Chaper 3 - The macro-economic environment Flashcards
Chapter aims are to: - Understand the implications of government economic decision - Appreciate the impact of fiscal and monetary policy - Understand the relationship of economic growth to inflation and the balance of payments
Governments seek to manage national economy, this may include the following aims:
- to achieve economic growth
- to control price inflation
- to achieve full employment
- to achieve a balance between exports and imports
Government influences diagram 1.3
+ Economic policy - Market demand; Cost of finance; Taxation
+ Industry policy - Protection vs Free Trade; Grants, incentives, sponsorship; Regulation; Entry barriers
+ Environment & Infrastructure - Distribution
+ Social policy - Workplace regulation;
+ Employment law; Labour supply, skills
+ Foreign policy - EU & GATT obligations; Export promotion to allies & aid recipients
Fiscal Policy.
The formal planning of fiscal policy (i.e. tax and spending policy) is set out annually with three components:
1) Expenditure Planning
2) Revenue Raising
3) Borrowing
What does PSNCR stand for?
Public Sector Net Cash Requirement
Explain what is meant by a budget deficit and a budget surplus.
A budget deficit is when a government spends more than it earns. A budget surplus is when its income exceeds its expenditure.
Governments can use fiscal policy to change the level of demand in the economy. They can increase demand by a) and decrease demand by b)
a) reducing taxation without changing spending, then demand is simulated.
or, spending more, but not altering tax
b) increasing taxation or reducing spending
Taxation is a key source of a) it b) and c)
a) revenue raising
b) serves to discourage activities (e.g. tobacco)
c) redistributes income and wealth (e.g. income support)
A good tax system should be what three things?
1) flexible
2) Efficient
3) Able to attain its purpose
Taxes can be either direct or indirect. Explain each & provide examples.
Direct taxes are paid directly to the Revenue authority e.g income, capital gains and inheritance tax.
Indirect taxes are collected by the revenue authority via a third party (a ‘supplier) who passes on the tax to customers e.g. per unit tax on petrol, ad valorem/ fixed percentage tax like VAT
Monetary policy uses money supply, interest rates, exchange rates and credit control to influence aggregate demand.
Instruments of monetary policy include:
- changing interest rates
- changing reserve requirements
- government intervention to influence to exchange rate
National Income and Economic Growth
Key Terminology
Equilibrium national income is where:
demand for goods and services is in balance with supply
An inflationary gap occurs:
if a country is in full employment, then any further increase in demand will lead to inflation as output is at maximum (excess demand over supply)
A deflationary gap occurs if:
there is unemployment of resources price and wages should go down. But because people do not want their wages to go down temporarily this creates a deflationary gap where prices stay fairly constant and output and demand change.
And ‘Stagflation’ occurs when:
there is a combination of high unemployment and high inflation caused by a price shock and inflexibility in supply
Phases in the business cycle.
What are the four main phases?
1) Recession
2) Depression
3) Recovery
4) Boom
Occurring in the recession phase:
- Consumer demand/ confidence falls
- Investment projects begin to look unprofitable
- Orders are cut, inventory levels reduced
- Some companies unable to sell their inventories become insolvent
if during the recession there is lack of stimulus to aggregate demand;
a period of depression will set in.
Recovery is usually slow to begin with due to a general lack of confidence in the economy:
- Governments look to boost demand (using fiscal & monetary policy)
- Together with confidence, output, income, and employment rise
- Investment flows into the economy
Once the actual output has risen above the trend line the ‘boom’ phase of the cycle is entered
- Capacity and labour become fully utilised
- Further rises in demand lead to price rises
- Business is profitable and high reward investment
Inflation and its consequences
Inflation is the name given to an increase in prices
High inflation is a problem because it leads to:
- Redistribution of income and wealth (rich get richer)
- Balance of payments effects - imports get cheaper so country buys more but export get more expensive so they sell less leading to debt
- Uncertainty of the value of money and prices
- Resource costs of changing prices- higher cost of living
- Lack of economic growth investment
The rate of inflation is measured by price indices.
A ‘basket’ of items which represent average purchases around the country is priced regularly and this forms the basis of a price index
In the UK there are now two key price indices:
RPI & CPI
Retail Price Index (RPI)
This index includes the price for all goods and services (including housing costs) purchased by UK consumers
Consumer Price Index (CPI)
This index, which excludes housing costs, is calculated on the same basis as the rest of Europe
RPIX
This is the underlying rate of inflation excluding mortgage interest payments
RPIY
This is the RPIX adjusted for the effects of any VAT changes
Unemployment
The rate of unemployed is the number of unemployed/total workforce x 100
What are the consequences of unemployment?
1) Loss of output - waste
2) Loss of human capital - people forget skills
3) Increases inequalities in income distribution - poor get poorer
4) Social costs - crime increases
5) Increased welfare payments - income support
What are the six categories of unemployment?
1) Real wage unemployment
2) Frictional (short therm delays)
3) Seasonal (e.g. tourism)
4) Structural (
5) Technological
6) Cyclical or demand deficient
Economic growth is measured by increases in GNP per head. What factors contribute to growth?
1) New investment
2) Natural resources
3) Labour sources
4) Capital availability
5) Technological progress
The balance of payments:
The UK’s bank account with the rest of the world. It related to foreign exchange movements in a country. It consists of a current a/c for trading, a capital a/c and a financial a/c
The current a/c is sub-divided into:
- Trade in goods
- Trade in services
- Income from remittance & capital return from other countries
- Transfers from interest & NGO payments from bodies in other countries.
The capital a/c comprises public sector flows of capital (e.g. gov loans to other countries)
The balance on the financial a/c comprises flows of capital to/from non government sector
When commentators speak of a balance of payments surplus or deficit they are only referring to the current a/c, which is also known as the balance of trade
Deficit - importing more than exporting
Surplus - Exporting more then importing
