Macroeconomics: Equilibrium, Inflation, and Unemployment
Exogenous and Endogenous Variables
Exogenous variables are those that feed the macroeconomic model, while endogenous variables are those that the model solves for. Adjustment variables help fine-tune the model.
National Accounts
National accounts are a system of records used to calculate aggregate figures, which are the primary focus of macroeconomics.
Classical Model of Equilibrium with Full Employment
This model assumes the labor market is always at full employment. Any unemployment is considered frictional (due to job search time) or voluntary (refusal to accept market wages).
Key Assumptions:
- Perfect competition in all markets.
- Flexible prices, including wages, ensuring market equilibrium.
- Ineffective monetary policy (money neutrality): changes in money supply only affect prices, not real variables.
- Limited role of fiscal policy: since the economy is at full employment, fiscal measures primarily lead to price increases.
This model is particularly relevant for understanding long-term economic trends.
Keynesian Model of Full Employment
Marginal Propensity to Consume (MPC)
The MPC measures the increase in consumption resulting from an increase in income.
Mathematical Formulation
MPC is defined as the change in consumption divided by the change in disposable income:
In Keynesian analysis, consumption (C) is expressed as:
Where:
- Co = Autonomous consumption
- c = MPC
- YD = Disposable income
- b = Marginal propensity to save (1-c)
Variation in MPC
While Keynes considered MPC constant, it’s more accurately a convex function of disposable income:
Keynesian View on Unemployment
In the Keynesian model, inadequate aggregate demand is the primary cause of unemployment. A decline in investment demand can trigger a chain reaction, leading to job losses across industries and reduced purchasing power, prolonging unemployment.
Keynesian Multiplier (k)
National income depends on production volume, which in turn relies on employment. Investment, influenced by business expectations, drives employment. If businesses borrow to invest, future profits must cover interest payments.
Say’s Law and Keynes’s Critique
Say’s Law, a cornerstone of classical economics, states that supply creates its own demand. Keynes challenged this view, arguing that insufficient aggregate demand can lead to unemployment.
Inflation
Inflation is the sustained increase in the general price level of goods and services in an economy. Some theories attribute inflation to rising costs (especially wages), while others point to excessive spending.
Measuring Inflation
Consumer Price Index (CPI)
The CPI measures price levels at a given time based on a representative basket of goods and services.
GDP Deflator
The GDP deflator converts nominal GDP (not adjusted for price changes) to real GDP (adjusted for price changes):
It’s a broad price index reflecting the overall price evolution in the economy.
Causes of Inflation
Two main theories explain inflation:
- Demand-pull inflation
- Cost-push inflation
Keynesian Explanation
Keynesians emphasize aggregate demand. If demand exceeds total production, prices rise.
Unemployment
The unemployment rate is calculated as:
Types of Unemployment
- Seasonal unemployment: Caused by fluctuations in labor demand throughout the year.
- Cyclical unemployment: Linked to changes in economic activity during business cycles.
- Frictional unemployment: Associated with job searching and transitions.
Causes of Unemployment
- Labor market dynamics
- Level of aggregate demand
Economic Effects of Unemployment
High unemployment is a major economic problem, impacting:
- The unemployed
- Employed workers
- The overall economy
Phillips Curve
The Phillips curve illustrates the inverse relationship between unemployment and inflation. Government intervention to boost employment can lead to inflation.
Aggregate Demand and Public Expenditure
The public sector interacts with the circular flow of income. In equilibrium:
S + T = G + I
Where:
- S = Savings
- T = Taxes
- G = Government expenditure
- I = Investment
The Keynesian approach advocates active government intervention to manage the business cycle.
Aggregate demand (AD) is:
AD = C + I + G
Including government spending shifts AD vertically upwards.
Assuming proportional net taxes and fixed government expenditure, higher income leads to a smaller deficit or larger surplus.
Money Supply and Demand
Money supply is the total money in an economy. Money demand arises from its function as a medium of exchange and store of value.
Keynesians identify three motives for money demand:
- Transactions
- Precautionary
- Speculative
IS-LM Model
The IS-LM model analyzes the interaction between real (IS curve) and monetary (LM curve) markets.
- I: Excess supply of goods, excess demand for money
- II: Excess demand for goods, excess demand for money
- III: Excess demand for goods, excess supply of money
- IV: Excess supply of goods, excess supply of money
The IS curve represents equilibrium between investment and savings. It slopes downward because investment is inversely related to interest rates.
The LM curve represents equilibrium in the money market. It slopes upward because higher income increases money demand, leading to higher interest rates.
Point E, where IS and LM intersect, represents simultaneous equilibrium in both markets.