2015 specimen AS paper Flashcards
define ‘economic growth’
- an increase in real GDP
* an increase in an economy’s productive capacity/potential
define ‘marginal propensity to consume’
• the proportion of one additional unit of income
that is spent
• ΔConsumption/ΔY
multiplier formulae
m = 1/mpw
m = 1/1-mpc
mpw = 1-mpc
mpw=mps+mpt+mpm
cause of an increase in the value of an economy’s multiplier
a decrease in the marginal propensity to import
define ‘inflation’
an increase in the average/general price level
limitation of using the CP to measure the rate of inflation
- CPI is not fully representative as it is a figure for the ‘average’ household
- CPI does not include mortgage interest payments/ it also excludes council tax, TV licences etc which may be a considerable expense to some households
- may suffer from sampling bias either in Living Costs and Food (LCF) Survey, or price survey
- difficult to account for the changing quality of goods and services so inflation may be overestimated.
budget deficit
- when government spending is greater than tax revenues
- reducing the deficit can be achieved by tax increases or cuts in government spending or a period of GDP growth which brings about a rise in direct and indirect tax revenues.
define ‘productivity’
output per unit of input
Keynesian long-run AS curve implies
that an economy may have a negative output gap in the long run
define real investment
- Investment is an increase in the capital stock
* Real means adjusted for inflation
likely effect of an appreciation of the £ against the US$ on the volume of UK imports from and exports to, the USA
Knowledge
• An appreciation means that one pound becomes
worth more US dollars
Application
• the pound has appreciated from £1 = $1.52 on 1
July 2013, to £1 = $1.65 on 1 January 2014.
Analysis
• The British pound price of goods and services
imported from the US will be lower
• The US dollar price of goods and services
exported from the UK will be higher
reasons consumer spending rose in 2013
• delayed impact of the cut in the bank rate to 0.5%, making borrowing cheaper and providing less incentive to save
• the Funding for Lending Scheme meant that
high street banks became more willing to lend to consumers/to lend at lower rates of interest, reducing the cost of borrowing
• rising consumer confidence: the FLS led to rising house prices, which created a positive wealth effect/raising consumers’ confidence and making them more likely to spend.
importance of interest rates in determining the level of business investment in the UK (KAA)
• willingness of banks to lend to firms (FLS)
• company profitability
• level of cash held by firms
• business confidence
• sustained consumer spending (may be linked to
rising real incomes)
• rate of depreciation of capital
• inflation rate (current and future expectations)
• cost of raw materials / wage rates.
interest rates
- current rates will influence the cost of servicing loans (interest payments)
- expectations of future interest rates may influence cost projections and project viability
effects of raising interest rates PERSONAL
1) increased cost of borrowing (e.g. loans more expensive so less disposable income so C falls)
2) improved return for savers (incentive to save rather than spend as higher interest rates)
3) higher mortgage interest payments (C falls)
4) banks may be more willing to lend
5) could reduce confidence of borrowers (less willing to take out risky investments and purchases)
effects of raising interest rates ECONOMY
1) currency will appreciate/increase in value (making exports less competitive, imports cheaper = reduced AD), due to hot money flows, investors more likely to save in British banks if IR higher
2) inflation - will tend to be lower
3) economic growth - will tend to be slower
4) unemployment - could rise
5) gov will see rising borrowing costs
6) Government debt interest payments increase. Higher interest rates increase the cost of government interest payments. This could lead to higher taxes in the future.
higher interest rates overall
reduce consumer spending and investment -> fall in AD:
- lower economics growth
- higher unemployment (If output falls, firms will produce fewer goods and therefore will demand fewer workers.)
- Improvement in the current account. (Higher rates will reduce spending on imports, and the lower inflation will help improve the competitiveness of exports.)
real interest rate
nominal interest rate - inflation
importance of interest rates in determining the level of business investment in the UK (Ev)
- Expectations of future values as important as current values (e.g. interest rates).
- Weighing up of different factors – extract implies confidence is the most important.
- Different factors may be more important for different firms/different regions of the UK.
effect of lack of investment on ‘inflationary measures’ in the UK (KAA)
- a lack of new investment may mean that depreciation occurs at a quicker rate than investment, reducing the productive potential of the economy
- this could lead to a decrease in the economy’s level of aggregate supply/an inward shift of its PPF
- candidates may draw an AS/AD diagram to show the effects of a reduction in (LR)AS
- cost-push inflationary pressures would build in the economy.
effect of an appreciation (stronger pound) of the £ on ‘inflationary measures’ in the UK (KAA)
• a stronger pound makes imports cheaper. The price
of imported goods in the CPI basket should fall, reducing inflationary pressures
• cheaper imports and more expensive exports may
lead to a worsening of the trade balance, reducing UK aggregate demand (this may be illustrated on an AS/AD diagram). This would lead to a fall in demand-pull inflationary pressures
• imported raw materials become cheaper (particularly oil, which is priced in US dollars). This could reduce firms’ production costs, leading to an increase in (SR)AS, and a reduction in cost-push inflationary pressures.
likely impact of lack of new investment and an appreciation of £ on ‘inflationary pressures’ in the UK (Ev)
• It depends on the rate of depreciation of capital.
• It depends on the level of spare capacity in the
economy.
• It depends on the elasticity of the AD curve, and/or
whether a lack of investment reduces AD too.
• Comment on the significance of the appreciation.
• The effect on the trade balance and hence AD of the appreciation depends on the PED for imports and exports.
evaluate whether the UK gov should focus on achieving economic growth as its key macroeconomic objective METHOD 1
Explanation of the likely benefits and costs of economic growth to: o consumers o firms o the government o income distribution o the environment o current and future living standards
evaluate whether the UK gov should focus on achieving economic growth as its key macroeconomic objective METHOD 2
• Explanation that economic growth may support the achievement of some of the government’s other macroeconomic objectives:
o low unemployment
o balanced government budget
o achieving environmental goals
• Explanation that economic growth may conflict with the achievement of some of the government's other macroeconomic objectives: o balance of payments equilibrium o low, stable inflation o reduced income inequality o achieving environmental goals
evaluate use of monetary policy to achieve UK’s macroeconomic objectives OVERALL
- Understanding of monetary policies.
- Understanding of macroeconomic objectives.
Candidates may consider either the impact of two monetary policies on one or more macroeconomic objectives each, or the impact of one monetary policy on all of the macroeconomic objectives.
In evaluation, candidates may consider either the macroeconomic objectives that wouldn’t be met through the use of monetary policies, or may consider the significance of their arguments more generally.
evaluate use of monetary policy to achieve UK’s macroeconomic objectives MONETARY POLICIES
• change in the interest rate
• change in the value of asset purchases to affect the money supply.
= to influence the levels of consumer spending and aggregate demand (AD). In particular monetary policy aims to stabilise the economic cycle – keep inflation low and avoid recessions.
aim of monetary policy
- Low inflation. UK target is CPI 2% +/-1. Low inflation is considered an important factor in enabling higher investment in the long-term.
- Stable economic growth. Monetary policy is also concerned with maintaining a sustainable rate of economic growth and keeping unemployment low.
Quantitative easing
- decreasing money supply decreases demand -> inflation target 2%
- increasing money supply increases demand and investment -> aim of avoiding recession
BofE setting interest rates
- look at : Unemployment, consumer confidence, spare capacity in the economy, exchange rate index, house prices, economic growth
- from this decide whether inflation is likely to rise or fall:
o If they expect higher inflation and higher growth, they will tend to increase interest rates.
o If they expect lower growth and a fall in the inflation rate, they will tend to cut interest rates.
loose monetary policy
- aims to increase AD and economic growth
- involves cutting interest rates or increasing the money supply to boost economic activity
- If the Bank of England anticipates inflation falling below the government’s target of 2% and economic growth is sluggish, or the economy is facing a recession. They are likely to cut interest rates.
- Lower interest rates, in theory, should stimulate economic activity. This is because lower interest rates reduce borrowing costs. This increases the disposable income of consumers with mortgage interest payments and should encourage spending.
tight monetary policy
- If the Bank feels the economy is growing too quickly and inflation is expected to exceed the government’s target, then they are likely to increase interest rates to reduce the rate of economic growth and reduce inflationary pressures.
- In this case, a rise in interest rates causes a fall in consumer spending and investment leading to lower inflation.
- causes an appreciation in the exchange rate which will make exports less competitive
limitations of monetary policy: difficult to control many objectives with one tool – interest rates.
For example, a rise in oil prices causes cost-push inflation and lower growth. The Bank could increase interest rates to reduce inflation, but, it would cause economic growth to fall as well. In 2009, inflation rose to rising oil prices, but the economy was also in recession; the Bank decided to ‘allow’ the temporary inflation and concentrate on economic recovery.
limitations of monetary policy: interest rates may affect some parts of the economy more than others.
e.g. higher interest rates increase the disposable income of people with savings. But, could cause homeowners to be unable to afford their mortgages.
aim of QE
1) Increase economic activity – Q.E. aims to encourage bank lending, investment and therefore help improve the rate of economic growth.
2) (increase) Higher inflation rate. Quantitative easing may also be used to avoid the prospect of deflation
3) Lower interest rates on assets
how QE works
1) The Central Bank creates money electronically. (This is similar effect to printing money, except they are increasing bank reserves which don’t need to be printed in the form of cash)
2) The Central Bank uses these extra reserves to buy various securities. These include government bond and corporate bonds.
buying securities in QE achieves:
1) Increased liquidity. Banks sell assets (bonds) for cash. Therefore banks see an increase in their liquidity (cash reserves). In theory, the bank will then be more willing to lend to customers. This lending will be important for increasing investment and consumer spending.
2) Lower interest rates. Buying assets reduce their interest rate. Lower interest rates on these securities may also encourage banks to lend rather than keep securities which are paying low interest. Higher lending should help improve economic growth.
liquidity trap
A liquidity trap occurs when low/zero interest rates fail to stimulate consumer spending and monetary policy becomes ineffective
effect of loose monetary policy on the macroeconomic objectives
• an increase in AD should lead to an increase in real
GDP, creating economic growth for the economy
but this depends on the level of spare capacity in the economy, as well as consumer and business confidence levels
• demand-pull inflationary pressures would be increased, affecting the low, stable inflation objective but inflation rates also depend on the level of cost-push inflationary pressures in the economy
• unemployment should fall in the economy
• time lag – unemployment tends to be a lagging
indicator, particularly if firms already have spare
capacity
• government budget balance would improve in the long run if the policy was successful in generating economic growth but contractionary fiscal policy might be more effective at achieving this objective, certainly in the short run
• the environment might be harmed by the increased levels of economic activity generated
• in developed economies such as UK, economic growth tends to reduce the level of environmental degradation
• income inequality might worsen as economic growth tends to widen the gap between high and low income earners but lower interest rates tend to redistribute income from savers to borrowers, which would tend to improved income distribution
how does expansionary/ loose monetary policy work
cut in interest rates increase overall demand in the economy
- Lower interest rates make it cheaper to borrow; this encourages firms to invest and consumers to spend.
- Lower interest rates reduce the cost of mortgage interest repayments. This gives households greater disposable income and encourages spending.
- Lower interest rates reduce the incentive to save.
- Lower interest rates reduce the value of the Pound, making exports cheaper and increase export demand.
fiscal policy
involves the government changing the levels of taxation and government spending in order to influence AD and the level of economic activity
purpose of fiscal policy
- Stimulate economic growth in a period of a recession.
- Keep inflation low (UK government has a target of 2%)
- Fiscal policy aims to stabilise economic growth, avoiding a boom and bust economic cycle.
- governments often prefer monetary policy for stabilising the economy.
expansionary/loose fiscal policy
- involves increasing AD.
- therefore the government will increase spending and cut taxes. Lower taxes will increase consumers spending because they have more disposable income
- this will tend to worsen the government budget deficit, and the government will need to increase borrowing.
deflationary/tight/contractionary fiscal policy
- involves decreasing AD
- therefore the government will cut government spending and/or increase taxes. Higher taxes will reduce consumer spending
- tight fiscal policy will tend to cause an improvement in the government budget deficit.
criticism of fiscal policy: crowding out
Some economists argue that expansionary fiscal policy (higher gov spending) will not increase AD because the higher gov spending will crowd out the private sector. This is because the government have to borrow from the private sector who will then have lower funds for private investment.
evaluation of fiscal policy
- depends on the size of the multiplier (if the multiplier effect is large, then changes in government spending will have a bigger effect on overall demand)
- depends on the state of the economy (Fiscal policy is most effective in a deep recession where monetary policy is insufficient to boost demand. In a deep recession (liquidity trap). Higher government spending will not cause crowding out because the private sector saving has increased substantially.)
- depends on other factors in the economy. (for example, if the government pursue expansionary fiscal policy, but interest rates rise, and the global economy is in a recession, it may be insufficient to boost demand)
- Bond yields. (if there is concern over the state of government finances, the government may not be able to borrow to finance fiscal policy. Countries in the Eurozone experienced this problem in the 2008-13 recession.)
