2.5 Economic Growth

Question 1

Factors which could cause short term economic growth

Answer 1

• increase in components of AD (consumer spending, investment, gov spending, net trade)

A cut in interest rates:

i. Will reduce the cost of borrowing, reducing the opportunity cost of doing so. Upon borrowing the disposable income consumers have increases allowing them to spend more. This will increase consumption shifting AD to the right AD1 to AD2.
ii. Reduce the rate of return on savings. This reduces the incentive to save and increases the incentive to spend. The savings ration in the economy will decrease with more consumer spending taking place. Increases C, AD1 to AD2
iii. Reduces the monthly payments for those with tracker or variable rate mortgages. Monthly, these homeowners will receive a boost to their disposable income, increasing the marginal propensity to consume thus boosting consumption in the economy- AD right AD1 to AD2
iv. Reduce the cost of borrowing for firms, enabling them to reach their hurdle more easily (the required rate of return for investment projects to go ahead). This increases the marginal propensity for firms to invest increasing I in the AD equation – shift right

Reducing the level of corporation tax- increases retained profits, easier to finance investment, increasing MPI. AD increases shifts right

Government can boost spending, infrastructure, education, healthcare, public sector wages etc. as G is core component of AD- sig increase AD and generate large multiplier effect in the economy whereby initial increase in spending will increase incomes in the economy facilitating further rounds of spending and income generation. End result = greater final increase in AD

The exchanges rate could be weakened- this could happen for example by reducing interest rates (increase hot money outflows), increasing the money supply or selling domestic currency reserves. WIDEC- economic theory suggests the demand for imports and therefore expenditure will decrease whereas the demand for exports and thus revenue generated by exports will increase. Both effects will lead to an improvement in the trade balance of the CA and reduce a CA deficit or move it to a surplus. AD will rise AD1 to AD2. Actual growth increases from Y1 to Y2. As with greater demand in the economy, firms will increase output exhausting spare capacity; Y2 is now closer to the FE level of output. This increase in output in an increase in Real GDP- increase in economic growth.

Governments could reduce the marginal rate of income tax for those in lower income tax banks or increase the income tax free allowance. This would increase disposable income for those on lower incomes. Consumers- higher MPC, consumption would increase in the economy increasing AD.

Question 2

Short run (actual) economic growth explained on graphs

Answer 2

• PPF curve
  (increase in economic growth moves economy closer to full unemployment (outer line) = increase in amount of goods services produced in economy = movement further towards PPF curve (but PPF curve doesn’t move)
• aggregate supply/demand diagram
  (Increase in components of AD shifts AD to the right (AD1 to AD2) = increase in price level (P1 to P2) & increase in real GDP (Y1 to Y2) = economy moves closer to full employment (YFE)

Question 3

What causes long run economic growth

Answer 3

= increase in quantity / quality of factors of production within economy

Government spending on education- this will improve the skills and therefore productivity of the labour force, increasing human capital. This reduces structural u/e by providing skills to fill job vacancies in the economy, increasing the quality of labour and thus LRAS.

Government spending on infrastructure- this reduces costs of productions for firms as transporting goods and services around the country and internationally- easier more efficient. Increases efficiency and competitiveness increasing LRAS. Also gov spending increases the quantity and quality of the capital stock of the economy- boosts productive potential

Government offering subsidies or tax allowances to increase the incentive for firms to invest- this improves the quantity and quality of the capital stock of the economy whilst also improving the productive efficiency of the economy. Such investment improves the quantity and quality of the capital stock whist also improving the productive efficiency of the economy, increasing LRAS: LRAS1 to LRAS2

Reducing the marginal rate of income tax- reducing income taxes increases the incentives to work harder as less income will be taxed away when earned increasing the productivity of labour. Lower incomes taxes will provide an incentive for those of a working age currently inactive in society- enter the labour force. Increase the quality and quantity of labour, LRAS from LRAS1 to LRAS2 – shift right

Reducing corporation tax- increases the incentive for firms to invest. Firms have a greater level of retained profit- funds investment. Improves both the quantity and quality of the capital stock in the economy whilst also improving the productive efficiency of the economy increasing LRAS

Privatisation- creates a profit motive, increases competition. Competition and profit maximisation objective incentivises max efficiency. This increases the productive efficiency of the economy

Deregulation- Involved reducing laws and gov imposed standards in the economy e.g. environmental laws, health and safety laws, products safety laws. This reduces the costs of productions for firms. The legal barriers to entry into a market are reduced increasing competition, incentivising max efficiency as firms look to remain competitive. Both improve the productive efficiency of the economy.

Trade liberalisation- involves the removal of trade barriers such as tariffs and quotas freeing up trade, promoting global competition. The fierce and intense nature of global competition forces producers to what whatever they can to compete. Competition and profit max obj incentivises maximum efficiency where firms aim to lower their costs of production – charge lower prices than rivals. This increases the productive efficiency of the economy, increasing LRAS from LRAS1 to LRAS2

Quantity
§ Changes in the workforce – African countries = increased number of workers
§ Changes in participation rates – proportion of workforce who are working or seeking work. More people retiring later in life.
§ Immigration – increase size of the labour force – inward flows of migrants from Eastern Europe

Quality
§ Workers need to be sufficiently educated to cope with the demands of the existing stock of capital. For instance lorry drivers can drive.
§ Workers need to be flexible – workers changing roles so need to have knowledge of different aspects of education. – human capital
§ Workers need to contribute to change

Potential growth and actual growth increase from YFE1 to YFE2. This is because with greater demand in the economy, firms respond by increasing output. This increase in output is an increase in real GDP, which is an increase in economic growth

Question 4

Long run economic growth explained on graphs

Answer 4

• PPF curve

(Productive potential of economy shifts outwards from A to B = total amount of consumer & capital goods produced increases) = outward shift of PPF curve

• AD/AS diagram

(Increase in quantity/quality of factors of production = LRAS increases (LRAS1 to LRAS2) = increase in real GDP (Y1 to Y2)
Increase in productive capacity of economy from Y1 to YFE, new level of full employment
But economy operating at Y2 = slightly below full employment = spare capacity in economy = reduced pressure on existing factors or production = price level decreased (P1 to P2)

Question 5

Distinction between actual & potential economic growth

Answer 5

Actual growth: increase in real GDP = results in increase of price level (increase in AD = more pressure on existing factors of production)

Potential growth: increase in productive capacity of economy (maximum possible output) = results in decrease in price level (AD remains same, but more goods/serviced produced = less pressure on existing factors of production)

Question 6

Importance of international trade for (export-led) economic growth (why might this be a problem)

Answer 6

Some countries (china) achieve large proportion of economic growth from exports (current account surplus from net trade of goods/services), only possible with international trade (due to comparative advantage = country able to produce good/service at lower opportunity cost than other countries)

state of other countries’ economies has big impact on countries with export led economic growth (recession in countries which are main trading partners with domestic country can massively reduce the demand for domestic exports = big impact on domestic economic growth)

Export led growth occurs when countries open up their economies to the international market. This has been effective - Germany, Japan and China- prevents the poor BOP that tends to occur as a result of economic growth

§ International trade is important for this. Countries can specialise where they have a comparative advantage- increases world output, lowers average costs.

§ A country has comparative advantage when it can produce goods and services at a lower opportunity cost than another

THIS WILL:

§ Initially increase AD- only bring about short term growth. However- encourages firms to invest - therefore bring about long term growth by improving the supply-side of the economy

§ Although increased exports initially increases AD rather than LRAS, sustained high export levels will encourage, or force, firms to invest and increase demand for labour, which will lead to economic growth.

§ Allows the gov to bring about economic growth and high employment without seeing a C.A deficit.

Export led growth = economy is unbalanced, since there is a surplus on the current account on the BOP. Whilst this means there are net injections into the economy, it is not necessarily sustainable. However, the growth in the economy may lead to an increase in imports which will balance the current account.

The country relies on the economic state of other countries, since these are the consumers of their goods and services. If there is a recession in a major export market, exports will fall and so will economic growth.

§ In order to be competitive in the international market, British firms will have to become more efficient

Question 7

Actual economic growth rates

Answer 7

= measured by changes in real GDP over time

Often volatile (various booms & recessions)

Question 8

Long term trends in growth rates

Answer 8

= average sustainable rate of growth over a period of time (without regular fluctuations), determined by changes in productive capacity of economy

Question 9

How to compare actual growth rates and long term trends in growth rates (with graph)

Answer 9

• actual growth rate above trend growth rate = positive output gap (sometimes a boom)

In this period there will be high levels of inflation due to lots of pressure on existing factors of production, caused by the economy operating past the level of full employment

• actual growth rate below trend growth rate = negative output gap (sometimes a recession)
  In this period there will be low inflation due to little pressure on existing factors of production , caused by the economy operating below full employment

Question 10

The output gap

Answer 10

= difference between the actual level of real GDP and maximum potential level of real GDP

Question 11

Negative output gap (definition & characteristics)

Answer 11

= actual level of real GDP is less than maximum potential level of real GDP

(spare capacity within economy)

Likely to be low inflation & high levels of unemployment

Question 12

Positive output gap (definition & characteristics)

Answer 12

= actual level of real GDP is greater than maximum potential level of real GDP

Likely to be high inflation & low levels of unemployment

Question 13

Why is it difficult to measure / estimate the size of the output gap of an economy

Answer 13

need to estimate economy’s maximum potential output level - many different variables make this difficult (changes in quantity of labour, productivity/quality of workforce, spare capacity of individual businesses) = data could be inaccurate & knowledge gaps = figure for maximum potential output of economy likely to be a very rough estimate

The exact position of the LRAS is unknown

§ Initial estimates of the real GDP are often inaccurate- , especially from emerging markets, and extrapolating data from past trends might lead to uncertainties.

§ Requires measuring AS – we need to measure skills of labour force and changes in capital assets – machinery.

§ Inaccurate data on labour force- difficult to measure skills and migration

§ Difficult to measure productivity

§ Potential output based on estimates of the supply of labour, capital stock and productivity of FOP

§ Changes in the exchange rate might offset some inflationary effects of a positive output gap

Question 14

Using a classical AD/AS diagram to show a negative output gap

Answer 14

Current output at Y1, price level at P1
Full employment output of economy at YFE

Output of YFE greater than Y1 = negative output gap within economy (spare capacity is difference between Y1 & YFE)

In the diagram, there is an equilibrium where AD=SRAS=LRAS. However, at AD1 , there is a negative output gap because the SRAS equilibrium is less than the LRAS equilibrium, so the www.pmt.education full capacity of the economy is not being met. At AD2 , there is a positive output gap as SRAS is higher than LRAS.

§ Classical economists would argue that this positive output gap would be filled by long-run economic growth moving the LRAS curve, a recession which would decrease AD or a rise in the costs of production which would decrease SRAS.

§ They would also argue that the negative output gap would be brought back to equilibrium by rising AD or a fall in SRAS due to lower costs of production.

Question 15

Using a classical AD/AS diagram to show a positive output gap

Answer 15

Current output at Y1, price level at P1
Full employment output at YFE

Output at YFE is less than output at Y1 = positive output gap within economy (able to operate past full employee point by using existing factors of production unsustainably)

Workers realised pay isn’t rising with inflation, overtime is persistent. Increases bargaining power for higher wages, increasing costs of production for firms shifting SRAS to the left from SRAS 1 to SRAS 2- Output returns to full employment levels- higher cost push inflation P3 (DRAW THIS ON DIGM).
Classical economists – no way to sustainably increase economic growth in L/R through an increase in AD- purely inflationary. Only way to reduce NRUE – supply side policies shifting LRAS to the right. Keynesians do not dispute this- stress this approach to macroeconomic management is only true if the economy is at or very close to full employment

Employers benefit in the s/r- rasie prices and keep wages fixed- increasing profits. Workers are employed form the natural rate of unemployment and existing workers are working longer hours to increase production. Inflationary gap, demand pull inflationary pressures

Question 16

Why are positive output gaps unsustainable in the long run according to the classical model of AS/AD

Answer 16

Workers will increase their wages in long run = causes SRAS to decrease = economy moves back to full unemployment

(factors of production used unsustainably, will eventually have to stop)

Question 17

Using a Keynesian AD/AS diagram to show a negative output gap

Answer 17

Current output at Y1, current price level at P1
Full employment level at YFE

Output at YFE is greater than output at Y1 = negative output gap

(spare capacity in economy = difference between Y1 & YFE)

Question 18

Why cant a positive output gap be shown on a Keynesian AS/AD diagram

Answer 18

Keynesian model only has one AS line = economy can’t operate at short run equilibrium past the full employment point

Question 19

Trade (business cycle)

Definition, characteristics, graph

Answer 19

Demonstrates recurring trends in economic growth that economies often experience (shows fluctuations of actual economic growth following trend growth of economy)

• boom
• slowdown
• recession
• recovery…

Question 20

Characteristics of a boom

Answer 20

• high rates of economic growth (lots of consumer spending / investment = large increase in AD)
• low rates of unemployment (increase in AS & high economic growth = equilibrium moves closer to, at, or past full employment (YFE))
• demand-pull inflation (economy moves closer to full capacity = increase on pressure on existing factors of production to keep up with increase in AD = increase in general price level)
• higher consumer/business confidence (rising incomes, rising house prices, job stability, positive outlook on economy, more consumer spending)
• improving gov budget balance (less unemployment = less welfare spending & increase in tax revenue (VAT, income tax))

Question 21

Characteristics of a recession

Answer 21

• negative rates of economic growth (decrease in consumer spending / investment = decrease in AD = decrease in real GDP)
• high rates of unemployment (decrease in AD = fall in real GDP = fall in demand for goods therefore labour = cyclical/demand-deficient unemployment)
• low rate of inflation (decrease in real GDP = lots of spare capacity = less pressure on existing factors of production = fall in prices level of goods/services)
• low business / consumer confidence (reduction in job security, fall in house prices, negative outlook on economy = increase in savings (MPW) = decrease in consumer spending, more business closures, economic uncertainty = decrease in investment)
• worsening of gov budget balance (unemployment rises = more gov welfare spending & less income tax/VAT/corporation tax = tax revenue decreases & gov spending increases)

Question 22

Benefits & costs of economic growth to consumers

Answer 22

+ consumer income (firms need to attract workers by offering higher wages as less people unemployed)

+ reduction in unemployment (increase in AD causes increase in real GDP = reduces spare capacity in economy, moves towards full employment, cyclical unemployment decreases, demand for labour derives from AD increase)

• high cost of living / high inflation (increase in AD = increase in price level = pressure on factors of production = decrease in purchasing power)

POSITIVE:

Increased demand for housing as people have more money – likely to increase house prices.

§ Shares are likely to increase in value as businesses are making more money and future prospects are good.

The rising prices of shares and housing will increase wealth and lead to positive wealth effect.

§ Improved productive efficiency due to better technology could lead to lower prices or higher quality goods

§ Economic growth will lead to increased happiness, but this is not necessarily the case.

COSTS:

Economic growth could lead to increased inequalities and so may not have any effect on the average consumer and may lead to inflation, which has negative effects for consumers.

§ Higher demand-pull inflation, due to higher levels of consumer spending.

§ Consumers could face more shoe leather costs,

§ The benefits of more consumption might not last after the first few units, due to the law of diminishing returns, which
states that the utility consumers derive from consuming a good diminishes as more of the good is consumed.

Question 23

Benefits & costs of economic growth to firms

Answer 23

+ increased revenues & profits (increase in AD (consumer spending) = increase in firms profit/revenue)

+ increased investment (increase in business confidence & profits = more firm investment = increased efficiency/productivity)

• decrease in amount of labour to choose from (unemployment decreases = less people looking for work = harder to fill jobs = firms may have to offer higher wages)
• menu costs (increase in inflation = firms may have to spend money changing prices (menu costs) of their good/service)

POSITIVE:

Profits, which might in turn increase investment. This is also driven by higher levels of business confidence- accelerator effect

§ Higher levels of investment could develop new technologies to improve productivity and lower average costs in the long run.(positive accelerator effect)

§ As firms grow, they can take advantages of the benefits of economies of scale.

§ If there is more economic growth in export markets, firms might face more competition- more productive and efficient, but it will also give them more sales opportunities

§ Opportunity for new firms to establish themselves and allows existing ones to make more profit.

Costs:

§ Firms could face more menu costs as a result of higher inflation. This means they have to keep changing their prices to meet inflation.

§ Firms who sell inferior goods (with negative income elasticities) may lose out. Changing technologies and globalisation also mean that some firms find their markets disappearing e.g. DVD rental stores.

Question 24

Benefits & costs of economic growth to government

Answer 24

+ improvement in government budget balance (increase in consumer spending = increase in tax revenue (VAT/income tax/corporate tax) , reduction in unemployment = less gov welfare spending)

• worsening in current account of balance of payments (increase in demand as consumer incomes increase, but most goods/services from abroad = increase in import expenditure = trade deficit,(E: net trade only a small component of AD) )
• macroeconomic instability (high inflation = uncertainty for firms, consumers, investors = increase in volatility of economic growth (more booms and recessions in economic cycle)

POSITIVE:

The government budget might improve, since fewer people require welfare payments and more people will be paying tax

§ Government has more money to put into the NHS, education, benefits etc.; the quality of these systems will be improved, and this will help to improve living standards.

Costs-

Governments might increase their spending on healthcare if the consumption of demerit goods increases.

§ People expect more from the government i.e. better education, better roads etc

Question 25

Benefits & costs of economic growth to current & future living standards

Answer 25

+ decrease in poverty rates (reduction in unemployment, increase in income)

+ higher standards of living (higher disposable income, less unemployment)

+ improvement in environment (increase in investment in efficient, cleaner tech, ( E: however only if firms decide to invest in this tech)

• negative impacts on environment (firms increase use of resources to increase output, some non-renewable & more pollution = increase in negative externalities)
• increase in relative income inequality (income increases may not be distributed equally, may be growth in some industries = increase in relative poverty)
• social effects of increased production (increase in AD = increase in pressure on existing factors of production = more stress & less leisure for workforce = decrease in happiness of population)

POSIITIVE:

§ Economic growth will result in lower poverty levels. An increase in the production of goods and services will increase jobs so there will be less unemployment and less people on benefits. Wages are also likely to increase.

§ More goods and services for people to enjoy

§ Economic growth is likely to have the highest benefits in developing countries.

§ Public services improve, higher tax revenues, spend on improving services- may increase life expectancy and education levels.

§ Housing standards and the quality of food increases due to economic growth. Health also tends to increase: not only
does life expectancy rise

§ Higher incomes are able to buy cleaner fuels and richer countries can devote resources for research and development
of cleaner resources and ‘greener’, more efficient technology.

Costs

§ Could be decreased future living standards due to exploitation of the environment. A rise in income means more people have access to electricity etc. and use it more freely. This causes depletion of non-renewable resources, concern about sustainability of growth for future generations and increased levels of pollution/waste/congestion- increase negative externalities

§ Economic growth may result in increased inequalities between rich and poor. The rich may be the only ones that have gained from the economic growth and they may even lower the living standards of the poor by exploiting the poor.

Question 26

What are the benefits of economic growth in general?

Answer 26

A fall in unemployment- labour= derived demand. Demand for goods and services increase- firms need more workers – reduces u/e. incomes will rise in the economy increasing both material and non-material SOL. The multiplier effect that this increase in consumer spending generates can materialise an even greater increase in growth and income.

Higher profits for firms- with more demand and higher household incomes, firms can sell more goods and services, increasing revenues and profitability. Consequently firms will have higher retained profits to finance investment increasing both s/r and L/R econ growth through the accelerator process thus enabling growth to persist over time

Fiscal dividend from government- with greater levels of economic growth, tax revenues collected from income tax, corporation tax, VAT will rise. If there are more imports being ‘sucked in’ tariff revenues could rise. The gov will have more money to spend on important public services in the economy such as education and healthcare. Welfare payments to those in need can improve helping to reduce income inequality. This can enable both s/r and L/R growth to persist over time.

Question 27

What are the costs of economic growth?

Answer 27

Unrestrained econ growth will accelerate demand pull inflation. This is because if demand is increasing faster than aggregate supply there are excessive pressures on existing factors of production therefore increasing the price of them filtering through higher prices in the economy. High inflation brings about a number of costs associated with it such as a loss of international competitiveness thus deterring people purchasing a country’s exports, a fall in purchasing power, erosion of saving, fiscal drag and these all can be detrimental to individuals, firms and the government.

Economics growth via an increase in REAL GDP only accounts for the quantity of output producers provides no info on quality.
Significant as production can lead to severe negative externalities air pollution, degradation, resource depletion. The existence of these externalities drastically reduce living standards but aren’t accounted for in the GDP figures.

Economic growth does not necessarily mean that incomes are increasing for all in society. Increases in Real GDP per capita, may only benefit the elite or small part of pop. This is because such growth may have been generated in one dominant sector- benefits those in this sector. Growth generated may have been capital intensive where only capital owners benefit from higher incomes. Corrupt governments may prevent effective redistribution of income from higher levels of GDP and increase in tax rev promote income inequality in society. Consequently the poor may see no improvements in their standards of living at all and relative or absolute poverty will remain or even increase.

Rising incomes is only one aspect of improving living standards. Living standards comprises of more than just incomes. Health and education factors- pivotal to living standards. Consequently, economic growth must translate into more for there to conclusively be a rise in living standards. Composite indicators like HDI which should be used alongside Real GDP in order to see whether increases in economic growth actually translate into higher living standards.

Question 28

What is the evaluation of economic growth?

Answer 28

Growth should be sustainable- future generations can benefit from and experience the same economic growth as current generations. E.g. growth without excessive inflationary pressures, significant environ costs and growth with the risk of resource depletion. For this to take place effective environmental policy should be enacted and persistent increases in LRAS through supply side policies should be pursued to reduce the risks of inflation conflicts.

Growth should be inclusive- all citizens benefit from economic growth not just the elite. Transparent, accountable and non- corrupt government’s must exist who can collect taxes efficiently and redistribute revenue where they will have the most benefit in improving the distribution of income and living standards for all.

Growth should be sustained- this is where growth continues to increase over time without sharp contractions. For this to take place, growth must be balanced and not confined to production form one dominant sector and must occur from both the demand and supply side. This will ensure that any shocks can be absorbed with other avenues available to keep growth strong, living standards increasing

Question 29

What are the statistical figures for economic growth?

Answer 29

Economic growth allows absolute poverty to be reduced. Since 1990-2010, China’s production doubled and this resulted in 600 million people lifted out of absolute poverty; their access to sanitation, clean water was much greater than before and social mobility had increased for many. China’s situation depicts how beneficial and advantageous economic growth can be for an economy as it highlights the improved living standards and material wellbeing they experienced

Poor may see no or little improvements in their living standards and absolute poverty may remain or increase. In china, there are huge regional disparities; the Gini coefficient measures income inequality and in china this figure was 0.3 in 1980 and then 0.52 in 2015. These figures depict an increase in relative poverty which can result in issues such as geographical immobility of labour and also regressive impacts on the poor.

In 2008 (UK) the top 1% income earners contributed to 50% of GDP growth thus capturing an in equal distribution of income consequently reinforcing the fact that GDP growth and economic growth doesn’t truly encapsulate living standards within a country.

Question 30

How can export- led growth lead to long run economic growth?

Answer 30

Export led growth- AD shifts right initially- using up spare capacity- LRAS increases, productive capacity increases- accelerator effect- invest, update capital stock, shift LRAS outwards to gain a comp adv

Efficiency gains- productively efficient-desire to decrease unit costs

§ The reason how export led growth increases long run economic growth is because a rise in exports will initially lead to an increase in aggregate demand. However, a permanent increase in exports, will force UK forms to invest more in capital equipment to add to the capital stock to update equipment and machinery. This will lead to a rise in demand for labour, both leading to an increase in the productive potential of the economy and hence economic growth.

§ Another impact of export led growth is on efficiency and competitiveness – with exporting UK firms have a competitive advantage over domestic firms in foreign markets so goods need to be lowered priced or a better design, so more export dominated encourages firms to be more efficient which leads to an increase in LRAS and economic growth.

§ Export led growth- firms receive more rev- employ more people, invest- creates a positive accelerator effect- invest in capital expenditure- better quantity and quality of infrastructure- improves PPF and increases LRAS and PPF- This has led to the success of the German and Chinese economy that can boast current account surpluses – in 2019 Germany stood at around 8% GDP

Question 31

What happens when AD shifts in output gap and evaluate?

Answer 31

AD shifts: increase in real disposable income= actual level of growth will increase, u/e decreases, demand pull inflation, worsening of trade position- exports less competitive

Evaluate
§ Economy is in deep recession. Actual growth less than potential growth. If AD shifts right due to increase in real disposable income levels- no inflationary pressure- elastic part of LRAS (PL remains at P1.

§ If economy was operating at full employment or very close to YFE- AD shifts to the right due to increased disposable income however growth comes at an expense of inflation PL increases from P1 to P2. Macro conflict with higher inflation

§ If we are at full employment and AD shifts right there’ll be no growth, no impact on u/e purely inflationary.

Question 32

What happens when LRAS shifts in output gap and evaluate?

Answer 32

When LRAS shifts to the right, increase in both actual and potential growth, fall in u/e and NRU decreases, cost push inflation decreases, exports more comp- trade position will improve.

Evaluate- If there’s a negative output gap classical:
LRAS shift – not enough AD in economy. LRAS shifts with not enough AD to meet new level of LRAS, no change to
equilibrium level.

Question 33

What are demand and supply shocks that impact trade cycle?

Answer 33

Demand Side Shocks (anything that impacts upon Aggregate Demand)

§ A housing market bubble may burst (asset bubble burst which is what led to GFC)– this occurs when house prices rise to high and then suddenly there is a collapse in demand for housing = sharp fall in house prices- erodes consumer confidence= less consumer confidence and fewer houses being built which affects output and employment. (this led to GFC in 2008/09)

§ Stock market may crash – stock market prices are too high and reduce wealth of individuals

§ Central bank could increase interest rates

§ Government may sharply raise tax or cut government spending – try to combat inflation or balance its budget.

§ World economy may go into a recession, damaging UK exports sharply and send the UK into a recession.

§ Sharp rise in the value of the pound against other currencies – this lower competitiveness of the UK economy sending exports down and imports up. Subsequent fall in aggregate demand could send economy into a recession.
Supply side shocks

§ A large rise in world commodity prices could both raise the price level in the UK and lead to a rise in import value if the demand for the commodity is inelastic.

§ An outbreak in trade union militancy – could see large wage rate increases which will raise the price level substantially potentially leading to a recession.

Is there a standard way to measure a trade cycle? What is known as a technical recession?

§ traditional economic cycle - four main phases. Milder cycles where GDP doesn’t fall. Instead the economy fluctuates around its long run real GDP growth path but real GDP continues to rise even in a downturn even if the rise is relatively small. Technical recession is when there are two consecutive quarters of negative GDP growth.

Question 34

What is hysteresis and how does it impact economic growth?

Answer 34

The trend rate of growth of an economy can shift downwards if there is a deep recession because of the permanent losses of human and physical capital.

§ Some economists argue – that in a deep recession economies don’t recover back to their trend level of growth (still grows at the previous trend rate). – This is hysteresis.

§ One reason why there economy may fail to recover - permanent loss in human capital e.g. millions people losing their job in a recession which consequently means a loss of output in the economy.

§ Another reason is there can be a permanent loss of physical capital, as during a recession firms cut backs on investment as if they fail to make this up in the next boom there is less physical capital in the economy then would have been the case so potential output must fall.

Question 35

Why is a recession not desirable?

Answer 35

Low unemployment- hysteresis- lack of skills within an economy, decline in long term trend growth rate- fall in living standards, human and physical capital decreases

§ Decrease in consumption= fall in AD, no growth in the economy, less consumption, income and output. Fall in demands, firms reduce, decrease investment= negative accelerator effect = fall in productive potential LRAS

§ Less taxation revenue= less expenditure on public sector e.g. merit goods- lower human capital. Hypothecation

§ Regressive impacts on poor

§ Increase in welfare payments

§ Fall in business/ consumer confidence- low animal spirits

§ MPS increases- withdrawals from circular flow of income – reduces Keynesian multiplier effect-

§ Paradox of thrift-
personal savings can be detrimental to overall economic growth- based on a circular flow of the
economy in which current spending drives future spending. It calls for a lowering of interest rates to boost spending
levels during an economic recession.

Question 36

Why is a recession desirable?

Answer 36

Marginal propensity to import decreases, improves CA position

§ Environmental improvements e.g. less pollution, less negative externalities

§ Falling demand, firms cut prices- fall in inflation can be beneficial to those on fixed incomes

§ Helps tackle inflationary pressures. Little spare capacity- prevent economy from overheating

§ Opportunities for diversity and growth in other sectors

§ Could make markets more competitive but relative to other countries

§ Firms selling inferior goods will benefit- aren’t adversely affected

§ Companies dealing with bankruptcies and loss of income. For example, pawnbrokers and firms selling pay day loans – People short of cash turn to loan-sharks.

§ Greater efficiency in long-term – It is argued by some economists that a recession can enable the economy to more productive in the long term. A recession tends to be a shock and inefficient firms may go out of business, but in recession – new firms can emerge. Joseph Schumpeter called it ‘creative destruction‘ – the idea when some businesses go bust, it allows new innovative firms to start and grow.

§ Falling asset prices can make it cheaper to buy a house. Good for first-time buyers. It can help reduce wealth inequality.