📄 IB Economics HL Unit 3 Macroeconomics — complete detailed revision guide

Three approaches to measuring GDP (all give same result)

• Expenditure approach — sum all spending on final goods/services: C + I + G + (X − M)
• Income approach — sum all incomes earned in production (wages + rent + interest + profit)
• Output/Value-added approach — sum value added at each stage of production (avoids double-counting)

C = household consumption, I = investment, G = government spending, X = exports, M = imports

Limitations of GDP as a measure of living standards evaluation essential

• Ignores income distribution — GDP can rise while inequality worsens
• Does not capture non-market activity (household work, volunteering, subsistence farming)
• Ignores negative externalities (pollution, environmental degradation included as positive if clean-up is paid for)
• Ignores informal/shadow economy (especially large in developing countries)
• No account of leisure time, working hours, or work-life balance
• Ignores qualitative factors: security, political freedom, happiness, health

Alternative indicators: HDI (Human Development Index — GDP per capita + life expectancy + education), Happy Planet Index, Genuine Progress Indicator, OECD Better Life Index

Business (trade) cycle diagram

• Peak (boom) — near/above potential output; high AD, low unemployment, inflationary pressure
• Recession — two consecutive quarters of negative real GDP growth; rising unemployment, falling AD
• Trough — lowest point; maximum unemployment, deflationary pressures
• Recovery (expansion) — rising GDP, falling unemployment, growing AD
• Trend growth line shows long-run potential output; short-run fluctuates around it
• Output gaps: positive gap (above potential = inflationary); negative gap (below potential = deflationary/recessionary)

Output gaps

Aggregate Demand (AD)

Total planned expenditure on final goods and services at each price level: AD = C + I + G + (X − M)

AD curve is downward sloping: at a lower price level, real wealth rises, interest rates fall, exports become cheaper → Qd rises.

Aggregate Supply — two models crucial distinction

Shifts of SRAS

• Changes in input/factor prices (wages, raw materials, oil — key!)
• Changes in indirect taxes or subsidies on producers
• Improvements in productivity or technology
• Supply shocks (e.g. oil price spike 1973 → SRAS left; COVID supply chains → SRAS left)
• Changes in exchange rates affecting import costs

Shifts of LRAS (= changes in productive capacity)

• Improvements in quantity or quality of factors of production
• Technological advances
• Improvements in education and training (human capital)
• Better infrastructure
• Immigration increasing the labour force
• Discovery of new resources

LRAS shift right = long-run economic growth = outward PPC shift. These are the goals of supply-side policies.

Macroeconomic equilibrium scenarios (must be able to draw all)

• Full employment equilibrium: AD intersects SRAS at LRAS — no output gap
• Inflationary gap: AD intersects SRAS to the right of LRAS — output above potential, price level rising
• Deflationary / recessionary gap: AD intersects SRAS to the left of LRAS — output below potential, unemployment above NRU
• Stagflation: SRAS shifts left (supply shock) — both higher price level AND lower output simultaneously (classic 1973 oil crisis)

Economic growth

• Actual growth — movement from inside PPC to on it (reducing unemployment of resources)
• Potential growth — outward PPC shift; rightward LRAS shift (increase in productive capacity)
• Benefits: rising living standards, employment, tax revenue, reduced poverty
• Costs/limitations: environmental degradation, inequality, inflation, unsustainability
• Sustainable growth: meeting present needs without compromising future generations' ability to do so

Unemployment — types & causes

Natural Rate of Unemployment (NRU) — rate of unemployment when economy is at full employment / potential output. Includes frictional + structural + seasonal. Does NOT include cyclical. Monetarists argue it cannot be permanently reduced below NRU using demand-side policy — only supply-side can lower it.

NAIRU (Non-Accelerating Inflation Rate of Unemployment) — Keynesian equivalent of NRU; the unemployment rate consistent with stable (non-accelerating) inflation.

Costs of unemployment evaluate

Inflation — types, causes & measurement

• Inflation — sustained rise in the general price level (CPI). Measured by CPI (basket of goods), also PPI, GDP deflator.
• Demand-pull inflation — caused by a rightward shift of AD (too much money chasing too few goods). Shown: AD shifts right, price level rises alongside real GDP.
• Cost-push inflation — caused by a leftward shift of SRAS (rising input costs). Shown: SRAS shifts left, price level rises BUT real GDP falls (stagflation risk).
• Built-in (wage-price spiral) — higher prices → workers demand higher wages → higher costs → higher prices again
• Disinflation — inflation rate is falling (still positive)
• Deflation — general price level falling. Can be harmful: consumers delay purchases, debt burden rises in real terms, negative spiral
• Hyperinflation — extremely rapid price rise (e.g. Zimbabwe 2008, Weimar Germany 1923)

HL — weighted CPI: Each item in the basket has a weight reflecting its share of typical household spending. Weighted price index = Σ(weight × price relative). Know how to calculate this from data.

Costs of inflation evaluate

Phillips Curve HL: SRPC & LRPC diagram

The Phillips curve shows the empirical trade-off between inflation and unemployment.

• Short-run Phillips Curve (SRPC) — downward sloping. As unemployment falls (AD rises), inflation rises. Policy can move along the curve.
• Long-run Phillips Curve (LRPC) HL — vertical at the NRU/NAIRU. In the long run, attempting to reduce unemployment below NRU via expansionary policy only raises inflation permanently; unemployment returns to NRU.
• Stagflation shifts the SRPC right — a supply shock (e.g. oil price spike 1973) moved economies to both higher inflation AND higher unemployment simultaneously, shifting the SRPC outward.
• Friedman & Phelps (1968): only unexpected inflation temporarily lowers unemployment. Once workers adjust expectations, economy returns to NRU.
• NAIRU: Keynesian version — rate of unemployment below which inflation accelerates. Reduces pressure on policymakers to push unemployment too low.

Measuring income inequality

• Lorenz curve — plots cumulative % of income against cumulative % of population (ranked lowest to highest). The 45° line = perfect equality. The further the curve bows below the 45° line, the greater the inequality.
• Gini coefficient = Area A / (Area A + Area B), where A is between the 45° line and the Lorenz curve. Ranges 0 (perfect equality) to 1 (perfect inequality). Sometimes expressed as 0–100 (Gini index).
• HL: construct Lorenz curve from quintile data — plot five points: bottom 20%, bottom 40%, etc., and their cumulative income shares.
• Limitations of Gini: two countries can have same Gini but different patterns of inequality; doesn't capture wealth inequality separately; ignores non-income sources of wellbeing.

Absolute vs relative poverty

Causes of income inequality

• Unequal ownership of factors of production (especially capital/land)
• Unequal human capital (education, skills) → wage differences
• Technological change favouring skilled workers (skill-biased technological change)
• Globalisation — labour in high-wage countries may lose jobs to lower-wage countries
• Gender and discrimination in labour markets
• Regressive taxation / weak social safety net
• Inheritance of wealth — intergenerational inequality
• Kuznets curve hypothesis: inequality first rises then falls as countries develop (inverted U-shape between income and inequality) — empirically contested

Consequences of inequality

• Reduced social mobility; poverty trap
• Worse health outcomes, higher crime, lower social cohesion
• Reduced aggregate demand (wealthy save more; high MPS at top)
• Political instability; erosion of democratic institutions
• Some inequality is argued to incentivise innovation and effort (efficiency argument)

Policies to reduce inequality and poverty

• Progressive taxation — higher earners pay larger proportion of income. Reduces inequality but may reduce work incentives. HL: calculate from tax data
• Transfer payments — benefits (unemployment, housing, child benefits) redistribute income. Risk of welfare dependency.
• Minimum wage — raises floor of income for lowest earners. Risk: unemployment if set too high.
• Government provision of merit goods — free/subsidised education and healthcare reduces inequality of opportunity
• Universal Basic Income (UBI) — unconditional payment to all citizens. Expensive; debated.
• Wealth taxes / inheritance taxes — target wealth concentration directly

Evaluation: Equity-efficiency trade-off — policies reducing inequality may reduce incentives and productive efficiency. Key tension in macroeconomic policy design.

Tax structures HL calculation

• Progressive tax — marginal tax rate rises with income (higher earners pay larger % of income). Reduces inequality.
• Regressive tax — takes a larger % of income from lower earners (e.g. indirect taxes like VAT — everyone pays same £, but it's a higher % of a poorer person's income)
• Proportional (flat) tax — same % of income regardless of level
• HL: Given data on income and tax paid, calculate average tax rate = tax paid / income. If average tax rate rises with income → progressive. Falls → regressive.

Tools of monetary policy

Limitations of monetary policy evaluation

• Liquidity trap — when interest rates are already near zero, further cuts have little effect (Japan 1990s–2010s; Europe post-2008). Investment may not respond to lower rates if confidence is very low.
• Time lags — policy takes 12–24 months to fully feed through to the economy
• Uncertain MPC — households may save rate cuts rather than spend (especially if indebted or uncertain about future)
• Effectiveness against cost-push inflation — raising interest rates to fight cost-push inflation also reduces output (worsens recession)
• Central bank independence — credibility and inflation targeting (e.g. 2% target) helps anchor expectations; lack of credibility reduces effectiveness
• In very open economies, exchange rate effects dominate over interest rate transmission

Inflation targeting

Most central banks (Bank of England, ECB, US Fed) use an inflation target (typically 2%) as a nominal anchor. Transparent communication of targets helps anchor expectations and adds credibility. When actual inflation exceeds target, contractionary policy is used; below target → expansionary.

Keynesian multiplier HL calculation formula

An initial injection into the circular flow leads to a proportionately larger increase in national income, because each round of spending becomes income for someone else, part of which is re-spent.

MPC = marginal propensity to consume. MPS = save. MPT = taxed. MPM = import. MPC + MPW = 1. Higher MPC (or lower MPW) → larger multiplier. Multiplier is larger in a closed economy with no taxes.

Worked example: MPC = 0.6 → k = 1/(1−0.6) = 2.5. Government spends $1bn → national income rises by $2.5bn.

Automatic stabilisers

Built-in fiscal mechanisms that automatically expand/contract with the economic cycle — without new legislation.

• In recession: tax revenues fall automatically (less income/profit); unemployment benefits rise → government spending rises → net stimulatory effect on AD
• In boom: tax revenues rise; welfare spending falls → net contractionary effect
• More powerful in countries with progressive tax systems and generous welfare states
• Help smooth the business cycle without discretionary policy lags

Budget balance, deficits & debt HL fine print

• Budget deficit — government spending > tax revenues in one year. Leads to government borrowing.
• Budget surplus — tax revenues > government spending. Allows debt repayment.
• Government (national) debt — accumulated sum of all past deficits (minus surpluses). Measured as % of GDP.
• Debt sustainability — concerns arise when debt/GDP is high: rising interest payments, risk of credit rating downgrade, crowding out private investment, future tax burden
• Cyclical deficit — caused by the business cycle (automatic stabilisers). Structural deficit — exists even at full employment; more concerning.
• Keynesian view: deficit spending is justified in recessions; will be repaid in booms. Monetarist view: deficit spending crowds out private investment and causes inflation.

Limitations of fiscal policy evaluation

• Time lags — recognition lag (diagnosing the problem), decision lag (political process), implementation lag (spending takes time to enter economy)
• Crowding out — government borrowing raises interest rates, reducing private investment
• Political constraints — expansionary policy is politically easier than contractionary; deficit bias
• Multiplier uncertainty — actual multiplier may be smaller than estimated if leakages are high (high MPM in open economies)
• Ricardian equivalence HL — if consumers anticipate future tax rises to repay deficits, they save now → fiscal stimulus is offset
• Rising national debt constrains future policy options

Effects of supply-side policies on AD/AS diagram

Successful supply-side policies shift LRAS (and SRAS) to the right: potential output rises. This allows the economy to grow without inflationary pressure (unlike demand-side which may be inflationary). The price level may fall or stay stable while real GDP rises.

This is why supply-side policies are considered the cure for structural unemployment and sustainable long-run growth — but they take a long time (especially education).

Evaluation of supply-side policies exam essential

• Time lags — especially education and infrastructure; benefits may take decades
• Equity concerns — market-oriented policies (tax cuts, deregulation) may widen inequality
• Cost — interventionist policies require significant government spending
• Labour market flexibility vs worker protection — weaker unions may reduce wages and job security
• Effectiveness of privatisation — natural monopolies may need regulation; efficiency gains not guaranteed
• Complementarity: supply-side works best alongside demand-side (e.g. AD expansion + LRAS growth avoids inflation)

Growth vs inflation

Expansionary policy boosts growth and reduces unemployment but increases inflationary pressure as the economy approaches potential output (AD rises → price level rises). The closer to full employment, the steeper the SRAS curve.

Unemployment vs inflation (Phillips curve)

In the short run there is a trade-off: reducing unemployment via expansionary AD policy raises inflation (SRPC). However, the LRPC is vertical — in the long run, attempts to push unemployment permanently below NRU only generate higher inflation, not lower unemployment.

Growth vs equity

Economic growth does not automatically reduce inequality. Growth may disproportionately benefit capital owners (who own most assets). However, growth increases the tax base and funds redistributive spending. Kuznets curve suggests inequality first rises then falls with development.

Growth vs sustainability / environment

GDP growth driven by resource use may increase pollution, carbon emissions, and environmental degradation. The key concept of sustainability (one of IB's nine key concepts) asks whether current growth compromises future generations' ability to meet their needs. Green growth / circular economy approaches aim to decouple growth from environmental damage.

Fiscal policy vs monetary policy comparison

Government debt sustainability HL fine print

• Debt/GDP ratio is the key measure — a rising ratio signals unsustainability
• Concerns: rising interest payments crowd out other spending; credit rating downgrades raise borrowing costs; IMF/creditor conditions may be imposed
• A deficit is sustainable if economic growth rate > interest rate on debt (Domar condition)
• Austerity (fiscal consolidation) risks: cutting G reduces AD → recession deepens → tax revenues fall further → paradox of thrift applies to governments