Macroeconomics and macroeconomic policy
Macroeconomics and macroeconomic policy
This domain tests national income accounting, aggregate demand and supply, the transmission of policy, and the constraints that stop stimulus from working as intended.
Core rules
- GDP by expenditure is C + I + G + (X − M). Real GDP strips out price changes; GNP adds net factor income from abroad; transfer payments and second-hand sales are excluded.
- Aggregate demand slopes down through wealth, interest-rate and net-export effects. Short-run aggregate supply slopes up because wages and prices are sticky; long-run supply is vertical at potential output.
- The multiplier with a proportional tax rate t is 1/(1 − c(1 − t)).
- Inflation is demand-pull or cost-push. The short-run Phillips curve offers a trade-off; the long-run curve is vertical at the NAIRU.
- Monetary transmission runs through market rates, asset prices, expectations and the exchange rate, with long and variable lags.
- Fiscal policy works through automatic stabilisers and discretionary measures; crowding out and Ricardian equivalence blunt it. Debt sustainability depends on whether r exceeds g.
- In a liquidity trap, conventional easing fails and quantitative easing is used instead.
Worked example
With c = 0.8 and t = 0.25, the multiplier is 1/(1 − 0.8 × 0.75) = 1/0.4 = 2.5. A £10bn rise in government spending raises equilibrium output by £25bn, assuming spare capacity and no crowding out. If the economy is already at potential, the effect falls mainly on the price level.
Traps
- Counting transfer payments in GDP.
- Applying the full multiplier when the economy is supply-constrained.
- Confusing a one-off rise in the price level with a sustained inflation rate.
- Mixing fiscal instruments with monetary ones.
- Ignoring lags and expectations in policy evaluation.