Real-world issue 1

Real-world issue 1 - Why does economic activity vary over time and why does this matter?

Conceptual understandings

• Change in the conditions of the demand and supply sides of the economy cause economic activity to vary over time.

• Fluctuations in economic activity impact the economic well-being of individuals and societies.

• Different schools of macroeconomic thought identify different causes and offer different solutions for macroeconomic problems.

• Key concepts: scarcity, choice, efficiency, equity, economic well-being, sustainability, change, interdependence, intervention.

3.1 Measuring economic activity and illustrating its variations

• National income accounting as a measure of economic activity

• Equivalence of the income, output and expenditure approaches to national income accounting, with reference to the circular flow model

  • Diagram: circular flow of income model showing the interactions between decision makers, leakages and injections

• [Nominal] Gross domestic product (GDP) as a measure of national output

  • Calculation: [nominal] GDP from sets of national income data, using the expenditure approach

• [Nominal] Gross national income (GNI) as a measure of national output

  • Calculation: [nominal] GNI from data

• Real GDP and real GNI

  • Calculation: real GDP and real GNI, using a price deflator

• Real GDP/GNI per person (per capita)

• Real GDP/GNI per person (per capita) at purchasing power parity (PPP)

  • Calculation: real GDP per capita and real GNI per capita

• Business cycle: short-term fluctuations and long-term growth trend (potential output)

  • Diagram: business cycle showing short-term fluctuations and long-term growth trend (potential output)

• Appropriateness of using GDP or GNI statistics to measure economic well-being—use of national income statistics for making:

  • comparisons over time

  • comparisons between countries

• Alternative measures of well-being

  • OECD Better Life Index

  • Happiness Index

  • Happy Planet Index

3.2 Variations in economic activity—aggregate demand and aggregate supply

• Aggregate demand (AD)

  • Aggregate demand curve

  • Diagram: AD curve

• Components of AD: consumption (C) + investment (I) + government spending (G) + net exports (total exports [X] - total imports [M])

• Determinants of AD components

  • C: consumer confidence, interest rates, wealth, income taxes, level of household indebtedness, expectations of future price level

  • I: interest rates, business confidence, technology, business taxes, level of corporate indebtedness

  • G: political and economic priorities

  • X - M: income of trading partners, exchange rates, trade policies

• Shifts of the AD curve caused by changes in determinants

  • Diagram: shifts of the AD curve

• Short-run aggregate supply (SRAS) curve and determinants of the SRAS curve

  • costs of factors of production

  • indirect taxes

  • Diagram: SRAS curve

• Shifts of the SRAS curve

  • Diagram: shifts of the SRAS curve

• Alternative views of aggregate supply (AS)

  • Monetarist/new classical view of the long-run aggregate supply (LRAS) curve

  • Keynesian view of the AS curve

  • Inflationary and deflationary/recessionary gaps

  • Diagram: alternative views of the AS curve

• Shifts of the AS curve over the long-run (monetarist/new classical LRAS) or over the long term (Keynesian AS)

  • Changes in the quantity and/or quality of factors of production

  • Improvements in technology

  • Increases in efficiency

  • Changes in institutions

  • Diagram: shifts of the LRAS or Keynesian AS

  • Macroeconomic equilibrium

  • Short-run equilibrium

  • Equilibrium in the monetarist/new classical model

    • Determination of long-run equilibrium at full employment level of output (potential output)

    • Automatic adjustment to full employment equilibrium

    • Unemployment at full employment equilibrium is equal to the natural rate of unemployment

  • Equilibrium in the Keynesian model

    • Persistence of deflationary/recessionary gaps: equilibrium level of output might not equal the full employment level of output

  • Diagram: macroeconomic equilibrium in both the short run and long run

• Assumptions and implications of the monetarist/new classical and Keynesian models

3.3 Macroeconomic objectives

• Economic growth

  • Short-term growth

    • Actual growth in the PPC model

    • Role of AD in the AD/AS model

  • Long-term growth

    • Shifts of the PPC (growth in production possibilities)

    • Role of LRAS in the AD/AS model

  • Measurement of economic growth

  • Consequences of economic growth, including:

  • impact on living standards

  • impact on the environment

  • impact on income distribution

  • Diagram: PPC model showing actual growth and growth in production possibilities

  • Diagram: AD increases showing increases in real output

  • Diagram: LRAS increases showing increases in full employment output

  • Calculation: the rate of economic growth from a set of data

• Low unemployment

  • Measurement of unemployment and the unemployment rate

  • Difficulties of measuring unemployment

  • Causes of unemployment—cyclical (demand deficient), structural, seasonal, frictional

  • Natural rate of unemployment—sum of the structural, seasonal, frictional unemployment

  • Costs of unemployment—personal costs, social costs, economic costs

  • Calculation: the unemployment rate from a set of data

  • Diagram: minimum wage to show unemployment

  • Diagram: showing a fall in the demand for labour for a particular market or geographical area

  • Diagram: deflationary gap to show cyclical unemployment

• Low and stable rate of inflation

  • Measuring the inflation rate, using consumer price index (CPI) data

  • The limitations of the CPI in measuring inflation

  • Causes of inflation—demand-pull and cost-push

  • Costs of a high inflation rate—uncertainty, redistributive effects, effects on saving, damage to export competitiveness, impact on economic growth, inefficient resource allocation

  • Causes of deflation—changes in AD or SRAS

  • Disinflation and deflation

  • Costs of deflation—uncertainty, redistributive effects, deferred consumption, association with high levels of cyclical unemployment and bankruptcies, increase in the real value of debt, inefficient resource allocation, policy ineffectiveness

  • Calculation (HL only): a weighted price index, using a set of data provided

  • Calculation: the inflation rate from a set of data using quantities purchased as weights in the CPI

  • Diagram: demand-pull inflation

  • Diagram: cost-push inflation

  • Diagrams: deflation

• Relative costs of unemployment versus inflation

• Sustainable level of government (national) debt (HL only)

  • Measurement of government (national) debt as a percentage of GDP

  • Relationship between a budget deficit and government (national) debt

  • Costs of a high government (national) debt—debt servicing costs, credit ratings, impacts on future taxation and government spending

  • Potential conflict between macroeconomic objectives

    • Low unemployment and low inflation

    • Trade-off between unemployment and inflation (HL only)

      • Short-run and long-run Phillips curve

    • Diagram (HL only): AD/AS curves

    • Diagram (HL only): Phillips curve showing the short-run and long-run relationship between inflation and unemployment

  • High economic growth and low inflation

  • High economic growth and environmental sustainability

  • High economic growth and equity in income distribution

3.4 Economics of inequality and poverty

• Relationship between equality and equity

• The meaning of economic inequality

  • Unequal distribution of income

  • Unequal distribution of wealth

• Measuring economic inequality

  • Lorenz curve and Gini coefficient (index)

  • Diagram: Lorenz curve showing the distribution of income and possible changes in the distribution of income

  • Construction (HL only): a Lorenz curve from income quintile data

• Meaning of poverty

  • Difference between absolute and relative poverty

• Measuring poverty

  • Single indicators including:

    • international poverty lines

    • minimum income standards

  • Composite indicators including the Multidimensional Poverty Index (MPI)

• Difficulties in measuring poverty

  • Causes of economic inequality and poverty, including:

  • inequality of opportunity

  • different levels of resource ownership

  • different levels of human capital

  • discrimination (gender, race and others)

  • unequal status and power

  • government tax and benefits policies

  • globalisation and technological change

  • market-based supply side policies

• The impact of income and wealth inequality on:

  • economic growth

  • standards of living

  • social stability

• The role of taxation in reducing poverty, income and wealth inequalities

  • Progressive, regressive and proportional taxes

    • Average and marginal tax rates

  • Direct taxes

    • Personal income

    • Corporate income

    • Wealth

  • Indirect taxes

  • Calculation (HL only): given the indirect tax rate, the amount of indirect tax paid from a given level/ amount of expenditure

  • Calculation (HL only): total tax and average tax rates from a set of data

• Further policies to reduce poverty, income and wealth inequality, including:

  • policies to reduce inequalities of opportunities/investment in human capital

  • transfer payments

  • targeted spending on goods and services

  • universal basic income

  • policies to reduce discrimination

  • minimum wages

Inquiry—possible areas to explore (not an exhaustive list)

• How the government of a chosen country has responded to business cycle fluctuations.

• The costs of unemployment or inflation on different stakeholders in a chosen country.

• The successes/failures in meeting government objectives, based on data collected for a variety of countries over a given period of time.

• The successes/failures of measures adopted to reduce income and/or wealth inequality, for a chosen country.

• How key stakeholders (such as businesses and governments) can continue to meet people’s needs with limited resources.

• The cause of trade-offs between economic growth and sustainable development and how these might be addressed.

• What sustainable economic growth might look like and how it might be achieved.

Theory of knowledge questions

• To what extent do political beliefs and ideologies influence a person’s preference for one school of macroeconomic thought over another?

• It is often the case that two or more economists, observing an identical set of macroeconomic data (national income accounts, inflation, unemployment), arrive at very different explanations of events. How can this be accounted for? Could this occur in a natural science?

• There are often conflicts between important macroeconomic objectives. What kind of knowledge criteria should policy makers use to make decisions in favour of pursuing one objective over another?

• Using the concepts of natural rate of unemployment and full employment output, how may language affect perceptions about economic events or situations?