Macroeconomics and Microeconomics
Macroeconomics
Macroeconomics – The study of aggregate economic activity. It investigates how the economy as a whole works.
Circular flow of income – A simplified model of the economy that shows the flow of money through the economy.
Leakages – Income received but not used to finance expenditure on domestic goods and services, i.e. not returning directly to firms.
Injections – Income that does not come directly from the households through their spending on goods and services.
Savings – Income that is not spent, but rather stored in a financial institution. Savings are a withdrawal (leakage) from the circular flow of income.
Transfer payment – When a payment is received without a productive service being rendered. There is no increase in output as it is a transfer of income, rather than income in exchange for output. Examples: unemployment benefits, old-age pension.
National income – The total value of all final goods and services produced in an economy during a given time period, usually one year.
Gross domestic product (GDP) – The total money value of all final goods and services produced in a country in one year, regardless of who owns the productive assets, or the total value of all spending in the economy which would be expressed as GDP = C + I + G + (X–M).
Gross national product (GNP)/Gross national income (GNI) – The total money value of all final goods and services produced in an economy in one year, plus net property income from abroad, i.e. the total income earned by a country’s factors of production regardless of where the assets are located.
Net national product (NNP)/Net national income (NNI) – The total money value of all final goods and services produced in an economy in one year, plus net property income from abroad (GNI) minus depreciation (capital consumption).
Nominal GDP – The total money value of all final goods and services produced in a country in one year, not adjusted for inflation.
Real GDP – The total money value of all final goods and services produced in a country in one year, adjusted for inflation.
Per capita GDP – The total money value of all final goods and services produced in a country in one year divided by the size of the population.
Green GDP – A measure of GDP that takes into account any environmental costs incurred from the production of the goods and services included in the GDP figures. Green GDP = GDP – environmental costs of production.
Economic Growth and Development
Economic growth – The growth of real output in an economy over time. It is usually measured as growth in real gross domestic product (GDP).
Economic development – A multidimensional concept involving improvement in standards of living, reduction in poverty, improved health and education, reduced income inequality and increased employment opportunities. It is also about increased freedom and economic choice.
Human development index (HDI) – A composite index that brings together three variables, namely the measurements of health, education, and living standards in order to attempt to measure relative development. Elements of the HDI are life expectancy at birth, adult literacy rate, school enrolment rate, and GDP per capita. The indicators are combined to give an index value between 0 and 1.
Business Cycle
Business cycle – Shows fluctuations in the level of economic activity in an economy over time measured by changes in real GDP, and suggests that the changes are cyclical. Stages in the business cycle include the trough, recovery, boom, peak and recession.
Recession – Two consecutive quarters of negative GDP growth, that is, falling GDP. Characteristics include increased unemployment and lower rates of inflation, or even deflation.
Aggregate Demand and Supply
Aggregate demand – The total spending on goods and services in an economy, consisting of consumption, investment, government expenditure and net exports. AD = C + I + G + (X – M).
Consumption – Spending by individuals or households on domestic goods and services over a period of time.
Investment – Spending by firms on the addition of capital stock to the economy in the form of factories, offices, machinery and equipment which is used to produce goods and services.
Demand-side/demand management policy – Any government policy, fiscal or monetary, designed to influence the level of aggregate demand in the economy, thus affecting the average price level and real output.
Fiscal policy – A demand-side policy using changes in government spending and/or taxation rates to achieve economic objectives, often relating to inflation and unemployment.
Monetary policy – A demand-side policy using changes in the money supply or interest rates to achieve economic objectives, often relating to inflation and unemployment.
Interest rates – The cost of borrowing money, usually expressed as a percentage, and it represents the opportunity cost of current consumption.
Exports – Domestic goods and services that are bought by foreigners, resulting in an inflow of export revenues (injection) to the country.
Imports – Goods and services that are bought from foreign producers, resulting in an outflow of import expenditure (leakage) from the country.
Aggregate supply – The total amount of goods and services, including both consumer goods and capital goods, supplied by all industries in the economy at every given price level.
Short-run aggregate supply (SRAS) – Aggregate supply that varies with the level of demand for goods and services and that is shifted by changes in the costs of factors of production.
Long run aggregate supply (LRAS) – Aggregate supply that is dependent upon the resources in the economy and that can only be increased by increases in the quantity and/or improvements in the quality of factors of production.
Inflationary gap – An inflationary gap is present when an economy is in equilibrium at a level of output that is greater than the full employment level of output, thus causing inflation.
Deflationary gap – A deflationary gap is present when an economy is in equilibrium at a level of output that is less than the full employment level of output, thus causing unemployment.
Supply-Side Policies
Supply-side policies – Government policies designed to shift the long run aggregate supply curve to the right, thus increasing potential output in the economy, by bringing about an increase in the quantity and/or improving the quality of the factors of production.
Privatization – The sale of government-owned firms to the private sector, in the hope that privately-owned, profit-maximizing firms will be more efficient, thus increasing the potential output of the economy.
Multiplier (HL only) – The ratio of a change in the level of national income to an initial change in one or more of the injections, i.e. investment, government spending or export revenue, into the circular flow of income. The final increase in aggregate demand will be greater than the initial injection.
Crowding out – A situation where the government spends more than it receives in revenue (mainly taxation), and needs to borrow money, forcing up interest rates and “crowding out” private investment and private consumption, since it becomes more expensive to borrow money.
Unemployment
Unemployment – A situation that exists when people of working age, who are available for work and actively seeking employment, cannot get a job.
Full employment – Exists when the number of jobs available in an economy is equal to the number of people actively seeking work, i.e. the supply of labor equals the demand for labor in the economy.
Underemployment – Hidden unemployment that exists when workers are carrying out jobs for which they are over-qualified, i.e. they are not using their full skills and abilities or when workers are employed part-time, even though they are available for full time employment or when workers in a planned economy are undertaking jobs that would not exist in a free market economy.
Unemployment rate – The number of unemployed workers (people of working age, who are available for work and actively seeking employment, but cannot get a job) expressed as a percentage of the total labor force.
Structural unemployment – Equilibrium unemployment that exists when the patterns of demand and production methods change in the long-term, and there is a permanent fall in the demand for a particular type of labour. There is a mismatch between skills and the jobs available.
Frictional unemployment – Short-term equilibrium unemployment that exists when people have left a job and are in the process of searching for another one, or leaving education and waiting to take up their first job.
Seasonal unemployment – Equilibrium unemployment that exists when people are out of work because their usual job is out of season, e.g. a ski instructor in the summer,many tourist industries etc.
Demand deficient/cyclical unemployment – Disequilibrium unemployment that exists when there is decreased aggregate demand in the economy, leading to a decrease in demand for labor, and wages do not fall to compensate for this.
Real wage unemployment – Disequilibrium unemployment that exists when real wages in the economy get pushed up above the equilibrium wage rate, either by the government or by trade unions.
Inflation – A persistent increase in the average price level in the economy, usually measured through the calculation of the consumer price index (CPI). Inflation results in a fall in the value of money.
Demand-pull inflation – A persistent increase in the average price level in the economy (inflation) that is caused by increasing aggregate demand in an economy, that is, a shift of the AD curve to the right.
Cost-push inflation – A persistent increase in the average price level in the economy (inflation) that is caused by an increase in the costs of production in an economy, that is, a shift of the SRAS curve to the left.
Deflation – A persistent fall in the average level of prices in an economy, caused by falling aggregate demand or an increase in aggregate supply.
Disinflation – A fall in the rate of inflation, i.e. the average price level rises, but at a lower rate than in the previous year.
Stagflation – A situation that occurs when real output, and hence employment, fall, yet there is inflation (a persistent increase in the average price level) in the economy. Stagflation is caused by a shift of the aggregate supply curve to the left.
Core rate of inflation – An adjusted measure of inflation (a persistent increase in the average price level in the economy) that removes the distortions of the most volatile prices of items such as food and energy.
Short-run Phillips curve (HL only) – A curve showing the inverse relationship between the rate of unemployment and the rate of inflation, which suggests a trade-off between inflation and unemployment.
Long-run Phillips curve (HL only) – Shows the monetarist (new classical) view that there is no trade-off between inflation and unemployment in the long run and that there exists a natural rate of unemployment that can only be affected by supply-side policies.
Natural rate of unemployment (HL only) – The rate of unemployment that is consistent with a stable rate of inflation. It is the rate where the long run Phillips curve touches the x-axis.
Economic growth – The growth of real output in an economy over time. It is usually measured as growth in real gross domestic product (GDP).
Equity in the distribution of income:
Lorenz curve – The Lorenz curve shows what percentage of the population owns what percentage of the total income in the economy. It is calculated in cumulative terms. The further the curve is from the 45 degree line of absolute equality, the more unequal is the distribution of income.
Gini coefficient – A coefficient (index) that measures the ratio of the area between a Lorenz curve and the line of absolute equality to the total area under the line of equality. The higher the figure, the more unequal is the distribution of income.
Direct taxes – Taxation imposed on people’s income or wealth, and on firms’ profits. In theory, such taxes are unavoidable (eg, income tax).
Indirect taxes – A tax on expenditure or consumption that is ‘hidden’. It increases the firm’s costs and is added to the selling price of a good or service. It is also known as an avoidable tax (eg, VAT and GST).
Progressive tax – A system of direct taxation where tax is levied at an increasing rate for successive ‘brackets’ of income. As a person’s income rises, so they pay a higher proportion of their income in taxes. The marginal tax rate is higher than the average tax rate.
Marginal tax rate – The marginal tax rate is the rate of tax paid on the additional income earned. It is calculated as follows: (additional tax paid ÷ additional income earned) x 100.
Regressive tax – A system of taxation in which tax is levied at a decreasing average rate as income rises. This form of taxation takes a greater proportion of tax from the low-income earner than from the high-income earner. Indirect taxes are regressive taxes.
Proportional tax – A system of taxation where the proportion of income paid in tax is constant for all income levels.
Transfer payment – When a payment is received without a productive service being rendered. There is no increase in output as it is a transfer of income, rather than income in exchange for output. Examples: unemployment benefits, old-age pension.
Short run – The period of time in which at least one factor of production is fixed in size. All production takes place in the short run.
Long run – The period of time in which all factors of production are variable. All planning takes place in the long run.
Total product – The total output that a firm produces, using its fixed and variable factors in a given period of time.
Average product – The output that is produced, on average, by each unit of the variable factor.
Marginal product – The extra output that is produced by using an extra unit of the variable factor.
Law of diminishing returns – The increased output per additional unit of variable input will ultimately fall. These diminishing returns will always set in if one or more factors of production are fixed.
Law of diminishing average returns – As extra units of a variable factor are applied to a fixed factor, the output per unit of the variable factor (AP) will eventually diminish.
Law of diminishing marginal returns – As extra units of a variable factor are applied to a fixed factor, the output from each extra unit of the variable factor (MP) will eventually diminish.
Economic costs – Economic costs are estimated by adding explicit costs (accounting costs) and implicit costs (the opportunity cost of using factors of production). Economic cost = accounting cost + opportunity cost.
Explicit costs – Costs to a firm that involve the direct payment of money to purchase factors not already owned by the firm.
Implicit costs – Earnings that a firm could have had if it had employed its factors in another use or hired out or sold them to another firm.
Fixed costs – Costs that do not change with the level of output. They are incurred whether the firm produces or not, and will thus be the same for one or any other number of units.
Variable costs – Costs that vary with the level of output. Variable costs increase as more of the variable factor is used.
Total costs – The total costs of producing a certain level of output, i.e. fixed costs plus variable costs.
Average cost – It is the average (total) cost of production per unit, calculated by dividing the total cost by the quantity produced. It is equal to the average variable cost plus the average fixed cost.
Marginal cost – It is the additional cost of producing one more unit of output.
Increasing returns to scale – Experienced when long-run unit costs are falling as output increases, meaning a given percentage increase in factors of production leads to a greater percentage increase in output, thus reducing long-run average costs.
Constant returns to scale – Experienced when long-run unit costs are constant as output increases, meaning a given percentage increase in factors of production leads to the same percentage increase in output, thus leaving long-run average costs the same.
Decreasing returns to scale – Experienced when long-run unit costs are rising as output increases, meaning a given percentage increase in factors of production leads to a smaller percentage increase in output, thus increasing long-run average costs.
Economies of scale – They are a fall in long run average costs that come about when a firm alters its factors of production in order to increase its scale of output, and lead to the firm experiencing increasing returns to scale.
Diseconomies of scale – They are an increase in long run average costs that come about when a firm alters its factors of production in order to increase its scale of output, and lead to the firm experiencing decreasing returns to scale.
Total revenue – The total amount of money that a firm receives from the sale of a particular quantity of output in a given time period. TR = price x quantity.
Average revenue – Total revenue received divided by the number of units sold. Usually, price is equal to average revenue.
Marginal revenue – The extra revenue gained from selling one more unit of a good or service in a given time period.
Normal profit/Zero economic profit – The amount of revenue needed to exactly cover all of the economic costs. It is the minimum amount of revenue needed to keep the firm in business.
Economic profit/Abnormal profit – A level of profit that is greater than that required to ensure that a firm will continue to supply its existing product. This occurs when total revenue is greater than economic costs.
Shut-down price – The price that enables a firm to cover its variable costs in the short-run, and occurs where price equals average variable costs. If price does not cover average variable costs, the firm will shut down in the short run.
Break-even price – The price that enables a firm to cover all of its costs in the long run, and occurs where price equals average total costs. If price does not cover average total costs in the long run, the firm will shut down for good.
Profit-maximizing level of output – The level of output where marginal revenue is equal to marginal cost, and the marginal cost curve is rising.
Satisficing – Refers to the acceptance of less than maximum profits in order to pursue other objectives.
Productive efficiency – Exists when goods are produced at the lowest possible cost per unit of output. This is achieved at the point where average total cost is at its lowest value, that is, where MC=AC.
Allocative efficiency – Occurs where suppliers are producing the optimal mix of goods and services required by consumers. In this scenario, the firm sells the last unit it produces at the amount that it cost to make it. It is the level of output where MC=AR.
Perfect competition – A market structure where there are a very large number of small firms, producing identical products. No individual firm is capable of affecting the market supply curve and thus cannot affect the market price. Because of this, the firms are price takers. There are no barriers to entry or exit and all the firms have perfect knowledge of the market.