economists put the eradication of poverty above the

maximisation of corporate profits, and this will strongly

influence their belief about how the tax system should be used.
In addition, different economists may use different economic
models and forecasting techniques, and this may lead them to
disagree about the need for, size of, or timing of policy
changes.

Macro-economics
The national economy pages introduce macro-economic
concepts, models, and theories, and explains how macroeconomic problems are analysed, and policies evaluated.
Macro-economic theory
Macro-economics is traditionally broken down into macroeconomic theory and macro-economic policy. Macro-economic
theory involves the construction and use of models of the
whole, macro, economy. Economists build such models so
that they can explain the structure of an economy, and the role
and significance of the parts that make up this
structure. Macro-economic models also help the economist
understand how the separate components of the macroeconomy are related.

Market Failures

Macro-economic models are also used to help economists and

policy makers make predictions, or forecasts, about the
economy, and about the effect of changes in one economic
variable, such as exchange rates, on other variables, such as
prices and output.

Monopoly power

Types of market failure

A market failure is a situation where free markets fail to
allocate resources efficiently. Economists identify the
following cases of market failure:
Productive and allocative inefficiency
Markets may fail to produce and allocate scarce resources in
the most efficient way.

Markets may fail to control the abuses of monopoly power.

Missing markets
Markets may fail to form, resulting in a failure to meet a need
or want, such as the need for public goods, such as defence,
street lighting, and highways.

Macro-economic policy objectives

Incomplete markets

Macro-economic policy refers to how governments and other

policy makers compensate for market failures in order to
improve economic performance and well-being. Improvements
in performance begin with the setting of policy objectives,
which include the achievement of sustainable economic growth
and development, stable prices and full employment. Some of
the objectives set are potentially in conflict with each other,
which means that, in attempting to achieve one objective,
another one is sacrificed. For example, in attempting to
achieve full employment in the short-term price inflation may
occur in the longer term.

Markets may fail to produce enough merit goods, such as

education and healthcare.
De-merit goods
Markets may also fail to control the manufacture and sale of
goods like cigarettes and alcohol, which have less merit than
consumers perceive.
Negative externalities
Consumers and producers may fail to take into account the
effects of their actions on third-parties, such as car drivers,
who may fail to take into account the traffic congestion they
create for others. Third-parties are individuals, organisations,
or communities indirectly benefiting or suffering as a result of
the actions of consumers and producers attempting to pursue
their own self interest.

Policy targets
In order to achieve policy objectives, policy makers will set
targets to aim for. Targets are often fixed, and widely known,
such as the current UK inflation target of 2%, but they may
also be flexible and less widely known, such as exchange rate
and employment targets.

Property rights
Markets work most effectively when consumers and producers
are granted the right to own property, but in many cases
property rights cannot easily be allocated to certain resources.
Failure to assign property rights may limit the ability of
markets to form.

Policy instruments
Once policy objectives and targets are established, policy
makers need to choose between alternative policy tools, or
instruments. These instruments are the levers of control of the
macro-economy and include monetary instruments such as
interest rates, and fiscal instruments such as tax rates and
government spending.

Information failure
Markets may not provide enough information because, during a
market transaction, it may not be in the interests of one party to
provide full information to the other party.
Unstable markets

Policy disagreements

Sometimes markets become highly unstable, and a stable

equilibrium may not be established, such as with certain
agricultural markets, foreign exchange, and credit markets.
Such volatility may require intervention.

Policy disagreements occur for a number of reasons. Macroeconomic policy is often shaped by long held normative beliefs
about what is essential, and this influences the choice of model,
objective, target, and instrument. For example, some

(MPC) will take exchange rates into account. Clearly, the MPC
would prefer a relatively high rate, as this reduces the price of
imports and works against inflationary pressure. However, the
MPC must keep an eye on export competitiveness, and, if rates
rise excessively, UK exports will become uncompetitive.

Inequality
Markets may also fail to limit the size of the gap between
income earners, the so-called income gap. Market transactions
reward consumers and producers with incomes and profits, but
these rewards may be concentrated in the hands of a few.

How exchange rates are manipulated

Remedies

Exchange rates can be manipulated by buying or selling

currencies on the foreign exchange market. To raise the value
of the pound the Bank of England buys pounds, and to lower
the value, it sells pounds. Rates can also be manipulated
through interest rates, which affect the demand and supply of
Sterling via their effect on inflows of hot money. Altering
exchange rates is commonly regarded as a type of monetary
policy.

In order to reduce or eliminate market failures, governments

can choose two basic strategies:
Use the price mechanism
The first strategy is to implement policies that change the
behaviour of consumers and producers by using the price
mechanism. For example, this could mean increasing the price
of harmful products, through taxation, and providing
subsidies for the beneficial products. In this way, behaviour is
changed through financial incentives, much the same way that
markets work to allocate resources.

Effects of a reduction in the exchange rate

Assuming the economy has an output gap, a reduction in the
exchange rate will reduce export prices, and, assuming demand
is elastic, export revenue will increase.

Use legislation and force

The second strategy is to use the force of the law to change
behaviour. For example, by banning cars from city centers, or
having a licensing system for the sale of alcohol, or by
penalising polluters, the unwanted behaviour may be
controlled.
In the majority of cases of market failure, a combination of
remedies is most likely to succeed.
Exchange rate policy
The exchange rate of an economy affects aggregate demand
through its effect on export and import prices, and policy
makers may exploit this connection.
Deliberately altering exchange rates to influence the macroeconomic environment may be regarded as a type of monetary
policy. Changes in exchanges rates initially work there way
into an economy via their effect on prices.
For example, if 1 exchanges for $1.50 on the foreign
exchange market, a UK product selling for 10 in the UK will
sell for $15 in New York. If the exchange rate now appreciates,
so that 1 buys $1.60, the UK product in New York will now
sell for $16. Assuming that demand in New York is price
inelastic, this is good news for UK exporters because revenue
in USDs will rise. However, if demand is elastic in New York,
the effect of the appreciation of the Pound would be damaging
to UK exporters.

A fall in the exchange rate will also raise import prices, and
assuming elasticity of demand, import spending will fall. The
combined effect is an increase in AD and an improvement in
the UK balance of payments.

If the UK also imports goods from the USA, the rise in the
exchange rate would mean that a $10 US product is now
cheaper in London, falling from 6.67p to 6.25p. Importers do
relatively well from the appreciation of the pound, in that the
cost of imported raw materials or finished goods falls.

Cost push inflation

A fall in the exchange rate is inflationary for a second reason the cost of imported raw materials adds to production costs and
creates cost-push inflation.

Therefore, whenever the exchange rate changes there will be a

double effect, on both import and export prices. Changes in
import and export prices will lead to changes in import and
export volumes, causing changes in import spending and
export revenue.
Exchange rates can be manipulated so that they deviate from
their natural equilibrium rate. To stimulate exports, rates would
be held down, and to reduce inflationary pressure rates would
be kept up. While the Bank of England does not specifically
target the exchange rate, the Monetary Policy Committee

trade-off between rapid economic growth today, and growth in

the future. Rapid growth today may exhaust resources and
create environmental problems for future generations,
including the depletion of oil and fish stocks, and global
warming.
Periods of growth are often triggered by increases in aggregate
demand, such as a rise in consumer spending, but sustained
growth must involve an increase in output. If output does not
increase, any extra demand will push up the price level.
Growth based on debt
In terms of sustainability, it may be argued that growth based
on short-term public debt, rather than long term productivity, is
unsustainable - hence worries about the build-up of sovereign
debt in Europe.
PPFs and economic growth
For an economy to continue to grow in the future, it needs to
increase its capacity to grow. An increase in an economys
productive potential can be shown by an outward shift in the
economys PPF.
Evaluation of exchange rate policy
The main advantage of manipulating exchange rates is that,
because a large share of UK output is traded internationally,
changes in exchange rates will have a powerful effect on AD.
For example, lowering exchange rates, called devaluation, can:
1.

Raise aggregate demand

2.

Increase national output (GDP)

3.

Create jobs, amplified through the multiplier effect

4.

In addition, assuming the demand for imports and

exports are price sensitive (price elastic), devaluation
will lead to an improvement in the balance of
payments - although this can also lead to inflation

Alternatively, raising exchange rates (revaluation) can:

1.

Help reduce excessive aggregate demand

2.

Keep inflation down

3.

Although the export sector may suffer and jobs might

be lost

Standards of living

On balance, UK policy makers in recent years have preferred

to allow the financial markets to determine exchange rates,
rather than manipulate them for policy objectives. The last time
exchange rates were directly targeted was between 1985 and
1992, when the UK shadowed movements in the Deutschmark,
and then, from 1990 to 1992, when the UK became a member
of the exchange rate fixing Exchange Rate Mechanism

Gross domestic product per capita is often regarded as the key

indicator of the standards of living of the citizens of an
economy, and of their economic welfare, though broader
measures of economic welfare are increasingly used in
preference to narrow GDP measures.
Measuring growth

(ERM).

GDP is the official base measure of output used in most

economies, including the UK. Gross measurements record the
output of all goods and services, including capital goods which
have been purchased to replace existing capital goods.
Replacing capital is called capital consumption, or
depreciation. The alternative to Gross output is Net output,
which indicates that depreciation is taken into account and
deducted from the gross measurement.

Sustainable growth
Economic growth occurs when real output increases over time.
Real output is measured by Gross Domestic Product (GDP) at
constant prices, so that the effect of price rises on the value of
national output is removed.
Sustainable economic growth means a rate of growth which
can be maintained without creating other significant economic
problems, especially for future generations. There is clearly a

Domestic product is the value of all UK goods and services

produced, including those produced for export. It does not

include property income which flows into and out of the UK

economy. Property income refers to income from various types
of investment abroad, such as profits and dividends. When this
is added, the measure becomes national product, called Gross
National Product, GNP.

monitors changes in unemployment and real investment and

confirms that the turning point has occurred. All indicators help
policy makers decide when to implement a policy and by what
degree.
The advantages of growth

Growth can be measured as an annual percentage increase in

real GDP, and in terms of a general trend. The trend rate of
growth is the long term non-inflationary average rate of growth
for an economy. In the UK it is around 2.5% per year.

Economic growth is associated with a number of material

benefits which increase economic welfare. These include the
following:
Higher GDP per capita

Why is stable growth an economic objective?

A rise in real national income means that wages and profits are
likely to rise. Assuming a stable population, this will raise GDP
per capita.

If growth rises significantly above or below the trend rate, the

economy is experiencing excessive growth or low growth. If
the rate becomes negative for at least 2 quarters in succession,
the economy is in recession.

More public and merit goods

The trade (growth) cycle

A growing economy means that the public sector can receive

more tax revenue and more resources can be allocated to public
and merit goods, such as more roads, hospitals and schools.

Changes in real national income tend to be cyclical, but it is

desirable that this cycle is stable rather than unstable. Unstable
growth is popularly called boom and bust.

Positive externalities

Although an economys growth is cyclical in nature, the

underlying trend can be derived from annual growth
statistics. Trends can be calculated by using a technique called
moving averages. The UK trend rate over the last 25 years is
around 2.5%.

Public and merit goods generate considerable external benefits.

More hospitals and schools mean a healthier and bettereducated population, which generates other economic benefits
in terms of the effectiveness of the labour force, and increases
in long-term aggregate supply.

Excessive growth can lead to:

More employment

1.

Goods and service inflation

2.

House price inflation

3.

Wage inflation

4.

Labour shortages

5.

Falling savings

Economic growth also brings some costs which reduce

economic welfare, including:

6.

Excessive credit

Negative externalities

7.

Trade difficulties

Growth is clearly likely to stimulate demand for labour, and it

is likely that more people will be employed and fewer
unemployed.
The disadvantages of growth

1.

Goods deflation

As production and consumption increase, negative

externalities, such as pollution and congestion, are likely to
arise. There is also the likelihood of increased depletion of
non-renewable resources, such as fossil fuels.

2.

House price deflation

Inflation and balance of payments difficulties

3.

Labour surpluses

4.

Unemployment

5.

Excessive debt burden

Too rapid a rate of growth can also lead to two significant

economic problems: inflationary pressure and a balance of
payments deficit, as imports rise to satisfy an increasingly
active household sector.

6.

Public sector debt

Widening income gap

Low or negative growth can lead to:

Growth can also widen the distribution of income, because

some groups may benefit much more than others. Certainly in
the UK, the relative income gap has widened during the growth
years of 1992 to 2008.

Predicting turning points

Changes, or turning points, in the level of national income can
be predicted and confirmed using economic indicators. Leading
indicators typically monitor changes in interest rates, business
confidence and new housing starts-ups - all of which provides
clues to the next turning point in an economys growth cycle.
Changes in these indicate that GDP is likely to change in 12 to
18 months time. The OECDs main indicator, the Composite
Leading Indicator (CLI), tracks deviations from the long-term
trend, which provides an early warning system for policy
makers.

Limitations of using GDP per capita over time

There are several limitations of using GDP statistics for
comparing changes in economic well-being over time,
including:
Changes in the distribution of income
Average GDP per capita may rise over time, but the
distribution of income may widen. For example, a rise in the
mean average income per head can be misleading because the

A short leading indicator can be used to monitor changes in

consumer credit and new car registrations. A lagging indicator

average may rise because just a few of the population increase

their personal income. Indeed, the mean average can rise, but
the median, the mid-point in a range of numbers, can fall.

For example, if we simply convert GDP in Japan to US dollars

using market exchange rates, relative purchasing power is not
taken into account, and the validity of the comparison is
weakened. By adjusting rates to take into account local
purchasing power differences, known as PPP adjusted
exchange rates, international comparisons are more valid.

Differences in hours worked

People may be working longer hours, in which case some of
the growth may be through increased work, rather than through
increased efficiency.

Difficulty of assessing true values

The true value of public goods and merit goods, such as
defence, education and transport infrastructure is largely
unknown. This means that it is difficult to compare two
countries with very different levels of spending on these goods
and assets.

Unpaid work is not recorded

People may undertake unpaid work, and this may not be
officially recorded.
Price changes

The unofficial economy

Prices are unlikely to remain constant over time, so GDP

figures must be converted to at constant prices and measured
from a base year. This process is called indexing and is
required to avoid the distorting effects of inflation.

Similarly, the existence of a large unofficial economy may

make comparisons based on official GDP very misleading. For
example, comparing the official GDP of the UK and Russia
may be misleading because of the size of Russia's unofficial
economy. While all countries have unofficial economies, their
size and significance can vary considerably.

Negative externalities
The quality of life may suffer as GDP increases, although this
is not included in GDP statistics. For example, more driving
raises GDP, but also adds to CO2 emissions, which can reduce
the quality of life.

Currency conversion
GDP figures for different countries must be converted to a
common currency, such as the US dollar, and this may give
misleading figures. For some countries, exchange rates against
the US dollar may be unrepresentative of the true value of the
currency, especially where international trade is relatively
small. In such cases, converting to US dollars may significantly
under-value national output. This explains why conversion to
purchasing power parity is often preferred to conversion to US
dollars.

Changes in the quality of products

Over time the quality of products tends to increase, so a given
amount of income per capita in 2010 may purchase a higher
quality product than it did in 2000. This is certainly true with
high-technology consumer products, like PCs, laptops and
mobile phones.
Limitations of using GDP statistics for international
comparisons

Sustainable development and quality of life

international

Differences in the distribution of income

In recognising that economic welfare is not simply about

economic growth, in 1999 the UK government introduced a
policy for sustainable development, and refined this further in
2005.

Although two countries may have similar GDP per capita

figures, the distribution of income in each country may be very
different.

Sustainable development is considered in four main categories

using 20 main indicators, and 68 indicators in total. The
categories are:

Limitations of using
comparisons include:

GDP

statistics

for

Differences in hours worked

As when comparing a country over time, the number of hours
worked to generate a given level of income may be quite
different. For example, workers in the UK tend to work longer
hours than those in France, and this would falsely inflate the
GDP figures in the UK relative to France.

1.

Sustainable consumption and production

2.

Climate change and energy

3.

Natural resource protection and enhancing the

environment

4.

Creating sustainable communities and a fairer world

International price differences

International prices will also vary. This is significant because
an individual's purchasing power is based on price in relation to
income. To solve this problem, GDP statistics can be recalculated in terms of purchasing power. The purchasing power
of a currency refers to the quantity of the currency needed to
purchase a given unit of a good, or common basket of goods
and services. Purchasing power is clearly determined by the
relative cost of living and inflation rates in different countries.
Achieving purchasing power parity means equalising the
purchasing power of two currencies by taking into account cost
of living and inflation differences.

National income
National income is the total value a countrys final output of all
new goods and services produced in one year. Understanding
how national income is created is the starting point for
macroeconomics.
The national income identity
This relationship is expressed in the national income identity,
where the amount received as national income is identical to
the amount spent as national expenditure, which is also

identical to what is produced as national output. Throughout

macroeconomics the terms income, output and expenditure are
interchangeable.

not the case, so any future second-hand sales are not included
when valuing national income. Such second-hand transactions
are called transfers.

See also: the circular flow of income

Calculating national income

National income accounts

Any transaction which adds value involves three elements

expenditure by purchasers, income received by sellers, and the
value of the goods traded. For example, if a student purchases a
textbook for 30, spending = 30, income to the bookseller =
30, and the value of the book = 30. All of the transactions in
an economy can be looked at in this way, giving us three ways
to measure national income.

Since the 1940s, the UK government has gathered detailed

records of national income, though the collection of basic data
goes back to the 17th Century. The published national income
accounts for the UK, called the Blue Book, measure all the
economic activities that add value to the economy.
Adding value

There are three methods of calculating national income:

National output, income and expenditure, are generated when

there is an exchange involving a monetary transaction.
However, for an individual economic transaction to be
included in aggregate national income it must involve the
purchase of newly produced goods or services. In other words,
it must create a genuine addition to the value of the scarce
resources. For example, a transaction that involves selling a
second-hand good, and which was new two years ago does not
add to national income, though the original production and
purchase does. Transactions which do not add value are called
transfers, and include second-hand sales, gifts and welfare
transfers paid by the government, such as disability allowance
and state pensions.
The creation of national income
The simplest way to think about national income is to consider
what happens when one product is manufactured and sold.
Typically, goods are produced in a number of 'stages', where
raw materials are converted by firms at one stage, then sold to
firms at the next stage. Value is added at each, intermediate,
stage, and, at the final stage, the product is given a retail selling
price. The retail price reflects the value added in terms of all
the resources used in all the previous stages of production.

1.

The income method, which adds up all incomes

received by the factors of production generated in the
economy during a year. This includes wages from
employment and self-employment, profits to firms,
interest to lenders of capital and rents to owners of
land.

2.

The output method, which is the combined value of

the new and final output produced in all sectors of the
economy, including manufacturing, financial services,
transport, leisure and agriculture.

3.

The expenditure method, which adds up all spending

in the economy by households and firms on new and
final goods and services by households and firms.

Chained value measurement

The components of national output are valued according to
their importance to the overall economy. The weights used
were based on estimates made every 5 years, but, from 2003,
an annual adjustment to the weightings was introduced to
improve the reliability of the weighting - a process called
annual chain linking. This allowed for a more up-to-date, and
therefore a more accurate measure of changes to the level of
national income.

Final output
In accounting terms, only the value of final output is recorded.
To avoid the problem of double counting, only the value of the
final stage, the retail price, is included, and not the value added
in all the intermediate stages - the costs of production, plus
profits. In short, national income is the value of all the final
output of goods and services produced in one year.

The main components of UK National Income

Example

National Income, by 'type' of income:

For example, consider the production of a motor car which has

a retail price of 25,000. This price includes 21,000 for all the
costs of production (6,000 for components, 10,000 for
assembly and 5,000 for marketing) plus 4,000 for profit. To
avoid double-counting, the national income accounts only
record the value of the final stage, which in this case is the
selling price of 25,000.

GDP - Income method, 2010, BnTaxes - subsidies,

In 2010, UK Gross National income at current prices was

1,458 billion, up from 1,392 in 2009.
The percentage contribution of different components in the
three different measures are shown below:

179Other

inc

rents,

168Corporate

profits,

307Wages and salaries, 799Taxes - subsidiesOther

- inc rentsCorporate profitsWages and salaries
With around 30m workers in the UK, and over 2m firms*,
wages and profits contribute the majority of income in the UK.

When goods are bought second-hand, the transaction does not

add new value and will not be included in national output. If
second-hand goods are included, double-counting will occur,
and this would falsely inflate the value of national income.

(*2.15m according to the ONS)

National output, by sector of the economy:

For example, if the car in question is sold in two years time for
15,000 it would provide the owner with money, but the sale
will not add to national income. If it were included in national
income, it would make the value of the car 35,000 - the initial
25,000 plus the second hand value of 15,000. This is clearly

GDP - Output method, 2010, BnConstruction,

90Water and services, 148Energy, 172Government
inc education, 261Health activities, 104Distribution

and

transport,

238Manufacturing,

28Agriculture,

7.5ConstructionWater

servicesEnergyGovernment

inflation) must be taken into account. This is done by holding

prices constant from a starting measure, called the base year.

131Mining,
and

Example

inceducationHealth

For example, if, in a hypothetical economy, 100 pens are

produced and sold for 1 each in year 1, the nominal value of
these transactions is 100. If, in year 2, inflation pushes prices
up to 1.20p per pen, but, as in year 1, only 100 pens are sold,
the nominal value at current (year 2) prices will rise to 120.
However, the nominal value has only risen because of
inflation, so to adjust the nominal value to find the real value
we take the constant price of 1 which is the price of pens at
the start of our measurement in the base year, year 1. However,
if in year 3 110 pens are sold at 1.20, the nominal value at
current prices will be 132 (an increase of 32%), but the real
value at constant (year 1) prices will be only 110 (a real
increase of only 10%). Therefore, to arrive at real values the
economist must take out the effects of price inflation by
holding prices constant in terms of the prices existing in the
base year.

activitiesDistribution
andtransportManufacturingMiningAgriculture
In terms of output, services dominate the UK economy, with
manufacturing a distant second. However, this is a typical
profile for a developed economy the more developed the
economy the more that income is allocated towards purchasing
services rather than manufactured goods.
National spending, by sector
GDP - Expenditure method, 2010, BnImports,
%A3476bnExports,
%A3224bnGovernment,
organisations,

%A3436bnInvestment,
%A3338bnNon-profit

%A338bnHousehold

spending,

Recent changes to UK national income

%A3900bnImportsExportsInvestmentGovernmentNo

In terms of spending, UK households account for the majority

of
spending,
export
spending
the
next
most
important. Spending on capital goods by firms, and spending
on public goods, merit goods, and transfers by government
accounts for the rest.

After a sustained period of rising national income from the

previous recession, which ended in 1992, the UK, like most
other advanced economies, entered a recession in the third
quarter of 2008. The recession lasted until the fourth quarter of
2009. Growth returned in 2010, but, following negative growth
in the fourth quarter of 2010, the UK economy failed to recover
fully, with growth in the third quarter of 2011 a modest 0.5%,
with a further drop to 0.2% in the last quarter of 2011.

Source - ONS

Performance indicators

Gross Domestic Product - GDP

The performance of an economy is usually assessed in terms of

the achievement of economic objectives. These objectives can
be long term, such as sustainable growth and development, or
short term, such as the stabilisation of the economy in response
to sudden and unpredictable events, called economic shocks.

n-profitorganisationsHouseholdspending

Gross Domestic Product (GDP) is the most important

aggregate of national income for accounting purposes, and for
economic analysis. In the UK, GDP is derived from the gross
value added (GVA) of all the UK's individual producers,
industries or sectors over one year, using the 'output' method.

Economic indicators
To know how well an economy is performing against these
objectives economists employ a wide range of economic
indicators. Economic indicators measure macro-economic
variables that directly or indirectly enable economists to judge
whether economic performance has improved or deteriorated.
Tracking these indicators is especially valuable to policy
makers, both in terms of assessing whether to intervene and
whether the intervention has worked or not.

Current and constant prices

As the level of economic activity between households and
firms increases, output is also likely to increase. However,
under certain circumstances the price level may also be driven
up.
The nominal value of national income, or any other aggregate,
is the value of national output at the prices existing in the year
that national income is measured - that is, at current prices. In
simple terms the nominal value of national income can be
found by multiplying the quantity of output by the retail
(market) price of this output.

Useful indicators include:

If demand increases at an unsustainable rate, resources become

increasingly scarce, and firms will raise prices. Similarly,
wages are likely to rise as the labour market clears and
unemployment falls. The more that workers are needed the
higher the wage rate. This will act as an incentive for workers
to enter this industry. The combined effect of higher wages and
prices is that the nominal value of national output may be
driven up, rather than its real value.
To find the real value of changes in output under inflationary
conditions, the effects of any general price increase (price

1.

Levels of real national income, spending, and output.

National income, output, and spending are three key
variables that indicate whether an economy is
growing, or in recession. Like many other indicators,
income, output, and spending can also be measured in
per capita (per head) terms.

2.

Growth in real national income.

3.

Investment levels and the relationship between capital

investment and national output.

4.

Levels of savings and savings ratios.

5.

Price levels and inflation.

6.

Competitiveness of exports.

7.

Levels and types of unemployment.

8.

Employment levels and patterns of employment.

9.

Trade deficits and surpluses with specific countries or

the rest of the world.

10. Debt levels with other countries.

11. The proportion of debt to national income.
12. The terms of trade of a country.
13. The purchasing power of a country's currency.
14. Wider measures of human development, including
literacy rates and health care provision. Such
measures are included in the Human Development
Index (HDI).

The circular flow of income forms the basis for all models of
the macro-economy, and understanding the circular flow
process is key to explaining how national income, output and
expenditure is created over time.

15. Measures of human poverty, including the Human

Poverty Index (HPI).

Injections and withdrawals

The circular flow of income

National income, output, and expenditure are generated by the
activities of the two most vital parts of an economy, its
households and firms, as they engage in mutually beneficial
exchange.

The circular flow will adjust following new injections into it or

new withdrawals from it. An injection of new spending will
increase the flow. A net injection relates to the overall effect of
injections in relation to withdrawals following a change in an
economic variable.

Households

Savings and investment

The primary economic function of households is to supply

domestic firms with needed factors of production - land, human
capital, real capital and enterprise. The factors are supplied by
factor owners in return for a reward. Land is supplied by
landowners, human capital by labour, real capital by capital
owners (capitalists) and enterprise is provided by
entrepreneurs. Entrepreneurs combine the other three factors,
and bear the risks associated with production.

The simple circular flow is, therefore, adjusted to take into

account withdrawals and injections. Households may choose to
save (S) some of their income (Y) rather than spend it (C), and
this reduces the circular flow of income. Marginal decisions to
save reduce the flow of income in the economy because saving
is a withdrawal out of the circular flow. However, firms also
purchase capital goods, such as machinery, from other firms,
and this spending is an injection into the circular flow. This
process, called investment (I), occurs because existing
machinery wears out and because firms may wish to increase
their capacity to produce.

Firms
The function of firms is to supply private goods and services to
domestic households and firms, and to households and firms
abroad. To do this they use factors and pay for their services.
Factor incomes
Factors of production earn an income which contributes to
national income. Land receives rent, human capital receives a
wage, real capital receives a rate of return, and enterprise
receives a profit.
Members of households pay for goods and services they
consume with the income they receive from selling their factor
in the relevant market.
Production function

The public sector

The simple production function states that output (Q) is a

function (f) of: (is determined by) the factor inputs, land (L),
labour (La), and capital (K), i.e.

In a mixed economy with a government, the simple model

must be adjusted to include the public sector. Therefore, as
well as save, households are also likely to pay taxes (T) to the
government (G), and further income is withdrawn out of the
circular flow of income.

Q = f (L, La, K)
The Circular flow of income

Government injects income back into the economy by spending

(G) on public and merit goods like defence and policing,
education, and healthcare, and also on support for the poor and
those unable to work.

Income (Y) in an economy flows from one part to another

whenever a transaction takes place. New spending (C)
generates new income (Y), which generates further new
spending (C), and further new income (Y), and so on. Spending
and income continue to circulate around the macro economy in
what is referred to as the circular flow of income.

= 1/0.2
=5
Hence, the multiplier is 5, which means that every 1 of new
income generates 5 of extra income.
The multiplier effect in an open economy
As well as calculating the multiplier in terms of how extra
income gets spent, we can also measure the multiplier in terms
of how much of the extra income goes in savings, and other
withdrawals. A full open economy has all sectors, and
therefore, three withdrawals savings, taxation and imports.
Including international trade

This is indicated by the marginal propensity to save (mps) plus

the extra income going to the government - the marginal tax
rate (mtr) plus the amount going abroad the marginal
propensity to import (mpm).

Finally, the model must be adjusted to include international

trade. Countries that trade are called open economies, the
households of an open economy will spend some of their
income on goods from abroad, called imports (M), and this is
withdrawn from the circular flow.

By adding up all the withdrawals we get the marginal

propensity to withdraw (mpw). The multiplier can now be
calculated by the following general equation:

Foreign consumers and firms will, however, also wish to buy

domestic products, called exports (X), and this is an injection
into the circular flow.

1/1- mpw
Applying the multiplier effect
The multiplier concept can be used any situation where there is
a new injection into an economy. Examples of such situations
include:
1.

When the government funds building of a new

motorway

2.

When there is an increase in exports abroad

3.

When there is a reduction in interest rates or tax rates,

or when the exchange rate falls.

The downward or 'reverse' multiplier

A withdrawal of income from the circular flow will lead to a
downward multiplier effect. Therefore, whenever there is an
increased withdrawal, such as a rise in savings, import
spending or taxation, there is a potential downward multiplier
effect on the rest of the economy.

The multiplier effect

Every time there is an injection of new demand into the
circular flow there is likely to be a multiplier effect. This is
because an injection of extra income leads to more spending,
which creates more income, and so on. The multiplier effect
refers to the increase in final income arising from any new
injection of spending.

Economic integration
There are several stages in the process of economic integration,
from a very loose association of countries in a preferential
trade area, to complete economic integration, where the
economies of member countries are completely integrated.

The size of the multiplier depends upon households marginal

decisions to spend, called the marginal propensity to consume
(mpc), or to save, called the marginal propensity to save (mps).
It is important to remember that when income is spent, this
spending becomes someone elses income, and so on. Marginal
propensities show the proportion of extra income allocated to
particular activities, such as investment spending by UK firms,
saving by households, and spending on imports from abroad.
For example, if 80% of all new income in a given period of
time is spent on UK products, the marginal propensity to
consume would be 80/100, which is 0.8.

A regional trading bloc is a group of countries within a

geographical region that protect themselves from imports from
non-members in other geographical regions, and who look to
trade more with each other. Regional trading blocs increasingly
shape the pattern of world trade - a phenomenon often referred
to as regionalism.
Stages of integration

The following general formula to calculate the multiplier uses

marginal propensities, as follows:
1/1-mpc
Hence, if consumers spend 0.8 and save 0.2 of every 1 of
extra income, the multiplier will be:
1/1-0.8

competitive practices. There may also be common policies

affecting key industries, such as the Common Agricultural
Policy (CAP) and Common Fisheries Policy (CFP) of the
European Single Market (ESM).
Economic Union
Economic Union is a term applied to a trading bloc that has
both a common market between members, and a common trade
policy towards non-members, but where members are free to
pursue independent macro-economic policies.
Monetary Union
Monetary union is the first major step towards macro-economic
integration, and enables economies to converge even more
closely. Monetary union involves scrapping individual
currencies, and adopting a single, shared currency, such as the
Euro for the Euro-16 countries, and the East Caribbean Dollar
for 11 islands in the East Caribbean. This means that there is a
common exchange rate, a common monetary policy, including
interest rates and the regulation of the quantity of money, and a
single central bank, such as the European Central Bank or the
East Caribbean Central Bank.
Video
Fiscal Union
A fiscal union is an agreement to harmonise tax rates, to
establish common levels of public sector spending and
borrowing, and jointly agree national budget deficits or
surpluses. The majority of EU states agreed a fiscal compact in
early 2012, which is a less binding version of a full fiscal
union.

Preferential Trade Area

Preferential Trade Areas (PTAs) exist when countries within a
geographical region agree to reduce or eliminate tariff barriers
on selected goods imported from other members of the area.
This is often the first small step towards the creation of a
trading bloc. Agreements may be made between two countries
(bi-lateral), or several countries (multi-lateral).

Economic and Monetary Union

Economic and Monetary Union (EMU) is a key stage towards
compete integration, and involves a single economic market, a
common trade policy, a single currency and a common
monetary policy.

Free Trade Area

Complete Economic Integration

Free Trade Areas (FTAs) are created when two or more

countries in a region agree to reduce or eliminate barriers to
trade on all goods coming from other members. The North
Atlantic Free Trade Agreement (NAFTA) is an example of
such a free trade area, and includes the USA, Canada, and
Mexico.

Complete economic integration involves a single economic

market, a common trade policy, a single currency, a common
monetary policy (EMU) together with a single fiscal policy, tax
and benefit rates in short, complete harmonisation of all
policies, rates, and economic trade rules.

Customs Union
Foreign Direct Investment (FDI)

A customs union involves the removal of tariff barriers

between members, plus the acceptance of a common (unified)
external tariff against non-members. This means that members
may negotiate as a single bloc with 3rd parties, such as with
other trading blocs, or with the WTO.

FDI refers to the flow of capital between countries. According

to the United Nations Conference for Trade and Development
(UNCTAD), FDI is 'investment made to acquire lasting
interest in enterprises operating outside of the economy of the
investor.'*

Common Market

FDI is distinguished from 'portfolio' investment in that, as well

as being 'lasting', it means that the investor has control over the
assets invested in. A single flow of capital between two
countries is described as outward for the investing country and
inward for the recipient country. FDI is undertaken by both
private sector firms and governments.

A common market is the first significant step towards full

economic integration, and occurs when member countries trade
freely in all economic resources not just tangible goods. This
means that all barriers to trade in goods, services, capital, and
labour are removed. In addition, as well as removing tariffs,
non-tariff barriers are also reduced and eliminated. For a
common market to be successful there must also be a
significant level of harmonisation of micro-economic policies,
and common rules regarding monopoly power and other anti-

FDI associated with cross-border mergers and aquisions can be

horizontal - where the firms are at the same stage of
production; vertical - where firms are at different stages of

10

production; and conglomerate - where firms are in different

industries.

2.

The creation of jobs.

3.

An increase in productive capacity, which can be

illustrated by a shift to the right in the Aggregate
Supply (AS) or the Production Possibility Frontier
(PPF).

4.

Producers have access to the latest technology from

abroad.

5.

Less need to import because goods are produced in the

domestic economy.

6.

The positive effect on the countrys capital account FDI represents an inflow (credit) on the capital
account.

7.

FDI is a way of compensating for the lack of domestic

investment, and can help 'kick-start' the process of
economic development.

*Source: UNCTAD.ORG : http://www.unctad.org

The growth of FDI has accompanied the rise of globalisation.
According to the World Investment Report, FDI flows in 2013
increased to $1.45 trillion, with developing countries
increasing their share of inflows to (a record level of) 54 per
cent, with Asia now ahead of both the EU and USA.
The benefits of investing abroad
Investing overseas can generate many benefits to multinational
organisations, including:
1.

Transport costs can be reduced by locating

manufacturing plant within a consuming country. This
is especially important for bulk increasing products,
such as motor vehicles.

2.

Inward investors gain easier access to a countrys

markets, especially where the product can be made
with local ingredients. For example, it makes clear
commercial sense for McDonalds to establish local
restaurants that use local ingredients, rather than
export ingredients from the USA. In addition,
investing firms gain access to a range of resources,
including cheap or skilled labour and local knowledge
and expertise.

3.

4.

Global FDI
Global FDI has declined as a result of the financial crisis and
global recession.
Comparative advantage
It can be argued that world output would increase when the
principle of comparative advantage is applied by countries to
determine what goods and services they should specialise in
producing. Comparative advantage is a term associated with
19th Century English economist David Ricardo.

Firms that build factories and plant in other territories

can exploit of economies of scope, such as spreading
fixed management costs between territories, or where
plant in one territory can be used to produce output for
many territories.

Ricardo considered what goods and services countries should

produce, and suggested that they should specialise by
allocating their scarce resources to produce goods and services
for which they have a comparative cost advantage. There are
two types of cost advantage absolute, and comparative.

Firms based outside one trading bloc can avoid

barriers to trade such as tariffs and quotas, as in the
case of Japanese car producers, such as Toyota and
Nissan, locating in the EU.

Absolute advantage means being more productive or costefficient than another country whereas comparative advantage
relates to how much productive or cost efficient one country is
than another.

Investment income

Example

Outward investment can lead to increased overseas investment

income for a country, including:
1.

Profits from overseas subsidiaries.

2.

Dividends from owning shares in overseas firms.

3.

Interest payments, from lending abroad, such as

lending by UK banks.

In order to understand how the concept of comparative

advantage might be applied to the real world, we can consider
the simple example of two countries producing only two goods
- motor cars and commercial trucks.

FDI in the balance of payments accounts appears in two ways:

1.

The initial outflow of FDI is entered as an outflow

(debit) on the capital account

2.

The resulting investment income is entered as an

inflow (credit) on the current account.

Inward investment
Countries receiving inward investment gain in a number of
ways, including:
1.

An increase in GDP, initially through the FDI itself,

but this will be followed by a positive multiplier effect
on the receiving economy so that the final increase in
national income is greater than the initial injection of
FDI.

Comparative advantage

11

Using all its resources, country A can produce 30m cars or 6m

trucks, and country B can produce 35m cars or 21m trucks.
This can be summarised in a table.
In this case, country B has the absolute advantage in producing
both products, but it has a comparative advantage in trucks
because it is relatively better at producing them. Country B is
3.5 times better at trucks, and only 1.17 times better at cars.

Opportunity cost ratios

It is being able to produce goods by using fewer resources, at a
lower opportunity cost, that gives countries a comparative
advantage.
The gradient of a PPF reflects the opportunity cost of
production. Increasing the production of one good means that
less of another can be produced. The gradient reflects the lost
output of Y as a result of increasing the output of X.

However, the greatest advantage - and the widest gap - lies

with truck production, hence Country B should specialise in
producing trucks, leaving Country A to produce cars.
Economic theory suggests that, if countries apply the principle
of comparative advantage, combined output will be increased
in comparison with the output that would be produced if the
two countries tried to become self-sufficient and allocate
resources towards production of both goods. Taking this
example, if countries A and B allocate resources evenly to both
goods combined output is: Cars = 15 + 15 = 30; Trucks = 12 +
3 = 15, therefore world output is 45 m units.

Having a comparative advantage in X, Country A sacrifices

less of Y than Country B. In terms of two countries producing
two goods, different PPF gradients mean different opportunity
costs ratios, and hence specialisation and trade will increase
world output.
Only when the gradients are different will a country have a
comparative advantage, and only then will trade be beneficial.
Identical PPFs

12

If PPF gradients are identical, then no country has a

comparative advantage, and opportunity cost ratios are
identical. In this case, international trade does not confer any
advantage.

Criticisms

4.

Complete specialisation might create structural

unemployment as some workers cannot transfer from
one sector to another.

5.

Relative prices and exchange rates are not taken into

account in the simple theory of comparative
advantage. For example if the price of X rises relative
to Y, the benefit of increasing output of X increases.

6.

Comparative advantage is not a static concept - it may

change over time. For example, nonrenewable
resources can slowly run out, increasing the costs of
production, and reducing the gains from trade.
Countries can develop new advantages, such as
Vietnam and coffee production. Despite having a long
history of coffee production it is only in the last 30
years that it has become a global player. seeing its
global market share increase from just 1% in 1985 to
20% in 2014, making it the world's second largest
producer.

7.

Many countries strive for food security, meaning that

even if they should specialise in non-food products,
they still prefer to keep a minimum level of food
production.

8.

The principle of comparative advantage is derived

from a highly simplistic two good/two country model.
The real world is far more complex, with countries
exporting and importing many different goods and
services.

9.

According to influential US economist Paul Krugman,

the continual application of economies of scale by
global producers using new technology means that
many countries, including China, can produce very
cheaply, and export surpluses. This, along with an
insatiable demand for choice and variety, means that
countries typically produce a variety of products for
the global market, rather than specialise in a narrow
range of products, rendering the traditional theory of
comparative advantage almost obsolete.

However, the principle of comparative advantage can be

criticised in a several ways:
1.

It may overstate the benefits of specialisation by

ignoring a number of costs. These costs include
transport costs and any external costs associated with
trade, such as air and sea pollution.

2.

The theory also assumes that markets are perfectly

competitive - in particular, there is perfect mobility of
factors without any diminishing returns and with no
transport costs. The reality is likely to be very
different, with output from factor inputs subject to
diminishing returns, and with transport costs. This
will make the PPF for each country non-linear and
bowed outwards. If this is the case, complete
specialisation might not generate the level of benefits
that would be derived from linear PPFs. In other
words, there is an increasing opportunity cost
associated with increasing specialisation. For
example, it may be that the maximum output of cars
produced by country A is only 20 million (compared
with 30), and the maximum output of trucks produced
by country B might only be 16 million instead of 21
million. Hence, the combined output from trade might
only be 46 million units (instead of the 51 million
units initially predicted).

13

10. However, the underlying principle of comparative

advantage can still be said to give some shape to the
pattern of world trade, even if it is becoming less
relevant in a globalised world.

So potentially, a rise in the terms of trade creates a benefit in

terms of how many goods need to be exported to buy a given
amount of imports. It can also have a beneficial effect on
domestic cost-push inflation as an improvement indicates
falling import prices relative to export prices.

Trade liberalisation

However, countries may suffer in terms of falling export

volumes and a worsening balance of payments.

Two opposing forces have shaped the changing pattern of

world trade over the last 200 years; the promotion of free trade
and the protection against free trade. Trade protection is the
process of erecting barriers to trade, such as taxes on imports,
called tariffs, and trade liberalisation is the process of making
trade free from such barriers.

The danger of an improving terms of trade is that it can worsen

the balance of trade if UK and overseas consumers are elastic
in their response to the relative export and import price
changes.

The advantages of free trade

Worsening terms of trade

It can be argued that free trade creates the following

advantages:

A worsening terms of trade indicates that a country has to

export more to purchase a given quantity of imports. According
to the Prebisch-Singer hypothesis, this fate has befallen many
developing countries given the general decline in commodity
prices in relation to the price of manufactured goods. However,
globalisation has tended to reduce the price of manufactured
goods over the past 15 years, so the advantage that
industrialised countries had over developing countries may be
falling.

Specialisation and comparative advantage

Free trade encourages countries to specialise and benefit from
the application of the principle of comparative advantage.
Increased world output
If countries specialise and trade, world output is likely to
increase as scarce resources will be used more efficiently. Mass
production will generate considerable economy of scale, which
reduce average costs.

The impact of globalisation has tended to halt the decline in the

terms of trade of developing economies.
The WTO

Increased competition and lower prices

The WTO attempts to promote free and fair trade an

increasingly difficult task, which it undertakes with varying
success. The WTO was established in 1995 when it replaced
the General Agreement on Tariffs and Trade (GATT). It has its
headquarters in Geneva, Switzerland and, by 2012, had 153
member countries, including China, which was the last major
nation to join.

Free trade increases competition, which generates further

benefits, including lower prices, greater use of new technology
and technology transfer between countries. Free trade will also
encourage the breakdown of domestic monopolies, and provide
greater choice for consumers and firms.
Higher quality

The purpose of the WTO is to promote free and fair trade

through multilateral talks and negotiations, and to arbitrate
between countries that are in dispute. The WTO itself claims
that, unlike GATT that preceded it, its rules of trade have been
worked out by the direct involvement of all countries, and not
just a few powerful ones.

Open economies are likely to see an increase in the quality of

products available as overseas firms compete on non-price
factors, such as design and reliability.
Terms of trade
A countrys terms of trade measures a countrys export prices
in relation to its import prices, and is expressed as:

Evaluation of the WTO

Trade liberalisation clearly brings many economic and political
benefits, but many argue that the WTO has had limited success
in certain areas. The main criticisms are:
Too few agreements
Critics argue that the number of trade disputes settled through
the WTO's DSU (Dispute Settlement Understanding) is
inadequate given the number of disputes. However, the number
of settlements did rise from 20 in 1990 to 157 in 2007. But
still, by January 2008, only 136 of the 370 cases had reached
the full panel process.

For example, if, over a given period, the index of export prices
rises by 10% and the index of import prices rises by 5%, the
terms of trade are:
110 x 100 / 105
= 104.8

(Sources: UNCTAD and WTO).

This means that the terms of trade have improved by 4.8%.

Failure to confront ethical issues

When the terms of trade rise above 100 they are said to be
improving and when they fall below 100 they are said to be
worsening.

Many argue that the WTO has failed to confront ethical issues,
such as the use of child labour and poor working conditions in
developing economies.

Improving terms of trade

Failure to tackle environmental issues

If a country's terms of trade improve, it means that for every

unit of exports sold it can buy more units of imported goods.

14

Similarly, many argue that it has failed to tackle environmental

issues, such as the depletion of global fish stocks,
deforestation, and climate change.

Trade protection is the deliberate attempt to limit imports or

promote exports by putting up barriers to trade. Despite the
arguments in favour of free trade and increasing trade
openness, protectionism is still widely practiced.

Takes too long to arbitrate

The motives for protection

Critics also complain that the WTO takes too long to arbitrate
and settle disputes. For example, it can take over five years
from the initial receipt of a complaint from one member to the
final panel ruling.

The main arguments for protection are:

Protect sunrise industries
Barriers to trade can be used to protect sunrise industries, also
known as infant industries, such as those involving new
technologies. This gives new firms the chance to develop,
grow, and become globally competitive.

See: Example of WTO process

Favours the powerful
Critics also argue that the WTO has an inbuilt bias favouring
developed and powerful nations and trading blocs such as the
USA and the EU, and operating against weaker, developing
ones.

Protection of domestic industries may allow they to develop a

comparative advantage. For example, domestic firms may
expand when protected from competition and benefit from
economies of scale. As firms grow they may invest in real and
human capital and develop new capabilities and skills. Once
these skills and capabilities are developed there is less need for
trade protection, and barriers may be eventually removed.

Failure to promote multilateralism

Despite the WTO operating as a multilateral organisation,
many member countries and trading blocs favour bilateral
discussions with partners or competitors. This is because
bilateral negotiations can be fully focussed and relatively quick
to complete. The result is that many countries prefer to bypass
the WTO process, and deal directly with other countries. The
failure of the most recent round of WTO negotiations, the
Doha round, is widely regarded as evidence of the inherent
problems of multilateral discussions. While the WTO is likely
to argue that it encourages such agreements when they do not
have a negative impact on third parties, it is very difficult to
find cases where third-party countries are not, at least
indirectly, negatively affected by a specific bilateral agreement.

Protect sunset industries

At the other end of scale are sunset industries, also known as
declining industries, which might need some support to enable
them to decline slowly, and avoid some of the negative effects
of such decline. For the UK, each generation throws up its own
declining industries, such as ship building in the 1950s, car
production in the 1970s, and steel production in the 1990s.
Protect strategic industries
Barriers may also be erected to protect strategic industries,
such as energy, water, steel, armaments, and food. The implicit
aim of the EUs Common Agricultural Policy is to create food
security for Europe by protecting its agricultural sector.

The Doha round

The most recent round of talks is the Doha Round, which
began in 2001, with major summit meetings in Cancun,
Mexico, Hong Kong, and Davos in 2003, 2005, and 2007
respectively. The Doha round of talks is also called the
development round, reflecting its emphasis on promoting free
trade for the benefit of developing nations. In particular, the
Cancun talks focussed on three areas: reducing agricultural
subsidies and industrial tariffs imposed by developed nations,
which limit the market access of developing nations;
harmonising competition rules within different countries; and
helping poor countries.

Protect non-renewable resources

Non-renewable resources, including oil, are regarded as a
special case where the normal rules of free trade are often
abandoned. For countries aiming to rely on oil exports lasting
into the long term, such as the oil-rich Middle Eastern
economies, limiting output in the short term through
production quotas is one method employed to conserve
resources.
Deter unfair competition

The talks collapsed for a number of reasons. Significantly,

while the US and EU failed to agree reductions in agricultural
support, many developing countries refused to agree new
investment rules which would make it easier for multinationals
to invest in their countries. Since the collapse, the USA and EU
have returned to bilateral agreements with favoured nations,
rather than entering into multilateral agreements. This
highlights a major limitation of the WTO in not gaining a
complete consensus that multilateral negotiations should be the
method of choice of its members.

Barriers may be erected to deter unfair competition, such as

dumping by foreign firms at prices below cost.
Save jobs
Protecting an industry may, in the short run, protect jobs,
though in the long run it is unlikely that jobs can be protected
indefinitely.
Help the environment
Some countries may protect themselves from trade to help limit
damage to their environment, such as that arising from CO2
emissions caused by increased production and transportation.

The failure of the Doha round means that the rich countries of
the world still protect themselves from goods produced by the
poor nations. By 2005, average agricultural tariffs imposed by
the USA and EU were 60%, against average industrial tariffs of
only 5%*.

Limit over-specialisation
Many economists point to the dangers of over-specialisation,
which might occur as a result of taking the theory of
comparative advantage to its extreme. Retaining some self-

Trade protectionism

15

sufficiency is seen as a sensible economic strategy given the

risks of global downturns, and an over-reliance on international
trade.
In addition to the economic arguments for protection, some
protection may be for political reasons.

An index of greater than 0.90 means high

development - for example, the HDI for France and
the UK in 2006 were 0.95 and 0.94. respectively.

The HDI is a very useful means of comparing the level of

development of countries. GDP per capita alone is clearly too
narrow an indicator of economic growth, and fails to indicate
other aspects of development, such as enrolment in school and
longevity. Hence, the HDI is seen as a broader and more
encompassing indicator of development than GDP, though
GDP still provides one third of the index.

Economic development
Economic development is a broader concept than
economic growth and reflects social and economic
progress and requires economic growth. Growth is an
important and necessary condition for development, but it
is not a sufficient condition. Growth alone cannot
guarantee development.

Life expectancy
A variety of factors may contribute to differences in life
expectancy, such as the stability of food supplies, war and the
incidence of disease and natural disasters.
According to World Bank figures, between 1980 and 1998
average life expectancy rose from 61 to 67 years, with the
largest increases occurring in low and middle income
countries. However, the changes are not evenly distributed, and
in many countries in sub-Saharan Africa, life expectancy is
falling due to the AIDS epidemic.

Indicators of development
The extent to which a country has developed may be assessed
by considering a range of narrow and broad indicators,
including per capita income, life expectancy, education, and
the extent of poverty.

(Source: www.worldbank.org/depweb/)

The Human Development Index (HDI)

Adult literacy

The HDI was introduced in 1990 as part of the United Nations

Development Programme (UNDP) to provide a means of
measuring economic development in three broad areas - per
capita income, health and education. The HDI is used to track
changes in the global position of specific countries over time.

Adult literacy is usually defined as the percentage of those

aged 15 and above who are able to read and write a simple
statement on their everyday life.
More extensive definitions of literacy include those based on
the International Adult Literacy Survey. This survey tests the
ability to understand text, interpret documents, and perform
simple arithmetic.

Each year the UNDP produces a development report providing

an update of changes during the year, along with a report on a
special theme, such as global warming and development, and
migration and development.

GDP per capita

GDP per capita is the commonest indicator of material
standards of living, and hence is included in the index of
development. It is found by measuring Gross Domestic Product
in a year, and dividing it by the population.

The introduction of the index was an explicit acceptance that

development is a considerably broader concept than growth and
should include a range of social and economic factors.
The HDI has two main features:
A scale from 0 (no development) to 1 (complete development).

Evaluation of the HDI

A composite index based on three equally weighted

components:
1.

Longevity, measured by life expectancy at birth

2.

Knowledge, measured by adult literacy and number

of years children are enrolled at school

3.

Standard of living, measured by real GDP per capita

at purchasing power parity

Despite the widespread use of the HDI, there are a number of

criticisms that are often made. These include:

What the figures mean:

An index of 0 0.6 means low development - for

example, in 2006 Ethiopia had an index number of
0.38 while in Bangladesh it was 0.51

An index of 0.61 0.85 means medium development

for example, in 2006 Croatia had an index of 0.85,
while Brazil and the Ukraine had 0.80 and 0.79
respectively.

16

1.

The HDI index is for a single country, and as such

does not distinguish between different rates of
development within a country, such as between urban
and traditional rural communities.

2.

Critics argue that the equal weighting between the

three main components is rather arbitrary.

3.

Development is ultimately about freedom, and there is

nothing in the index which directly measures this. For
example, access to the internet might be regarded by
many as a freedom which improves the quality of
individual's lives.

4.

As with GDP per capita, the more narrow measure of

living standards, there is no indication of the
distribution of income.

5.

6.

In addition, the HDI excludes many aspects of

economic and social life that could be regarded as
contributing to or constraining development, such as
crime, corruption, poverty, deprivation and negative
externalities.

percentage of the population not using an improved

water source and the percentage of children underweight for their age.
As a region of the world, Sub-Saharan Africa has the highest
level of poverty as a proportion of total population, at over
60%. The second poorest region is Latin America, with 35% of
its population living in poverty.

GDP is calculated in terms of purchasing power

parity, and this value can frequently change.

HPI-2 (for developed - OECD countries)

The indicators of deprivation are adjusted for advanced
economies in the following ways:

Poverty
The alleviation of poverty is increasingly seen as a
fundamental economic objective. Poverty creates many
economic costs in terms of the opportunity cost of lost output,
the cost of welfare provision, and the private and external costs
associated with exclusion from normal economic activity.
These costs include the costs of unemployment, crime, and
poor health. In addition, the poor have little disposable income,
and so cannot spend and generate income for firms and jobs for
other individuals.
Widespread poverty is also an important constraint preventing
economic development.
There are two ways to define poverty:
Absolute poverty

Relative poverty
It can be argued that poverty is best understood in a relative
way what is poor in New York is not the same as in Mumbai.
One approach is to look at deprivation, the poor being
defined as those who are deprived from the benefits of a
modern economy, such as clean water and education.
The Human Poverty Index - HPI
The Human Poverty Index (HPI), which was introduced in
1997, is a composite index which assesses three elements of
deprivation in a country - longevity, knowledge and a decent
standard of living.

The HPI for developing countries has three components:

3.

The third element is to have a decent standard of

living. Failure to achieve this is identified by the

3.

A decent standard of living is measured by the

percentage of the population living below the poverty
line, which is defined as those below 50% of median
household disposable income, and social exclusion,
which is indicated by the long-term unemployment
rate.

Investment

HPI-1 (for developing countries)

The second element is knowledge, which is assessed

by looking at the adult literacy rate.

Knowledge is assessed in terms of the percentage of

adults lacking functional literacy skills, and;

The I - S stands for Investment and Saving and the IS

curve displays the equilibrium in the goods and service
market for various interest rates.

There are two indices; the HPI 1, which measures poverty in

developing countries, and the HPI-2, which measures poverty
in OCED developed economies.

2.

2.

This video is the second in a set of four explaining

the Hicks-Hansel model of Keynes' theory of Aggregate
Demand, specifically the IS-LM interpretation. This model
is very important to short run macroeconomics and
attempts to explain shifts in the aggregate demand curve.
These topics are usually taught in an intermediate
Macroeconomics class, and these videos are intended as
a visual aid to further your understanding of the
models.This video covers the investment demand curve,
integrates investment into the aggregate demand curve,
introduces the IS-curve and provides an overview of the
factors that determine the slope and position of the IS
curve. If you did not view the introductory video, you can
find it here

One straightforward definition of absolute poverty is being

unable to subsist that is, unable to eat, drink, have shelter
and clothing. A common universal measure of extreme poverty
is .receiving less than $1.25 a day. Extreme poverty if defined
as not being able to buy enough food to survive.

The first element is longevity, which is defined as the

probability of not surviving to the age of 40.

Longevity, which for developed countries is

considered as the probability at birth of not surviving
to the age of 60.

Part 2: IS Curve

Absolute poverty is poverty that is unrelated to a particular

economic or social context. In other words it is a general
definition of poverty which is valid at all times and for all
economies. Agreeing such a definition is extremely hard to do.

1.

1.

17

the IS curve, so it's put here now for consistency.

Exogenous investment determines the initial level. Again,
a higher interest rate results in lower investment
spending. A high interest rate means firms reduce their
investment spending to avoid high interest payments. A
low interest rate means firms can increase their capital
spending and pay relatively low interest.

Slope & Position

To begin we revisit the aggregate demand equation.

While investment was previously considered to be
exogenous, we're going to see how it relates to interest
rate, so it becomes endogenous and loses the bar above
the variable.
There is, however, still a portion of investment that is
unaffected by interest rate. It is represented by "I-bar"
and called exogenous investment. Next we have interest
rate, represented by "i". And as you see by the minus
sign, investment is negatively related to the interest rate.
The degree to which firms adjust investment spending
relative to the interest rate is called interest sensitivity
which is represented by "b". This coefficient will be
anywhere between zero and one.

Investment Curve
The slope of the investment curve is determined by the
interest sensitivity coefficient. A high interest sensitivity
results in a more gradual slope. In this case, there is a
drastic increase in investment spending in reaction to a
relatively small reduction in the interest rate, because of
the higher sensitivity.
The position of the curve is determined by the exogenous
investment. An increase would result in an outward shift
of the curve.

Incorporated Investment into the Aggregate Demand

Equation

Now we'll examine this relationship graphically.

Investment is on the x-axis and interest rate is on the yaxis. Typically the independent variable (in this case,
investment) is put on the Y-axis, but we will be using
interest rate as the independent variable when we graph

18

Now we're going to incorporate this investment function

into the aggregate demand equation. Recall in the first
video we separated the components into exogenous and
endogenous to arrive at this formula. Investment was
previously grouped with the exogenous components, but
our new formula has endogenous as well as exogenous
components. The "I-bar" will go back into the exogenous
group, while the interest and sensitivity coefficient move
to the back of the equation.
Review: AD for aggregate demand. A-bar for exogenous
demand, lower case c is the marginal propensity to
consume. lower case t for tax rate, Y for income, lower
case b for interest sensitivity and i for interest rate. You
will notice that all of the lower case variables are rates
between zero and one.

A reduction in the interest rate results in an upward shift

in the aggregate demand curve. This results in a higher
equilibrium level of national income. So the interest rate
went down and the equilibrium income went up.

Aggregate Demand Curve with Investment

Increase in Interest Sensitivity

We're going to display this function graphically, and just

as before the 45 degree line where aggregate demand =
income is our equilibrium criteria. Here is upward sloping
demand function. Higher levels of national income lead to
higher levels of aggregate demand. The y-intercept is
given by exogenous demand minus interest rate *
sensitivity. The intersection of the lines gives us the
equilibrium level of national income.

An increase in interest sensitivity results in a downward

shift in both aggregate demand curves. The downward
shift is more pronounced for the curve with the higher
interest rate (i-1). This means that the distance between
the two resulting equilibrium levels of income is larger.

IS Curve

Reduction in Interest Rate

19

Now we can move on to the IS Curve, which denotes the

equilibrium levels of national income for different interest
rates. Just as we did in the previous slide, we will be
graphing the aggregate demand curve for different
interest rates in the top graph. The bottom graph also has
income on it's x-axis and will show the different interest
rates.

Now we're going to discuss the determinants of the IS

curve's slope. Holding other factors constant, an increase
in interest sensitivity will result in a more gradually sloped
IS curve. b prime will signify the new, higher level of
interest sensitivity. Lets watch how this happens. For i-1,
the higher interest rate, the downward shift is more
prominent and produces a low equilibrium level of
national income, Y* 3. For i 2, the lower interest rate,
there is a downward shift, but not as big. When we
connect the points to form the second IS curve we see
that it's slope is more gradual.

Here is the curve for interest rate #1. The equilibrium

level of income is the same for both graphs. When we put
interest rate #1 on our bottom graph we have the first
point of our IS curve. The second aggregate demand
curve has a lower interest rate, so its parallel and higher
up. On the lower graph the intersection of interest rate #2
and equilibrium income #2 produce the second point of
the IS curve. This could be repeated for every different
interest rate in this range to produce the IS curve. Since
this model only uses linear curves, we need a minimum
of two points to graph the IS curve. There you have it, at
any point on this IS curve the goods & services market is
in equilibrium.

Slope of IS Curve - MPC

Slope of IS Curve - Interest Sensitivity

20

The last determinant of slope is the tax rate. An increase

in the tax rate reduces the slope of the aggregate
demand curve. t prime will represent the higher tax rate.
The flatter aggregate demand curves produce an IS
curve that is steeper as a result of the increase tax rate.

Position of IS Curve - Exogenous Demand

Another determinant of the IS curve's slope is the

marginal propensity to consume. As we saw in the
introductory video, An increase in the MPC creates a
steeper aggregate demand curve. c prime will represent
the higher MPC. When we graph the steeper aggregate
demand curves it becomes apparent that the second IS
curve is more gradual as a result of the increased MPC.

Moving on to the position of the IS curve, an increase in

exogenous demand results in an upward shift of the
aggregate demand curve. 'A' bar prime will represent the
higher level of exogenous demand. The higher aggregate
demand curves produce an IS curve that is shifted
outward as a result of the increase in exogenous
demand.

Slope of IS Curve - Tax Rate

This concludes the video on the IS curve. We covered

the investment demand curve, integrated investment into
the aggregate demand curve, introduced the IS curve
and looked at the determinants of its slope and position.
Please watch the third video, which explains how to find
equilibrium in the money market

Part 3: LM Curve
The LM curve is used to determined equilibrium in the
money market. The L stands for liquidity and M for

21

Money. The video covers the demand for money, the

supply of money, the LM curve, the factors affecting its
slope and position and finally the algebraic formula for
the curve.

Now we're going to examine this relationship graphically.

Interest rate, the independent variable, goes on the Yaxis because its going to be relating to the LM graph,
which as interest rate on the same axis. Demand for
money, the dependent variable, goes on the X-axis. As
the interest rate decreases, the demand for money
increases, which gives us the downward sloping demand
for
money
curve.

Demand for Money

An increase in the national income results in an upward

and outward shift of the demand for money curve. The
amount of shift depends on the increase in income as
well as the income sensitivity of demand for money.

Increase in Interest Sensitivity of Demand for Money

Demand for real money is represented by the letter 'L'.
Real money is adjusted for inflation, so this indicates the
actual purchasing power of money. The amount of
demand depends on income, because that determines
the amount people have to spend and it depends on the
interest rate because money can be put to better use if it
is invested. As the minus sign indicates, the higher the
interest rate, the more inclined people are to invest their
money rather than having it available to spend.
These two variables are moderated by sensitivity
coefficients: the income sensitivity of demand for real
money and the interest sensitivity of demand for real
money. Both of these have a value greater than zero.

Demand for Money Graph

An increase in the interest sensitivity for real money

reduces the slope of the demand for money curve. The
original h value is low because a large drop in interest
rate is required to increase the demand for money.
h' is higher, meaning the interest sensitivity is higher. The
slope is less steep which means a relatively small
decrease in interest rate causes a large increase in the
demand for money.

Money Supply

22

equilibrium rate of interest, i1. This line is extended to the

LM space and creates our first point as it intersects with
Y1. This is repeated for a higher level of national income,
Y2. This produces the second equilibrium rate of interest,
i2. We extend this line across to the LM space and it
intersects with Y2. These two sampled points are all we
need to draw the LM curve. It denotes the levels of
national income and interest rates that allow the money
market to be in equilibrium.

Slope of the LM Curve

Now that we've covered the demand for money, we're

going to introduce the supply of real money. This is
composed of the nominal money supply, the number
value of all the cash balances in a country. In this model
the amount of money is set by the central bank and
therefore exogenous. This value is divided by price level,
the correction for inflation. Since this model is applied to
the very short run, inflation is not a factor so the price
level is exogenous. This calculation produces the real
money
supply.
Represented graphically, the money supply is a vertical
line. In the very short run it is fixed. This graph shows two
demand for money curves for different levels on national
income. The intersection of the demand for money curves
and the money supply line indicate the equilibrium rates
of interest, i1 and i2.

Now we're going to examine the determinants of the LM

curve's slope. Here we have the original LM curve. We're
going to increase the income sensitivity of demand for
real money, k. When we graph the new demand for
money curves on the left they have shifted upward.
Because k' is a coefficient of Y, the upward shift for Y2
will be even more pronounced. When the new equilibrium
interest rates i3 and i4 are extended over to the LM
space we can see that the slope of the LM curve has
increased.

LM Curve

We're ready for the LM curve. On the left we have the

money demand/money supply graph. The LM curve will
be graphed in the interest, income space on the left. The
vertical money supply line is already showing. Here is the
demand for money curve for Y1. The point at which it
crosses the money supply line produces the first

In this example the initial demand for money curves are

relatively flat. We're going to decrease the interest
sensitivity of demand for real money. The curves

23

produced with the lower h' indicate that it would take a

relatively large decrease in interest rate to produce a
dramatic increase in the demand for money. When the
lines are drawn for both our sample income levels we see
that the resulting LM curve's slope has increased.

Slope of LM Curve

***Correction: In the video I read this as income sensitivity but

it should be interest sensitivity***

Position of LM

The slope of the LM curve is the coefficient of Y, k over h,

or the income sensitivity of demand for real money over
the interest sensitivity of demand for real money. This
ratio
is
important
for
monetary
policy.
That concludes the video on the LM curve. It covered the
demand for money, the supply of money, the LM curve,
the factors affecting its slope and position and then the
formula behind it. Please watch the next video regarding
the interaction of IS and LM curves and the policy
implications of the model.

As for the position of the LM curve, this is determined by

the real money supply. An increase shifts the money
supply line outward. The resulting equilibrium interest
rates are lower. This results in a downward shift of the
LM curve.

Goods Market
Algebraic Relationship

Now that we've gone through the relationship graphically,

we're going to examine this equilibrium condition
algebraically. Here is the demand for real balances
formula. Equilibrium is reached when supply equals
demand so we will substitute real money supply in for L.
We want to solve this equation for 'i' because it is the
dependent variable in the LM curve. We bring 'h i' over to
the left side of the equation and move the money supply
to the right side. We divide both sides by h', the interest
sensitivity of demand for money. It cancels out on the left
side and stays on the right side. And here is the formula
for the LM curve. This will give you the equilibrium
interest rates for different levels of national income, Y.

24

This section covers the finding simultaneous equilibrium in the

goods market and the money market by combining the IS and
LM curves. This leads to a method for deriving the Aggregate
Demand curve. This model is also used to anticipate the
economy's response to fiscal and monetary policy.
This slide displays the goods and services market on the top
right hand side. The money market is on the left.
First, in the goods market, the horizontal line is the
equilibrium condition and the aggregate demand equation
extends upward. The equilibrium interest rate and level of
income are extended down to derive the IS curve. The higher
interest rate results in a higher equilibrium income.
Connecting these points creates the IS Curve.

The intersection of the IS and LM curves denotes the

equilibrium level of interest and income that will have both
markets in simultaneous equilibrium.

In the money market, on the left, the real money supply is the
grey vertical line. When the demand for money curve crosses
it the equilibrium interest rate is found. For a higher level of
national income (Y2), the equilibrium interest rate is higher,
these
points
create
the
LM
curve.

Deriving the Aggregate Demand Curve

The intersection of the IS and LM curves denotes the

equilibrium level of interest and income that will have both
markets in simultaneous equilibrium.

Money Market

In the money market, on the left, the real money supply is the
grey vertical line. When the demand for money curve crosses
it the equilibrium interest rate is found. For a higher level of
national income (Y2), the equilibrium interest rate is higher,
these points create the LM curve.

From this information we can derive the aggregate demand

curve in the Price/Income graph on the top right. This is done
by finding the IS-LM equilibrium for different price levels. Price
levels are in the real money supply equation that is
represented by the grey vertical bar. By drawing LM curves for
different price levels, we can produce enough points in the

Simultaneous Equilibrium

25

P/Y

space

to

derive

the

aggregate

demand

curve.

The LM curve is drawn for the first price level, producing the
first point at the intersection of P1 and the resulting
equilibrium level of national income.

A reduction the price level increases the real money supply

because people can buy more with the money they have. The
lower price level shifts the money supply line outward. This
causes the LM curve to shift down and the equilibrium income
(Y2) to be further to the right. Where this line intersects with
P2, the second point of the Aggregate demand curve is drawn.
This process could be repeated again to produce an even
higher level of equilibrium with lower prices. By connecting
these points the downward sloping demand curve is formed.

26

Monetary Policy

Now for the reactions of the markets to a change in monetary

policy. If the central bank increases the money supply (M) the
real money supply line shifts outward and the LM curve shifts
outward
accordingly.

The immediate result is that the interest rate drops from its
original equilibrium to the intersection of Y1 and the lower LM
curve. This is based on the assumption that the money
markets adjust quickly. At this point the money market is in
balance because the point is on the LM curve, but the interest
rate is too low for the goods market to be in equilibrium. At
this position there is an excessive demand for goods so output
and income start to increase. The Money market adjusts
quickly to the increased income: an increase in income
increases the demand for money and in turn increases the
interest rate. This plays out as the point of equilibrium moves
up the LM curve until it reaches the IS curve. At this point the
interest rate and Income stabilize and the economy reaches
equilibrium. So the end result of the policy of increasing the
money supply lower interest rates and a higher level of
national income.

Here is the LM curve being formed for M1, a low supply of

money. This forms the first point of equilibrium at i1 and Y1.
When the central bank increases the money supply to M2 the
LM curve shifts down.

27

Fiscal Policy

Fiscal policy takes the form of government spending. The two

red aggregate demand functions contain exogenous demand,
of which government spending is a factor. Here the IS curve is
derived using the first value of exogenous demand.
Equilibrium income and interest rate are found.

By increasing government spending the red aggregate demand

curves are shifted upward. The resulting IS2 is shifted
outward. The money market quickly responds and a new point
of equilibrium is reached at i2 and Y2. So by increasing
government spending, the equilibrium level of national
income has risen and the interest rate has also risen

28