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Macroeconomic Fundamentals

In this lecture, we will turn to macroeconomic fundamentals. After this lecture, you should be able to understand contemporary economic relations at a global level. By the end of this lecture, you will have explored the key questions in macroeconomics:

What you will learn

This introductory lecture to macroeconomics fundamentals provides a thorough view of what economists know about market demand, market supply, and market equilibrium. The lecture goes on further to cover aggregate demand, supply, and equilibrium. You will also learn about the components of Gross Domestic Product, inflation, determinants of national income, and the circular flow of income model.

Basic demand and supply

  • In standard economics, the marketplace typically has two dimensions - that is market demand and market supply.
  • Market demand is defined as the total amount of goods and services that all consumers are willing and able to purchase from a supplier at a specific price level in the market.

Figure 1. The demand curve for a single product or service [D(0)].

Price level (p)

P (1)

P (0)

                                                                                                                                                      D(1)

D(0)

Q (1)  Q (0)Quantity demanded

  • As expected, the higher the price, the lower the quantity demanded by consumers, as prices are negatively correlated with demanded quantities. If prices rise from p(0) to p(1), the quantities demanded fall from q(0) to q(1). This refers to changes along the curve (curve shifts from D(0) to D(1)
  • Market supply refers to the quantity of a good or service that a producer is willing and able to supply onto the market at a given price in a given time period.

Figure 2. The supply curve for a single product or service [S(0)].

Price level        S(0)

P(1)        S(1)

P(0)

Q (0)           Q (1)         Quantity supplied

  • The basic law of supply is that as the selling price of a product rises, so businesses expand supply to the market. The higher selling price acts as an incentive for businesses to produce more - and it may also attract other suppliers into the market.
  • Each of these opposing dynamics can be portrayed by a specific schedule: the demand curve and the supply curve. Each of these curves is related to a specific good or service associated with a specific market. If prices rise from p(0) to p(1), the quantities demanded also rise from q(0) to q(1) (curve shifts from S(0) to S(1).

Market equilibrium - In any given market for a specific good or service, the market transaction takes place when both these schedules occur simultaneously, i.e., when both the demand and the supply curve intersect. This point of intersection is called the market equilibrium point, and this point is characterised by a single market price (at equilibrium) and a single quantity (at equilibrium). This equilibrium point thus presents two coordinates (price, quantity) that satisfy both consumers and producers alike. The market equilibrium is depicted in Figure 3 (Sloman, et al., 2012).

Figure 3. Market equilibrium for a specific good or service.

Price level       AS’AS

P*

AD   AD’

Q* Market equilibrium (P*, Q*)

Aggregate demand and aggregate supply

  • Aggregate demand is a fundamental macroeconomic concept that essentially depicts the relationship between the aggregate price level in any given economy and the total quantity of joint (i.e., aggregate) output demanded by a set of economic agents comprising business firms, households, the government, and by other economic agents located in the rest of the world.
  • Aggregate demand thus constitutes an economic measurement reflecting the sum of all final goods and services produced within a given economy, as expressed by the total amount of money exchanged for those goods and services (in theory, it reflects price P times quantity Q, summed up for all the complete range of goods and services produced and exchanged by a given economy). It should be taken into consideration that this economic indicator is measured using market values that reflect current prices for these goods and services.
  • it should also be noted that this important economic measurement does not possess any specific economic welfare implication; but instead constitutes an accounting and economic tally for the complete set of goods and services produced within a given economy, as these are necessarily consumed by the three types of economic agents above mentioned described within a given economy - business firms, households, and the government.

The AD curve takes into consideration the total impact in aggregate demand from a variation in the overall price level. That is, recognising that the price level might influence aggregate demand, the higher the price, the lower the level of aggregate demand. Therefore, the relationship between the aggregate demand curve and the overall price level is a negative one, insofar as higher prices lead to a decreased demand for goods and services in the economy. The negative relationship between aggregate demand and the overall price level is depicted in the aggregate demand curve depicted in Figure 4.

Figure 4. The aggregate demand curve AD.

Price level (p)

P*

AD

Q* Aggregate demand level (q*, for p*)

In Figure 4, it is quite noticeable that the higher the price level, the lower the total quantity associated with aggregate demand (labelled AD in the negative schedule), simply because, at higher prices, the demand side economic agents (e.g., business firms; households; the government) consume less, all other variables remaining equal (“ceteris paribus” condition).

  • Aggregate supply constitutes an economic measurement reflecting the sum of all final goods and services produced and supplied within a given economy, as expressed by the total amount of money exchanged for those goods and services. Aggregate supply thus reflects the economic activity occurring on the productive dimension of the economy (e.g., in the business firms providing goods and services to the economy) (Mishkin, 2015).
  • The aggregate supply curve depicts the relationship between the economy’s aggregate supply of final goods and services produced by the suppliers that are willing to supply the market, and the overall price level in the economy. In the specific case of the aggregate supply curve, this relationship is positive sloping, as a higher price level induces producers to increase their production of goods and services as higher prices increase turnover and profits; while a lower price level induces producers of goods and services to produce a much lower volume of production, due to depressed turnover and profits.

Figure 5 illustrates an upward sloping aggregate supply curve (Mishkin, 2015).

Figure 5. The aggregate supply curve AS.

Price levelAS

P*

Q* Aggregate supply level (q*, for p*)

  • The overall market equilibrium occurs when the two curves intersect. When the two curves meet, this intersection point reveals the optimal combination of overall prices and quantities produced (P*,Q*) that satisfy both schedules. That is, the market equilibrium in the overall economy results from the intersection of the aggregate demand curve and the aggregate supply curve, as evinced in Figure 6 (Mishkin, 2015).

Figure 6. Equilibrium between aggregate demand and aggregate supply

Price levelAS

P*

AD

Q* Aggregate equilibrium (q*, for p*)

  • Lastly, it should also be pointed out that the shape for the aggregate supply curve in the long run is vertical (and not upward sloping as AS in Figure 6). This is because, in the long run, each and every producer of goods and services would see any profit accruing from a potential price increase (decrease) entirely neutralised by a correspondingly increase (decrease) in production costs, so that profits per unit produced would remain neutral.

G.D.P. - its assessment, components and different variations

  • Gross Domestic Product (G.D.P.) is defined as the total value of all final goods and services produced in a given economy during a given period.
  • There are essentially three ways through which a given country’s G.D.P. numbers can be estimated. The first estimation method addresses the surveying of producers of goods and services in order to assess the overall value of their production in each individual case, and adding up the total production value of all final goods and services across the economy.
  • A second estimation method addresses tallying the total spending on final goods and services consumed in the economy. Specific economic agents spend their income (or part of their wealth) in acquiring goods and services in the marketplace. This specific method comprehensively adds aggregate spending on the amount of goods and services produced domestically in the economy.
  • A third estimation method is based on aggregate income earned by economic agents established in the economy. Business firms employing human capital typically pay a share of their earnings accruing from their business activities to households, through the payment of individual wages. Accordingly, a third method for assessing G.D.P. addresses the aggregate sum of total factor income earned by a given economy’s households and other economic agents in the economy (Sloman, et al.  2012) (Krugman, et al., 2011). 

GDP components

  • G.D.P. = C + G + I + X - M, for a given civil year t         
  1. personal consumer expenditure (C); investments (I); government expenditure (G); and exports (X). Adding these components, and deducting for the amount of imports (I).
  • Nominal G.D.P. measures total production of goods and services throughout the economy in a given year; accordingly, this sub-concept does not take single out the existence of inflation as variations in prices are also incorporated in nominal G.D.P. Real G.D.P. takes into consideration the measurement of G.D.P. using prices that were applicable in a given base year in the past. That is, real G.D.P. could be measured using quantities associated with year t, but using prices associated with year t - n (for example, a measurement of real G.D.P. for 2016 could be estimated using prices associated with, say, the base year of 2000). The essential difference between these two concepts addresses the fact that real G.D.P. effectively captures variations in quantities produced from one year to the following, therefore eliminating increases in nominal G.D.P. that might be attributed to an increase in prices.
  • A major issue associated with the measurement of G.D.P. is related to the fact that the economy also encompasses what might be termed the ‘underground’ economy. This sector essentially consists of undeclared transactions and/or illegal economic transactions (the former address transactions of legally tradable goods in tax-evading circumstances; while the latter addresses transactions of goods and/or services that are themselves illegal). This poses a tremendous problem for national statistical authorities, as G.D.P. might be seriously under-estimated because the ‘underground’ economy is not duly accounted for, thus evading the control of policy makers, tax authorities, and regulators (Sloman, et al., 2012).

Inflation

Inflation reflects the general increase of the overall price level associated with a given economy. Persistent inflation is typically a very noxious economic phenomenon, as it erodes the purchasing power of economic agents. That is, persistent inflation corrodes economic growth and the expenditure outlay of economic agents, as it can greatly reduce the amount of goods and/or services a given amount of income can buy in the market place.

Determinants of national income

There are multiple determinants that might condition the measurement of national income in a given country. These determinants can be comprehensively categorised as follows (Economic Concepts, n.d.):

  • the joint stock of factors of production: may generically be categorised as capital, labour, and land.
  • capital: critically finances economic production and develops a given country’s productive capacity, critically providing financing to these production activities.
  • labour: fundamental as the provider of household income to the economy, and its availability is judged not only in terms of quantity, as well as in terms of its quality.
  • entrepreneurial skillset: skills involve the management of organisational abilities and human relations, the management of intellectual property rights, business strategy, etc.
  • state of technological knowledge: contemporary production methods are quite dependent on technological advances and the management of intellectual knowledge, which becomes a critical ingredient in a business’s transformative production processes.
  • geo-political factors: political stability vastly leverages business activities, as it mitigates the onset of economic uncertainty. If a given country presents a high degree of political stability, then the country’s productive processes can operate without major disruptions, maintaining production levels both in terms of quantity and quality at the highest level. When political instability sets in, national income stands to be affected, through diminished business activity and lesser economic growth.

Circular flow of income

The circular flow of income constitutes a simplified framework for the assessment of the relationship between households and business firms.

A simplified diagram depicting this relationship is presented in Figure 7.

Figure 7. The circular flow of income model.

https://stevenduan.files.wordpress.com/2010/07/circular-flow-model1.gif?w=640

Source: Rookie Economics (n.d.).

  • In the resource market, businesses have to incur in economic costs in order to produce goods and services. These organisational inputs essentially comprise labour, capital, and land (typically the property of households), and are brought by business firms as organisation resources to their corresponding transformative business processes.
  • In the product markets, and once the transformative business leads to the production of the underlying goods and services, business firms sell these wares to households, who consume them as personal consumption expenditures.
  • It should be pointed out that the above-mentioned diagram constitutes a very simplified representation of economic reality, as, for example, the complex role of the financial system is not addressed, as the introduction of credit would excessively complicate the underlying economic analysis.

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