further processing, or manufacturing i.e., eliminate any intermediate goods. Why? The value of the final GNS already includes the value of all intermediate goods that were used to produce them. Alternatively, measure only the value added at each stage of production. Excludes Non-Production Transactions This is because they have nothing to do with the generation of the final GNS. Types of non-production transactions: Existing assets or property sold or transferred, including used items Purely financial transactions ○ Public transfer payments e.g., social security or cash welfare benefits, zakat ○ Private transfer payments e.g., student allowances or alimony payments. ○ Stock market transactions e.g., sale of stocks and bonds (but the brokers’ fees are included as a service). Second-hand sales are excluded as they do not represent current output (but any value-added between purchase and resale is included, e.g., used car dealers.) Prepared by DRIZ 4 Measuring GDP National income accounting measures the economy’s overall performance. Uses of national income in the GDP can be computed in two ways: Malaysian context: 1. By adding up the total amount 1. See the country’s rate of economic spent on all GNS in a year – growth “expenditure approach” 2. See the total contribution of 2. By adding up the total amounts economic sectors to national earned by all factors of production production in producing the final GNS – 3. Economic planning “income approach” 4. Standard of living comparison 5. Indication of success or failure of government policies Prepared by DRIZ 5 Measuring GDP: The Expenditure Approach This approach adds up the entire amount spent on GNS by four categories of buyers in the market i.e., household consumers, businesses, government, and foreign buyers. 1. Household/Personal Consumption (𝑪) Durable goods (lasting 3 years or more), e.g., cars, refrigerator Non-durable consumer goods and services, e.g., milk, vegetables, dentist, lawyer 2. Gross Private Domestic Investment (𝑰𝒈 ) All final purchases of machinery, equipment and tools by businesses All construction, including residential Money spent on R&D or the creation of new creative works Changes in business inventory (stock of unsold final goods) Why “changes”? Because total o Increase in inventory – must add to GDP. If total output produced exceeds current sales. stock will Counted as “investment” because they are not used during the year but as part of the include past productions –we production only want current year’s o Decrease in inventory – must subtract from GDP. If businesses are able to sell more than production they currently produce, this entry will be a negative number. Not produced this year although sold in the current year Prepared by DRIZ 6 Measuring GDP: The Expenditure Approach 2. Gross Private Domestic Investment (𝑰𝒈 ).. Cont’d Creation of new capital assets o Investment does NOT include transfers of ownership of paper assets (stocks, bonds) or real assets (houses, jewellery, art) i.e., noninvestment transactions Net private domestic investment 𝐼 o Each year as current output is being produced, existing capital equipment is wearing out and buildings are deteriorating – this is called depreciation or consumption of fixed capital. o 𝐺𝑟𝑜𝑠𝑠 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐼 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐼 o When more new capital equipment is produced in a given year than are used up, the productive capacity of the economy will expand (positive 𝐼 ) o When gross investment and depreciation are equal, a nation’s productive capacity is static (zero 𝐼 ). o When gross investment is less than depreciation, an economy’s production capacity declines (negative 𝐼 ). GDP is the value of what has been produced in the economy over the year, not what was sold. Prepared by DRIZ 7 Measuring GDP: The Expenditure Approach 3. Government Purchases (𝑮) Includes spending by all levels of government (federal, state and local). Spending on all consumer and capital goods to provide public services Spending on publicly owned capital e.g., schools, hospitals etc Spending on R&D to improve know-how Includes all direct purchases of resources (labour in particular). Excludes transfer payments since these outlays do not reflect current production. 4. Net Exports 𝑿𝒏 All spending on final goods produced in the nation must be included in GDP, whether the purchase is made here or abroad. Often goods purchased and measured in the nation are produced elsewhere. Need to subtract imports to avoid overstating total production in the country. Therefore, 𝑋 = 𝑋 − 𝑀 and can be either a positive or negative number depending on which is the larger amount. Prepared by DRIZ 8 Measuring GDP: The Income Approach This approach adds up all the incomes earned by households in exchange for the inputs contributed towards the production of GNS. Categories of income: 1. Compensation of employees Wages, salaries, fringe benefits, and payments made on behalf of workers like social security and other health and pension plans. 2. Rental income Income received by households and businesses that supply property resources e.g., monthly payments to landlords, and lease payments corporations pay for National Income office space (adjusted for depreciation). 3. Net interest (National income is NOT equal to GDP) Money paid by businesses to the supplier of loans to purchase capital. Interest received on savings deposits, certificates of deposits, and corporate bonds. 4. Profits All final purchases of machinery, equipment and tools by businesses Proprietors’ income (sole proprietorships, partnerships, and cooperatives) Corporate profits (dividends, retained earnings, and corporate income taxes) Prepared by DRIZ 9 Measuring GDP: The Income Approach To get GDP, we need to make adjustments to the national income: 5. Taxes on Production and Imports (add to NI) “Income” to the government – general sales tax, excise tax, business property tax, license fees, and customs duties (these are reflected in the prices of GNS) GDP 6. Depreciation/consumption of fixed capital (add to NI) National Income Included to reflect incomes from the replacement of plants and machinery. Depreciation allowance is a cost of production, so must be included in the gross value of output. 7. Net foreign factor income (minus from NI) Incomes of foreigners who supply resources in Malaysia minus incomes of Malaysians abroad Prepared by DRIZ 10 The Circular Flow of Income Model The circular flow of income model shows how money flows in an economy. It is useful for showing the relationship between AD and output. Components of the circular flow model The inner flow - shows the direct money flows between households and firms. Withdrawals (W) are flows of money that leave the circular flow – money not spent (net saving, 𝑆), money paid to the government (net taxes, 𝑇) and money spent on GNS abroad, 𝑀). 𝑾 = 𝑺 + 𝑻 + 𝑴 Injections (J) are flows of money that enter the circular flow – investment on domestically produced capital (𝐼𝑑), government purchases of domestic GNS (𝐺𝑑) and money earned from selling domestic GNS abroad (𝑋𝑑). 𝑱 = 𝑰𝒅 + 𝑮𝒅 + 𝑿𝒅 How does the circular flow model relate to AD? AD is equivalent to total spending by the household sector on domestically produced goods and services, plus the three injections i.e. AD = Cd + J Prepared by DRIZ 11 The Circular Flow of Income Model in the Real World Households: Parents work at Sime Darby, earning wages. They spend some of their income on daily necessities and save the rest. Firms: Sime Darby hires workers, pays wages, and sells products derived from palm oil to households. It also exports products to China and imports machinery from Germany. Government: Collects taxes from Sime Darby and its employees. Uses taxes to provide public services e.g. provides education, improve the skills of future employees for companies like Sime Darby. Foreign Sector: Sime Darby exports palm oil to China, earning foreign revenue. Imports machinery from Germany, paying foreign suppliers. Chinese investors buy stocks in Sime Darby, bringing investment into Malaysia. Prepared by DRIZ 12 The Relationship Withdrawals and Injections in Between Withdrawals the Real World and Injections During the COVID-19 pandemic, Malaysian households increased their savings due to economic uncertainty and reduced There are indirect links between withdrawals and consumption opportunities. This reduced the flow of money injections via financial institutions, the circulating in the economy, leading to lower consumer spending government and foreign countries respectively: and a contraction in economic activity. To counteract the economic slowdown, the Malaysian If more money is saved, there will be more government introduced several stimulus packages e.g. available for banks etc to lend out. PRIHATIN and PENJANA. These measures increased household If tax receipts are higher, the government may disposable income and supported consumer spending. be keener to increase its expenditure. If imports increase, the extra income generated How they relate: abroad may stimulate demand for exports. The increased household savings during the pandemic acted as a withdrawal by reducing the flow of money in the economy, But these links do NOT guarantee that 𝑆 = 𝐼𝑑 or leading to lower consumer spending and economic contraction. 𝑇 = 𝐺𝑑 or 𝑀 = 𝑋𝑑. Since decisions on both sides The government’s injection through stimulus packages are made by different people and involve countered this leakage by increasing disposable income, different amounts, planned injections (𝐽) may supporting employment, and boosting spending. This helped to NOT equal planned withdrawals (𝑊). stabilize the economy and foster a quicker recovery. Prepared by DRIZ 13. Equilibrium in the Circular Flow The circular flow of income model helps us to understand How does this happen, and how fluctuations in AD can how much will national cause fluctuations in national income change when AD income. changes? When injections ≠ withdrawals, disequilibrium will exist. AD will rise or fall, and so will national Simple Keynesian income. Model of National Disequilibrium results in a chain Income reaction that brings the Determination economy back to equilibrium where injections = withdrawals. Prepared by DRIZ 14 Simple Keynesian Model of National Income Determination Keynesian economics is a macroeconomic theory of total spending in the economy and its effects on output, employment, and inflation. It was developed by British economist John Maynard Keynes during the 1930s in an attempt to deal with the effects of the Great Depression. The simple Keynesian model of income helps us to examine the relationship between national income and the components of the circular flow of income (consumption, withdrawals and injections). Prepared by DRIZ 15 How Do Changes in AD Affect National Income? Production level in the economy depends on the level of spending or aggregate demand (AD). Start with equilibrium (𝑱 = 𝑾), where AD is constant. Assume that there is a fall in injections (so now it’s 𝐽 < 𝑊 ). What happens next is: the level of spending will be lower – fall in AD (𝐶𝑑 + 𝐽) firms will respond to the lower demand by producing less and using less labour and other resources, and paying out less incomes (𝑌) to households – national income will fall household consumption will fall and so firms will sell less. firms will respond further by producing even less, and using even less labour and other resources. household incomes will fall again. consumption and production will fall again, and so on – there will be a multiplied fall in national income and employment – this is known as the multiplier effect but this process does not go on forever. Each time household income falls, withdrawals fall (why?). When fall in withdrawals match the fall in injections, equilibrium will be restored. 𝐽 < 𝑊 → Y falls → W falls until 𝐽 = 𝑊 Similarly, if there is a rise in injections or fall in withdrawals ( 𝐽 > 𝑊), when rise in withdrawals match the rise in injections, equilibrium will be restored: 𝐽 > 𝑊 → Y rises → W rises until 𝐽 = 𝑊 Prepared by DRIZ 16 Showing Equilibrium on a Keynesian Diagram The “withdrawals and injections” approach To construct this diagram: Equilibrium is reached when 𝑊 and 𝐽 lines intersect at point 𝑥 and equilibrium National income (𝑌): horizontal axis while national income level is Ye. withdrawals (𝑊) and injections (𝐽): vertical axis. The withdrawals line (𝑊) is upward-sloping – positive relationship between national income and each of the withdrawals (𝑆, 𝑇 and 𝑀) – so a rise in national income will cause a rise in each of the three withdrawals. The slope of 𝑊 (∆𝑊/∆𝑌) is called the marginal propensity to withdraw (𝒎𝒑𝒘). It is the proportion of a rise in national income that is withdrawn from the circular flow. The injections line (𝐽) is a straight line – injections are independent of national income because in the short run, investment and government expenditure plans are likely made in advance and exports depend on foreign incomes not this country’s income. Prepared by DRIZ 17 The Withdrawals & Injections Approach Explained Disequilibrium cases: If 𝑾 < 𝑱 national income is below equilibrium level (a-b) this extra injection into the economy would encourage firms to produce more, causing national income to rise. as people’s incomes rose, they would save more, pay more taxes and buy more imports – withdrawals would rise. There would be a movement up along the 𝑊 curve. This process would continue until 𝑊 = 𝐽 at point 𝑥. If 𝑾 > 𝑱 national income is above equilibrium level (c-d) this deficiency of demand would cause production and national income to fall. as it did so, there would be a movement down along the 𝑊 curve until again point x was reached and 𝑊 = 𝐽. Prepared by DRIZ 18 Showing Equilibrium on a Keynesian Diagram The “income and expenditure” approach (Keynesian cross) To construct this diagram: Equilibrium is reached when 𝑊 and 𝐽 The 45-degree line is a reference line representing all lines intersect at point x and equilibrium points where 𝑌 = 𝐶𝑑 + 𝑊 national income level is 𝑌𝑒. The aggregate expenditure line (𝐸) represents AD, where 𝐸 = 𝐶𝑑 + 𝐽 Aggregate expenditure is based on the consumption function (𝐶𝑑), which shows the relationship between consumption and income. It has a positive slope because 𝐶 increases with 𝑌. The 𝐶𝑑 is flatter than the 45° line because for any rise in national income, only part will be spent on domestic products, while the remainder will be saved. So, 𝐶𝑑 rises less quickly than 𝑌. The slope of 𝐶 (∆𝐶𝑑/∆𝑌) is called the marginal propensity to consume domestically produced goods (𝒎𝒑𝒄𝒅). It is the proportion of a rise in national income that is spent on domestic goods and services. Since national income must be spent on domestically produced goods or withdrawn from the circular flow, 𝑚𝑝𝑐𝑑 + 𝑚𝑝𝑤 = 1 Prepared by DRIZ 19 The Income and Expenditure Approach Explained Disequilibrium cases: If 𝑬 > 𝒀 at 𝑌1, there would be excess demand in the economy (e - f) people would buy more than what is currently being produced. Firms would increase their level of production. In doing so, they would employ more factors of production. National income would rise. as it did so, 𝐶𝑑 and 𝐸 would rise. There would be a movement up along the 𝐸 line. But because not all the extra income would be consumed (i.e. some would be saved), expenditure would rise less quickly than income – 𝐸 line is flatter than the 𝑌 line. As income rises towards 𝑌𝑒, the gap between 𝐸 and 𝑌 gets smaller. Once point 𝑧 is reached (𝑌 = 𝐸), there is no further tendency for income to rise. If 𝑬 < 𝒀 at 𝑌2, there would be insufficient demand for the goods and services currently being produced (g-h) firms would find their stocks of unsold goods building up. They would respond by producing less and employing fewer factors of production. National income would fall and go on falling until 𝑌𝑒 was reached. Prepared by DRIZ 20 MPW in the Real World Saving (Marginal Propensity to Save, MPS) Suppose Malaysian households experience an increase in wages due to improved economic conditions or a government stimulus. Some households choose to save a portion of this extra income rather than spend it immediately on goods and services. The MPS determines how much of the additional income is withdrawn from the circular flow of income, reducing the initial impact of the income increase on consumption and overall economic activity. Taxes (Marginal Propensity to Tax, MPT) The Malaysian government implements a tax policy that increases income tax rates for higher-income earners. Higher-income households face an increase in income taxes, reducing their disposable income. This reduces the amount of income available for consumption and saving, impacting household spending decisions. The MPT affects the overall demand for goods and services in the economy, potentially moderating economic growth and consumption patterns. Imports (Marginal Propensity to Import, MPI) Malaysia experiences a surge in consumer demand for electronic gadgets, leading to increased imports of electronics. Malaysian consumers prefer imported electronics due to brand preference or technological specifications not met by domestic products. The MPI determines how much of the consumer spending leaks out of the domestic economy to foreign suppliers. Higher MPI reduces the domestic multiplier effect of consumer spending, affecting local businesses and employment in the electronics sector. Prepared by DRIZ 21 MPCd in the Real World Increase in Disposable Income Promotion of Local Products The Malaysian government introduces a new policy to increase the minimum wage. A local supermarket chain launches a campaign A factory worker’s monthly wage increases to promote Malaysian-made products. The from RM1,200 to RM1,500. The worker supermarket offers discounts and promotions on decides to spend part of this extra RM300 on locally produced food items and household local products such as groceries, clothing, goods. and services like haircuts and entertainment. Malaysian consumers, influenced by the If the 𝑀𝑃𝐶𝑑 = 0.8, the worker spends RM240 campaign, decide to purchase more local (80% of RM300) on domestically produced products. For e.g., eats more locally made snacks. goods. If the 𝑀𝑃𝐶𝑑 = 0.9 (high), the household spends This increase in domestic consumption 90% of the additional income on local products. boosts demand for local businesses, This boosts demand for local manufacturers and increasing production and employment. suppliers, supporting domestic economic growth. Prepared by DRIZ 22 The Multiplier When injections rise or withdrawals fall, national income will rise (vice versa). But by how much? National income will rise by more than the rise in injections or fall in withdrawals. The size of the multiplier is given by k = ∆Y/∆J The size of the multiplier indicates the size of the rise or fall (or how much is the change) in national income. What determines the size of the multiplier? This can be shown graphically by the two approaches: The income and expenditure approach The withdrawals and injections approach (Keynesian cross) Prepared by DRIZ 23 The Multiplier (The withdrawals and injections approach) Assume injections rise from 𝐽1 to 𝐽2. Equilibrium will move from point a to point b. Income will rise from 𝑌𝑒1 to 𝑌𝑒2. But this rise in income (∆𝑌) is bigger than the rise in injections (∆𝐽) that caused it. This is the multiplier effect: (c - a)/(b - c) i.e. 𝒌 = ∆𝒀/∆𝑱 (= ∆𝑌/∆𝑊). Recall that the slope of 𝑊 (𝑚𝑝𝑤) = ∆𝑊/∆𝑌 So, the multiplier formula is the inverse of the mpw, 𝒌 = 𝟏/𝒎𝒑𝒘 The size of the multiplier depends on the 𝑚𝑝𝑤 i.e. the bigger the 𝑚𝑝𝑤 , the smaller the multiplier. (the more is withdrawn each time incomes are generated round the circular flow, the less will be recirculated and the smaller the rise in national income will be) And since 𝑚𝑝𝑐𝑑 + 𝑚𝑝𝑤 = 1, an alternative multiplier formula is 𝒌 = 𝟏/(𝟏 − 𝒎𝒑𝒄𝒅) Prepared by DRIZ 24 The Multiplier (The income and expenditure/Keynesian cross approach) Assume aggregate expenditure (E line) shifts to E2. This could be due to either a rise in any of the three injections or a rise in the consumption of domestic gns. Equilibrium national income will rise from Ye1 to Ye2. What is the size of the multiplier? The initial rise in expenditure was b - a The resulting rise in income is c - a So, the multiplier is (c - a)/(b - a) i.e. k = ∆Y/∆J Prepared by DRIZ 25 The Multiplier in the Real World Tourism Sector Growth Multiplier Effect Tourist Spending: International tourists spend money on accommodations, dining, transportation, shopping, and tourist Malaysia promotes its attractions within Malaysia. tourism sector Revenue Generation: Hotels, restaurants, tour operators, and retail shops benefit from increased tourist spending, leading to higher through international revenues. marketing campaigns, Job Creation: The tourism industry hires more workers to handle attracting more increased tourist arrivals and service demands, including hotel staff, tour guides, and transport providers. tourists from around Local Spending: Income earned by workers in the tourism sector is the world. spent on local goods and services, further stimulating economic activity. Secondary Effects: Higher economic activity in the tourism sector supports related industries such as food and beverage suppliers, souvenir makers, and cultural events. Prepared by DRIZ 26 Multiplier and the Full-Employment Level of National Income Keynesian theory assumes that there is a maximum level of national income that can be obtained at any one time. This level of income is called the full-employment level of national income. Unfortunately, the equilibrium level of national income could fall below or go above the full-employment level of national income resulting in either a recessionary gap or an inflationary gap. Prepared by DRIZ 27 Recessionary Gap A recessionary or deflationary gap happens when there is a shortfall of national expenditure below national income (and withdrawals over injections) at the full employment level of national income. When this happens (𝑌𝑒 < 𝑌𝐹), it is usually accompanied by demand-deficient unemployment. The size of the recessionary gap is less than the amount by which 𝑌𝑒 falls short of 𝑌𝐹. This is an illustration of the multiplier at work. If injections were raised by (c - d), income would rise by (𝑌𝐹 − 𝑌𝑒). So, the multiplier is 𝒌 = (𝒀𝑭 − 𝒀𝒆)/(𝒄 − 𝒅) In this Keynesian model, the cure for demand-deficient unemployment is to close the recessionary gap i.e. an increase in aggregate expenditure is needed. How? By an expansionary fiscal policy of increasing government expenditure and/or lowering taxes, or by an expansionary monetary policy of reducing interest rates and increasing the amount of money in the economy. The full-employment level of national income (𝑌𝐹) is represented by the vertical line. The equilibrium level of national income is Ye, where 𝑊 = 𝐽 (withdrawals and injections approach) and 𝑌 = 𝐸 (income and expenditure approach). The recessionary gap is (a – b), the amount that the 𝐸 line is below the 45° line at the full-employment level of income. It is also (c - d), the amount that injections fall short of withdrawals at the full-employment level of income. Prepared by DRIZ 28 Inflationary Gap An inflationary gap is the excess of national expenditure over income (and injections over withdrawals) at the full employment level of national income. This happens when 𝑌𝑒 > 𝑌𝐹. But 𝑌𝐹 represents a ceiling to output. So, real national income cannot expand beyond this point except for a very short time where resources are used intensively. Since this is not sustainable, it will result in demand-pull inflation. To eliminate this inflation is to close the inflationary gap i.e. by either raising withdrawals or lowering injections. How? By either a contractionary fiscal policy of lowering government expenditure and/or raising taxes, or a contractionary monetary policy of raising interest rates and reducing the amount of money in the economy. The inflationary gap is illustrated by (e - f), which is the amount where aggregate expenditure exceeds national income at the full-employment level of national income. It is also shown by (g - h) when injections exceed withdrawals at the full-employment level of national income. Even if the government does not actively pursue its fiscal or monetary policy, the inflationary gap may still close automatically via mechanisms that would move the E line down and the J line up and/or the W line up. These include the following: When prices rise, wages may not, so consumers would spend less. Higher domestic prices will lead to fewer exports (lower J) and more imports (higher W) Higher prices reduce the real value of people’s savings, so they may save more to compensate. Higher prices increase the demand for money. If money supply is unchanged, the shortage of money drives up interest rates –reduces investment (lower J) and encourages saving (higher W). But these automatic effects may take some time to take effect and may be difficult to predict. Prepared by DRIZ 29