1 Government Macro Objectives and Indicators of National Economic Performance
1.1 Circular Flow of Income
The circular flow of income model illustrates economic activity between economic agents
1.1.1 The difference in
micro & macroeconomics is
Macroeconomics studies aggregate or total behaviour ie how all consumers, firms the government and overseas economic agents
interact. Microeconomics considers how individual firms and consumers behave in individual markets, why markets work and fail
1.1.2 What does
macroeconomics study?
Macroeconomics is concerned with the study of the economy as a whole and in particular:
• Economic Growth: what factors causes increases in Gross Domestic Product (GDP) hence living standards.
• The causes and consequences of unemployment – why are some workers seeking employment, jobless?
• Inflation: reasons why general prices rise persistently and associated problems
• International trade: does the UK ‘pay its way’ in trading with other countries? Why do exchange rates fluctuate?
• Economic cycle: why does the economy move in a regular cycle of booms and slumps?
1.1.3 List Government
macro objectives
The government is responsible for managing the economy. Government macroeconomic objectives include low and stable inflation
& unemployment, high & sustainable economic growth, a satisfactory balance of payments and an acceptable distribution of income
Govts also seek stable
exchange rates
1.1.4 What are economic
sectors?
For the purposes of analysis, the economy is divided up into four sectors:
• Households receive payments (income) for their services (eg labour) and then buy the output of firms (consumption)
• Firms hire land labour and capital (resources) owned by households to produce goods and services for which they pay
wages rent etc (income). Firms receive payment (expenditure). Firms invest (I) in new producer goods
• Government collect taxes (T) to fund spending on public services (G)
• International The UK buy overseas products, imports, (M)) and overseas economic agents buy UK products, exports (X)
Economists sometimes
refer to households, firms
the government and
overseas sector as
economic agents
1.1.5 What is the circular
flow of income model?
The circular flow of income (CFY) illustrates economic
activity in a given time period.
It identifies the main sectors in the economy
(households, firms the government and overseas) and
linkages between sectors eg wages, government
spending & interest payments
The real circular flow of income shows flows of goods
and services and factors of production between firms
and households.
The money circular flow of income shows the flow of
money to pay for economic activity. Households receive
payments for their services (income) and use this money
to buy the output of firms (consumption).
Use the circular flow of
income model to illustrate
1) Economic activity
2) Components of AD
Income expenditure &
output methods ie NY =
NEx = NQ, and
3) Multiplier effect
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Households
Income
Y
Money Circular Flow
of Income
Firms
© Richard Young
Leakages or withdrawals
Savings S
Taxation T
Imports M
Consumption
C
Injections
Investment I
Government G
Exports X
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1.1.6 What are flow and
stock values?
A flow value is an amount per period of time eg the UK produces £900Bn worth of goods and services each year. A stock value is an
amount at a given moment in time eg UK at the end of 2002 UK firms held £5Bn worth of stocks
1.1.7 What are injections &
leakages in the CFY model ?
A leakage (withdrawal) from the CFY is when part of earned
household income is not spent on final goods. Consumers
• Keep some income for future spending saving (S)
• Use part of their income to pay government tax (T)
• Buy foreign made products ie imports (M)
1.1.8 What is consumption
Consumption (C) is spending by UK households on UK made goods and services
1.1.9 What is investment
Investment (I) is spending by UK firms on capital goods such as new factories, plant or buildings, machinery & vehicles
1.1.10 Define net
investment
Production results in capital consumption – machines become worn out and obsolescent. Net investment only occurs after such
depreciation of fixed assets is taken into account. Net investment = gross investment - depreciation
1.1.11 Govt spending is
Government (G) is spending by the UK government on public services eg NHS doctors salaries & new equipment for state schools
1.1.12 Define imports &
exports
Imports are products a country buys from other nations. Exports are domestically produced items sold abroad. In the CFY:
• Imports (M) is spending by UK residents on goods and services produced overseas
• Exports (X) is spending by overseas residents on goods and services produced in the UK
• Net exports (X-M) is the difference between a country’s income earned from exports and total spending on imports
1.1.13 What factors
determine consumption
The main determinant of consumer spending is disposable household income. An increase in income usually
increases consumption. Other influences include interest rates, consumer confidence and house & share prices.
1.1.14 Marginal
propensity to consume
The marginal propensity to consume (mpc) is the proportion of extra income spent on consumption: The
proportion of extra income spent (mpc) declines as household get richer because consumers are more able to save
mpc = ∆C/∆Y and falls
as income rises
1.1.15 What factors
increase investment
Lower Interest rates, new technologies, corporation tax cuts, improved business confidence in a booming economy
where firms are operating close to capacity, encourage investment.
Interest rates are the
cost of borrowing for I
1.1.16 Govt spending
depends on?
The higher national income (GDP), the more taxes paid to government and the greater its ability to spend on public services. A
slump reduces income tax & corporation tax revenues forcing the government to make cuts or borrow to maintain services
Demographic changes eg
aging pop also affect G
1.1.17 What factors
determine net exports
Spending on a country’s imports or exports is affected by incomes at home (M) & abroad (X), relative prices, relative quality (design,
reliability & after-sales service) of products, the level of the exchange rate and the degree of trade restrictions eg tariffs & quotas
Households
1.1.18 Main components of
UK spending
2001
% of GDP
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588
70%
Government
156
18%
Gross I
151
18%
Firms
Stock changes
0
0%
An injection into the CFY occurs when firms supply products to
non-household sectors. Firms receive income from selling to
• Other firms, ie investment expenditure (I)
• The government, ie government expenditure (G)
• Foreigners, ie export expenditure (X)
Overseas
Exports
Imports
289
340
34%
40%
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GDP
846
In equilibrium flows out of
the CFY are
counterbalanced by flows
back in.
Resources can be used to
create items for
immediate use
(consumption) or to
create producer goods
that increase future
productive potential.
UK Annual Spending by
Sector GDP at constant
1995 prices (£bn)
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1.2 Calculating National Income
1.2.1 Economic activity is?
Economic activity refers to the production, distribution exchange or consumption of goods and services.
1.2.2 What is national
income?
National income (NY) is the monetary value of goods and services produced in an economy in a given time period, usually the last
12 months. NY estimates the value of products available to a country from its economic activity. Measures of national income
include Gross Domestic Product (GDP) & Gross National Income (GNI)UK GDP in 2004 was £1,109,574Bn
1.2.3 What is Gross
Domestic Product?
Gross Domestic Product the total value of final goods & services produced within a country's borders in a year. Note: gross:
depreciation of capital is not subtracted; Product: only final output is included; domestic: only output within a country is counted.
1.2.4 What is Gross
National Income?
Gross National Income (GNI) is a broader measure of national income than GDP.
• GDP measures the value of economic activity within the territory of the UK over a period of time
• GNI measures the value of economic activity by UK citizens anywhere in the world over a period of time. Cars produced by
Honda in the UK are included in UK GDP but profits sent back to Japan add to Japan’s GNI.
The ONS defines national income as gross national income: the income available to the residents arising from GDP, and receipts
from, less payments to, the rest of the world of employment income, property income and current transfers.
1.2.5 Why increase GDP
A rise in real GDP (economic growth) means a more output and improved economic welfare as more wants & needs can be satisfied
1.2.6 What is national
income accounting?
National income Accounting (NYA) is the process of trying to estimate the monetary value of goods and services produced in an
economy, in a given time period, eg a year. Measures include Gross Domestic Product (GDP) and Gross National Income (GNI)
1.2.7 Why is national
income calculated?
Measuring the monetary value of goods and services produced within a country (GDP) or by its citizens (GNI) allows economists to
evaluate UK economic performance eg calculate economic growth, changes in standard of living & income distribution, over time.
1.2.8 How is national
income estimated
The Office of National Statistics (ONS) estimates national income (NY) using three alternative but complementary approaches:
• Income method: add up the incomes earned from the current production of goods and services
• Expenditure method: add up the money spent on all current finished goods and services, less the cost of imports
• Output method: add up value added by every firm or the value of final current UK output. Intermediate output is ignored
1.2.9 Define value added
Value added is the difference between the value of a firm’s inputs (items firms purchase) and their output (items firms sell). Value
added measures a firm's contribution to GDP.
1.2.10 Give an example of
value added
Stage of production
Input (£)
Output (£)
Value Added
Wheat Farmer
0
200
200
Flour Miller
200
300
100
Baker
300
600
300
Supermarket
600
1000
400
Final consumers
1000
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1000
The level of national
income indicates the size
of the economy.
GDP is the most common
measure of national
income
GDP is a monetary
estimate of the total
amount of economic
activity within a country
in a given time period.
GDP is estimated by
totalling up a country’s
output, income or
expenditure in a year.
GDP & GNI are different
ways of stating a
country’s national income
ie the monetary value of
its total output in a year
Each method of
estimating GDP is
imprecise and contain
errors & omissions that
give different rent results.
The money spent on making goods (inputs) is taken away
from the money received from the sale of items (outputs) to
give value added. Taking final output or adding up each
sector’s value added gives national income.
Wheat, flour and bread supplied to the supermarket are
examples of intermediate output and are ignored in NYA
The value of loaves sold by the supermarket to the consumer
gives final output and this figure is included in NYA
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1.2.11 The main problems
of using the output method
Intermediate output is goods & services used in making the final ‘finished’ product eg raw materials, components & transport.
Final output is items sold to the customer. Including intermediate output in national income results in double counting eg the
value of flour, etc would be counted once when sold to the baker, and again when the loaf is sold to the consumer. Over time, the
quality of products may improve and prices fall. For example computers get faster and cheaper
Statisticians ignore
intermediate output &
count only value added or
final output
1.2.12 The main problems
of using the income
method
The income method only counts incomes earned in return for providing a good or a service. This means:
• Non-marketed output the value of DIY, unpaid housework and voluntary activities do cause an official incomeexpenditure flow and so are not recorded in official NY figures. Subsistence farming in less developed countries (LDCs) does
not result in an income and so form no part of official NY figures. GDP figures for LDC understate economic activity
• Transfer payments received for no corresponding output (eg unemployment & child benefits) must not be counted
• Undeclared economic activity in the informal economy means official figures may underestimate true GDP by up to 13%
The informal economy
refers to economic activity
undeclared to the
government resulting in
lost tax revenue.
1.2.13 Current & capital
expenditure
Current expenditure is spending on items that only last a limited period of time. Products are ‘consumed’ in the current time period
ie this year. Capital expenditure is spending on producer goods that items that last and are used to help create products in future
years ie investment
1.2.14 Problems of using
the expenditure method
Adding up the money spent buying current output gives an inaccurate value of national income. GDP at market prices includes
indirect taxes & subsidies. Deducting indirect taxes & subsidies gives GDP at factor cost – a more accurate valuation of NY
Second-hand goods also pose a problem as they have already been counted. If a second hand car is bought for £5000, serviced &
repaired and then sold for £8,000, only the value added created in the current time period is counted in NYA ie £3,000
1.2.15 Effect of inflation
on national income
National Income has a price and a quantity component. If the price level doubles with the same amount of goods and services
produced, then nominal national income also doubles but real national income remains constant.
1.2.16 How are inflationary
effects eliminated?
Inflationary effects are eliminated by valuing current output at constant prices ie by calculating each year’s GDP using base year
prices. UK GDP values in the table below are valued at 2002 prices
1.2.17 What is real and
nominal GDP?
GDP is measure in both real and nominal terms. Real GDP is a better indicator of economic performance because it strips out the
effects of inflation. Nominal or money GDP is current output measured at current prices eg 2006 output valued at 2007 prices. Real
GDP is current output valued at constant or base year prices eg 2006 output valued at 2002 prices (where 2002 is the base year)
Base year is the reference
year of data set eg 2002
1.2.18 How is real GDP
calculated?
To calculate real GDP use the formula Real GDP = Nominal GDP x CPI in base year/Current CPI
Eg if nominal GDP is £900Bn and the CPI = 200 then real GDP = £900Bn x 100/200=£450Bn
CPI: consumer price index
- base year is 2005
1.2.19 What is current GDP
Year
GDP at constant (2002)
market prices (£ms)
Growth rate %pa
2000
1,005,542
2001
1,027,905
2002
1,048,456
2003
1,074,858
2004
1,109,574
2.2%
2.0%
2.5%
3.2%
n/a
Constant 2002 prices means output
in all years are both being valued at
2002 prices ie any inflationary
effects are removed
1.2.20 Chained volume
Chained volume measures refer to data sets where the level of prices is held the same for all years. Figures measured in today's
prices (current prices) have been deflated by the change in prices since a particular reference or base year.
1.2.21 What is the
standard of living?
The standard of living refers to the average amount of GDP for each person in a country ie per capita real GDP. It is found by
dividing real GDP by the size of the population.
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The effect of price
changes is excluded
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1.2.22 Does GDP measure
welfare?
National income statistics simply measure changes in output. GDP figures do not take account of:
• negative externalities and sustainability issues associated with increases in economic activity
• Lost leisure and increased stress if GDP increases because people are working harder and longer hours
• Inequality issues such as national and region income distribution differences – equity issues
Economic development is
best measured by broad
composite indices such as
the HDI
1.2.23 Can GDP be used to
make comparisons of SoL
between countries?
GDP places a monetary value on the amount of goods and services created by a country in one year and so can be used to make
economic comparisons between countries. However raw GDP figures will need adjusting for:
• Divide GDP by the size of population to establish standard of living (SoL) ie average GDP per person,
• Inflation (use real not nominal) and exchange rate effects (convert local currencies into a common currency ie $) ie use
purchasing power parity PPP$.
• Even then per capita real PPP$ ignores issues such as size of informal economy, length of work week, extent of
externalities, sustainability, and income & regional inequality factors
Dollar purchasing power
parity exchange rate
($PPP) adjusts exchanges
rates to ensure $1 buys
the same quantity of
products in each country.
1.2.24 What are the
limitations of national
income measures of
economic performance?
Economists are criticised for over emphasising economic growth as ‘the’ indicator of performance. GDP is a narrow measure of
economic welfare. Economic development requires improvements in growth and broader indicators of human ‘well-being’ eg:
• A reduction of poverty, inequality and unemployment. Less ‘stress’ and shorter working hours allowing more leisure.
• Improvements in life expectancy, educational attainment, individual self esteem, expanding economic & social choice
GDP figures can be
misleading and reflect
only one dimension of
development.
1.2.25 What is economic
development
Economic Development requires sustainable economic growth and improvements in other indicators eg a reduction in poverty,
inequality and unemployment and improvements in life expectancy, educational attainment and other indicators.
Sustainability: the ability
to continue.
1.2.26 Is growth economic
Development?
Economic growth is not necessarily economic development. GDP is a narrow measure of economic welfare that does not take account
of key non-economic aspects eg life expectancy, access to health & education, environment, freedom or social justice.
1.2.27 What is sustainable
development?
Sustainable development is development that meets the needs of the present without compromising the ability of future generations
to meet their own needs. Brundtland Report
1.2.28 How is economic
development measured?
The UN has developed a widely accepted set of indices to measure development against a mix of composite indicators:
• UN’s Human Development Index (HDI) measures a country’s average achievements in three basic dimensions of human
development: life expectancy, educational attainment and adjusted real income ($PPP per person).
• UN’s Human Poverty Index (HPI) measure deprivation using % of people expected to die before age 40, % of illiterate
adults, % of people without access to health services and safe water and the % of underweight children under five
Sustainable growth is just
one aspect of
development.
Development results in
higher GDP and less
poverty, inequality and
unemployment; improved
SoL, life expectancy,
educational attainment, &
social choice
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1.3 Economic Growth
Economic growth is an increase in the capacity of the economy to produce goods and services, and can be illustrated by an outward
shift in the production possibility boundary. The economic growth rate is the percentage increase in real GDP over twelve months.
1.3.2 How is economic
growth measured?
The rate of economic growth is the percentage increase in real GDP over twelve months.
A 1% growth rate means standards of living double every 72 years; 2% 72/2 = 38; 10% = 72/10 = 7.2
1.3.3 What is the UK’s
average growth rate?
The UK’s average growth rate for the last century is 2.4%. This means, year on year, the UK economy is producing 2.4% more goods
and services than 12 months earlier. British standards of living typically double every 30 years.
1.3.4 What is the
opportunity cost of
economic growth?
Economic growth is achieved by increasing the:
• quantity of resources through investment
• the quality of resources through training
• improving technology and the use of existing
resources
The government of a developing country just meeting its
essential needs may chose to reallocate resources from the
production of consumer gods to investment goods. The
economy moves from A to B
The short run opportunity cost of HG extra investment is ED lost
consumer goods – possibly essentials. People may starve for
extra producer goods
1.3.5 What are the
consequences of economic
growth?
The potential advantages of growth include:
• More products to satisfy more wants & needs
• Higher employment allows higher wages so that
poverty is reduced.
• Workers earn higher incomes for producing more
goods and services
• Bigger tax receipts rise allowing more public services
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Capital Goods
1.3.1 Define economic
growth
Economic growth is a rise
in real GDP.
T
Process of Growth using PPBs
L
H
B
A
G
D
E
Opportunity cost
measures the cost of an
economic choice in terms
of the best alternative
foregone.
Production possibility
curves are an effective
method of illustrating the
process, opportunity cost
and outcome of growth
V
M
Consumer Products
The potential disadvantages of growth include:
• Environmental Increased pollution from increased
economic activity
• Sustainability Depletion of non renewable natural
resources may be unsustainable and threaten the well
being of future generations
• Equity benefits may be narrowly distributed to the rich
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1.4 Productivity
1.4.1 The supply side is?
The supply side refers to factors affecting the quantity or quality of goods and services produced by an economy eg productivity
1.4.2 Production is
Production is the value or volume of output (Q) in a given time period.
1.4.3 How is productivity
measured?
Productivity is the amount of output produced per unit of input. Labour productivity refers to output per worker and is found by
dividing total output (Q) in a given time period (eg a week or hour) divided by number of workers AP= Q/L.
1.4.4 What determines
labour productivity?
The amount of output produced by one worker depends on a) the skill & training of the labour force b) the quantity and quality
complementary factors eg machines, building which can be improved with investment and c) the quality of management and
leadership. Low productivity is caused by a combination of poorly managed, under trained, workers using outdated machinery.
Productivity is a key
determinant of overseas
competitiveness
1.4.5 How is UK economic
performance measured?
The main measure of UK performance is productivity ie is the amount of output produced per unit of input. The UK’s standard of
living is determined by productivity. International Competitiveness ie productivity levels between different economies.
Productivity determines
prosperity
1.4.6 Is the UK competitive
The UK has lower productivity than competitor nations such as the USA Germany or France – there is a productivity gap.
1.4.7 Why does the UK have
a productivity gap?
Skills – good at the top (eg Oxbridge) but poor at the bottom (22% functional illiteracy rate). Low skill levels reduce economic
performance. Too many workers lack the key basic and intermediate level skills. DTI Solution: Education & training
Investment The level of business investment still remains below that of our major competitors. DTI Solution: improve incentives for
investment – especially in ICT & communication
Innovation requires spending on Research & Development (R&D). The UK has global scientific excellence that attracts FDI.
However UK firms are undertaking less R&D than their competitors. Solution: improve incentives for R&D
Enterprise UK staff are more ‘risk adverse’ than USA counterparts ie they prefer to accept tenured employment rather than start a
business. Solution: improve incentives for risk taking eg lower corporation tax & capital gains tax for small firms
Competition The UK has flexible & efficient labour market and the lowest unemployment rate in the G7
1.4.8 What is the impact of
an increase in investment?
Investment affects both the demand and supply side of the economy. More investment stimulates aggregate demand and generates
a multiplier effect. Also a country’s productive capacity increases with new and better machinery allowing higher productivity.
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I also affects the supply
side of the economy
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1.5 Government Macroeconomic Policies & Objectives
Governments have macroeconomic objectives and use policy instruments to achieve these aims. Incomplete & inaccurate data, time delays and unexpected external shocks make
managing the economy difficult. Moreover objectives can conflict. The application of macroeconomic policy is covered in depth in Section 3 of these notes
1.5.1 What are
government policy
objectives for the
macro-economy
1.5.2 What is the
current Government's
economic strategy
The government’s macroeconomic policy objectives for the economy is to improve the country’s economic welfare through
•
•
•
Low & stable inflation within 1.0 to 3% pa range
Maintenance of low unemployment
High and sustainable real economic growth
•
•
•
Higher levels of investment and productivity
Satisfactory balance of payments
Acceptable distribution of income
•
Delivering macroeconomic stability by ensuring the
golden and sustainable rules met
Improving productivity ie increase in Q/L
Increasing employment opportunity for all with, ideally,
full employment;
•
Ensuring fairness for families and community ie
acceptable income distribution and a fall in relative
poverty (numbers living on income below 60% of average
median income)
Protect the environment.
•
•
•
1.5.3 Distinguish
between internal and
external objectives
Objectives are quantified eg the inflation target is met if prices rise within the stated target range of 1.5 to 2.5%; ensuring fairness if
numbers of those living in relative poverty fall to X million
• Internal economic objectives: controlling price inflation, maintaining high employment and sustainable economic growth
• External objectives: the balance of payments and in particular the current account and exchange rate
1.5.4 Why do
governments set
objectives
Objectives enable evaluation. A government has a successful economic policy if the stated objective is met by the end of the stated time
period. Eg inflation held at 2%, full employment achieved. Inflation exceeding the target means an unsuccessful economic management
of the economy by the government.
1.5.5 How does a
government seek to
meet its objectives?
Government attempts to achieve its macroeconomic objectives using macroeconomic tools or policy instruments :
• Demand management policies - measures to change AD eg fiscal, monetary and exchange rate policy
• Supply side policies – measures to change AS eg measures that improve product and factor (eg labour) market productivity
1.5.6 What is demand
management?
Demand management occurs when the government attempt to influence the level of aggregate demand (AD) hence the levels of national
income, employment, rate of inflation, economic growth and the balance of payments position.
• Reflationary policies to increase the level of AD to at, or near, the level of potential GDP
• Deflationary policies decrease the level of AD to at, or near, the level of potential GDP
1.5.7 Why are policies
needed?
. New products & technologies, changes in taste, world booms & slumps, volatile oil prices, etc means the UK economy continually has to
adjust to shocks. Macroeconomic policies enable the govt to influence economic activity to achieve set objectives
1.5.8 Policies to
Reduce Poverty
Governments seek to reduce relative poverty by
• redistributing income via the tax and benefits system eg progressive taxes and means tested grants to
• Reducing unemployment hence poverty eg Welfare to Work & Sure Start scheme increase employment and household incomes
• Legislation eg National Minimum Wage
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Source: The Treasury
Demand & supply side
polices are linked eg
changing benefits affects
consumption and
incentives to work
Economies are inherently
unstable
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1.6 Economic (Business) Cycle
1.6.1 Define the
economic cycle
The economic cycle is when actual GDP tends to move up and down in a regular pattern causing booms and slumps (depressions), with
recession and recovery as intermediate stages.
1.6.2 Actual GDP is
Actual GDP is the level of output produced by an economy in a given year.
1.6.3 Potential GDP is?
Potential output: the maximum level of real GDP in a given year consistent with stable inflation. All markets are in equilibrium eg all
labour seeking jobs at the going wage rate can find work. Actual GDP may diverge from potential GDP causing output gaps
Measures maximum
sustainable output
1.6.4 Trend growth is
Trend growth is the expected long-term increase in output (GDP) caused by an increase in the economy’s productive capacity
Path of long run output
1.6.5 Illustrate the
economic cycle
Over time the UK economy grows as a result of
net investment and improved productivity –
trend growth.
The output gap is usually
expressed as a percentage
of the level of potential
output eg 2%
3
Real GDP
Trend growth measures how fast an economy can
grow without inflation - also known as the
economy’s ‘speed limit’
In the shorter term, actual GDP moves through
an economic cycle, periods above and below the
trend (potential) growth path.
actual output
3
4
2
2
1
1
4
1
Potential
or trend output
Economic cycle Phases
2 1. slump
2. expansion or
recovery
3. peak or boom
4. recession
time
1.6.6 Output gaps
An output gap is the difference between potential and actual GDP. A positive output gaps occurs when actual GDP is above trend GDP
generating inflationary pressure. Negative output gaps mean actual GDP is below trend causing unemployment
1.6.7 Is the economic
cycle a problem?
Each stage of the economic cycle present challenges to the government’s macroeconomic objectives:
• In the recovery/boom stages demand may exceed supply in various markets causing a) inflation as wages and prices to rise
and b) a deterioration in the balance of payments current account as imports rise
• In the recession/slump stages, supply exceeds demand resulting in a) layoffs & unemployment b) falling government tax
revenues & c) increased benefit payments (G>T). However inflationary pressure falls and the current account improves.
1.6.8 What is the impact
of the economic cycle?
The impact of the economic cycle will vary by:
• The length and depth of the recession eg a short six-month recession with a 0.1% fall in GDP has minimal impact. A 10 year
depression with output falling by 30% has severe implications for the economy
• Sector: It is quite possible for manufacturing to be in recession while the service sector is booming
• Industry: firms producing luxury goods with a high income elasticity of demand are more affected by the economic cycle
than firms producing essentials
• Region: the impact of a recession will be different in the South East with a strong service sector than the midlands north with
large manufacturing
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Sometimes called the
business cycle
In 2005 the govt moved
the beginning date of the
current economic cycle
from 1999 to 1997.
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1.7 Employment & Unemployment
1.7.1 What is the working
age population?
Using Labour Force Survey data the working age population
(16-64 male 16-59 female) has two main categories:
• Economically active, workforce or labour force made
up of the employed and job seekers ie unemployed
workers actively seeking work
• Economically inactive are people of working age not in
employment or satisfying LFS unemployment criteria
through early retirement, looking after family and
home, long-term sickness or full-time education.
Working age population of 47,727 million is made up of:
Employed
Economically
active ie the
labour force
LFS measure of Unemployed (job seekers)
30,080
1,424
Source ONS Dec 2005
28,656
Economically inactive
The labour force shows
the total number of
people able available and
willing to participate in
paid employment plus
those registered as
unemployed and actively
looking for new work.
17,633
1.7.2 What is the labour
force
The labour force is the total number of people able available and willing to participate in paid employment ie 1) the employed
labour force plus 2) those registered as unemployed and actively looking for new work.
Also called whole
economy labour supply
1.7.3 Define
unemployment
Unemployment occurs when individuals are jobless but willing and able to work at the going wage rate. Official government figures
only count people who register as unemployed and are actively searching for work.
1.7.4 Define the
unemployment rate
The unemployment rate is the percentage of the labour force are out of work but actively seeking employment ie:
unemployment rate = number unemployed/labour force x 100
1.7.5 How is
unemployment (U)
measured?
There are two methods of estimating unemployment:
• Claimant count only includes those who are unemployed and claiming benefits ie those eligible to claim the Job Seeker's
Allowance. This method is quick and inexpensive but understates the ‘true’ level of unemployment because many people
are interested in finding work but do meet all of the criteria for claiming JSA.
• The International Labour Organisation’s Labour Force Survey (LFS) or ILO measure counts only those who have looked for
work in the past month and are able to start employment in the next two weeks. The LFS is an internationally used broader,
if slower & more expensive, method of measuring unemployment then the claimant count method.
Is unemployment simply
people without a job?
What about those only
willing to accept high
paid fulltime jobs?
Discouraged workers
would like to work but
have given up looking for
jobs after an unsuccessful
search and are not
included in official
unemployment statistics
1.7.6 Is the LFS an accurate
measure of
unemployment?
Using LFS methodology, only persons actively looking for work are classified as unemployed. This excludes:
• Discouraged workers who want a job but have given up looking because they have decided the search is hopeless.
• Diversion from unemployment to sickness. 2.5 million non-employed adults of working age claim sickness related
benefits but are not officially classified as unemployed
1.7.7 What are the
consequences of
unemployment
1.7.8 Unemployment raises
equity issues?
•
•
•
lost output (opportunity cost),
lost government tax revenue and
Increased expenditure on unemployment benefits
•
•
External costs eg poverty and diminished social
cohesion; loss of status, alienation and frustration.
The effects of depend on the rate & duration
The longer the average
time workers are jobless,
the higher the costs of U
The unemployed have the lowest incomes. Finding jobs raises incomes and reduces inequality – even low paid jobs. Reallocating
resources involves people losing and finding a job – a painful not costless process.
Tutor2u Macroeconomics Q&A 2006 Edition
© Richard Young
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1.7.9 State the main
categories of
unemployment
Listing all the types of
unemployment
Type
Description
Cause
Remedy
demonstrates low level
understanding.
Unemployed temporarily
Improve job information, eg better job
Frictional
Normal labour turnover and the resultant
Focus on causes
between jobs eg newly
delays in applying for interviewing & accepting centres. Reduce amount & duration of
implications and ‘cures’
redundant worker
unemployment benefits
jobs. Job searches take time.
for the three main types:
Mismatch of labour skills of Changed supply & demand from evolving
Offer retaining to improve occupational
Structural
frictional, structural and
unemployed to job
immobility and relocation grants to improve cyclical
consumer tastes & new technologies and the
opportunities.
geographical immobility
immobility of labour.
Which policies are most
efficient effective and
Cyclical or Demand Fluctuating unemployment Insufficient AD, given potential AS, creates a Manage the economic cycle to reduce or
from insufficient AD
equitable for reducing
deficient
negative output gap. Linked to economic cycles. even eliminate output gaps
unemployment?
Categories of Unemployment
Classical
Unemployment caused by
market disequilibrium
Real wages held above their market clearing
level causing excess labour supply
Improve the operation of labour markets eg
weaken trade union power
1.7.10 Voluntary &
involuntary unemployment
is?
Voluntary unemployment: when a worker chooses not to accept a job at the going wage rate but to remain unemployed. This may
be the result of the unemployment trap: take home pay from working is less than unemployment benefits. Involuntary
unemployment when a worker is willing to accept a job at the going wage but cannot get a job offer.
1.7.11 What is full
employment?
Full employment is the highest possible level of employment and occurs when those seeking work can find jobs at the going wage
rate ie there is no cyclical unemployment
1.7.12 How can there be
unemployment when an
economy is at full
employment?
Full employment does not mean that everyone is employed. Economies are dynamic and respond to changes in consumer taste and
new technologies by reallocating resources. Frictions & structural changes mean there is always unemployment
1.7.13 The natural rate of
unemployment is?
The natural rate of unemployment is the unemployment rate at the full employment level of national income where there is no
cyclical unemployment but inevitable frictionally and structurally unemployed.
1.7.14 Zero cyclical
unemployment?
For Keynesian economists, cyclical unemployment is linked to the economic cycle and only occurs in times of recession. In long run
equilibrium where actual and potential GDP are identical there is no cyclical unemployment - only frictional and structural
1.7.15 Outline the
Unemployment trap
The unemployment trap occurs when workers calculate that lost benefits and extra tax mean they are no better off working than if
remain unemployed. Government supply side polices such as Families Working Tax Credit & Sure Start seek to break this trap.
1.7.16 What are UK
employment trends?
Unemployment has fallen since 1993 to circa 3% using the claimant count and 5% using the labour force survey method. Falling
unemployment is mainly due to actual real GDP growth outstripping trend GDP; Many workers have given up active job search and
left the labour market; the expansion of higher education means fewer job entrants.
•
Frictions: Businesses take time to advertise & recruit workers. Job seekers need time to find and take up new employment
•
Structural changes: new technologies and competitors create job losses in industries and regions. It takes time to
overcome the occupational & geographical immobility of labour through retraining or for workers and relocation grants
Tutor2u Macroeconomics Q&A 2006 Edition
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Full employment does not
mean zero
unemployment: there is
frictional & structural but
no cyclical (demand
deficient) unemployment
3% unemployment
indicates full employment
in the UK
Economics can sound very
clinical when discussing
unemployment. There is
nothing natural about
unemployment – especially
for the unemployed
Powell.
The demand for labour is a
derived demand.
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1.7.17 Unemployment
spider diagram
Involuntary labour want employment at
lost output
going wage but cannot get a job offer.
Voluntary: labour decline job offer at
going wage rate
(opportunity cost)
More unemployment
benefits
Labour Force
lost government
tax revenue
Survey
Measurement
Unemployment
Costs
External costs
eg poverty
Claimant
Count
effects depend on the
rate & duration of U
Categories
Frictional workers temporarily
between jobs
Structural unemployed have the
wrong skills in the wrong place
immobility of
labour
geographical
Cyclical fluctuating unemployment
linked to the business cycle.
Involuntary
Lack of AD
given AS
occupational
large regional differences in
unemployment levels
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