4. The Macroeconomy

National income is the income earned by the factors of production from current production during a period. In the national accounts, it corresponds in principle to the value of output and expenditure after the relevant adjustments.

The flow must be dated and measured consistently. Domestic and national concepts differ according to whether factor income crosses borders.

Wages, rent, interest and profits generated by production over one year contribute to national income, even though the underlying assets are stocks.

National income is not national wealth, and it is not simply the government’s tax revenue.

GDP measures output produced within a country’s borders. GNI adjusts GDP for net primary income from abroad. NNI further accounts for depreciation of capital, giving a measure closer to income after wearing out productive assets.

Use the geographic boundary and depreciation adjustment explicitly. A country can have GDP above GNI if more factor income flows abroad than in; NNI is lower than GNI when depreciation is positive.

GDP £1,000bn plus net factor income from abroad £20bn gives GNI £1,020bn; subtracting £70bn depreciation gives NNI £950bn.

GDP is not automatically the income of residents, and NNI is not GDP minus every kind of government spending.

Market prices include taxes on products and exclude subsidies, while basic prices measure the amount received by producers before product taxes and after product subsidies. To move from market to basic prices, subtract taxes on products and add subsidies.

State which valuation is used before adjusting; otherwise the sign can be reversed.

If GDP at market prices is 900, product taxes are 80 and subsidies are 20, GDP at basic prices is 840.

Basic prices are not “lower prices” in every case; the adjustment depends on the relative size of taxes and subsidies.

A gross measure includes the value of capital used up during production; a net measure subtracts depreciation (consumption of fixed capital). Thus net national income is gross national income minus depreciation.

The adjustment removes the amount needed to maintain the productive capital stock. Do not subtract every business cost or intermediate input.

If GNI is 1,020 and depreciation is 70, NNI is 950 in the same currency units.

Gross does not mean inaccurate and net does not mean after tax; the distinction concerns capital consumption.

In a closed economy, households provide factors to firms and receive income, then spend on firms’ output. Government collects taxes and spends; in an open economy exports and imports connect the flow to the international sector.

Real flows are resources and goods; money flows are wages, rent, interest, profits and expenditure. Each receipt for one sector is spending or income for another.

A household receives wages from a firm, buys its output, pays tax to government and may buy an imported good; exports bring spending into the domestic flow.

The circular flow is not a claim that every pound circulates instantly or that saving disappears; it describes linked flows over a period.

Investment, government spending and exports are injections into the circular flow. Saving, taxation and imports are leakages (withdrawals).

In a simple model, total injections equal total leakages when the circular flow is stable. A change in one component affects income and output through linked spending, even when the multiplier is not calculated.

A rise in government infrastructure spending is an injection; households saving more is a leakage. If injections exceed leakages, national income tends to expand initially.

A leakage is not automatically harmful and an injection is not automatically beneficial; effects depend on capacity, inflation and what is spent.

The circular flow is in equilibrium when planned injections equal planned leakages. If injections exceed leakages, income tends to rise; if leakages exceed injections, income tends to fall, subject to model assumptions.

Marginal propensities and multiplier calculations are not needed here; focus on the direction and the condition for stability.

If I + G + X equals S + T + M, planned spending matches withdrawals and aggregate income has no built-in pressure to change.

Equilibrium does not mean full employment or zero inflation; it is a flow condition that can occur at different output levels.

Aggregate demand (AD) is the total planned expenditure on domestically produced goods and services at a given price level: consumption + investment + government spending + (exports − imports).

Consumption depends on households, investment on firms, government spending on public decisions and net exports on foreign and domestic demand. AD is a flow over a period, not a stock of wealth.

If C=500, I=120, G=180, exports=90 and imports=110, AD = 780 in the same units.

Imports are subtracted because they are spending on foreign output; adding them would double-count expenditure that is not domestic production.

Aggregate demand is AD = C + I + G + (X − M): consumption, investment, government spending and exports minus imports.

Each component is planned spending on current domestic output. Imports are subtracted because they are spending on foreign production, while exports add foreign spending on domestic production.

If C=500, I=120, G=180, X=90 and M=110, AD is 780.

Adding imports would count foreign output as domestic output; AD is not simply all spending by residents.

Consumption, investment, government spending and net exports are the components of AD. Income, interest rates, expectations, taxes, wealth, exchange rates and foreign income can change those components.

A determinant that increases planned spending shifts AD right; one that reduces it shifts AD left. Trace the component before drawing the curve.

A lower interest rate may raise consumption and investment, shifting AD right; a fall in foreign income can reduce exports and shift AD left.

A change in the price level is movement along AD, while a change in a component determinant shifts AD.

The AD curve shows the total real output demanded at different average price levels, holding other determinants constant. It slopes downward in the standard model.

A lower price level can increase real purchasing power, reduce interest rates and improve net exports, so planned real expenditure rises. These are mechanisms, not movements of the curve’s determinants.

A fall in the domestic price level can make exports more competitive and reduce the money needed for transactions, increasing real output demanded along AD.

AD is not the household demand curve for one good and its vertical axis is the price level, not one product’s price.

AD shifts when planned spending changes at every price level. Expansionary fiscal policy, lower interest rates, stronger confidence, higher wealth or greater foreign income can shift AD right; contractionary changes shift it left.

Check the channel and direction: a tax cut may raise consumption, while an exchange-rate appreciation may reduce exports and shift AD left.

Higher consumer confidence increases consumption at each price level, shifting AD right; a fall in export demand shifts it left.

Do not call every rise in output an AD shift; a movement along AD follows a change in the price level itself.

Aggregate supply (AS) is the total real output firms are willing and able to produce at different average price levels over a period, given production conditions.

The supply side includes wages, input prices, productivity, technology, taxes, infrastructure and the available labour and capital. Distinguish a movement along AS from a shift of AS.

A rise in firms’ costs can reduce real output supplied at each price level, while productivity improvement can increase it.

AS is not the sum of one firm’s short-run supply curve without considering the economy-wide price level and costs.

Aggregate supply shifts when firms’ cost conditions or productive capacity change. Wage and raw-material costs, taxes, subsidies, productivity, technology, labour force, capital stock and supply shocks are key determinants.

Lower unit costs or greater capacity shift AS right; higher costs or a destructive shock shift it left. State whether the change affects output, the price level or both through the model.

A fall in energy prices can shift AS right, while a supply-chain disruption can shift it left and create cost-push inflation pressure.

A higher price level alone is movement along AS; a cost change shifts the curve.

Short-run aggregate supply (SRAS) is generally upward sloping because firms may face rising marginal costs as output approaches capacity. Long-run aggregate supply (LRAS) represents the economy’s sustainable productive capacity and is drawn according to the model used.

The short run contains fixed factors or sticky costs; the long run allows capital, labour and technology to adjust. Keep the chosen classical or Keynesian LRAS convention explicit.

An economy can raise output along SRAS when spare capacity exists, but a lasting expansion of productive capacity requires an outward LRAS shift.

LRAS is not simply SRAS made steeper, and the curve’s shape is a model assumption with an economic interpretation.

SRAS shifts when firms’ current costs change, such as wages, raw materials, taxes or energy prices. LRAS shifts when sustainable capacity changes through labour, capital, technology, skills or institutions.

A supply shock can move SRAS left without permanently reducing capacity; investment or productivity can shift LRAS right and may also shift SRAS.

A sudden oil-price rise shifts SRAS left; improved infrastructure and worker skills can shift LRAS right over time.

Not every short-run cost change changes long-run capacity, and an LRAS shift is not a movement along SRAS.

A movement along AD or AS follows a change in the average price level, holding other determinants constant. A shift changes the whole curve because spending, costs or productive capacity change.

Identify the changed variable first, then decide whether the new equilibrium lies on the old curve or requires a new curve.

A higher price level moves the economy along AD; a tax change that alters consumption shifts AD. A wage shock shifts SRAS; a higher price level alone does not.

A new equilibrium point is not automatically a curve shift; compare the original and new determinants.

In the AD/AS model, equilibrium occurs where planned aggregate expenditure equals firms’ aggregate supply at a given price level. The intersection determines real output and the average price level; employment is related through production.

If AD exceeds AS at the current price, firms see unintended stock falls and may increase output; if AS exceeds AD, inventories rise and output pressure weakens.

The intersection of AD and SRAS gives short-run output and price level; compare it with LRAS to judge whether output is above or below sustainable capacity.

Equilibrium output is not automatically full-employment output or a socially optimal price level.

A rightward AD shift usually raises real output, the price level and employment in the short run. A leftward SRAS shift tends to lower output and employment while raising prices; an LRAS increase permits higher sustainable output with less inflation pressure.

The final effect depends on the curve’s slope, spare capacity, expectations and whether the shift is temporary or structural.

Higher consumer confidence can create demand-pull inflation and more employment; a supply shock can create stagflation—higher prices with lower output.

Demand expansion is not always inflation-only, and supply contraction is not simply “lower prices because less is produced”.

Economic growth is an increase in an economy’s real output or productive capacity over time. It is commonly measured by the percentage change in real GDP, with population growth considered when judging output per person.

Distinguish short-run recovery toward existing capacity from long-run growth that shifts productive potential. Growth can raise material living standards but may have distributional and environmental costs.

If real GDP rises from 1,000 to 1,030, growth is 3%; if population also rises 3%, real GDP per capita may be unchanged.

Nominal GDP growth can reflect price rises rather than more output, and aggregate growth does not prove every household is better off.

Economic growth is a sustained rise in an economy’s real output. The usual rate is the percentage change in real GDP, because nominal GDP can rise only because prices rose.

Real GDP per capita is a better first indicator of the change in average material output: divide real GDP by population before comparing countries or years. It is still an average, not a complete measure of welfare.

If real GDP rises from 1,000 to 1,040, growth is 4%. If population rises from 100 to 104, real GDP per person is unchanged, so the headline growth rate overstates the typical output gain.

A positive GDP growth rate does not prove living standards rose for every household; distribution, unpaid work, quality and environmental costs may move differently.

Nominal GDP is valued at current prices, whereas real GDP removes the effect of changing prices by valuing output at constant prices or using a GDP deflator.

The distinction matters whenever inflation is present. A base year gives a common price structure for a time series; the exact index method can differ, but the purpose is the same—separate quantity change from price change.

If nominal GDP rises 8% while the general price level rises about 5%, real output has grown by roughly 3% rather than 8% (the exact result depends on the index calculation).

Nominal GDP is not “wrong”; it is the current-money measure. It becomes misleading only when it is treated as a direct measure of real production or living standards.

Economic growth can result from an increase in the quantity of factors of production or from higher productivity—the ability to produce more output from the same inputs.

Investment raises the capital stock; education and training improve human capital; better technology, infrastructure, entrepreneurship and institutions can raise total factor productivity. More labour or land can expand capacity, but diminishing returns may limit the effect.

A factory that buys an additional machine may produce more with the same workforce. If software then lets each worker coordinate twice as many orders, productivity—not merely the number of machines—has improved.

A temporary rise in spending can raise actual output without increasing productive potential. Long-run growth requires a lasting capacity or productivity change.

Higher real output can increase employment, incomes and tax revenue, but the consequences of growth are not automatically positive or evenly shared.

Growth may reduce poverty and fund public services, yet rapid demand can create inflation, inequality or external costs such as congestion and emissions. Supply-side growth is usually more sustainable than a purely demand-led boom, but even it can have opportunity costs.

A productivity gain that raises real wages and tax receipts can improve living standards; if the gain is concentrated in one sector while pollution rises, average GDP growth hides distributional and environmental losses.

“More GDP” is not identical to “more welfare”. Judge the direction and distribution of effects, and distinguish a temporary cyclical recovery from sustainable growth.

A person is unemployed when they are without a job, available to work and actively seeking work under the definition being used. The unemployed are part of the economically active labour force, unlike people who are not seeking or available for work.

The definition separates unemployment from inactivity. It also differs from underemployment, where someone has work but wants more hours or a better use of their skills.

Someone who has lost a job, can start next week and has applied for vacancies is unemployed. A full-time student who is not seeking work is economically inactive, even though they have no job.

A person doing no paid work is not automatically counted as unemployed; availability and active search matter, and the statistical definition must be stated.

The claimant count records people claiming an unemployment-related benefit, while a labour force survey asks a sample about work, availability and job search. Neither measure is a perfect census of every person without work.

Claimant data are relatively frequent and administrative, but eligibility rules and benefit incentives can change the series. Survey data apply a consistent labour definition more directly, yet sampling error, non-response and recall problems affect estimates.

If benefit rules become stricter, claimant unemployment may fall even when survey unemployment does not. A worker who wants a job but has stopped searching may be missed by an active-search definition and classified as inactive.

A change in the measured rate need not equal a change in the underlying labour market. Check the definition, coverage and method before comparing periods or countries.

Frictional unemployment is the short gap while people move between jobs; structural unemployment occurs when skills or locations do not match vacancies; cyclical unemployment follows weak aggregate demand. Seasonal unemployment follows predictable changes in demand or production.

The same worker may pass through more than one category. Classify the mechanism first: search time, mismatch, the business cycle or a recurring seasonal pattern.

A ski instructor without winter work is seasonal; a former printer whose skills no longer match local vacancies is structural; a graduate searching between offers is frictional; a factory closure during recession can create cyclical unemployment.

“Voluntary” and “involuntary” are not interchangeable with every named type, and one policy cannot remove all unemployment.

Unemployment reduces the output that could have been produced and can lower the income and security of affected households.

At economy level, unemployment can reduce tax receipts and increase benefit spending, weaken demand and erode skills. The social cost may include poorer health, stress and regional inequality; the size depends on duration and who is affected.

If a recession leaves trained workers idle, GDP and tax revenue fall while benefit payments rise. A long spell can also make later job matching harder, so the cost persists after demand recovers.

The unemployment rate alone does not show duration, hardship or lost output per person; two economies with the same rate can face very different consequences.

Inflation is a sustained rise in the general price level; deflation is a sustained fall; disinflation means the inflation rate is falling while prices are still rising.

Use the rate and the price level together. A fall from 8% to 3% inflation is disinflation, not deflation. Deflation can raise the real burden of debt and encourage delayed spending, but its effects depend on expectations and causes.

If an index moves from 100 to 108 and then to 111, inflation has slowed from 8% to about 2.8%; prices have not returned to 100.

A fall in the inflation rate is not a fall in prices. Only a negative inflation rate indicates a general price-level decline.

The consumer price index (CPI) estimates changes in the price of a representative basket of goods and services. Each item is weighted according to its share of household spending, then the basket cost is compared with a base period.

Weights and the basket are updated because spending patterns change. Quality changes, new products, substitution and differences between households make CPI an estimate rather than a universal personal inflation rate.

If food has a larger basket weight than cinema tickets, a 10% food-price rise contributes more to the index than a 10% cinema-price rise, even if the ticket change is more noticeable to one household.

The CPI is a price-level index, not an index of quantities or wages; an index value of 125 means the basket costs 25% more than in the base period.

Nominal income or output is measured in the prices of the period. Real data adjust for price changes, so they are better for comparing purchasing power or quantities across time.

A nominal increase can coexist with a real decrease if prices rise faster. The adjustment uses a price index or deflator; the exact formula depends on the index convention, but the economic question is always whether buying power or physical output changed.

A wage rises from 2,000 to 2,080 while prices rise 6%. Nominal pay is up 4%, but real purchasing power has fallen because the price increase is larger.

Real does not mean “inflation-free in every household”. It means adjusted using a chosen index, so the basket and base period still matter.

Demand-pull inflation occurs when aggregate demand grows faster than the economy’s ability to supply output. Cost-push inflation follows higher unit costs, such as wages, energy or imported inputs.

Expectations can make either process persistent: workers and firms adjust wages and prices when they expect inflation. Imported inflation depends on exchange rates and foreign prices. Identify the initiating shock before naming the mechanism.

A consumer-spending boom can move AD right and raise the price level. A sudden energy-price rise can shift SRAS left, creating higher prices with weaker output—the pattern called stagflation.

Not every price rise is economy-wide inflation, and a one-off tax change may raise the price level without creating a continuing inflation process.

Inflation reduces the purchasing power of money: a given income buys fewer goods and services when prices rise. Its wider effects depend on whether incomes, interest rates and expectations adjust.

Unexpected inflation can transfer real wealth from lenders to borrowers and from people on fixed incomes to those whose incomes rise faster. It can reduce international competitiveness, create menu and shoe-leather costs, and make planning harder; mild predictable inflation may be less disruptive.

A pension fixed in nominal terms loses purchasing power if prices rise 6%. A borrower with a fixed-rate loan may gain in real terms, while a saver’s outcome depends on the real interest rate.

Inflation does not hurt everyone equally, and a wage rise is not a real gain if prices rise by more.