Principles of Economics 6.1 - Introduction to Macroeconomics*

Question 1

What’s aggregation?

Answer 1

The process of summing individual economic variables to
obtain economy-wide totals

Question 2

What’s the name for ‘the process of summing individual economic variables to
obtain economy-wide totals’?

Answer 2

Aggregation

Question 3

What does ‘aggregate’ mean?

Answer 3

Total

Question 4

What are the 3 major issues in macroeconomics?

Answer 4

• Inflation
• Unemployment
• Economic Growth

Question 5

What’s inflation?

Answer 5

A general increase in the level of prices in an economy

Question 6

What’s the name for ‘a general increase in the level of prices in an economy’?

Answer 6

Inflation

Question 7

What’s unemployment?

Answer 7

The state of not having a job

Question 8

What’s the name for ‘the general change in the size of an
economy’?

Answer 8

Economic Growth

Question 9

What’s ‘Economic Growth’?

Answer 9

The general change in the size of an economy

Question 10

What are the broad, desirable objectives of macroeconomic policymaking?

Answer 10

• Low and stable inflation
• A high rate of employment (i.e. a low rate of unemployment)
• A high and sustainable level of economic growth

Question 11

Describe & explain the ‘fallacy of composition’

Answer 11

• Microeconomics analyses individual markets whilst macro (on a
  simplistic level) is the study of all markets…
• As a result, one might think that macroeconomic questions can be
  answered by aggregating microeconomic answers.
• You might think to yourself, “can’t we just take micro intuition and blow it
  up to a macroeconomic scale?”
• Sadly, this is not true; this is ‘fallacy of composition’.
• The macroeconomy is unfortunately more complicated than this

Question 12

What’s the name for ‘the false assumption that macroeconomic questions can be
answered by aggregating microeconomic answers’?

Answer 12

Fallacy of Composition

Question 13

What does the macroeconomy encompass?

Answer 13

Markets for goods & services, financial markets and the involvement of
government

Question 14

What’s the difference between micro analysis and macro analysis?

Answer 14

By looking at the ‘bigger picture’, macroeconomists often focus
on trends rather than specifics.
* Micro analysis = often quite specific and more detailed.
* Macro analysis = typically more general and less detailed (by necessity)

Question 15

How can we illustrate the macroeconomy?

Answer 15

Using a simple diagram called
the ‘circular flow of income’

Question 16

What’s the ‘circular flow of income’ used for?

Answer 16

To illustrate the macroeconomy

Question 17

Describe & explain the basic circular flow of income

Answer 17

• Initially, suppose there are only two parties: firms and households
  Firms and households supply things to one another:
• Firms make goods and provide services (they supply ‘output’), which is
  bought by households (i.e. consumed).
• Households work (i.e. they supply labour), and we assume that they are
  the owners of ‘capital’ (i.e. machinery, etc.), which is utilised by firms
  (thus, households also supply capital to firms).
• In exchange, money flows between firms & households:
• ‘Factor payments’ (sources of income) flow from firms to households
  (i.e. wages for labour and rent for capital).
• Payment for goods/services flows in the opposite direction

Question 18

Build on the basic circular flow of income by describing & explaining the extended circular flow of income

Answer 18

• In addition to the flows between firms and households, there are also
  ‘injections’ into, and ‘withdrawals’ from, the system.
• In other words, money does not just flow from households to firms
  and from firms to households - some comes from, or goes to,
  elsewhere.
• Injections and withdrawals involve:
  1. Financial institutions (banks).
  2. The government.
  3. Persons elsewhere in the world (“abroad” or “overseas”) – parties outside of our economy of interest (this is only encompassed in an open economy, NOT a closed one)

Question 19

Describe & explain the ‘injections’ in the circular flow of income

Answer 19

• Households account for only part of output. There is also:
• Investment (I) - Think of this as spending by firms on ‘capital goods’
  (think: equipment that contributes to the production of other things)
  Investment is typically regarded as funded by loans from banks.
• Government expenditure (G) - Spending on goods & services by the government.
• Export expenditure (X or EX) - Households from other countries buy domestic goods & services.
• Injections are therefore given by: I + G + X
• Note: exports and imports only apply in the case of an ‘open economy’ (i.e. one that interacts with the rest of the world)

Question 20

Describe & explain the ‘withdrawals’ in the circular flow of income

Answer 20

Similarly with injections, not all income is spent on domestic goods and services.
There is also:
* Saving (S) - Households don’t necessarily spend all of the income they earn.
* Net taxes (T) - Taxes are paid to the government whilst ‘transfer payments’ (i.e.
‘benefits’) flow in the opposite direction – hence net taxes.
* Import expenditure (M or IM) - Domestic households purchase goods & services from abroad.
* Withdrawals are given by: S + T + M

Question 21

Describe how people have been trying to measure economic activity for a very long time

Answer 21

People have been interested in measuring economic activity for a very long time. For example, in the mid-17th Century, Englishman Sir William Petty
conducted a detailed survey of the land and wealth of Ireland in order to determine how the Irish people could be taxed

Question 22

Describe & explain the main way the size of an economy can be captured

Answer 22

The size of an economy can be captured by what is known as Gross Domestic Product (GDP). GDP is the total value of final goods and services produced in a country during a given time. It acts as a proxy for the size of an economy

Question 23

What’s the name for ‘total value of final goods
and services produced in a country during a given time’?

Answer 23

Gross Domestic Product (GDP)

Question 24

What are the 3 ways to quantify GDP?

Answer 24

• The output method
• The income method
• The expenditure method
  These methods should yield consistent values under certain
  simplifying assumptions

Question 25

Describe what the ‘output method’ does to quantify GDP

Answer 25

Measures GDP by aggregating the value of final
goods & services produced in an economy I.e. the size of an economy = the value of the things made in it
Important: to avoid double-counting, we only count the value of final
goods and not ‘intermediate goods’ (i.e. those goods that are
components in the production of other things).

Question 26

Which method of quantifying GDP ‘measures GDP by aggregating the value of final
goods & services produced in an economy’?

Answer 26

The output method

Question 27

What does the ‘income method’ do to quantify GDP?

Answer 27

The income method measures GDP by adding up the incomes paid
to the factors of production in an economy

Question 28

Which method of measuring GDP ‘measures GDP by adding up the incomes paid
to the factors of production in an economy’?

Answer 28

The income method

Question 29

What does the ‘expenditure method’ do to quantify GDP?

Answer 29

The expenditure method measures GDP by adding together the
amount spent on final goods and services. I.e. the amount of spending by the final consumers of output

Question 30

Which method of measuring GDP ‘measures GDP by adding together the amount spent on final goods and services’?

Answer 30

The expenditure method

Question 31

Describe how the basic circular flow of income depicts how all 3 methods of measuring GDP should come up with the same value

Answer 31

In the basic circular flow, we can see why these things are
equivalent:
* A good that is produced (output method) is purchased by someone
(expenditure method) & this results in income for someone else
(income method).
In the extended circular flow, it is perhaps a little less clear cut because
some spending comes from other sources

Question 32

Elaborate on the formula for GDP

Also, what other terms do we denote to GDP interchangeably?

Answer 32

• In macro, we often use the terms ‘GDP’, ‘output’ and ‘income’
  interchangeably, and we denote these by ‘Y’.
• An important identity: Y = C + I + G + NX
  Where:
  1. C = household consumption.
  2. I = investment.
  3. G = government spending.
  4. NX = net exports or the ‘trade balance’

Question 33

Explain what GNP is and how it differs from GDP

Answer 33

• GNP, Gross National Product, is the value of final goods and services produced by
  domestically-OWNED factors of production.
• This is as opposed to GDP, which is about domestically-located production.
• One captures the value of things that are made in an economy (GDP) whilst the other captures the value of things that are made by
  entities that are owned by, or originate from, an economy (GNP).
• For GDP, the LOCATION of the product is important – if Toyota has a factory in the UK, it would contribute to the GDP of the UK but the GNP of Japan because GNP focuses on who OWNS the product or factory, wherever output is occurring

Question 34

Explain the different ways of expressing GDP

Answer 34

GDP can be thought of as output, income,
or expenditure) and GDP is the value of goods and
services produced in a country. However, this “value of production” can be quantified in a couple of different ways: we can express it in nominal terms or in real terms
* Nominal GDP is the value of production in terms of current prices,
i.e. in terms of the prices that prevailed at the time in question.
* Real GDP is the value of production in terms of constant prices, i.e.
the prices of a base period

Question 35

What does it mean if nominal GDP increases vs if real GDP increases?

Answer 35

We note that:
* If nominal GDP increases, this might be because output has
increased or it might be because prices have increased (or it might be
both).
* If real GDP increases, this can only be due to greater output (because
prices are held constant)

Question 36

Explain which expression of GDP is better for measuring economic growth

Answer 36

• A common reason for wishing to quantify GDP is because we want to
  measure economic growth.
• Economic growth is the rate at which the size of an economy is
  growing (in other words the percentage change in GDP).
• Based on the above, real GDP is the appropriate form of GDP to use
  when calculating economic growth.

Question 37

Describe what short-run fluctuations are

Answer 37

• In the short-run, economies typically fluctuate between:
• Periods of positive growth (usually accompanied by falling
  unemployment and low/stable inflation) – periods with high positive rates
  of growth are known as booms.
• Periods of negative growth – known as recessions (note: a recession
  is specifically defined as two successive quarters of negative growth).
• The short run is where some factors are
  fixed, long run is where all are variable

Question 38

Explain actual growth vs potential growth

Answer 38

We must distinguish between actual & potential growth.
* Actual growth is the % annual increase in output.
* This is ‘economic growth’ - the rate of growth in real GDP.
* Potential growth is the speed at which the economy could grow.
* This is the rate of growth in ‘potential output’.
* Potential output is the level of output that would arise when the
economy is operating at ‘normal capacity utilisation’.
* Normal capacity utilisation allows for firms having planned a degree of
spare capacity to meet unexpected demand – it is not the same as
producing at ‘full capacity

Question 39

Explain actual and potential output

Answer 39

• You can think of potential output as trend output, broadly increasing
  over time as an economy’s factors of production rise (i.e. the levels
  of labour, capital, and the level of technology).
• …whilst actual output fluctuates, depending on economic conditions.
• Resultantly, at any given time, actual output could be above, below or
  equal to potential output. This refers to the ‘output gap’.
• The output gap = the difference between actual and potential
  output (often measured as a % of potential output).
• If actual output > potential output, the output gap is positive and the
  economy is operating above normal capacity utilisation.
• If actual < potential, the output gap is negative and the economy is
  operating below normal capacity utilisation.

Question 40

Explain what the business cycle is

Answer 40

When we talk about short-run fluctuations (booms, recessions, etc.)
we are talking about fluctuations in actual growth (growth in actual
output). These fluctuations are captured by the ‘business cycle’.
* The business cycle consists of four phases:
1. Upturn or trough: A low point, after which output begins to grow.
2. Expansion: When there is rapid economic growth. A prolonged
expansion in economic activity is a boom (a series of positive
deviations from trend).
3. Peak / ‘peaking out’: A high point, after which growth slows down.
4. Contraction (a slowdown or recession): When there is little or no
growth or even a decline in output.
* Note: the level of output is highest in phase 3, whilst the rate of
growth in output is highest in phase 2

Question 41

Describe the business cycle model

Answer 41

‘National output (GDP)’ on vertical axis; ‘Time’ on horizontal axis; wavy curve with a general upward slope labelled ‘Actual Output’, this has labels ‘1.’ at its troughs, ‘2.’ at the upward sloping parts, ‘3.’ at its peaks and ‘4.’ at its downward sloping parts; dotted, straight line with positive gradient that’s going through the wavy line labelled ‘Trend output’; solid straight line with positive gradient that’s tangently touching each peak of the wavy line labelled ‘Full-capacity output; finally, there’s a key for the numbers with ‘1. Trough/Upturn’, ‘2. Expansion’, ‘3. Peak’ and ‘4. Contraction/Recession’