Chapter 6 Flashcards
What are the four major objectives of government?
1) Employment
2) Inflation
3) Growth
4) Balance of Payments
These four are sometimes called the ‘economic diamond’
What are the additional two objectives that government would like to achieve in an ideal world?
1) Redistribution of wealth in favour of the poor
2) To protect the environment
Explain the ‘Employment’ objective
-To maintain low levels of unemployment.
-Anyone who wants a job but doesn’t have one will only be out of work for a short period of time
Explain the ‘Inflation’ objective?
-Inflation is usually defined as a sustained rise in the general level of prices.
Generally, governments are happy if they can keep the inflation rate down to a low percentage
What is the technical definition of inflation?
Inflation is measured as the annual rate of change of the RPI (Retail Price Index)
RPI is often refered to as the headline rate of inflation
What type of inflation does the UK Government target?
-UK Gov prefers to target the underlying rate of inflation
-This is the annual perscentage change in the RPIX.
-The RPIX is the same as the RPI except housing costs are removed in the shape of mortgage interest payments
Explain the ‘Growth’ objective?
Governments want high but sustainable growth
-Economic growth tends to measured in rate of change of real GDP
real = inflation has been removed
Explain the ‘Balance of Payments’ objective?
-The balance of payments that flows into and out of the UK
-As a generalisation, Govs want this in eqm
What tools can the government use to acheive the ‘economic diamond’ objectives? (Main two categories)
-Demand side policies
-Supply side policies
What are ‘Demand side policies’?
Policies that aim to influence aggregate demand within an economy
-The two main components of these policies are
–Fiscal policy: Gov spending and taxation
–Monetary policy: supply of money, Int Rates, XR and the availability of credit
What are ‘Supply side policies’?
Supply side policies aim to stimulate growth by influencing the supply within the economy by promoting competition, reducing trade union power and use of tax incentives
What is Macroeconomics?
Macroeconomics is concerned with decisions that affect the economy as a whole
What are the three ways of measuring the size of the flow of an economy?
1) The output method: The total amount of goods and service produced in one year
2) The expenditure method: The total amount of domestics spending by consumers, government, and foreigners
3) The income method: The total incomes earned by the factors of production involved in the production of goods and services in one year
The result of each of the three methods is GDP.
What is national income accounting?
NIA is the process whereby countries attempt to measure these flows.
What is GDP?
Gross Domestic Product (GDP)
GDP measures the value of output produced within the domestic boundaries of the UK
–It includes the output of the many foreign-owned firms that are located in the UK
–It excludes the value of the output produced by UK firms located overseas
GDP is sometimes called Gross Value Added (GVA)
What is GNP?
Gross National Product (GNP) measures the output from assets belonging to the country’s population and hence includes earnings from investments abroad.
This measure is not therefore confined to the boundaries of the country itself.
What does examination of NIA give insight on?
An examination of the national income accounts gives an insight into the economy. It provides data which governments and external agencies can use in a variety of different ways.
Including:
-To determine extent of economic growth
-To measure changes in living standards over time
-To make comparisons of economic performance and living standards between countries
-To examine and judge the performance
How does a government go about increasing overall national income?
If a government wants to increase overall national income by $500m then it will not be necessary to directly spend $500m, it can be achieved with a lower initial boost to spending.
Together, two fundamental principles create this effect:
-The multiplier principle
-The Accelerator principle
What is a basic explanation of the Multiplier principle?
- The multiplier principle suggests that you can stimulate an economy with a relatively small initial increase in spending because an initial injection into the economic system (eg gov spending) will trigger further rounds of spending
What is consumption and what are its two components?
When households spend money with firms for goods and services
Two components:
-Autonomous consumption
-Income induced consumption
What is Autonomous consumption?
Consumption that is not income dependent.
(Even if you didn’t earn any money you would still consume (e.g. food). You would have to rely on savings,
welfare payments and borrowing.)
What is Income induced consumption?
consumption that increases as your level of income increases. It is driven by your marginal propensity to consume
What is MPC
MPC = Marginal propensity to consume.
-represents the proportion of any additional income earned that is spent on consuming goods and services.
General observations are that poorer people have a higher MPC and that in a developed economy a normal MPC will be in the region of 0.7 – 0.8
What is APC?
The Average Propensity to Consume (APC) is calculated by taking total consumption ÷ income.
How can the overall consumption function be represented?
C = a + bY
Where a = autonomous consumpution
b = MPC
Y = Income level
How is the value of the multiplier found?
Multiplier = Final change in national income/ Initial change in aggregate demand
What injections are income dependant?
C - a fixed element and income dependent elemement
G, I, X-M are all assumed to be non-income dependant
eqn for an economy to be in equilibrium?
E = Y
Where E = C + G + I + (X-M)
and Y = national Income
The E vs Y graph is therefore 45*
E = Planned expenditure
Y =National Income
In context of a Planned expenditure (E) vs National income (Y) graph. When does growth occur?
Growth is likely to occur if E > Y
Equilibrium will occur at Y(E) where the expenditure line intersects the 45* E=Y line
In a simple, closed economy: How do you calculate the multiplier?
Multiplier = 1/MPS or 1/1-MPC
In a simple closed economy, all income is either spent on consumption (C) or saved (S)
On average 75% of any additional income is spent - MPC = 0.75
On av, 25% of any additional income is saved, MPS =0.25
MPC = Marginal propensity to consume
MPS = Marginal propensity to save
NBL in a simple closed economy, MPC + MPS = 1
In an open economy , how do you calculate the multiplier?
Multiplier = 1/1-MPC or 1/(MPS +MPM+MPT) or 1/MPW
Where MPT = marginal propensity to tax (how much of extra income goes in tax)
MPM = marginal propensity to import (how much of each extra $ of income is used to buy goods from abroad)
MPW = Marginal propensity to withdrawals
In an open economy MPC + MPS + MPT + MPM = 1
Can a multiplier operate in reverse
YES
- A fall in spending leads to greater overall decline in the level of national income.
-This can be one contributing factor to the boom and recession cycles that occur in the economy#
What is ‘The Accelarator Effect’
Planned capital investment by private sector businesses is linked to the growth of demand for goods and services.
When consumer or export demand is rising strongly, businesses may increase investment to expand their production capacity and meet the extra demand
The main idea is that businesses will sekk to maintain a stable capital:output ratio
Can the accelarator effect work in the negative direction?
YES! A slowdown in consumer demand can create excess capacity and may lead to a fall in planned investment demand
What are the two types of capital investment
1) Replacement investment - replacing capital items as they become old and reach the end of their useful lives. Productive capacity remains unchanged
2) Net investment - investment that leads to an increase in productive capacity (i.e. over and above replacement investmen
A product has 200 machines to make a product, each machine has a life of 4 years… what is the investment for constant demand plus an increase and decrease
Constant demand
Replacement = 50, Net = 0, Total = 0
Increase demand
Replacement = 50, Net = 40, Total = 90
Decrease demand
Replacement = 10, Net = 0, Total = 0
What is MEC?
Marginal Efficiency of Capital
- Represents the percentage return that each additional unit of capital generates.
-Sometimes called Internal Rate of Return
If the MEC> IntR, then an investment will show a profitable return and would be undertaken
Observations suggest that overall short term interest rates do not have a large impact on investment decisions. The need to innovate with technology and overall economic confidence have a greater
impact on investment
MEC - Keynes concept
Keynes used this concept to suggest that the overall relationship between the short term interest rate and amount of investment was an inelastic one. In other words, the level of investment is
more dependent on long term expected interest rates.
What is an MEC curve?
On an axis of Interest rate vs Level of investment
The MEC curve shows the relationship between the level of interest rates and the level of investment and is generally seen as an inverse relationship (i.e. the higher the level of interest rates the lower the level of investment
What could cause a MEC curve to move?
The MEC curve could shift outward due to:
-New tech increasing productivity of capital invested
-More expensive direct labour making it more attractive to automate production and invest in new equipment
-General boots to the economic environment, boosting business confidence.
What happens when you combine the multiplier and accelerator in the trade cycle?
Together the multipler principle and the accelerator effect can create large swings in the trade cycle (booms and recessions)
If there is a slowdown of initial spending due to a lack of confidence in the economy, this leads to a reduction in investment (per accelerator theory) and the downward effect of the multiplier exaggerates the ultimate change in national income and may potentially lead to a recessionary situation or even a depression.
The reverse could happen in a buoyant economy. An initial increase in spending not only causes a greater increase in national income due to multiplier effects but also there will be a rise in total investment per the accelerator and this in turn will have its own multiplier effect. These factors acting
together may well turn a buoyant economy into one with boom characteristics
What are the general phases of economic cycles?
-Recession
-Depression
-Slump
-Recovery
-Boom
What is a general definition of a recession?
Two consecutive periods of a reduction in the rate of growth of an economy
What happens in a recession
- Businesses cut back on production
- Some businesses may become insolvent
- Individuals may lose their jobs (unemployment increases)
- More money is spent by the Government on unemployment benefits
- Less money is collected by the Government in income tax and VAT
- Prices start to fall
- Reduced trade deficit
What happens in a boom?
-Businesses produce more goods and invest in more machinery - unemployment reduces
-Consumers spend more money.
-Less money is spent by the Government on unemployment benefits
-More money is collected by the Government in income tax and VAT
-Prices tend to increase (inflation) due to extra demand
-Increased demand for goods from overseas leads to trade deficits
What is a general definition of a boom
Growth above a long term sustainable level
What policies are adopted during the trade cycle?
In general policies that are adopted are done so in order to reduce the peaks and troughs (i.e. the swings) in the trade cycle.
During a boom phase, what policies are adopted?
Policies adopted will aim to slow down the rate of growth to minimise inflationary pressures
Policies include:
-Raising taxes (Fiscal)
-Reduce government spending (Fiscal)
-Raising interest rates
How is the rate of unemployment calculated?
No. of unemployed/Total Workforce x 100%
Total workforce is generally defined as the number of people willing and able to work.
How is the rate of unemployment calculated?
No. of unemployed/Total Workforce x 100%
Total workforce is generally defined as the number of people willing and able to work.
What are the main types/causes of unemployment
-Real wage
-Demand deficient
-Frictional
-Structural
-Seasonal
-Hidden
What are the consequences of unemployment?
-Greater need for benefits and welfare payments
-Increased crime
-Creates a greater divide between rich and poor
-Lost workplace skills
-Slowdown or reduction in economic output
What is seasonal unemployment?
-When demand for workers varies according to time of year in some industries (coastal resorts, ice cream, ski etc)
What is Hidden unemployment?
Whatever the published figures for unemployment, there are bound to be people who are interested in taking paid work but who, for one reason or another, are not classified as unemployed
Poverty trap - Jobless workers may not apply for jobs because of financial disincentives created by the interaction of the income tax and state benefits system
Discouraged workers - people who have effectively given up active search for jobs perhaps because they have been out of work for a long time and have lost both the motivation to apply for jobs and also the skills required
What is structural unemployment?
Structural unemployment occurs when people are made unemployed because of capital-labour substitution (which reduces the demand for labour) or when there is a long run decline in demand in their particular industry. Structural unemployment exists where there is a mismatch between their skills and the requirements of the new job opportunities. This can occur where there is a major change
in technology (sometimes known as technological unemployment)
What is Frictional unemployment?
-Transitional unemployment due to people moving jobs
-This could be fresh grads or newly redundany.
-It may take time to find appropriate jobs at wage rates they are prepared to accept.
-Unemployment time is typically short.
-Some of the frictionally unemployed may not accept jobs if they believe the tax and benefit systems will reduce significantly the net increase in income from taking paid work - a dis-incentive.
What is real wage unemployment?
Real wage unemployment is a form of dis-equilibrium environment that occurs when real wages for jobs are forced above the market clearing level
What is demand deficient unemployment?
Demand deficient/Cyclical unemployment is due to a lack of aggregate demand for goods and services. It is associated with the transition of the economy through the business cycle.
During a recession phase, what policies are adopted?
Policies include:
-Decreasing taxes (Fiscal)
-Increase government spending (Fiscal)
-Decreasing interest rates
In many developed countries there are policies which automatically help to reduce the extreme swings in the trade cycle..
These are called Automatic stabilisers
Examples include:
-Recessionary phase: Where unemployment levels are increasing, welfare benefits help to ensure that a minimum spending/consumption level is maintained
-Boom phase: When more workers are employed, the progressive tax system (increased % tax rate for high earners) increases the proportion of workers income that gets withdrawn from the circular flow. Reducing scale of the boom
What is the deeper explanation of real wage (classical) unemployment
Classical unemployment is thought to be the result of real wahes being above their market clearing level leading to an excess supply of labour.
-Think of the P vs E diagram
-Some economists believe that introducing a NMW may create some classical unemployment in industries where average wage rates are close to the NMW level and where international competition from low-labour cost producers is severe.
What is the macroeconomic equilibrium for an economy? What are the graph axis
When AD intersects with short run AS
Graphy y = Price level x = real national income
real = (minus inflation)
real national income = output of goods/services an economy produces
What is aggregate demand? what does its graph look like?
Combined total of all demands
aka. the overall demand for goods and services in an economy
downward slope: at lower prices, people want to buy more stuff
P1 etc used on graphs
What is aggregate supply?
Combined total of all supply
aka. the amount of goods and services that can be produced
First bit: increase - as prices go up, more producers will be encouraged into an economy
Second bit: When you reach full emploment (YF), output reaches it maximum and hence national income reaches its maximum and plateaus upwards.
Y1 etc used on graphs
In macroeconomic equilibrium, what happens if prices are too high or too low?
Price too high - there will be an excess supply of output
Price too low - there will be an excess demand in the long run
What is the circular flow of income?
The model considers the flow of goods/services and money around an economy
Circular flow illustration 1
Y = INCOME E = Expenditure
E=Y
2 sectors: households and firms
-Firms use factors of production (land, labour, capital and entrepreeneurship) to produce a good or service
Firms pay householes a reward for using these factors (rent, eages, interest, profit) (INCOME = Y)
When households recieve this income they use it to buy the goods and services from the firms = Expenditure - E
Circular flow illustration 2
Added complexity by adding another factor: Financial sector
Housholds save some income (income not spent)
firms receive investment
‘additions to the capital stock’
what is capital?
Man made goods used to produce other goods
Circular flow illustration 3
Added complexity by adding another factor: Gov sector
Households are required to pay taxes T
government then use these taxes in government spending G
Circular flow illustration 4
overseas sector is added
-This model is now an open model as it includes foreign trade
Imports (M) and Exports (X) are therefore added
Circular flow illustration 5
-Bc this model is open to the outside world
-Domestic spending on goods and services which originate outside the economy must be subtracted
E = C + I + G+(X-M)
IGX = Injection STM = Withdrawals
what is the formula for total expenditure in an economy?
Aggregated demand
AD = C + I + G + (X-M)
When is an economy in equilibrium ?
When planned injections and withdrawals balance each other out
If injections > withdrawals
-EG drop in IntR -> greater levels of investment
- there is more coming in to the circular flow than going out
-Period of growth
If withdrawals > injections
-EG rise in IntR -> greater levels of investment
-there is more going out than coming into the circular flow
-period of slowdown in an economy
