Chapter 7 (part 1)

Question 1

What does RPI stand for?

Answer 1

Retail Price Index (RPI)

Question 2

What is RPI?

Answer 2

1) RPI is used as a general measure of inflation
2)The RPI compares the price of a basket of goods against a similar basket in 1987 (the base year).
-The basket is updated periodically, but typically includes food, alcohol, tobacco, DVDs and household goods.

3) RPI is a weighted price-based index

Question 3

What are the Consequences of inflation

Answer 3

1) Wealth redistribution
2) Balance of Payments
3) Creates uncertainty
4) Costs associated with changing prices

Question 4

What are the Causes of inflation

Answer 4

1) Cost push inflation
2) Demand pull inflation

Question 5

Consequences of inflation: Wealth redistribution

Answer 5

-People on fixed incomes (e.g. pensioners) often suffer in periods of higher inflation since even though they may get some sort of inflationary rise it will often not match the true increase in costs that they face due to their buying patterns.
-A saver would see the ‘real’ value of their savings decrease
-A borrower would see the ‘real’ value of their debt actually decrease

Question 6

Consequences of inflation: Impact on balance of payments

Answer 6

-Higher inflation in the UK compared to its world trading partners makes UK goods relatively more expensive and the foreign goods relatively cheaper.

-This will have an adverse effect on exports and
potentially UK employment.
-This may ultimately be corrected by a weakening of the £ relative to the $.

Question 7

Consequences of inflation: Creates uncertainty

Answer 7

-A significant problem with inflation is that the higher it gets the more difficult it is to plan for the future.

-Businesses may hold back on investment projects or require those projects to generate much higher returns before they will take them on.

-Projects may therefore get postponed until there is more
certainty and this damages the demand within the economy.

Question 8

Consequences of inflation: Costs associated with changing prices

Answer 8

In periods of excessive price changes, shopkeepers will need to keep changing shop price levels (labels, tills, computer systems etc) all the time.
Consumers will also face a tougher task to compare prices of goods.

Question 9

What is hyperinflation? What is a case study for hyperinflation?

Answer 9

Hyperinflation may be reached if inflation becomes excessive.
Hyperinflation may lead to an ‘economic meltdown’

Zimbabwe is a good example
-They have had inflation estimated to be well into six-figure percentages
-This results in massive devaluation of the currency
-Price changes for goods twice a day
-Huge wage increase demands
-Collapse of the economy with no goods to buy in shops
-Big black market

Solution: Zimbabwe Government stopped printing bank notes
- Now common for trade in Zimbabwe to be conducted in US dollars (Currency substitution)

Question 10

Many countries operate inflation targets, what does the UK do?

Answer 10

The British Gov has pursued an explicit inflation taget for the economy.
in 1997 Labout set the target for RPIX inflation at 2.5% +/-1%
This approach has been broadly maintainted.
Currently target is approx 2% but actual rates are closer to 10%

Question 11

How is the Bank of England involved in interest rate setting

Answer 11

The BoE Monetary Policy Committee (MPC) sets interest rates with a view of meeting the inflation target over the next two years,

If RPIX inflation moves 1% either side of the 2% target, the Gov of the BoE has to write an open letter to the Chancellor to explain the reasons for inflation undershoot or overshoot and the subsequent steps they will take to bring inflation back into the target range.

Question 12

Causes of Inflation: What is cost push inflation (basic)

Answer 12

-Cost Push Inflation occurs when firms increase prices to maintain/protect profit margins after experiencing a rise in their costs of production.

-Common input costs that cause inflationary pressure are wages, oil prices and increased cost of imported goods used in production (import cost push inflation)

Question 13

Causes of Inflation: What is cost push inflation (economics)

Answer 13

If costs of production increase, supply will decrease
-There is an inward shift of the short run aggregate supply curve (AS to AS1)
-This leads to a contraction in AD and a fall in real output (Y1 to Y2)
-And an increase in the general price level from P1 to P2

Relevent Graph: Price Level vs National Income

Question 14

What is a wage price spiral?

Answer 14

Workers demand greater wage increases ->
Firms increase prices to maintain margins ->
Prices are expected to rise further ->

as a loop

Question 15

Causes of Inflation: What is demand pull inflation (basic)

Answer 15

-Demand pull inflation occurs when total demand for goods and services exceeds total supply.
-This type of inflation happens when there has been excessive growth in aggregate demand and there is an
inflationary gap.
-Demand pull inflation is often monetary in origin - because the authorities allow the money supply to grow faster than the ability of the economy to supply goods and services.
-The phrase that is often used is that there is “too much money chasing too few goods”.

Question 16

Causes of Inflation: What is demand pull inflation (economics)

Answer 16

Graph Price level vs National income (real terms)
If AD is at a level where there is effectively excess demand in the economy (AD1)
ADfe level demonstrates a full employment level of AD - where the eqm price level would be set at P2

In either case the national income in real terms (i.e. quantity of goods and services) will be the same since the economy is at full employment, however with the excess demand level AD1 we see higher prices (i.e. inflationary tendencies).
The excess prices P1 – P2 caused by the excess demand is referred to as an inflationary gap

Question 17

Most govs want to keep both unemployment and inflation low, what is the problem with this?

Answer 17

There is a fundamental conflict between the two objectives

Research by Phillips indicated that there is an inverse relationship between inflation and unemployment. (One low - other high)

This suggests that any attempt to reduce unemployment below the natural rate would cause inflationary pressures.

Question 18

What is NAIRU?

Answer 18

Non-Accelerating Inflation Rate of Unemployment (NAIRU)
– the ‘natural rate of unemployment’

Question 19

What is a Phillips curve?

Answer 19

Inflation(%) vs Unemployment rate(%)
-Suggests there is a trade off between keeping inflation low and unemployment low

Question 20

In regards to inflation and unemployment, what do the phillips curve and Keynesian approaches to economics not allow for?

Answer 20

They do not allow for the possibility of inflation and unemployment occuring together.
This is exactly what happened in the 1970s in the UK - Stagflation

Question 21

What is stagflation

Answer 21

In economics, stagflation is a situation in which the inflation rate is high or increasing, the economic growth rate slows, and unemployment remains steadily high.

It presents a dilemma for economic policy, since actions intended to lower inflation may exacerbate unemployment.

Question 22

What is the Expectations augmented Phillips curve?

Answer 22

-Made by Milton Friedman revising the Phillips curve
-It is an updated PC to reflect that the inflationary expectations distort the inflationary process.

-Milton noted that as an economy is stimulated to reduce unemployment, for example by boosting aggregate demand to move up PC1 then there will be pressure on wages since there is an excess demand for labour.
Workers will realise that they are no better off in real terms and hence unemployment will revert back to what it was before and would now be operating on PC2, and so on

Question 23

What is the LRPC

Answer 23

Ultimately Milton said that the result is that any attempts to reduce unemployment below a certain level are simply going to cause an increase in inflation such that in the long run the Phillips curve is a
vertical line (LRPC

Question 24

What are the three main policy tools used to achieve economic policy goals?

Answer 24

1) Fiscal
2) Monetary
3) Supply Side

Question 25

What is brief description of Fiscal Policy?

Answer 25

Fiscal policy involves the use of government spending taxation and borrowing to influence both the pattern of economic activity and also the level and growth of AD, output and employment.

-Changes in fiscal policy affect both AD and AS

Question 26

What are some e.g’s of how a change in fiscal policy affects the economy?

Answer 26

1) Cut in personal income tax -> Boost disposable income -> Adds to consumer demand
2) Cut in indirect taxes -> lower prices (higher real incomes) -> Adds to consumer demand
3) Cut in corporation tax -> Higher ‘post tax’ profits for businesses -> Adds to business capital spending
4) Cut in tax on interest from saving -> boosts disposable income of people with net savings -> adds to consumer demand

Question 27

What does the multiplier effect of an expansionary fiscal policy depend on?

Answer 27

-How much spare productive capacity the economy has
-How much of any increase in disposable income is spec rather than save/spent on imports
-The effects of fiscal policy on variables (e.g. interest rates)

Question 28

Fiscal: How much of the GDP is spend on government spending

Answer 28

40%

Question 29

Fiscal: What are the three main areas of spending by the public sector?

Answer 29

1) Transfer Payments
2) Current Government Spending
3) Capital Spending

Question 30

Fiscal: Gov spending: What are transfer payments?

Answer 30

Transfer payments are government welfare payments made available through the social security system.

The main aim of transfer payments is to provide a basic floor of income or minimum standard of living for low-income households in our society. And they also provide a means by which the government can change the overall distribution of income in a country.

e.g.s State pension, Jobseekers allowance, housing/child benefits

Question 31

Fiscal: Gov spending: What is Current government spending?

Answer 31

spending on state-provided goods & services that are provided on a recurrent basis every week, month and year, for example salaries paid to people working in the NHS and resources used in providing state education and defence. Current spending is recurring because these services have to be provided day to day throughout the country.

Question 32

Fiscal: Gov spending: What is capital spending?

Answer 32

-Include infrastructural spending such as spending on new motorways and roads, hospitals, schools and prisons. This investment spending by the government adds to the economy’s capital stock and clearly can have important demand and
supply side effects in the medium to long term

Question 33

Fiscal: How do we justify government spending?

Answer 33

1) To provide a socially efficient level of public goods and merit goods
2) To provide a safety-net system of welfare benefits to supplement the incomes of the poorest in society – this is also part of the process of redistributing income and wealth
3) To provide necessary infrastructure via capital spending on transport, education and health facilities – an important component of a country’s long-run aggregate supply
4) As a means of managing the level and growth of AD to meet the government’s main macroeconomic policy objectives such as low inflation and high levels of employment

Question 34

Fiscal: What are the key principles of taxation called?

Answer 34

Canons of Taxation
1) Certainty - taxpayeres should be able to predict the tax they are likely to pay
2) Conveneience - paymentes should be easy to make
3) Equity - based on ability to pay
4) Economy - collection by gov should be cost effective

Question 35

Fiscal: What is the difference between direct and indirect taxes?

Answer 35

Direct taxation is levied on income, wealth and profit. Direct taxes include income tax, national insurance contributions, capital gains tax, and corporation tax
(Tax on income - Income tax, corporate tax and national insurance)
(Tax on capital - Inheritance tax, capital gains tax)

Indirect taxes are taxes on spending – such as excise duties on fuel, cigarettes and alcohol and Value Added Tax (VAT) on many different goods and services
(Tax on spending - Vat, Customs and excise duties)

Question 36

Fiscal: What is Progressive Tax?

Answer 36

-The marginal rate of tax rises as income rises
-As people earn more income, the rate of tax on each extra pound goes up.
-This causes a rise in the average rate of tax (the percentage of income paid in tax)

e.g. UK income tax

Question 37

Fiscal: What is Proportional Tax?

Answer 37

-The marginal rate of tax is constant.
-Eg. a standard rate of tax of N% across all income levels.
If the marginal rate of tax is constant, the average rate of tax will also be constant

UK eg. - closest is NI

Question 38

Fiscal: What is regressive tax?

Answer 38

-The rate of tax falls as incomes rise - the average rate of tax is lower for people of higher incomes

-UK e.g. = excise duties of items of spending eg alcohol and cigarettes

Question 39

What is the impact of high taxation levels?

Answer 39

• Shown by the Laffer curve: Tax Revenue vs Tax rate (%)
  T* - the optimum tax rate where the maximum amount of tax revenue can be collected

The Laffer Curve suggests that, as taxes increased from fairly low levels, tax revenue received by the government would also increase. However, as tax rates rose, there would come a point where people would not regard it as worth working so hard. This lack of incentives would lead to a fall in income and therefore a fall in tax revenue.

The suggestion is that high levels of tax reduce the incentive for people to go out and get work or that the high tax levels can lead to increased avoidance of tax (using loopholes in legislation or tax planning specialists to minimise the amount of tax that is suffered)

Question 40

FIscal: What is Balancing the budget

Answer 40

a balanced budget is when government spending = taxation in a given year (G=T)

If G> T = a budget/fiscal deficit - need for the government to borrow. The amount of excess spending over the tax income = PSNCR = Public Sector Net Cash Requirement

If T> G

Government Debt = Amounts outstanding on GILTS

Question 41

FIscal: What is Balancing the budget

Answer 41

a balanced budget is when government spending = taxation in a given year (G=T)

If G> T = a budget/fiscal deficit - need for the government to borrow. The amount of excess spending over the tax income = PSNCR = Public Sector Net Cash Requirement

If T> G = a budget/fiscal surplus. PSNCR is negative and the gov would be able to repay some of the national debt

Government Debt = Amounts outstanding on GILTS

Question 42

What has fiscal policy traditionally been seen as?

Answer 42

An instrument of demand management
-Changes in gov spending, taxation and the budget balance can be used to smooth out some of the volatility of real national output particularly when the economy has experience an external shock.

Question 43

What is the Keynesian school argument on fiscal policy

Answer 43

Keynesian school argues that fiscal policy can have powerful effects on aggregate demand, output and employment
-when the economy is operating well below full capacity national output and where there is a need to provide a demand stimulus to the economy

They believe there is a clear justified role for the government to make active use of fiscal policy measures to manage level of aggregate demand

Question 44

What do monetarist economists feel about fiscal policy?

Answer 44

They believe that gov spending and taxation can only have a temporary effect on aggregate demand, output and jobs

-They believe monetary policy is a more effective instrument for controlling demand and inflationary pressure

They are more sceptical about the wisdom of relying on fiscal policy as a means of demand management

Question 45

Can fiscal policy affect the supply-side capacity of the economy?

Answer 45

yes - the effects tend to be longer term in nature
Policies include
1) Labour market incentives
2) capital spending
3) Entrepreneurship and new business creation
4) R&D +I
5) Human capital of the workforce

Question 46

Fiscal: How do labour market incentives effect the supply-side capacity of the economy?

Answer 46

Cuts in income tax might be used to improve incentives for people to actively seek work and also as a strategy to boost labour productivity. Some economists argue that welfare benefit reforms are more important than tax cuts in improving incentives – in particular, to create a “wedge” or gap between the incomes of those people in work and those
who are in voluntary unemployment.

Question 47

Fiscal: How does capital spending effect the supply-side capacity of the economy?

Answer 47

Government capital spending on the national infrastructure (e.g. improvements to our motorway network or an increase in the building programme for new schools and hospitals) contributes to an increase in investment across the whole economy. Lower rates of corporation tax and other business taxes might also be used as a policy to
stimulate a higher level of business investment and attract inward investment from overseas

Question 48

Fiscal: How does entrepreneurship and new business creation affect the supply-side capacity of the economy?

Answer 48

Government spending might be used to fund an expansion in the rate of new small business start-ups

Question 49

Fiscal: How does research, development and inovation effect the supply-side capacity of the economy?

Answer 49

government spending, tax credits and other tax allowances could be used to encourage an increase in private business sector research and development – designed to improve the international competitiveness of domestic businesses and contribute to a faster pace of innovation and invention

Question 50

Fiscal: How does human capital of the workforce effect the supply-side capacity of the economy?

Answer 50

Higher government spending on education and training (designed to boost the human capital of the workforce) and increased investment in health and transport can also have important supply-side economic effects in the long run. An enhanced transport infrastructure is seen by many business organisations as absolutely essential if the UK
is to remain competitive within the European and global economy

Question 51

Do people support that fiscal policy effects the supply side of the economy?

Answer 51

Free market economists are normally sceptical of the effects of government spending in improving the supply-side of the economy. They argue that lower taxation and tight control of government spending and borrowing is required to allow the private sector of the economy to flourish. They believe in a smaller sized state sector so that in the long run, the overall burden of taxation can come down and
thus allow the private sector of the economy to grow and flourish

However, targeted government spending and tax decisions can have a positive impact even though fiscal policy reforms take a long time to feed through. The key is to help provide the right incentives for individuals and businesses – for example the incentives to find work and incentives for businesses
to increase employment and investment

Question 52

In the UK who sets the interest rates?

Answer 52

Used to be by the government (the Chancellor)
-Control was passed to the Bank of England in 1997

The operational indepence of the BoE means that it can set targets for inflation and set interest rates at the level most appropriate to achieve those targets
The level is set at monthly meetings of the MPC ‘monetary polict committee
A majority decision of the comittee is all that is requied to change the level of interest rates

Question 53

Monetary: What are Policies to reflate? Interest rates

Answer 53

If MPC considers inflation is falling and they will easily meet their inflation target - they may consider cutting interest rates.
-If there is danger of the economy suffering a downturn, this will help reinforce this decision.

-Cutting IntR will encourage people and firms to borrow more money
-Gives those with mortages more money to spend each month due to reduced mortage payments.

Overall, this increases the level of consumption and investment, which are 2 key components of AD, cutting interest rates should result in increased economic growth and reduced unemployment.

Question 54

Monetary: What are Policies to reflate? Money Supply

Answer 54

The government could allow the money supply to increase to encourage spending
–Monetarists argue that if this is allowed to happen, too much inflation will result (Quantity theory of money)

Question 55

What are the two reflationary monetary policies

Answer 55

1) Cutting interest rates
2) Allowing money supply to increase - by lowering the banks reserve requirements or relaxing direct controls over the banks ability to lend

Question 56

What are the two deflationary monetary policies

Answer 56

1) Increasing interest rates
2) Reducing money supply

If MPC wanted to try and slow down the economy because they were in danger of inflation going above their target 2.5% rate

Question 57

How can exchange rates be used as part of monetary policy?

Answer 57

-To influence key policy targets
E.g. in order to reduce inflationary pressure the Government could seek to strengthen the £ such that UK consumers find purchasing from abroad now more attractive and foreign customers find UK goods now too expensive (thus dampening demand for UK goods and reducing price increase
pressure)

Question 58

What are monetarist economists view of inflation

Answer 58

Monetarists don’t believe that fiscal policy was the most effective way of controlling inflation in the long term.
They believe that monetary policy and the money supply had the most direct effect.
Their theory is developed from the ‘ quantity theory of money’ which follows the fisher equation

Question 59

What is the Fisher equation

Answer 59

MV = PT or Monetary value of demand = monetary value of supply

where M = Money Supply
V = Velocity of Circulation
P = Price Level
T = Number of transations

Question 60

What are Supply side Polices? (basic definition)

Answer 60

These seek to enhance long term growth prospects in an economy by adopting policies that improve efficiency and improve aggregate supply within the economy.

Question 61

What are typical supply side policies?

Answer 61

1) Increasing competition
(deregulation, privatisation)

2) Increase effeciency of labour
(training incentives, reduce disincentives to work, reduce union power, reduced taxation, relaxation of employment legislation on minimum wages)

3) Encourage firms to invest
(tax incentives)

Question 62

What are the benefits and drawbacks of Fiscal Policy

Answer 62

Benefits
-Shown to be effective for short term impact on demand
-Can be targeted at certain sectors

Drawbacks
-Potential inflationary tendencies
-Potential impact on debt burden of the economy

Question 63

What are the benefits and drawbacks of Monetary Policy?

Answer 63

Benefits
-Effective at controlling key policy target of inflation

Drawbacks
-Not as flexible at targeting individual market sectors (interest rates)

Question 64

What are the benefits and drawbacks of Supply Side Policies?

Answer 64

Benefits
-Not inflationary
-Doesn’t automatically lead to increases in Government borrowing
-Increases competitive standing in the world

Drawbacks
-Long term policy
-Tax cuts in the short term may lead to inflation (supply cant match demand quick enough

Question 65

What is globalisation?

Answer 65

Globalisation refers to the increasing integration of national economies in terms of trade, financial flows, ideas a, information and technology.

Developing economies may gain through foreign direct investment (‘FDI’), the benefits of trade or technology transfer.

Question 66

What are factors driving globalisation?

Answer 66

1) Improved communications, 2) Political re-alignment, 3) Growth in global industries and institutions 4) Cost differentials

-Improved communications (internet, satellite tellite telecoms)
-Political re-alignment (often a significant change in political leadership instigates a desire to form a better trading relationship with the rest of the world)
-Growth in global industries and institutions (for example, the development of multinational businesses and financial institutions
-Cost differentials - The reduction of transport costs and the differences in industry cost structures in different countries makes it potentially advantageous for international trade to occue to reduce overall costs of production

Question 67

What is the impact of globalisation?

Answer 67

Relocation of certain industries to places where there are more favourable operating characteristics (cheap labour, skills/expertise clusters).

2) Increased competition (competing on a world rather than a local stage) leading to better value for money for consumers (theoretically getting better quality and lower prices).

3) Increased cross border merger and acquisition activity and other cross national alliances (e.g. strategic airline alliances). As a result, we have seen a great increase in the number of MNCs

4) There may be a widening of economic divisions between countries. It is more likely that the more developed nations will be in a better position to take advantage of free trade thus enabling them to do even better (“the rich get richer… and the poor get poorer”).

5) Emergence of new growth markets which are able to be exploited by the entrepreneurs

Question 68

What is an MNC?

Answer 68

MULTINATIONAL CORPORATIONS (MNC) (generally defined as a company that has a physical operating presence in more than one country). These MNC’s are often in a position to have an impact on the economies of the countries in which they operate (taxation, employment, balance of payments etc).

Question 69

How does the UK income tax system work?

Answer 69

The UK income tax system is progressive. Everyone is entitled to a tax-free income. Thereafter, as income grows, people pay the starting rate of tax (10%) before moving onto the basic tax rate (22%). Higher income earners pay the top rate of tax (40%) on each additional pound of income over the top rate tax limit. This is the
highest rate of income tax applied

Question 70

What is the theory behind the “quantity theory” of money?

Answer 70

Monetarists assume that the number of transactions in an economy is fixed (T) due to output being fixed and the money of all transactions can be calculated as PT.

They also assume that velocity is constant and not affected by the money supply.

The premise therefore is that if V and T are constant, then any changes in money supply will have a direct effect on prices

Question 71

Why is the threat of interest rate change bad for business?

Answer 71

It adds risk to decision-making (change during/before an investment period)
-May directly affect the sales of the business (particularly if an item is traditionally sold on credit term)
-May affect demand in the economy with a negative connotation for sales generally

Question 72

Why is the threat of interest rate change bad for business?

Answer 72

It adds risk to decision-making (change during/before an investment period)
-May directly affect the sales of the business (particularly if an item is traditionally sold on credit term)
-May affect demand in the economy with a negative connotation for sales generally

Question 73

How can businesses manage risks associated with interest rate change?

Answer 73

Similar to how FX risk is managed
-By buying contracts and guarantees to fix future interest rates

eg A forward rate agreement
or interest rate guarantee?

Question 74

What is a FRA?

Answer 74

Forward rate agreement
-A contract which fixes a target interest rate.
-This hedges both adverse and favourable movements in the exchange rate.
If the interest rate paid on the loan is higher than the target rate, the bank will pay back the difference to the company. If it is lower, the company pays the difference to the bank.

Question 75

What is an IRG

Answer 75

Interest rate guarantee
-An option to buy a FRA with a particular target IR for a period of time
-A company can enter into a loan, and if there is an adverse movement of interest rates, they can exercise the IRG and buy the FRA at that time. If there is a beneficial movement of interest rates, the IRG can simply lapse (and the company would benefit from the movement in interest rates). IRGs are expensive, as they give the
company added flexibility