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?
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