Macro Economics

Overview

Think of macroeconomics as a sequence of enlargements. National income tells you the size of the economy and how fast it grows. The Keynesian cross tells you why demand can determine output when prices are sticky. IS-LM adds the interest rate and the money market, so fiscal expansion is no longer free because it raises interest rates and crowds out investment. Aggregate demand and aggregate supply add the price level, so demand shocks move output in the short run but prices in the long run. The Phillips curve adds the labour market and expectations, so attempts to hold unemployment below its natural rate eventually produce accelerating inflation. If you can place any question on that ladder, you know which model to use, which variables are fixed and which adjust, and what the policy conclusion should be. Always draw the relevant diagram first and label the axes, because a macro diagram with the wrong axis or an unlabelled shift is the most common source of lost marks.

National income: concepts and measurement

Gross domestic product is the market value of all final goods and services produced within a country in a given period. Final goods are counted to avoid double counting: intermediate goods used up in producing other goods are excluded, because their value is already embodied in the final good. GDP can be measured three ways that agree in principle. The production or value-added method sums value added, output minus intermediate consumption, across sectors. The income method sums compensation of employees, operating surplus including rent, interest and profit, and mixed income of the self-employed, plus net taxes on production and imports. The expenditure method sums consumption, investment, government spending and net exports. Any difference between the three in published data reflects measurement error, timing and the informal economy, not a conceptual disagreement. Gross national product adds net factor income from abroad to GDP, giving income earned by residents wherever production occurs. Net concepts subtract consumption of fixed capital, or depreciation, from gross concepts: net domestic product equals GDP minus depreciation, and national income is net national product at factor cost in the older terminology, now usually expressed as net national income at market prices minus net indirect taxes. Personal income adjusts national income for undistributed corporate profits, corporate taxes and social contributions, plus transfer payments, while disposable personal income subtracts personal taxes and is the income households can actually spend or save. Nominal values are measured at current prices and rise with both output and prices; real values are measured at base-period prices and isolate changes in quantities. The GDP deflator, nominal GDP divided by real GDP multiplied by one hundred, is a broad price index covering all final goods, unlike a consumer price index that covers a fixed basket of household goods. Per capita income divides an aggregate by population and is a rough welfare indicator, but it hides distribution, non-market work, environmental costs and leisure, so it must never be presented as a complete measure of well-being.

Determination of output and employment

The classical theory of output and employment rests on flexible wages and prices and on Say law, the proposition that supply creates its own demand because production generates the income needed to buy the output. In the classical labour market, employment is determined where labour demand, derived from marginal productivity, equals labour supply, and the real wage adjusts to clear the market, so involuntary unemployment cannot persist. Output is then determined by the production function at full-employment labour, and the aggregate supply curve is vertical at that level. Demand determines only the price level: more money raises prices proportionally without changing real output, which is the neutrality of money and the basis of the quantity theory. Any unemployment in this view is voluntary, frictional or caused by wages held above equilibrium by institutions or policy.

Keynes rejected this picture for economies in depression. With wages and prices sticky, a fall in aggregate demand reduces output and employment rather than prices, and the economy can settle at an underemployment equilibrium with no automatic force restoring full employment quickly. The Keynesian cross formalises this: planned expenditure equals consumption plus investment plus government spending plus net exports, consumption depends on disposable income, and equilibrium output is where planned expenditure equals actual output. The paradox of thrift follows: if everyone tries to save more, consumption falls, output falls, and total saving may not rise at all. Aggregate demand slopes downward because of the wealth effect, the interest rate effect and the exchange rate effect, while short-run aggregate supply slopes upward because input prices are sticky, and long-run aggregate supply is vertical at potential output. A demand shock therefore moves output and prices together in the short run, while a supply shock moves them in opposite directions, producing stagflation. The adjustment path matters: over time wages and expectations adjust, short-run supply shifts, and the economy returns toward potential output, but the speed of that return is an empirical question and the reason stabilisation policy is debated at all.

Consumption, investment, multiplier, accelerator

Consumption is the largest component of aggregate demand, so its behaviour drives the multiplier. The Keynesian consumption function relates current consumption to current disposable income: consumption equals autonomous consumption plus the marginal propensity to consume multiplied by disposable income. The marginal propensity to consume is the fraction of an extra unit of income spent, and the marginal propensity to save is one minus that fraction. The average propensity to consume falls as income rises if autonomous consumption is positive, which fits cross-sectional data but not long-run time series, a puzzle resolved by later theories. The life-cycle hypothesis says households smooth consumption over their lifetime, saving during working years and dissaving in retirement, so consumption depends on lifetime resources and wealth, not only current income. The permanent income hypothesis makes a similar point: consumption responds strongly to permanent income changes and weakly to transitory windfalls, which are mostly saved. The relative income hypothesis adds social comparison: consumption depends on income relative to peers and on past peak income, producing habit persistence and ratchet effects. Investment is more volatile than consumption because it depends on expectations about future returns, the interest rate and the existing capital stock. In the neoclassical view, firms invest until the marginal product of capital equals the user cost of capital, which includes the interest rate, depreciation and expected capital gains, adjusted for taxes and subsidies. Tobin q compares the market value of installed capital with its replacement cost: investment rises when q exceeds one. The accelerator principle says investment responds to changes in output rather than its level: a growing economy needs a growing capital stock, so even steady growth requires positive net investment, and a slowdown in growth can turn net investment negative. The multiplier links spending to output: an initial rise in autonomous spending raises income, which raises consumption, which raises income again. With a constant marginal propensity to consume, the simple multiplier is one divided by one minus the marginal propensity to consume, or one divided by the marginal propensity to save.

Demand and supply of money, IS-LM model

Money is whatever is generally accepted as a medium of exchange, a store of value and a unit of account. The demand for money in Keynesian theory has three motives: transactions demand rises with income, precautionary demand rises with income and uncertainty, and speculative demand falls as the interest rate rises, because higher rates raise the opportunity cost of holding idle cash and increase the expected capital loss on bonds if rates rise further. The liquidity preference schedule therefore slopes downward in interest-rate space. The supply of money is controlled by the central bank through the monetary base and amplified by the banking system through the money multiplier, which depends on the reserve ratio and the public currency-deposit ratio. Equilibrium in the money market equates real money supply, nominal supply divided by the price level, with real money demand, determining the interest rate for a given income level. The IS curve shows combinations of interest rate and income where the goods market is in equilibrium: planned expenditure equals output. It slopes downward because a lower interest rate raises investment and therefore output through the multiplier. The LM curve shows combinations where the money market is in equilibrium: it slopes upward because higher income raises money demand, which at a fixed money supply requires a higher interest rate to restore equilibrium. Their intersection gives simultaneous equilibrium in both markets. Fiscal expansion shifts IS right, raising both income and interest rates; the rise in rates crowds out some investment, so the final income rise is smaller than the Keynesian-cross multiplier suggests. Monetary expansion shifts LM right, lowering interest rates and raising income. Effectiveness depends on slopes: fiscal policy is powerful when LM is flat, the liquidity trap case where money demand is infinitely elastic and monetary policy cannot lower rates further, and when IS is steep. Monetary policy is powerful when LM is steep and IS is flat. At full employment, demand expansion raises prices rather than output, and the classical case with vertical LM makes fiscal policy fully crowded out.

Inflation, business cycles and policy

Inflation is a sustained rise in the general price level, not a one-off rise in a single price. Demand-pull inflation comes from excess aggregate demand pressing against capacity, while cost-push inflation comes from rising input costs, especially wages or imported energy, shifting short-run aggregate supply upward. The quantity theory links sustained inflation to money growth in excess of output growth in the long run, while expectations determine how quickly a given shock becomes embedded in wage and price setting. The costs of inflation include shoe-leather costs of economising on cash, menu costs of changing prices, distortions from a tax system not fully indexed to inflation, arbitrary redistribution between debtors and creditors when inflation is unanticipated, and uncertainty that shortens planning horizons. Anticipated inflation that is fully indexed is far less costly than unanticipated inflation, which is why credibility and anchoring of expectations matter so much. Unemployment is classified as frictional, from normal job search and turnover; structural, from mismatch of skills or location; cyclical, from deficient demand; and seasonal. The natural rate of unemployment is the rate consistent with stable inflation, comprising frictional and structural components, and the Phillips curve originally plotted an inverse relation between wage inflation and unemployment. The expectations-augmented Phillips curve says unemployment below the natural rate raises inflation only while expectations lag behind; once expectations catch up, the short-run curve shifts up and unemployment returns to its natural rate at a higher inflation rate, so the long-run Phillips curve is vertical. Business cycles are recurrent fluctuations in output around trend. Theories emphasise demand shocks amplified by the multiplier-accelerator interaction, monetary shocks, political cycles, and real business cycle theory, which attributes fluctuations to technology and supply shocks with flexible prices and intertemporal substitution of labour. Policy debate turns on lags, knowledge and credibility: discretionary policy can stabilise if timed well but may destabilise if recognition, decision and implementation lags are long; rules such as steady money growth or inflation targeting aim to anchor expectations and prevent political misuse, while discretion retains flexibility for genuine emergencies.

Classical versus Keynesian determination of output

Policy effectiveness in IS-LM

Types of unemployment