Macroeconomics AS Part 1


Major Objectives of Governments

Most governments have four main macroeconomic objectives:

  • Low (positive) inflation, meaning that wages and prices will remain stable, therefore firms are more likely to invest and the value of incomes doesn't erode as fast. Purchasing power of consumers and firms remains stable.
  • Low unemployment, meaning that more people have an income, and so will be more likely to have a better standard of living. Also as the government will be spending less on welfare, meaning they have more money available for spending on other things.
  • Positive, sustainable economic growth, this means greater income, more output and better living standards in the future, but must be sustainable to avoid negative effects later on.
  • Balance of Payments stability/equilbrium, neither a deficit or a surplus is beneficial in the long-term - deficits mean the economy is keeping less of its income and so will grow slower, a surplus will often lead to other countries taking protectionist action, reducing trade. 
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Minor Objectives of Governments

In addition to their major objectives, governments also have several minor objectives:

  • Economic stability, by preventing fluctuations in output, unemployment and inflation it is easier for households to plan, firms to invest and governments to change spending patterns.
  • (Re)distribution of income, the government aim to ensure everyone has access to the basic necessities and/or to more equally distribute income. However if done too much, this will reduce business incentives and working for income.
  • Potential and Actual growth, by achieving both potential and actual growth, inflation (caused by a positive output gap) and unemployment (caused by a negative output gap) are kept low as the output gap is held constant.
  • Reduction in 'regrettables', increased spending on things such as police to deal with an increase in crime will lead to negative impacts on standard of living if this spending is ineffective because of the opportunity cost of the spending
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Parts of the Macroeconomy

In macroeconomics there are 4 main parties:

  • Households: receive income through wages and salaries from their jobs and from their investments and then buy the output of firms (this is known as consumer spending and is labelled as C)
  • Firms: Businesses hire land, labour and capital inputs when making products for which they pay wages and rent (income). Firms receive payment from consumers and profitable businesses may invest (I) a percentage of profits in new producer goods such as equipment and technology
  • Government: collect taxes (T) to fund spending on public services such as education, healthcare and defence. Government spending is given the label (G)
  • International sector: The UK buys imports from other countries, (M) and overseas businesses and consumers buy UK products – known as exports (X). International trade is important for the UK. 
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Labour Force Survey

The Labour Force Survey is the official measure of unemployment in the UK.

This uses the ILO definition of unemployment, i.e. people who are able, available and willing to work at the current wage rate but do not have a job. The ONS interviews the residents of 60,000 households each quarter as a sample of the total population. They ask about the residents' employment status and nature of employment. Statistics for the entire UK are then extrapolated from the sample.

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Claimant Count

The claimant count simply counts the number of people claiming unemployment-related benefits.

All those who are registered as claiming Job Seekers Allowance at benefit offices on the day of the count are counted as unemployed. Therefore to be recognised as unemployed, the individual must satisfy the conditions for claiming the benefit. This process happens once per month, however is not the official measure of unemployment for the UK.

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Problems with Measuring Unemployment 1

  • By changing the criteria for unemployment-related benefits, the government can influence the unemployment figures. This means the claimant count is unreliable as a means of comparison over a long period of time since changes in eligibility have, generally, decreased the unemployment rate.
  • By classing people as 'unfit for work' they are not counted in unemployment figures, which leads to 'hidden unemployment'. If some of these people are actually able to work, the unempoloyment statistics will be incorrect.
  • Both the measures are susceptible to fraudulant claims, and so may be too high. Such fraudulant claims may include people claiming who are not actively seeking work, or those who claim but work in the informal economy. 
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Problems with Measuring Unemployment 2

  • The Claimant Count does not include a range of people, including 16-17 year olds, the sick, disabled and single parents who are looking for work, men over 60 and those who do not qualify for benefit but do not have a job, for example if the savings of their partner are too high. Therefore the CC is likely to be an understatement of unemployment.
  • The LFS includes people who (arguably) should not be included, such as people who are frictionally unemployed and people with disabilities.
  • The LFS is based on extrapolation of data from a survey, and so may not be representative of the population as a whole. If the sample chosen by the ONS is not representative of the UK as a whole the figure could be either too high or low.
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Measuring Inflation

Inflation is measured using index numbers. Each month, the average price level is calculated and recorded as the CPI (Consumer Prices Index). The rate of inflation is calculated by finding the % change in CPI.

The CPI measures the average level of prices, replacing the RPI in 2003. CPI is based on the HICP (Harmonised Index of Consumer Prices) used throughut the EU.

The Bank of England target inflation rate is 2%, with a 1% fluctuation allowance either side.

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Measuring Inflation 2

The CPI is calculated each month and measures the average change in the prices of consumer goods and services. Items are weighted according to what consumers spend most of their money on. Every year the weightings are recalculated and the goods included in the CPI are changed. It is calculated by the ONS.

The weights are calculated by the Expenditure and Food Survey, which is conduceted every year to find out the spending patterns of 7,000 households. These households are supposed to represent a typical cross section of the population. 

The 650-700 items that take up the greatest proportion of consumer speding are selected for the 'basket' of goods for the CPI. Each item is given a weighting reflecting their share of total spending as consumers will be more affected by a price increase in these goods. 

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Measuring Inflation 3

Price data for each of the items in the basket is collected every month, using a range of retail outlets in 180 different areas, with more than one price collected for each item. The average price of the item is then calculated.

The percentage changes in the prices of the items are multiplied by their weights, and combined to give the overall CPI for the month.

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Problems with Measuring Inflation

  • Measures of price change do not take into account changes in quality, which may increase at a different rate to prices. The CPI can therefore under- or over-estimate inflation because of this.
  • The CPI does not take into account substituion effects in the market. When prices rise, consumers are likely to substitute purchases of items which are relatively expensive for those tha are relatively cheaper. This helps reduce the cost of their spending, but means spending patterns have changed, meaning the CPI not only over-estimates inflation, but could also be consider irrelavent.
  • The CPI also does not take into account special offers, or the price of products in when they are not purchased from new. This also means that the CPI is probably an over-estimate
  • Trends in consumer spending change very quickly, and so the yearly revision of weightings is not frequent enough. This mean some of the price changes monitored by the index are irrelavent.
  • Lastly, the CPI is prone to ststistical errors. If the sample of households does not represent the general population, then the inflation figures calcuated will not be useful. The inflation value calculated will also not apply exactly to any household, because every household is different, and the average household used to calculate the CPI does not exist.
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Economic Growth

Economic growth is the increase in the output of an economy of goods and services. This is generally considered to be good, as this means more goods and services are being consumed, which we assume will increase our standard of living.

Actual Growth: This is when an economy produces more goods and services.

Potential Growth: This is when there is an increase in the productive capacity of a economy.

On a PPC, actual growth is shown by making more and better use of resources, shown by moving closer to the PPC. Potential growth is shown by an expansion (rightward movement) of the PPC. This shows an increase in the quality and/or quantity of FoP. 

If the PPC (Potential output) expands faster than actual output, this creates spare capcity, known as the output gap

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Sustained, Sustainable Growth and National Income

Sustained growth is when both potential and actual growth are achieved simultaneously.

An unsustainable activity is anything that comprimises the ability of future generations to meet their needs. For example the use of fossil fuels may mean that future generations have limited access to energy, hindering output. Sustainable growth is when these things do not happen.

National income is what is newly produced in an economy in a year, and adds to national wealth. National wealth is the stock of goods, services and money (assets). However, depreciation reduces national wealth as assets lose value.

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The Circular Flow of Income

This is a two sector model with just two economic agents; Households and Firms. It assumes that these two agents have the property rights for all FoP. 

Households provide firms with factor services, and firms pay for these by providing factor incomes such as wages. Households then use these incomes to pay for the products firms produce, and firms provide these products in return for payment.

The flows of products and factor services are said to be real flows, and the flows of expendtiure and factor incomes are said to be monetary flows.

This means that GDP can be measured in 3 ways; The output method (value of products made by firms), Income method (Value of earnings of households) and the Expenditure method (Value of expenditure by households on the products firms provide). In theory, all of these should give the same answer, as the assumptions are made such as that there is no saving and that all products made are purchased.

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Measuring Growth

Growth is usually measured yearly using the output method, by calculating the % change since last year. There are 3 different measures of growth:

  • GDP, the total value of a nation's domestically produced output within a time period
  • GNP, the value of income accruing to a nation's citizens irrespective of the location of the FoP tht generated it, within a time period
  • NNP, value of a nation's income within a time period

Collectively, these are known as the National Income Statistics (NIS). GDP is used most often, and GNP is used occasionally. NNP is rarely used as depreciation is almost impossible to measure accurately.

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Income and Output Methods

Income is a total of all factor incomes/rewards, i.e. the total of:

Rent + Wages + Interest + Profit

Although HMRC collect this data for tax purposes, not all incomes are recorded as not all income is declared. Some is black market or informal activity and so no tax is paid.

Output is the aggregate of the value of all new products produced in an economy over a year. When products do not have a market price (i.e State provided services), the cost of their provision is used. This is often inaccurate as the cost of provision will not equal benefit gained from consumption.

Also, double counting can occur if a product is used in the production of another product, and so is counted twice, although the 'final output' method is designed to counteract this.

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Expenditure Method

This method aggregates expenditure made in a year by both individuals and organisations on new products. There are 5 main types of expenditure:

  • Consumption (C) - Expenditure by consumers on domestic products
  • Investment (I) - Expenditure by firms in new capital goods
  • Government (G) - Expenditure by government on the provision of products
  • Exports (X) - Expenditure by foriegn individuals/organisations on domestic products
  • Imports (M) - Expenditure by domestic individuals/organisations on foriegn products

GDP = C + I + G + X - M

X - M (Exports - Imports) equals net exports

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GNP (Gross National Product) = GDP + Net property income from abroad.

Net property income from abroad is income made by individuals and organisations that is repatriated to the countyr of origin. This adds profits made by British firms overseas, and removes money sent back to countries of origin by immigrants.

NNP (Net National Product) = GNP - Depreciation

This takes into account that wealth and capital stocks depreciate over time as they become out of date. The effect of depreciation on standard of living has to be taken into account to give a true representation of how the economic welfare of the citizens of an economy has changed. 

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Uses of and adjustments to NIS

The NIS are used to calculate growth, compare living standards and compare economic performance. To accurately compare data, three adjustments are made:

  • Divide by population size to get GDP per capita for fair representation of the population.
  • Convert to $ using the Purchasing Power Parity exchange rate to easily compare GDP in relation to costs of living in different economies.
  • Real GDP accounts for rises in prices during the period of production, nominal GDP is adjusted to remove inflationary price rises. Real GDP is calculated by measuring GDP at constant prices from a selected base year. 
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Problems with NIS 1

Although they are probably the best (and indeed only) measure of economic performance that we have, NIS have several problems:

  • Composition of Output - a nation may have a high GDP p/c, but living standards may be relatively low if the products made are not for current consumption, for example an economy based largely on military expenditure will generally not have high living standards
  • Distribution of Income - a nation may have a high GDP p/c, but this may not reflect how the income is distributed, and so may not reflect the relative living standards of its citizens. Middle Eastern countries are a good example of this.
  • Poor Data - In LEDCs, data is often incomplete, unreliable or simply not available. There are no sophisticated recording mechanisms in place, and the governments do not have either the resources or expertise to record or share data.
  • Illegal activities - The black market, tax evasion and benefit fraud all increase standard of living, but are not recorded or are recorded when they should not be.
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Problems with NIS 2

  • Inaccuracies and guesstimates when calculating productivity and value of government workers
  • Non-marketed economic activities also contribute to improvements in economic welfare, such as DIY and housework. We do not value these things as they are unpaid, but makes up a significant sector of LEDC economies as subsistence farmers are not paid for their work, they work to survive.

There are also other factors that affect economic welfare that are not quantifiable, such as:

  • Leisure
  • Political freedoms
  • Quality of products made
  • Pollution and envionmental quality
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Balance of Payments

The BoP is a record of all the inflows and outflows of money in a country. It is calculated by subtracting outflows from inflows (debits from credits).

If inflows are greater than outflows, there is a BoP surplus, if ouflows are greater than inflows there is a deficit.

There are 3 categories to the BoP:

  • Current Account
  • Capital Account
  • Financial Account
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Capital and Financial Accounts


The capital account shows transfers of capital/money, such as government investment and the purchase and sale of intangible fixed assets (such as patents and trademarks). For example, spending by government on an embassy or a firm buying a patent to a particular idea


This shows flows of investment such as FDI from MNCs and international borrowing. For example the investment by Japanese car firms in the north of England.

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The Current Account

This is split into 4 main sections:

  • (Balance of) Trade in Goods
  • (Balance of) Trade in Services
  • Income
  • Current Transfers

The trade in goods is calculated by exports minus imports, and is also called the balance of trade.

Trade in services is calculated by service exports minus service imports, and is also called the balance of trade in services.

Combined, these two factors make up net exports.

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The Current Account 2

Income is flows that come from international lending and investment. It is made up of 3 main categories:

  • Profits from MNCs that are repatriated
  • Dividends from shares bought in other countries
  • Interest paid on international loans or ganied on bonds

Current transfers are when money changes hands without the taking place of an economic transaction, for example:

  • Aid flows from government or charities sent abroad
  • Remmitances from people from another country sending their earnings home
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