2.0 Flashcards
Output gap
Output gap is to do when we are not at long run economic equilibrium
What happens if real GDP is above full employment level
We say there is a inflationary gap or a positive output gap
What happens if real gdp is below full employment level
We say there is a deflationary gap or a negative output gap
What is a business cycle
An economic cycle or business cycle is the natural variation in economic activity (real GDP) over time
What is a full business cycle composed of ?
Recession,recovery, boom and slowdown phase
What is a recession ?
It is a fall of real GDP accompanied by unemployment. A recession is defined in the UK as two quarters of falling real GDP. A deep recession would be a situation where actual output remains below potential output for servers quarters.
What is the recovery phase
The economy is still in a negative output gap but real GDP is steadily rising and unemployment may start to go down
What is a “boom”?
Actual output is above potential output. Real GDP is increasing at a faster rate than the trend rate of growth. The price level tends to rise rapidly (inflation)
What is the “slowdown phase”
There is still a positive output gap but it is shrinking as the growth rate of real GDP starts to fall
What is short run economic growth ?
Short run economic growth is an increase in real GDP of an economy at a given period of time, using current resources and technology.
Short run economic growth is actual economic growth.
Short run equilibrium real GDP can increase due to an increase in either aggregate demand or short run aggregate supply.
What is long run economic growth
Increase in an economy’s potential level of real output over time (an increase in the productive capacity of an economy)
Causes of long run economic growth
Anything which increase the quantity or quality of factors of production will increase long run aggregate supply
Meaning of productivity
Output per unit of factor input in a given period of time.
What is infrastructure
This is the large scale capital that is necessary for economic activity to take place
The majority of large scale capital is funded/provided by the government
Meaning of institutions
This refers to the established system of rules which facilitate socio-economic interactions
Characteristics of a highly efficient institution
-a stable and democratic political system
-a well functioning legal system
-free press
-developed welfare systems
- effective institution means that firms are more likely to undertake investment and entrepreneurs are more likely to take a risk to make a profit. This leads to an increase in the productive capacity over time
Benefits of economic growth
higher employment
Higher living standards
Increased tax revenue
Multiplier and accelerator effect
Increased business confidence
Greater opportunity for the government to redistribute income
Costs of economic growth
Growth might become unsustainable
Rising income and wealth inequality
Growth and happiness
Higher employment - economic growth
Economic growth will lead to an increase in employment as firms demand more labour to produce goods and services
However, may not be true because growth might come from increased capital, higher productivity, increased mobility of labour
Higher living standards - economic growth
Economic growth leads to higher employment which leads to higher income for households, which leads to a higher consumption of goods and services. If there is an increase in real gdp we can say there is a higher standard of living.
Increased tax revenue (economic growth)
Economic growth has a positive effect on government finances, there will be higher tax revenue generated and less money spent on benefit payments. If this extra revenue is spent on education, health or infrastructure then this can also increase output
Multiplier and accelerator effects - economic growth
Economic growth encourages investment in capital by firms (accelerator) and the increased investment can lead to further multiplier effects on national income. If increased investment increase the quantity and/or quality of capital then this will increase LRAS and further enhance growth
Increased business confidence - economic growth
Economic growth has a positive effect on profits and business confidence. Positive impact on stock market and could encourage entrepreneurship and growth of business
Redistribution of income - economic growth
Government finances are likely to improve with economic growth, the government can introduce policies to reduce inequality and poverty
Unsustainable growth - cost of economic growth
Meaning that Current growth in the productive capacity of the economy leads to a fall in the potential output for future generations
For example, exhaustion of non renewable resources
Rising income and wealth inequality Growth- cost of economic growth
The benefits of economic growth tend to benefit the upper echelon of society and this may carry on to future generations
Growth and happiness - cost of economic growth
Research shows that happiness and income are positively related, at low levels of income. Beyond a certain point, further consumption of good and services does not make any different to happiness.
What is the basic ides of Harrod domer model
Increase in investment -> higher capital stock -> rise in real GDP -> higher factor incomes -> increasing in national savings -> increase in investment (repeat)
The importance of savings
LR economic growth occurs through an increase in the capital stock market
Investment is the purchase of new capital
Investment in an economy is finance through saving
(People save money in banks, firms come to banks and banks lend this money to firms)
Equations of Harrod domer model
S=sY. Saving is a proportion of national income. s can be thought of as the average propensity to save
Investment is the change in a capital stock. I=deltaK
Marginal capital output ratio (the additional capital required to produce a certain level of extra output) = k=deltaK/delta Y
A low k is preferable as it shows capital is productive
Investment is financed by saving therefore I=S
Equation of growth rate
s/k = delta Y/Y
Therefore, this tell us economic growth requires high saving rate at lower incremental capital output ratio
This is because:
A higher savings rate leads to more investment
And technological progress can lower the incremental capital output raio
Definition of savings gap
This is where savings are inadequate in developing countries
Difficulty in closing savings gap - developing countries
Higher savings is unlikely to be turned into higher investment if the economy lacks an efficient financial system to bring borrowers and lenders together
Higher investment is unlikely to generate economic growth if the economy lacks human capital and infrastructure
People might choose to save abroad because it is deemed more secure and yields higher returns
Foreign aid and loans can be squandered due to corruption, foreign debt can build up rapidly and interest payments become unsustainable
Definition of economically active individuals (labour force)
Those of working age who are willing and able to work. This includes people who are employed and unemployed.
Definition of economically inactive
People of working age who are not able and/or not willing to work. The economically inactive are not part of the labour force. For example, people in full time education, stat at home parents, early retirement, disability.
calculating labour force participation rate
(Labour force / population of working age) x 100
Definition of unemployed
The part of the economically active/ labour force without paid work, available for work, and actively seeking employment at the going wage rate
Calculating unemployment rate
(Unemployed/(unemployed+employed)) x 100
Calculating employment rate
(Number of employed workers/population of working age) x 100
Definition of underemployed
Workers who are in paid work, but experiencing a lack of enough of paid work or work that does not make full use of their skills or abilities
Labour force survey
Quarterly survey of a sample of approximately 25,000 uk households
In this measure, the level of unemployed is the total of those of working age who declared themselves
Advantages of labour force survey
A wide measure which is thought to give a more accurate reflection of the number of people who are unemployed than the claimant count
Other information bout the nature of unemployment/employment is collected in the survey
The LFS is an internationally comparable measure
Disadvantages of labour force survey
Samples may be unrepresentative and subject to response errors as well as low rate of response
Relatively costly to administer
Takes time to compile data and can be subject to time lags
What is claimant count
Is a measure of the individuals claiming unemployed related benefits. In the UK unemployed benefits is called job seekers allowance (JSA)
The claimant count often tends to generate a different level and rate of unemployment as compared to the LFS as not all unemployed individual will claim JSA due to various reasons (eligibility)
Advantages of claimant count
Easy to collect as it is simply a tally of those receiving unemployed related benefits
Relatively cost less to obtain
An accurate measure of those claiming unemployed related benefits
Disadvantages of claimant count
Heavily influenced by eligibility rules
There maybe be fraudulent benefit claims
Not internationally compatible as different countries have different eligibility requirements
Reasons why unemployment is usually underestimated
LFS does not include part time worked who would like full time work (unreflective of underemployment)
Measure of unemployment do not include those in jobs below their skill level (unreflective of underemployment)
Some individuals are not classified as unemployed. E.g. moving from employment to inactivity
Areas with high unemployment have high inactivity levels. This may mask greater true employment
What is frictional unemployment.
Is a short term unemployment occurring when workers are out of work and are between jobs
Search unemployment - frictional
Unemployed workers take time to find suitable, or most appealing jobs
Casual unemployment - frictional
Those who work on an occasional basis may be between periods of employment or in between contracts e.g. actors
Seasonal unemployment - frictional
Those who are employed in seasonal industries may be unemployed when there is low demand for labour at particular times of the year e.g. construction workers in winter
Structural unemployment
Is workers losing jobs due to the change in the ‘structure’ of an economy because of changes in patterns of economic activity
Regional unemployment - structural
Caused by the decline of certain industries and occupations, concentrated in geographical areas
Technological unemployment - structural
If workers lose their jobs due to technological advances
International unemployment - structural
Due to outsourcing and loss of competitiveness to international sources of production
What is occupational mobility
Occurs when workers are willing and able to move between different types of jobs and occupations
What is geographical mobility
This is where workers are willing and able to travel further to work, and also to move between different areas and regions for work
What is cyclical unemployment
This occurs due to a lack of aggregate demand. When an economy experiences a downward turn in economic activity, unemployment increases.
Occurs when the total supply of labour is greater than the total demand for labour at the going wage rate in the short run.
Keynesians believe this unemployment will last in the long run
Neoclassical economists believe in only frictional and structural unemployment
Consequences of unemployment
Fall in income and living standards
Increased income inequality between employed and unemployed
Fall in consumer spending (lower AD) in the economy
Output (real GDP) foregone/ opportunity cost of higher unemployment
Increased government spending to support unemployed workers and their families
Loss of self esteem for the unemployed
Increased spending on policing, if higher unemployment leads to higher crime rates
Possible emigration
Potential costs of unemployment for other countries
Loss of export earnings due to reduced demand for countries with high unemployment
Possible social instability in economies with immigration from countries with high levels of unemployment
Possible benefits of unemployment
Firms wishing to expand will be able to draw from a larger pod of available workers
Wage inflation is likely to be reduced, as firms are less likely to raise wages to attract workers
There maybe a reduction in pay related industrial actions (strikes)
Unemployment allows workers to search for the most suitable job
Unemployment can also provide an opportunity for workers to retain and increase occupational mobility in future
Natural rate of unemployment
Structural plus frictional
Policies to reduce unemployment
government can provide direct regional assistance (helping ,
cost affected areas by creating new jobs)
Retraining unemployed workers to match employers requirements
The government can provide improved transport infrastructure (increase in geographical mobility of workers)
In the case of international unemployment, the government can introduce protectionist policies to protect domestic workers
A government/central bank may also manipulate the exchange rate to artificially make good and services less expensive to foreign buyers, which would increase demand for labour by domestic firms (only for countries with fixed exchange rates)
Reducing frictional unemployment
- Industries affected by seasonal fluctuations in demand may be encouraged to diversify their products and to provide greater range of goods/services to attract demand throughout the year
- Workers affected by seasonal and / or causal frictional unemployment can be encourage to train to compete for jobs in a variety of sectors
3.reduce unemplomyent benefits to increase the incentive to spend less time between jobs and reduce time spent searching for jobs - Improve information provision about job ability
Reducing cyclical unemployment
Expansionary fiscal policy: is increase spending or decreasing taxation to end a recession
Increased government spending on goods and services produced by domestic firms will increase aggregate demand. (Because AD= C+G+I+X-M)
Reduced taxation lead to greater disposable income for household and firms which should increase consumer expenditure and investment thus increasing AD
Expansionary monetary policy - reducing cyclical unemployment
Reducing central bank rate - this filters through to other market interest rates - households and firms are more likely to borrow and less likely to save - increasing consumer spending and investment - higher AD - higher output - lower cyclical unemployment
Possible policies for reducing natural rate of unemployment - neoclassical
Lower unemployment related benefits / make them more difficult to claim
Reduce the power of trade unions
Cut income tax rates
Reduce any unnecessary labour market regulations
Reduce or remove national minimum wage
Inflation definition
Inflation is defined as the sustained increase in the average price level of an economy over a given period of time
Deflation definition
The sustained decrease in the average price level of an economy over a given period of time
Difficulties in measuring inflation
The basket may not be representative for any specific household as it is based only a section of products and it is difficult to judge a typical household
Changing technology can make it difficult to accurately calculate a change in price level (might take a while for a new item to be included)
Time lags in inflation calculations as the basket is fixed
Difficult to account for increasing quality
Shrinkflation: changing the side of products
Sampling errors and errors in producing estimates
Consumers may switch to relatively cheaper alternatives of some products meaning the cost of living will not increase as much as CPI
CPI does not include price of owner occupying housing costs especially as a large proportion of income is spent on housing
Method of using inputs value of owner occupying housing costs is relatively new and may not be comparable to other countries
Demand pull inflation
The price level has been pulled up by increase in the aggregate demand
Causes of demand pull inflation
Anything the causes an increase in AD
C+G+I+X-M
Cost push inflation
This is where the price level has been pushed up by a sustained increase in the cost of production and a decrease in short run aggregate supply
Causes of cost push inflation
Anything that increases the cost of production for firms
-increasing wage costs
-increasing raw material costs
-increasing cost associated with regulation
-increase cost of finance
Monetary expansion (inflation)
Classical economists believe in the theory of money, where inflation is caused by a persistent increase in the supply of money. The price level is directly related to the quantity of money in the economy. If the money supply expands faster than the increase in real GDP, household and firms have access to extra money balances and, when spent, will pull up the price level.
Or in simpler terms more money chasing a fixed amount of goods and services will pull up the price level
Consequences of inflation pt1
Menu costs: additional cost incurred by firms when they need to change their prices (catalogue menus, price lists and website prices)
Shoe leather costs: costs incurred in terms of time and effort to ensure money does not lose its value. When inflation is high the central bank raises interest rates. Households and firms are less likely to hold on to cash and will make more trips to the bank. In the modern economy, this is less of an issue
Administrative cost: cost of negotiating contracts with customers, costs incurred adjusting accounts and costs of increased negotiation with workers/ unions over wages
Consequences of inflation part 2
Reduction in the value of money: the purchasing power of money falls as price increases. The same amount of money now will buy progressively less over time and the cost of living increases
Redistribution effects: if some workers do not receive wage increases that keep pace with inflation, while others do, there can be redistribution effects.
Fall in real income and standards of living: if nominal wages do not rise by the inflation rate then real income will fall. This means that households will not be able to afford the same goods and services as before. This could lead to an increase in relative poverty.
Consequences of inflation pt 3
Redistribution from savers to burrowers: inflation leads to fall in the real value of savings because nominal interest rates may not rise by the same rate as inflation. Accumulated stocks of saving may purchase less goods. This means people who save lose out. Debtors gain because the value of debt falls in real terms
Inflationary ‘noise’ : rising prices can lead to market signals being distorted. It is difficult for consumers to recognise if price increases are due to the general level of inflation or if they reflect a change in price relative to other products. This could further decrease the confidence of firms and households and there may be greater shoe leather costs and search costs
Fiscal drag: if tax brackets do not change in line with price rises, there can be redistribution from taxpayers to government. As price rises, more economic transactions are taxed, and some at a higher rate. If tax payers pay a higher proportion of their income in tax, there will be fiscal drag. If the government does not adjust tax thresholds and tax bands as income increase this can be a way the government increase overall tax burden on households and firms.
Consequences of inflation pt 4
Inflation causing further inflation: inflation can lead to expectations that prices will continue to rise in the future AD may increase as goods and services are demanded. Increased wage demands due to expectation of future inflation may lead to more inflation.
Uncertainty: firms will be less certain of future costs and prices they will receive for their products. Firms experience a loss of business confidence and are less likely to spend on capital goods, reducing investment. Consumers will be less certain about the future spending.
Loss of international confidence: if domestic inflation is higher than in other countries, this may lead to domestically produced goods and services becoming less price competitive in international markets. This is likely to reduce demand for exports and possible increase demand for imports, which are now relatively cheaper.
Benefits of low and stable inflation
- Greater certainty for firms and consumers, increasing business confidence and consumer confidence
- Low expectation of future inflation
- More flexibility for producers to decrease real wages by not increasing nominal pay at the same rate as inflation
- Avoiding deflation - the consequences of deflation may be far more significant than any possible costs associated with inflation
Evaluating the consequences of inflation
The rate of inflation
The inflation rate relative to other countries
The duration
Cause of inflation ( cost push inflation is likely to be more harmful than demand pull it is likely to be associated with a fall in output)
Distribution of income - may be harmful to some and less harmful to others
Definition of disinflation
A reduction in the rate of inflation. Price level is rising at a slower rate
Causes of deflation
- Benign deflation - occurs when the price level is falling due to falling costs of production shown by a shift to the right of the SRAS curve
- Malign deflation - when the price level is forced down by lower total spending on goods and services produced in the domestic economy shown by a shift to the left of the AD curve
Harmful effects of deflation
Increasing value of money - the purchasing power of money increases as price falls. Thus, there will be less incentive to spend money. Thus increasing savings and slowing down economic activity
Reduce consumer spending - consumers expect the price level to fall further in the future. They delay purchases particularly of ‘big ticket’ items like cars.
Fall in consumer spending ——> fall in AD
Reduced investment - as price falls more investment opportunities are deemed unprofitable as the real value of the borrowing to fund investment rise relative to the income. Increased real cost of borrowing ——-> lower profit for firms
Government fiscal harm ——-> the real value of outstanding debt increases. This will reduce the ability of the government to borrow more in the future
Possible benefits of deflation
- Improved national price competitiveness - deflation in the domestic economy and inflation in the foreign economy = the domestic product become more internationally price competitive. This causes a rise in exports and a fall in imports
- Possible increase in output - deflation from increased efficiency and lower costs of production can increase the willingness and ability of firms to supply good and services, shifting the SRAS curve to the right.
Evaluation of consequences of deflation
- The rate of deflation
- The cause of deflation (malign is likely to be more harmful) because a fall in AD is likely to be associated with lower output and higher unemployment
- The international trade effect - the extent to which the economy experiences the beneficial effect of an increase in price competitiveness depends on PED for import and PED for exports. If both are responsive, there will be a more significant improvement
- The level of indebtedness in the economy - the greater the level of existing debt, the more likely the decline in the level of economic activity
Definition of nominal wage
Money paid as the reward to labour per period of time at current prices. The nominal wage rate does not take inflation into account
Definition of real wage
Reward paid to labour for work adjusted for inflation. Another way we can think about it is real wage reflect the amount of good and services the nominal wage can buy.
Formula for wage
%change real wage rate is approximately equal to %change in nominal wage rate - rate of inflation
Wage price level spiral
Rising inflation -> falling real incomes -> workers bid for improved wages -> lead to high labour costs - > firms raise their price levels -> rising inflation (so on and so forth)
