AL Unit 9: The Macroeconomy Flashcards
The multiplier
It measures the extent to which an increase in an injection into the circular flow brings about a magnified effect on the level of national income. An increase in injections will also affect the withdrawals. Each successive increase in AD will therefore become progressively less
Calculation of the multiplier
2-sector economy (households and firms): 1/MPS
3-sector economy (households, firms and the government): 1/MPS+MPT
4-sector economy (households, firms, governments and foreign trade): 1/MPS+MPT+MPM
Overall 1/marginal propensity to withdraw
Average propensity to consumer and save
The proportion of income spent on consumption can be measured by the average propensity to consume. This refers to the average proportion of income that is actually spent on goods and services. The proportion of income that is not spent is saved so can refer to the average propensity to save
Dissaving
Consumption may exceed income so needs to be financed by past savings
Paradox of thrift
Saving is generally regarded as good because people can buy in the future but it is also a withdrawal from the circular flow so could contribute to a fall in national income which is the paradox of thrift
Marginal propensity to consume and save
Consumption can also be measured by the marginal propensity to consume which is concerned with a change in income and the proportion of that extra income that is spent. The proportion of extra income not spent is saved so refers to the marginal propensity to save
Influences on conusmption
Main influence is the level of disposable income but also includes:
Distribution of income and wealth
Rate of interest
Availability of credit
Expectation about future economic prospects
Average and marginal propensity to tax and import
Will also be needed to calculate the multiplier in a 4-sector economy
National income determination with AD and income
The level of income in an economy is determined at the point where AD equals output. The economy is at equilibrium where AD crosses the 45 degree line at Ye
Changing AD effect on national income
A change in AD can have a greater final impact on the level of equilibrium national income than the initial change due to the multiplier. An initial injection into the circular flow stimulates the future rounds of spending. Will eventually lead to a bigger effect on output and employment than initially. The size of the multiplier = change in real GDP/ change in AD
Positive multiplier
When an initial increase in an injection or a decrease in a leakage leads to a greater final decrease in real GDP
Negative multiplier
When an initial decrease in an injection or an increase in a leakage leads to a greater final decrease in real GDP
Components and determinants of AD
AD is the total demand for and expenditure on all that is produced in an economy. AD = C+I+G+(X-M)
The consumption function
Shows the relationship between consumer spending and the factors affecting it. The main influence on consumption is the level of disposable income and the consumption function shows the relationship between income and consumption
Autonomous consumption
Consumption that is not related to income
Induced consumption
Consumption related to income. As extra income is gained, some of this will be spent
The savings function
Shows the relationship between saving and the factors affecting it
Autonomous saving
Savings that are not related to income
Induced saving
Savings related to income. As extra income is gained, some of this will be saved
The investment function
Investment is the capital expenditure by firms in an economy over a period of time. The investment function shows the relationship between investment spending and the factors affecting it
Influences on investment decisions
Rate of interest
Changes in technology
Productivity of labour
Cost of capital goods
Changes in consumer demand
Expectations about future economic prospects
Government policies
Autonomous investment
Refers to expenditure on capital investment that is not the result of any changes in the level of national income. An increase or decrease will be shown by an upward or downward shift of the AD curve
Induced investment
Refers to expenditure on capital equipment directly related to changes in income. It is an important part of the accelerator theory of investment
The accelerator
Based on the link between changes in the level of national income and changes in induced investment. It states that investment is a function of change in national income and it assumes a fixed capital:output ratio. Concerned not with the level of output but with the rate of change of output
Government spending
Can include current spending on wages and salaries of the public sector and capital spending on investment projects
Influences on government spending decisions
Policy commitments on aspects of society
Amount of tax revenue
Demographic changes
Net exports
Exports-imports determined by relative prices of a countries exports and imports, the quality, reliability and reputation of a countries exports and imports and exchange rate movements
Inflationary gap
A situation where equilibrium income is greater than full employment equilibrium. AD is greater than full employment of AS
Deflationary gap
Where equilibrium income is less than the full employment equilibrium. AD is less than full employment of AS
Actual economic growth
Economic growth can come about using existing factors of production more effectively. Shown by movement from within a PPC to a position on the curve. Also known as demand side economic growth because it is affected by changes in demand measured by an increase in real GDP over time
Potential economic growth
The PPC can shift outward due to an increase in the quantity or quality of available factors of production
Output gaps
An output gap indicates the difference between actual output and maximum potential output of an economy as a percentage of GDP
Positive output gaps
Where an economy is outperforming expectations because actual output is higher than the recognised maximum capacity output
Negative output gaps
Where actual output is below full capacity output
The business cycle
The business or trade cycle is the fluctuations in the full employment level of national output. The cycles vary in length and seriousness but tend to follow the path of economic growth
Phases of the business cycle
Boom: a period of relatively high economic growth
Recession: a period of economic downturn defined as 2 successive quarters of negative GDP growth
Trough: a period of low AD and relatively high unemployment
Recovery: a period when the level of AD begins to increase
Causes of the trade cycle
Changes in interest rates
Changes in technology
Changes in global trade
Changes in levels of economic confidence
Changes in exchange rates
Changes in house prices
The multiplier effect
The accelerator effect
Changes in the level of liquidity in the financial sector
Volatility in stock market indices
Changes in fiscal policy
The role of automatic stabilisers
Reduce the rate of economic growth. A government will receive more tax revenue creating a greater withdrawal. from the circular flow
Increasing the rate of economic growth. A government will increase spending on unemployment benefits creating an injection into the circular flow
Policies to promote economic growth
An increase in the number of workers
An improvement in the quality of labour
Greater commitment to R&D in invention and innovation
An improvement in the state of technology
Investment in capital stock
A move towards more capital intensive production
Increasing mobility and flexibility of factors of production
More efficient allocation of resources
Development of new markets to export to
Reduction in taxes on profits to allow firms to finance investment
Upturn in the business cycle
The effectiveness of policies to promote economic growth
Effectiveness will depend on economic circumstances but key factor are investment which increases productivity, education and training which enhances the quality of human capital, technological change which leads to the availability of better machines and new markets for exports which increase demand for a country’s goods and services
Inclusive economic growth
Growth that is distributed fairly across society and creates opportunities for all
Impact of inclusive economic growth on equity and equality
It aims to ensure that economic growth benefits everyone and therefore has a positive impact on equity and equality
Policies to promote inclusive economic growth in specific areas
Takes place in sectors in which the poor work
Occurs in places where the poor live
Uses factors of production that the poor possess
Reduces prices of goods that the poor consume
Policies to promote inclusive economic growth on poverty reduction and eradication
Expand access to quality education
Expand access to quality healthcare
Investing in infrastructure
Deepening financial inclusion for vulnerable poeple
Incentivising female labour force participation
Ways to bring about inclusive economic growth
Progressive incomes and wealth taxes can contribute to reducing inequality without sacrificing growth. A universal basic income where a government provides a guaranteed minimum income for all and has the potential to reduce poverty and inequality
Sustainable economic growth
Sustainability is the ability to use existing resources to satisfy the needs of the present generation without compromising the ability of future generations to satisfy their needs. Sustainable economic growth takes into account the needs of the future and present generations. Refers to a rate of economic growth a country can maintain without creating other economic problems. There is a trade off between rapid economic growth today and growth in the future
Using and conserving resources
The use of resources can contribute to economic growth but many natural resources are finite in supply so will eventually run out. It is argued in many economies that there should be conservation of resources. This is a more sustainable approach
The impact of economic growth on environment and climate change
Higher levels of resource consumption
The depletion or loss of non-renewable resources
Greater pollution causing health problems and reduced quality of life
Policies to mitigate the impact of economic growth on the environment and climate change
Technology
Human capital development
Deregulation
Incentivisation
Pollution permits
Alternative transportation
Taxation
Legislation
Financial support
Recycling
Commitment to action on climate change
Reforestation
Full employment
A situation where everyone who wants a job has a job
Unemployment
Where a number of people in an economy are able and willing to work but are unable to gain employment. The unemployment rate is a percentage of the number of unemployed people divided by the labour force
Equilibrium unemployment
When the labour market is at equilibrium meaning jobs exist but people are unwilling or unable to take them. Frictional, seasonal and structural
Disequilibrium unemployment
When the wage rate rises above equilibrium and the labour market is prevented from clearing. Cyclical and real-wage
Voluntary unemployment
Where a worker deliberately chooses not to work because of a low wage rate
Involuntary unemployment
Where a worker is willing to work at the market wage but is prevented from doing so by factors beyond their control. There is a surplus of labour
Natural rate of unemployment
Shows the link between the level of unemployment and the rate of inflation. The level of unemployment which contributes towards a rate of inflation that is non-accelerating. AD for labour is equal to AS of labour at the current wage rate so there is no upward pressure on prices
Determinants of the natural rate of unemployment
Information: determines how quickly people are frictionally unemployed find work
Benefits: Generous unemployment benefits discourage people taking jobs at the current wage rate, f benefits are low the natural rate will fall
Education: Quality of skills and education influences occupational mobility. A better trained workforce is more occupationally mobiles so the natural rate falls
Geographic mobility: The more people are willing to move, the more mobile they are so the natural rate falls
Labour market: Trade unions can restrict labour supply to certain labour markets making them less flexible and increasing the natural rate
Hysteresis: A recession may cause a rise in the natural rate because when people are unemployed for a long time they become deskilled and demotivated so it is harder to find jobs
Policy implications of unemployment
Improved education and training to reduce occupational immobility
Better information about job vacancies in different regions to reduce geographical immobility
Greater flexibility of labour markets
Patterns and trends in unemployment
If unemployment trends upwards the government will devise policies to reduce it. The unemployment rate will fluctuate with changes in economic activity and phases of the business cycle. Economists are interested in long term trends and patterns such as in relation to the primary, secondary and tertiary sectors
Forms of labour mobility
Mobility of labour is the ability and willingness of labour to move from one place or occupation to another. Geographical mobility refers to a workers ability to move places. Occupational mobility refers to workers ability to move occupations
Factors affecting labour mobility
Education and training: the more a person is education, the greater the occupational mobility
Transport and communication: more developed will encourage geographical mobility
Job information: availability of appropriate information will improve overall mobility
Wage differences: differences will influence the extent of overall mobility
Cost of living: can vary between regions impacting geographical mobility
Immigration policy: ability to move countries can be restricted
Fiscal policy to reduce unemployment
Will involve the reduction of taxation to increase consumption and investment. Government expenditure can also be increased. This will increase AD and reduce unemployment
Monetary policy to reduce unemployment
Interest rates could be lowered or money supply increased to encourage spending. A reduced cost of borrowing will encourage more spending and less saving. This is also likely to reduce the exchange rate making exports more price competitive internationally increasing demand for them and therefore derived demand for labour to produce them
Supply side policy to reduce unemployment
Especially effective to reduce the natural rate of unemployment. Making markets more efficient will increase the number of workers employed. Making the labour market more flexible like with restrictions on trade unions will lead to greater employment as will education and training schemes
Barter and its disadvantages
Bater involved the direct exchange of goods and services
Needs a double coincidence of wants
Difficult to compare the value of different products
Some products are indivisible
Some products are hard to store while looking for a buyer
Money definition
Anything that is generally acceptable as a means of payment. Near money is an asset that can be immediately changed into money so can perform some but not all (medium of exchange) functions of money
Liquidity and cheques
Liquidity is how easy a financial asset can be turned into cash. Many deposits are in the form of bank deposits so is electronic. A cheque is a means of payment but is not always acceptable. The reward for parting with liquidity is interest. Cash desposits in a savings account receive money in the future together with the original deposits
Functions of money
Medium of exchange: no need to establish a double coincidence of wants
Unit of account: the value of different products can be compared
Store of value: wealth can be stored as money but inflation will reduce value
Standard for deferred payment: people can borrow money and pay it back later which encourages credit and trade
Modern characteristics of money
Acceptability
Portability
Scarcity
Recognisability
Stability of value
Divisibility
Durability
Money supply
The total amount of money in an economy at any time
Broad money
Reflects the total purchasing power that is available including notes, coins and bank and building society deposits
Narrow money
The cash available including notes and coins held by the general public, cash machines and in balances that financial institutions have with the central bank. Also called a monetary base
Quantity theory of money Fischer equation
Shows the relationship between money supply, price level and level of output
MV = PT where M is the value of the money supply, V is the velocity of circulation, P is the general price level and T is the number of transactions
Quantity theory of money
V and T are considered to be constant. M and P are directly linked. If money supply rises, people have access to more funds so greater purchasing power so the general price level will rise. Persistent inflation can only arise through persistent excessive money supply growth so outward AD movement. Criticised for being less of a theory and more of an identity. MV shows total spending and PT is total money received for goods and services
Functions of commercial banks
Providing deposit accounts: accounts provided include demand deposit or current accounts when money can be deposited or withdrawn at any time, fixed deposit where money is deposited for fixed time and different savings accounts
Lending money: can lend money as an overdraft, where a current account can be withdrawn up to a maximum, a loan where a specific amount of money is lent for a set time and a mortgage
Cash, securities and equity: can hold or provide cash as notes and coins and securities like shares or equities in governments of companies
Reserve ratio
Refers to central bank regulations that establish minimum capital reserves a commercial bank mush hold as a percentage of deposits. A higher proportion of reserves indicates financial soundness because they could meet any future losses. Calculated by reserves divided by capital
Capital ratio
Measures the funds it has against the riskier assets it holds that could be vulnerable in a crisis. They sometimes carry out stress tests to check they have enough capital buffer to cope. It is a banks core equity capital divided by total risk weighted assets
Objectives of commercial banks
Liquidity: their ability to finance all monetary obligations to creditors when due
Security: need to demonstrate they are a safe, secure and trustworthy means of storing money so customers have confidence in them
Profitability: main aim is to make a profit for shareholders
Commercial banks as sources of credit creation
Financial institutions can create new money due to additional deposits. Only a certain proportion of customers want to take out money at any time. A large proportion of deposited money can be loaned to customers through fractional reserve banking being the requirement that commercial banks need to hold a certain percentage of total liabilities of cash reserves
The bank credit multiplier
The ratio of new money created to initial deposits is the credit multiplier calculated as 1 divided by deposited cash ratio that is held. The smaller the cash ratio the larger the credit multiplier
The role of a central bank
May wish to control the ability of commercial banks to lend money through open market operations. This is the process of buying or selling government securities which are bonds or shares issued by the government. If a central bank wants to encourage lending it will buy government securities
Government deficit financing
If expenditure is greater than revenue there is a budget deficit. Deficit financing is the generation of funds to finance the deficit. Could be financed by borrowing from commercial or central banks leading to an increase in money supply from an increased ability to lend
Quantitative easing
Is the process of the central bank buying existing government securities. They are leading to an increase in bank deposits creating more liquidity and a greater money supply
Changes in the balance of payments
Total currency flow is a part of a balance of payments and shows the total inflow and outflow of money due to international transactions. If the flow is positive, it will increase the foreign exchange reserves of a country. This net inflow of money will increase its money supply
Fiscal policy to reduce inflation and its effectiveness
If a government reduces spending or increases taxation, this will reduce AD reducing inflation which is especially useful when inflation is demand-pull
Monetary policy to reduce inflation and its effectiveness
If a government increases the rate of interest or reduces the money supply, this will reduce AD reducing inflation. Especially useful when inflation is demand-pull
Supply side policy to reduce inflation and its effectiveness
If the labour market is made more competitive and efficient such as by reducing the power of trade unions or reducing unemployment benefits, this will increase AS. Could also increase market competition by privatising state owned firms and encouraging SM businesses, AS will increase
Liquidity preference theory
Demand for money and determination of interest rates can be shown by liquidity preference theory. Based on 3 motives for holding money being transactions demand for money, precautionary demand for money and speculative demand for money
Transactions demand for money
Where money is demanded for everyday purchases. This is an active balance and interest elastic
Precautionary demand for money
Where money is demanded for unexpected expenses. It is an active balance and is interest inelastic
Speculative demand for money
Where money is demanded to buy government bonds. Is an idle balance is interest elastic. An influence on demand for a bond is the yield which is the annual income obtained from the bond as a proportion of current market price. Price of government bonds and interest rates move in opposite directions because if interest rates are high, the desire to hold money falls. If the interest rate is low there is less incentive to switch out of money into other assets. The demand curve is downward sloping.
Liquidity trap
At low rates of interest, liquidity preference become horizontal so a change in money supply has no effect on interest rates. Demand for money is perfectly elastic. The liquidity trap occurs when an increase in money supply does not affect interest rates so does not affect investment or AD. A shift of the money supply curve to the right would normally lead to a fall in interest rates but when there is a liquidity trap there is no effect
Keynesian theory of interest rate determination
Suggests that interest is a reward for parting with liquidity for a time. The rate of interest is determined by the supply and demand of money. The demand for money comes from the transaction, precautionary and speculative motives. The supply of money is fixed and controlled by the monetary authority and is perfectly interest inelastic
Loanable funds theory of interest rate determination
States that the rate of interest is determined by the supply and demand of loanable funds in financial markets. The demand for loanable funds comes from firms wanting to invest, households wanting to buy consumer products and a government aiming to fund a budget deficit. Demand curve for loanable funs slopes down from left to right. Supply comes from savings and slopes up from left to right. The intersection is the rate of interest
