Week 3 – The Macroeconomic environment of business

1. Introduction

This week’s notes will offer an introduction to the macroeconomic environment of business and will review
key macroeconomics variables and how these are connected in shaping the macroeconomic conditions for
business. During this week, you will study how the macroeconomic environment shapes the conditions under
which business operates and you will consider how business contributes to shaping the macroeconomic
conditions. Finally, issues of macroeconomic policy will be considered.

1.1.Topic Learning Outcomes

During this topic you should be able to achieve the following learning outcomes:

LO1. Understand the key determinants of the macroeconomic environment of business

LO2. Understand key macroeconomic concepts, such as growth, unemployment and inflation

LO3. Examine the circular flow of the income model

LO4. Explain the implications for management practice of the macroeconomic environment of business

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2. The Macroeconomic Environment

Macroeconomic analysis is looking at the economy as a whole and is concerned with the analysis of the
aggregate behaviour of whole sectors of the economy. The key economic variables concerning
macroeconomic analysis can be categorised under the following headings (Sloman, et al., 2019):

• economic growth
• unemployment
• inflation
• balance of payments and exchange rates
• sector accounts (income account, financial account, capital account, national balance sheet)
• financial stability

The macroeconomic analysis aims to understand things like, why does an economy grow over time, or what
determines the level of prices in an economy, or what are the drivers of changes in the level of output of an
economy (Rossana, 2011, p. 7).

A country’s economy, as well as the global economy, will be impacted by instability as a result of which these
macroeconomic indicators will fluctuate. The purpose of macroeconomic policy is to ensure that key
macroeconomic variables are at acceptable levels and to create a stable economic environment for the
economy to grow. Let’s look at these macroeconomic variables in more detail.

Economic growth and Gross Domestic Product (GDP)

The Gross Domestic Product (GDP) is the most commonly used indicator in order to be able to measure the
economic growth of the economy. The GDP measures the value of a country’s output (all goods and services
produced in the country) over a given time (Sloman et al., 2019; Farnham, 2014).

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 Measuring National Income and Output: Three ways of measuring GDP

The production method; the income method; the expenditure method.

Source: Landedeld, J.S., Seskin, E.P. & Fraumeni, B.M. (2008)

Economic growth captures the change in an economy’s output over time and the rate of economic growth
measures percentage changes in growth over time. In the short term, it is typical to measure the rate of
economic growth annually (over a period of 12 months) or quarterly (over a period of 3 months). In the longer
term, many economies tend to have positive growth. Also, in the longer term, the economic growth of different
economies tends to differ. This can be demonstrated in Figures 3.1 and 3.2 below. Figure 3.1 shows the world
outlook of the annual economic growth rate, in real GDP and Figure 3.2 shows the real GDP rate of growth
trend from 1980 to 2026 (expected).

Figure 3.1 Economic Growth, Real GDP – World outlook

Source: IMF (2021)

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Figure 3.2 Real GDP Growth trend

Source: IMF (2021)

In the short term, growth may fluctuate, and it may be positive (these are periods of expansion of the economy)
or negative (these are periods of contraction of the economy). When you look at growth statistics, such as
those in Figures 3.1 and 3.2, what you are looking at is actual growth; this is the change in an economy’s
output over time and the rate of economic growth measures percentage changes in growth over time (Sloman
et al., 2019; Farnham, 2014). Potential growth measures the rate at which an economy could grow. In terms
of output, potential growth captures the potential output, in other words, an economy’s capacity to produce
over time. The potential output is the level of output that an economy can produce when the sources of
production are utilised at ‘normal capacity’. In the short term, if actual growth is smaller than potential growth,
then the spare capacity of sources of production is increases. If on the other hand, the actual growth rate is
higher than the potential growth rate, then the spare capacity in sources of production is decreased. The
capacity of an economy to produce (its potential output) may increase if there is an increase in the availability
of the country’s sources of production and/or if these sources of production are used more efficiently (e.g. due
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to technological advancements, skills development, improved organisation, etc.). Differences between actual
and potential output are called output gaps. Figure 3.3 below shows actual and potential GDP growth in the
UK between 2000 and 2019, as well as the growing gap for that period.

Figure 3.3 Actual and potential GDP growth – UK

Source: CFR (2021)

Given a country’s resources, in the long term, the country’s potential growth tends to be steady. A country’s
actual growth, however, may fluctuate and the country may experience booms (high rates of economic
growth) or recessions (low or negative rates of economic growth). The term business cycle captures this cycle
of booms and recessions in the economy of a country. Figure 3.4 below represents the business cycle. At point
1, the economy begins to pick up and resume growth. This phase, where the economy is picking up, represents
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an upturn. Point 2, between 1 and 3, represents the expansion phase. This is a point where the growth of the
economy is rapid, and this represents a boom in the economy. At point 3, the economic growth is starting to
slow or even stop, and this is a point that is peaking out point. Finally, point 4 is a point where the decline in
output is the sharpest. This is a recession or slowdown (Sloman, et al., 2019).

Figure 3.4 The business cycle

Source: Sloman, et al. (2019)

The figure also shows the trend output production over time as well as the full-capacity output, which is the
output that the economy can produce if all sources of production are utilized at full capacity all the time.

In reality, the length of the phases shown in Figure 3.1 above may differ. For example, a recession may last
longer than a boom of the economy or the other way around. Also, the curve may be stepper in some cases

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 and flatter in other cases. This will happen when for example there is a higher rate of growth (or slow down)
in some phase of the cycle (for example this could be point 2 on the left side of the figure) and a lower rate of
growth (or slow down) in a different phase of the cycle (for example this could be point 2 on the right side of
the figure.

As mentioned earlier, the quantity and productivity of the factors of production will impact the potential output
an economy can produce. If the quantity/availability of the factors of production increases, then this may lead
to an increase in potential output. Note that this will depend on the ability to utilise these additional factors of
production as well. For example, there is no benefit in accumulating idle factors of production and this practice
will not lead to the growth of potential output. Also, the potential output will grow if factor productivity
grows. This can happen for example because workers may have the equipment or physical space to utilise
which may increase their productivity. Alternatively, workers may increase their knowledge and skills.
Finally, technological advancements may increase the productivity of labour.

Governments may choose to intervene in order to increase their country’s growth rate and in this direction,
they may pursue two types of policies: demand-side policies or supply-side policies. Demand-side policies
are aimed at achieving higher aggregate demand in order to increase the incentives for producers to invest in
increasing potential output. Supply-side policies on the other hand focus on measures that can increase the
supply of potential output, such as innovation and training or research and development, which will lead to
increased factor productivity. Also, governments may choose to pursue market-oriented policies which are
aimed at creating free-market conditions where the growth potential is the result of the ability of the market
to enjoy the rewards of increasing the growth potential.

3. Unemployment

Fluctuations in the economic business cycle impact the number of people who are at work and those who are
out of work. Unemployment is typically measured either as a number or as a rate. The number unemployed is
defined as “persons at working age who during the reference period are ‘without work’, ‘currently available
for work’ and ‘seeking work’, i.e. taking specific steps to find employments” (Sengenberger, 2011, p. 11).
The rate of unemployment is defined as:

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 𝑁𝑢𝑚𝑏𝑒𝑟 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 =
𝐿𝑎𝑏𝑜𝑢𝑟 𝑓𝑜𝑟𝑐𝑒

where the labour force is the sum of employed and unemployed. Figure 3.5 shows unemployment rate data
between January 2005 and March 2021 across the G20, highlighting unemployment rates in the EU19, U.S.,
UK and Japan.

Figure 3.5 Unemployment rate, G20

Source: OECD (2021a)

Note that in the definition of unemployment (number or rate) in order to count as unemployed, someone has
to be actively seeking a job. Another measure often used to capture unemployment is claimant unemployment.
Claimant unemployment “is a count of the number of people who claim unemployment-related benefits”

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(Clancy & Stam, 2010, p. 21). As Figure 3.6, which captures unemployment and claimant unemployment
numbers in the U.S. between 1980 and 2010, demonstrates, these two numbers can be distinctly different.

Figure 3.6 Unemployment and claimant unemployment in the U.S. between 1980 and 2010

Source: Clancy & Stam (2010)

Another measure that captures unemployment is the unemployment-to-population. According to the ILO
(2015) Key Indicators of the Labour Market (KILM), “the employment-to-population ratio is defined as the
proportion of a country’s working-age population that is employed”. What these different measures of
unemployment demonstrate is that one would have to be careful when comparing unemployment statistics, in
order to make sure that the statistics are measuring the same thing. In order to be able to compare
unemployment across countries and over time, the standardised unemployment rate is used, which is the
measure of the unemployment rate as defined and used by the ILO and the OECD (Sloman et al., 2019).

The duration of unemployment measures the number of weeks that an individual is without work and seeking
work (Rossana, 2011). The long-term unemployment rate captures the rate of individuals who have been
unemployed for 12 months or more (OECD, 2021). Figure 3.7 shows the countries with the highest long-term
unemployment rates based on 2019 or the latest data.

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Figure 3.7 Long-term unemployment rates

Source: OECD (2021b)

Unemployment is costly to the unemployed themselves, who are earning lower-income (unemployment
benefits) than they were earning when they were in employment. Also, there is a psychological and social
impact of being unemployed. Also, families and friends may experience the negative impact of unemployment
either as a loss in income (e.g. for the family) or as a negative impact on personal relationships. In addition,
unemployment has a cost to society and the economy at large. Firstly, unemployment benefits are costly, and
they are paid through taxpayers’ money. In addition, unemployment represents a loss of output that is not
produced by workers who are out of work (Sloman et al., 2019).

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Unemployment is largely impacted by the business cycle. In times of recession unemployment rates tend to
be higher and in times of boom unemployment rates tend to be lower.

Unemployment can be classified into two types: equilibrium unemployment and disequilibrium
unemployment. Employment and unemployment are determined by the aggregate demand for and aggregate
supply of labour. Figure 3.8 shows the aggregate demand for the labour curve (𝐴𝐷𝐿 ) and the aggregate supply
of labour curve (𝐴𝑆𝐿 ). The aggregate demand curve shows the number of jobs seeking to be filled at each
wage rate. The curve slopes downward because the higher the wage rate, the fewer jobs will seek to be filled.
The aggregate supply curve shows the number of individuals who will accept jobs at each wage rate. This
curve slopes upward because the higher the wage rate, the more individuals will be willing to accept jobs. The
left side of Figure 3.8 shows that the market for labour will be in equilibrium at the wage rate 𝑊𝑒 , where
demand for labour equals the supply of labour. If the wage rate is 𝑊1 , then the aggregate supply of labour will
exceed aggregate demand for labour by A-B, and the labour market will be characterised by disequilibrium
unemployment. Disequilibrium unemployment may be the result of real wages being higher than the market-
clearing (equilibrium level). This can be an outcome of trade union power for example. Disequilibrium
unemployment may be associated with recessions and lower output. This type of unemployment is
characterised as demand-deficient or cyclical unemployment. Also, disequilibrium unemployment may be
due to an increase in the supply of labour with no corresponding increase in the demand for labour. As supply
for labour changes relatively slowly and the wage rate usually adjusts to take account of the increase in the
supply of labour, this cause of disequilibrium unemployment is usually less concerning.

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Figure 3.8 Equilibrium and disequilibrium unemployment

Source: Sloman et al. (2019)

The N curve on the right side of Figure 3.8 represents total labour. Even in equilibrium, there will be some
individuals who will not be in employment. The excess supply of labour between points D and E on the right
side of Figure 3.8 is called equilibrium unemployment. Disequilibrium unemployment is classified in two
types: frictional unemployment and structural unemployment.

Frictional (search) unemployment is related to the information asymmetries and the time it takes to match a
worker to a job. For example, someone seeking a job may not know that a job is available, or they may not
have all the information about a job posted. Also, time will pass from the point when someone applies for a
job until the point when someone is appointed to this job.

Structural unemployment is a result of the changing structure of the economy. Reasons that may generate a
change in the structure of the economy are changing patterns of demand, technological advancements (for
example where the technology may replace workers at completing certain tasks), regional unemployment, and
seasonal unemployment (for example where certain industries are subject to a seasonal cycle).

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4. Inflation

Inflation is “an increase in the level of all prices in the economy” (Rossana, 2011, p. 46) and deflation is a
decrease in the level of all prices in the economy. In order to create a stable business environment,
governments wish to keep inflation low and stable. The inflation rate measures the percentage increase in
prices over a certain period, typically a 12-month period. According to the OEDC (2021c) the Consumer Price
Index (CPI) is a measure that captures “the change in prices of a basket of goods and services that are typically
purchased by specific groups of households”. These groups of households are representative households and
the basket of goods includes food, energy and total (excluding food and energy). Figure 3.9 shows the inflation
forecast in terms of the CPI in G20 countries.

Figure 3.9 CPI forecast Q4 2019 – Q4 2022

Source: (OECD, 2021d)

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Another measure used to capture inflation is the GDP deflator, which is “the price index of all final
domestically produced goods and services” (Sloman et al., 2019, p. 520). In other words, this is a price index
that takes account of all goods and services that contribute to the country’s GDP.

The level of prices in a country is determined by aggregate demand and aggregate supply of goods and services
in the economy of the country. Figure 3.10 demonstrates the aggregate demand and aggregate supply of the
economy. The aggregate demand curve represents the level of output (GDP) that is demanded at different
price levels, and since output demanded is higher as the price level increases, this curve slopes downwards.
The aggregate supply curve represents the level of output (GDP) that is supplied at different price levels, and
since more output will be produced as the price level increased, this curve slopes upwards. The equilibrium
price level is at the point where aggregate demand equals aggregate supply at 𝑃𝑒 . If aggregate supply exceeded
aggregate demand, which is the case at a price level 𝑃2 , then the price level would rise until 𝑃𝑒 where aggregate
demand equals aggregate supply.

Figure 3.10 Aggregate demand and aggregate supply

Source: Sloman et al. (2019)

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 Keep in mind that this analysis is done at the country/economy level, not at the market level or the firm level.
What this means is that in the short run, the economy will be slower to adjust than a single market or a single
firm. For example, in the short run, certain factors of production may be fixed (e.g. production technologies
may be fixed). If technology changes in the short run, for example, if technology makes production more
efficient, then the aggregate supply curve will shift (jump) out (to the right) and a new equilibrium price level
will emerge at the point where aggregate demand equals aggregate supply.

According to Sloman et al. (2019), if firms can pass any increases in prices to consumers and if workers’
wages keep up with inflation, then inflation should have a relatively very low cost. But in reality, people
cannot adjust to increases in the price level so quickly. This is because it is difficult to predict inflation. Also,
some will have less bargaining power, for example, to negotiate a wage rate that keeps up with inflation. As
a result, some individuals will suffer more from increases in the price level and others may benefit. Also,
inflation causes business uncertainty, especially if the price level fluctuates. In this case, it is difficult for firms
to predict the cost of the factors of production and the price of their goods/services and this may create
disincentives for investment and impact economic growth. Also, a higher price level for domestic products
creates an imbalance of payments, as imported products become less expensive than domestic products and
domestic products become more competitive in the international market.

According to Oner (2010), inflation can be caused by shocks on aggregate supply or aggregate demand. For
example, a natural disaster that may impact the availability of factors of production may result in a significant
reduction of the overall supply of output, which will result in an increase of the price level. This is called cost-
push inflation. Similarly, if a government decides to follow expansionary policies, but production capacity is
not sufficient to follow this expansion, causing a strain on resources, then this will result in an increase of the
price level. This is called demand-pull inflation. Finally, according to Oner (2010), expectations can drive
inflation, if people expect that the price level will increase.

5. Business cycle and key macroeconomic objectives

A country’s macroeconomic policy will aim at things like low unemployment, low and stable inflation, high
and stable economic growth, avoiding balance of payment deficits and exchange rate fluctuations, to name a
few. These macroeconomic objectives may be conflicting as Figure 3.11 demonstrates. For example, point 3,
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 which is a peaking out point, may be associated with high output and low unemployment is low, but it may
also be associated with high inflation and a current account deficit. Similarly, point 1, which represents an
upturn of the economy, may be associated with low inflation and a current account surplus, but also with low
output and high unemployment. It is very important to be able to understand these policies objectives and the
consequences of pursuing them.

Figure 3.11 The business cycle and macroeconomics objectives

Source: Sloman et al. (2019)

6. The circular flow of income

The circular flow of income model offers a useful tool to understand the interaction between individuals and
businesses and how this interaction affects the macroeconomy and macroeconomic outcomes Marks &
Kotula, 2009; Daraban, 2010). Figure 3.12 demonstrates the circular flow of the income model. In this model,

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individuals are consumers of goods and services and they are suppliers of labour and other factors of
production as well. Businesses on the other hand are producers of goods and services and they are employers
of labour and other factors of production as well. As Figure 3.12 demonstrates, income flows from businesses
to individuals in the form of wages and other factor payments and from individuals to businesses in the form
of payments for the consumption of goods and services. Also, income may be withdrawn from the economy,
in the form of savings, taxes or import expenditure (money spent on imported goods) or it may be injected
into the economy in the form of government expenditure, investment or export expenditure (income earned
from selling domestic goods and products abroad).

Figure 3.12 The circular flow model

Source: Sloman et al. (2019)

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Injections and withdrawals may be linked, in that for example, savings may be invested, government
expenditure will come from taxes and imports and exports will be linked, but savings will not necessarily
equal investment, and the same will be the case with government expenditure and taxes and import and export
expenditure. What this means is that withdrawals will not necessarily equal injections and when that is the
case, then the economy is in disequilibrium. A disequilibrium between injections and withdrawals will impact
macroeconomic variables through aggregate demand and aggregate supply.

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References

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