Welcome to Macroeconomics: The Big Picture!

In this chapter, we explore how aggregate economic activity is determined and how fluctuations in activity affect unemployment, inflation, and the business cycle. Understanding these aggregate dynamics is vital for actuaries because shifts in economic activity directly drive interest rates, asset valuations, claims frequency, and investment returns.

1. Determining Business Activity: The Aggregate Demand–Expenditure Model

At the macroeconomic level, total business activity is reflected in national output and income ( \( Y \)). In the simple Keynesian aggregate demand–expenditure model, planned expenditure ( \( E \)) determines the equilibrium level of national income.

A. Components of Aggregate Expenditure

Aggregate planned expenditure consists of four main sectors:

\( E = C + I + G + (X - M) \)

  • Consumption (\( C \)): Household spending on domestic goods and services. A key driver is disposable income ( \( Y_d \)), where \( C = a + b Y_d \), with \( a \) representing autonomous consumption and \( b \) representing the Marginal Propensity to Consume (MPC).
  • Investment (\( I \)): Capital expenditure by firms on plant, machinery, and inventories.
  • Government Spending (\( G \)): Public spending on infrastructure, services, and public sector operations.
  • Net Exports (\( X - M \)): Export demand from abroad minus domestic spending on imports.

B. Equilibrium National Income

Equilibrium in the goods market occurs where actual output and income equal aggregate planned expenditure:

\( Y = E \)

Equivalently, equilibrium can be expressed through the circular flow of income as the balance between total Injections (\( J \)) and total Withdrawals (\( W \)):

\( I + G + X = S + T + M \)

Where \( S \) is savings, \( T \) is net taxation, and \( M \) is imports. If planned injections exceed planned withdrawals (\( J > W \)), unintended inventory decumulation causes firms to expand output and employment until \( Y \) rises to equilibrium.

2. The Concept and Calculation of the Multiplier

An initial autonomous change in expenditure (such as a rise in private investment or government spending) generates a larger final change in equilibrium national income. This phenomenon is known as the multiplier effect.

A. How the Multiplier Works

When autonomous expenditure increases by \( \Delta J \), firms pay out that expenditure as wages, rent, and profits. Households receive this income and spend a fraction of it domestically while leaking the rest into savings, taxes, and imports. That spent fraction becomes income for other producers, setting off successive rounds of expenditure.

B. Calculating the Multiplier

The size of the multiplier (\( k \)) depends on the Marginal Propensity to Withdraw (MPW), which is the sum of the marginal propensities to save (\( MPS \)), tax (\( MPT \)), and import (\( MPM \)):

\( MPW = MPS + MPT + MPM \)

Since any additional income is either spent domestically on domestic goods (\( MPC_d \)) or withdrawn, we have \( MPC_d + MPW = 1 \), giving the multiplier formulas:

\( k = \frac{\Delta Y}{\Delta J} = \frac{1}{1 - MPC_d} = \frac{1}{MPW} \)

Example: If \( MPS = 0.15 \), \( MPT = 0.20 \), and \( MPM = 0.15 \), then \( MPW = 0.15 + 0.20 + 0.15 = 0.50 \). The multiplier is \( k = \frac{1}{0.50} = 2.0 \). An autonomous rise in investment of £100 million leads to a total rise in equilibrium national income of \( 2.0 \times £100\text{m} = £200\text{m} \).

3. The Impact of a Rise in the Money Supply on Output and Prices

The level of business activity is also heavily influenced by monetary conditions. An increase in the money supply impacts the economy through the monetary transmission mechanism:

  • Short-Run Impact: When the central bank expands the money supply, commercial bank liquidity increases and interest rates fall. Lower interest rates reduce the cost of borrowing for firms and households, increasing planned investment (\( I \)) and consumption (\( C \)). Aggregate Demand shifts to the right, causing real output and business activity to expand while exerting modest upward pressure on the price level.
  • Long-Run Impact: Over time, as firms compete for scarce factors of production (labour and raw materials), nominal wages and input costs rise, shifting Short-Run Aggregate Supply (SRAS) to the left. If the economy was already operating near potential capacity, real output returns to its natural level, and the sustained consequence of the higher money supply is purely a higher price level (inflation).

4. Unemployment and Inflation: Is the Relationship Stable?

Historically, macroeconomists observed an inverse empirical relationship between unemployment and wage inflation, known as the Phillips Curve.

A. The Traditional Short-Run Phillips Curve (SRPC)

When business activity is high, labour markets tighten. Employers compete for workers by bidding up nominal wages, and firms pass on higher wage costs as higher consumer prices. Conversely, during economic downturns, high unemployment tempers wage demands. This implied that governments could choose a policy trade-off: lower unemployment at the cost of higher inflation, or lower inflation at the cost of higher unemployment.

B. The Breakdown and the Long-Run Phillips Curve (LRPC)

During the 1970s, economies experienced stagflation (simultaneous high unemployment and high inflation), demonstrating that the original Phillips Curve is not stable. Milton Friedman and Edmund Phelps showed that the position of the Short-Run Phillips Curve depends on inflation expectations:

  • Adaptive Expectations: Workers form expectations of future inflation based on past inflation rates. If the government stimulates AD to push unemployment below its natural level, inflation rises. Workers gradually realise their real wages have fallen and demand higher nominal wages, shifting the SRPC upwards and returning unemployment to its original level.
  • Rational Expectations: Under the rational expectations hypothesis, economic agents use all available information, including anticipated government policies. Unanticipated monetary stimulus may have temporary real effects, but anticipated stimulus is immediately factored into wage and price demands, having no lasting impact on real output or unemployment even in the short run.

Consequently, the Long-Run Phillips Curve (LRPC) is vertical at the Natural Rate of Unemployment (or NAIRU — Non-Accelerating Inflation Rate of Unemployment). There is no permanent trade-off between unemployment and inflation.

5. Independent Central Banks and Inflation Targeting

Because governments face short-term electoral incentives to boost output before elections (creating an inflationary bias), modern macroeconomics emphasizes delegating monetary policy to an independent central bank operating under an inflation target.

  • Credibility and Expectations: An independent central bank with a clear, credible inflation target anchors public inflation expectations. When businesses and workers expect inflation to stay at target, wage and price setters do not build excessive inflation premiums into contracts.
  • Impact on Unemployment and Business Cycles: By anchoring expectations, inflation targeting smooths the boom-bust cycle. Monetary policy responds counter-cyclically (raising interest rates when output exceeds potential to prevent demand-pull inflation, and cutting rates during downturns to support activity). While central banks cannot lower unemployment below its natural rate in the long run, stable inflation provides certainty that promotes long-term business investment and sustainable economic growth.

6. The Business Cycle: Turning Points and Causes

Real economies do not grow along a smooth trend path. Instead, they experience regular fluctuations in economic activity known as the business cycle.

A. The Four Phases of the Business Cycle

  • Upturn / Recovery: Output begins expanding, spare capacity decreases, and confidence improves.
  • Boom / Peak: Real GDP grows faster than potential capacity, unemployment reaches cyclical lows, and inflationary pressures emerge.
  • Downturn / Slowdown: Growth decelerates; output growth falls below trend or contracts into recession.
  • Trough: Activity hits its lowest point, spare capacity and cyclical unemployment are at their peak, setting the stage for renewed recovery.

B. Turning Points

Turning points occur because economic expansions and contractions contain self-reversing mechanisms:

  • Upper Turning Point (Boom to Downturn): As the economy hits resource constraints (capacity ceilings), costs rise, interest rates increase (via central bank tightening), and the accelerator effect leads to cuts in capital investment as demand growth slows down. High consumer debt and inventory buildup prompt firms to trim orders.
  • Lower Turning Point (Trough to Recovery): Physical capital and consumer durables eventually wear out and must be replaced, forming an investment "floor." Lower interest rates and reduced asset prices eventually make investment attractive again, restoring business activity.

C. Causes: Aggregate Demand, Aggregate Supply, or Both?

Economists debate whether business cycle fluctuations originate on the demand side or the supply side:

  • Aggregate Demand Shocks: Keynesian and Monetarist models emphasize demand-side shocks, such as sudden shifts in consumer/business confidence (animal spirits), changes in government policy, or monetary volatility.
  • Aggregate Supply Shocks: Real Business Cycle (RBC) and classical theorists argue cycles are driven by structural supply-side shocks, including technological innovations, changes in global energy/commodity prices, or supply chain disruptions.
  • Modern Synthesis: In practice, business cycles are caused by both demand and supply shocks. A supply shock (e.g., an oil price spike) raises costs and reduces real disposable incomes, which in turn triggers a demand contraction and alters inflation and unemployment dynamics.

7. Summary of Key Terms for Actuaries

Equilibrium Income (\( Y = E \)): The level of national income where planned expenditure equals actual output, or equivalently, planned injections equal planned withdrawals (\( I+G+X = S+T+M \)).
Multiplier (\( k \)): The ratio of change in equilibrium income to an autonomous change in injections, calculated as \( k = 1 / MPW \).
Phillips Curve: The short-run inverse trade-off between unemployment and inflation; unstable in the long run because changes in expected inflation shift the curve.
Natural Rate of Unemployment (NAIRU): The equilibrium unemployment rate where inflation remains stable, representing the vertical Long-Run Phillips Curve.
Inflation Targeting: A framework where an independent central bank uses interest rate policy to anchor inflation expectations, stabilizing output around its potential level.