Economic Performance

Question 1

What is the difference between short run and long run growth?

Answer 1

Short-run economic growth refers to an increase in real GDP due to the utilization of existing resources more efficiently. It occurs when there is a rise in aggregate demand (AD) or an improvement in supply-side factors without expanding productive capacity.

Long-run economic growth refers to an increase in the productive capacity of an economy, leading to a sustained rise in potential output. This happens due to improvements in factors such as investment, technological advancements, and education.

Question 2

What can causes a short run growth?

Answer 2

Demand-Side Factors (Affecting AD = C + I + G + (X - M))
Consumer spending (C) – A rise in disposable income or lower interest rates can increase consumption.
Investment (I) – Increased business investment due to lower interest rates or improved business confidence.
Government spending (G) – Higher public spending (e.g., infrastructure projects).
Net exports (X - M) – A weaker exchange rate makes exports cheaper, boosting demand.

Supply-Side Factors
Short-term supply shocks – Changes in oil prices, labor costs, or raw material costs.
Changes in productivity – Temporary improvements in efficiency.
Wage flexibility – Adjustments in wages affecting employment and output.

Question 3

What can causes a long run growth?

Answer 3

Investment in capital goods – More machinery and infrastructure boost productivity.

Technological progress – Innovations improve efficiency and production methods.

Education and training – A more skilled workforce increases productivity.

Institutional and policy stability – Good governance, strong property rights, and efficient financial systems encourage investment.

Labor force growth – More workers (e.g., through migration or natural population growth).

Question 4

What are advantages of economic growth?

Answer 4

1. Higher living standards – Increased income and improved access to goods and services.
2. Lower unemployment – Growth creates jobs and reduces cyclical unemployment.
3. Higher tax revenue – Allows governments to fund public services (e.g., healthcare, education).
4. Increased investment – Confidence in the economy leads to further investment and innovation.
5. Positive externalities – Growth may lead to better healthcare and education access.

Question 5

What are disadvantages of economic growth?

Answer 5

1. Income inequality – Growth can disproportionately benefit the wealthy, increasing inequality.
2. Inflation risk – Rapid growth may lead to demand-pull inflation.
3. Environmental damage – Industrial expansion can result in pollution and resource depletion.
4. Over-reliance on certain industries – Growth in one sector may cause imbalances in the economy.
5. Potential for boom-and-bust cycles – Unsustainable growth can lead to recessions.

Question 6

What is the impact of growth on individuals, the economy and the environment?

Answer 6

Individuals
Higher wages and employment opportunities improve living standards.
Rising costs of living can erode real wages, especially if inflation outpaces wage growth.
Structural unemployment if growth is concentrated in capital-intensive industries.

Economy
More investment and innovation lead to increased productivity.
Stronger tax base allows governments to invest in social infrastructure.
Potential for asset bubbles if growth is fueled by excessive credit expansion.

Environment
Increased pollution and deforestation due to industrial expansion.
Depletion of natural resources if growth relies on non-renewable resources.
Climate change concerns if energy-intensive production increases CO₂ emissions.
However, higher GDP can fund green technologies and sustainable development.

Question 7

What is the economic cycle?

Answer 7

The economic cycle (or business cycle) refers to fluctuations in economic activity over time. It consists of four main phases:

1. Boom – High economic growth, rising GDP, low unemployment, high investment, and rising inflation.
2. Slowdown – Growth slows, inflation may remain high, and investment declines.
3. Recession – Two consecutive quarters of negative GDP growth, rising unemployment, falling demand, and low inflation or deflation.
4. Recovery – Growth resumes, unemployment falls, and investment picks up.

Question 8

How to use economic indicators to identify cycle phases?

Answer 8

Real GDP – Measures total output, adjusted for inflation. Rising GDP indicates growth, while falling GDP signals recession.

Inflation Rate – Rising inflation is common in a boom, while low or negative inflation (deflation) is seen in recessions.

Unemployment Rate – Low unemployment during booms, rising unemployment in recessions.

Investment Levels – High investment in booms, declining investment in recessions.

Consumer Confidence and Spending – High in booms, low in recessions.

Question 9

What is the difference between positive and negative output gaps?

Answer 9

Positive Output Gap (Inflationary Gap): Actual GDP exceeds potential GDP.
This leads to inflationary pressures due to excessive demand.

Negative Output Gap (Recessionary Gap): Actual GDP is below potential GDP.
This indicates unused capacity, high unemployment, and weak demand.

Question 10

What can causes the change of various phases of the economic cycle?

Answer 10

Demand-Side Shocks
Changes in consumer confidence – Higher confidence boosts spending, while uncertainty reduces it.
Monetary policy changes – Interest rate cuts encourage borrowing and spending, while rate hikes slow the economy.
Fiscal policy changes – Government spending boosts growth, while austerity measures can slow it.
Global economic conditions – A global slowdown reduces export demand, affecting domestic growth.

Supply-Side Shocks
Oil price shocks – Higher oil prices increase production costs and inflation.
Technological advancements – Innovation can boost productivity and long-run growth.
Natural disasters or pandemics – Can disrupt production, leading to economic downturns.
Labor market changes – Skills shortages or labor strikes can reduce output

Question 11

What are the main UK measures of unemployment e.g. the claimant count and the labour force survey measure.

Answer 11

Claimant Count
Measures the number of people claiming Jobseeker’s Allowance (JSA) or Universal Credit due to unemployment.
Advantages: Updated monthly, simple, and cost-effective.
Disadvantages: Excludes those not eligible for benefits (e.g., long-term unemployed, those not claiming).

Labour Force Survey (LFS)
A survey-based measure following the International Labour Organization (ILO) definition.
Counts people who:
Are without a job.
Have been actively seeking work in the last four weeks.
Are available to start in the next two weeks.
Advantages: Includes all unemployed individuals, internationally comparable.
Disadvantages: Based on a sample, which may lead to inaccuracies.

Question 12

What are voluntary and involuntary unemployment?

Answer 12

Voluntary Unemployment – When individuals choose not to work at the current wage rate (e.g., due to high benefits or preference for leisure).

Involuntary Unemployment – When individuals want to work at the current wage rate but cannot find a job due to economic conditions.

Question 13

What are different types of unemployment?

Answer 13

1. Seasonal Unemployment
   Occurs due to seasonal fluctuations in demand (e.g., tourism, agriculture, retail).
   Example: Ski instructors facing unemployment in summer.
2. Frictional Unemployment
   Short-term unemployment caused by job transitions (e.g., people switching jobs or entering the workforce).
   Example: A recent graduate seeking their first job.
3. Structural Unemployment
   Caused by a mismatch of skills due to industry decline or technological changes.
   Often regional or sectoral.
   Example: Coal miners losing jobs due to a shift to renewable energy.
4. Cyclical Unemployment (Demand-Deficient Unemployment)
   Occurs due to a lack of aggregate demand (AD) in the economy, often during recessions.
   Example: Factory workers losing jobs during an economic downturn.

Question 14

How employment and unemployment may be determined by
both demand-side and supply-side factors?

Answer 14

Demand-Side Factors (Affecting AD = C + I + G + (X - M))
Economic growth – Higher GDP leads to job creation.
Interest rates – Lower rates encourage business investment and hiring.
Consumer and business confidence – Optimism leads to higher spending and employment.
Government spending – Public sector investment can boost job creation.
Global demand – Strong export demand can create jobs in exporting industries.

Supply-Side Factors
Education and skills – A skilled workforce increases employability.
Labor market flexibility – Easier hiring and firing can affect unemployment rates.
Welfare and benefits – Generous benefits may reduce incentives to work.
Demographic changes – A growing working-age population can affect employment levels.

Question 15

What is the real wage unemployment?

Answer 15

Occurs when wages are set above the equilibrium level, leading to excess supply of labor (more workers willing to work than jobs available).

Often caused by minimum wages or strong trade unions bargaining for higher wages

Question 16

What factors can determine real wage unemployment?

Answer 16

1. Minimum wage laws – If the minimum wage is set above equilibrium, firms hire fewer workers.
2. Trade union power – Strong unions can negotiate higher wages, causing excess labor supply.
3. Government policies – Policies that restrict wage flexibility (e.g., labor market regulations) may increase real wage unemployment.
4. Productivity changes – If wages rise without a proportional increase in productivity, firms may cut jobs.

Question 17

What is natural rate of unemployment? (NRU)

Answer 17

The unemployment rate when the labor market is in equilibrium (i.e., when there is no cyclical unemployment).

Consists of frictional and structural unemployment.

Even in a booming economy, some unemployment persists due to job transitions and skill mismatches.

Question 18

What factors can determine the natural rate of unemployment?

Answer 18

1. Labor market flexibility – More flexible markets (e.g., fewer hiring/firing restrictions) reduce NRU.
2. Education and training – Better skills reduce structural unemployment.
3. Welfare and benefits – Generous benefits may reduce incentives to find work, increasing NRU.
4. Demographics and mobility – High labor mobility (workers moving to where jobs are) reduces NRU.

Question 19

What are the consequences of unemployment?

Answer 19

For Individuals
1. Lower income and living standards – Loss of earnings can lead to poverty.
2. Psychological effects – Unemployment can cause stress, anxiety, and depression.
3. Loss of skills (hysteresis) – Long-term unemployment can lead to skill deterioration, making re-employment harder.
4. Social exclusion – Unemployment can lead to isolation and lower social mobility.

For the Economy
1. Lower GDP – Less output due to unused labor resources.
2. Higher government spending – Increased welfare payments and lower tax revenues strain public finances.
3. Lower consumer spending – Unemployed individuals spend less, reducing aggregate demand.
4. Potential social unrest – High unemployment may lead to crime and political instability.
5. Worsening fiscal deficit – Governments may borrow more to cover unemployment benefits and lost tax revenue.

Question 20

What are inflation, deflation and disinflation?

Answer 20

Inflation: A sustained increase in the general price level of goods and services, reducing the purchasing power of money. Measured by indices like the Consumer Price Index (CPI).

Deflation: A fall in the general price level over time, increasing the real value of money. Can be caused by weak demand or improved productivity.

Disinflation: A slower rate of inflation (prices are still rising, but at a slower pace). Common during periods of monetary tightening.

Answer 21

Inflation: A sustained increase in the general price level of goods and services, reducing the purchasing power of money. Measured by indices like the Consumer Price Index (CPI).

Deflation: A fall in the general price level over time, increasing the real value of money. Can be caused by weak demand or improved productivity.

Disinflation: A slower rate of inflation (prices are still rising, but at a slower pace). Common during periods of monetary tightening.

Question 22

How does demand-pull and cost-push inflation occur?

Answer 22

Demand-Pull Inflation
Caused by excess aggregate demand (AD), pushing prices up.
Factors influencing demand-pull inflation:
Rising consumer confidence → Increased consumption.
Expansionary monetary policy → Low interest rates encourage borrowing.
Expansionary fiscal policy → Higher government spending or tax cuts.
Strong global demand → Higher exports boost AD.

Cost-Push Inflation
Caused by higher production costs, forcing firms to raise prices.
Factors influencing cost-push inflation:
Rising wages → Higher labor costs.
Supply shocks → Oil price hikes, raw material shortages.
Currency depreciation → More expensive imports.
Increased indirect taxes (e.g., VAT) → Higher consumer prices.

Question 23

What is fisher’s equation of exchange MV = PQ?

What the quantity theory of money in relation to the monetarist model?

Answer 23

M = Money supply
V = Velocity of money (how often money is spent)
P = Price level
Q = Real output (GDP)

Quantity Theory of Money (Monetarist View)
Assumes V is stable and Q grows at a steady rate in the long run.
Suggests that changes in M directly affect P, meaning inflation is caused by excessive growth in the money supply.
Monetarists argue controlling money supply is key to managing inflation.

Criticism of the Monetarist Model
Keynesian economists argue that V is not constant and that increasing M does not always lead to inflation (e.g., in liquidity traps).
Inflation may also be influenced by supply-side factors, not just money supply growth.

Question 24

What are the effects of expectations on changes in the price level?

Answer 24

1. Wage-Price Spiral
   If workers expect higher inflation, they demand higher wages.
   Firms pass these costs onto consumers by raising prices, reinforcing inflation.
2. Interest Rates and Borrowing
   If inflation is expected to rise, central banks may increase interest rates to control it.
   Higher interest rates reduce borrowing and investment, slowing economic growth.
3. Consumer and Business Behavior
   High expected inflation → Consumers spend more now before prices rise.
   Low expected inflation (or deflation) → Consumers delay spending, worsening economic slowdowns.

Question 25

What are the consequences of inflation?

Answer 25

For Individuals 1. Erosion of Purchasing Power – Higher prices reduce the real value of money, making goods and services less affordable. 2. Income Redistribution – Those on fixed incomes (e.g., pensioners) suffer, while borrowers benefit as real debt values fall. 3. Uncertainty and Reduced Saving – High inflation discourages saving, as money loses value over time. For the Economy 1. Menu Costs – Businesses spend more on changing prices (e.g., reprinting menus, updating systems). 2. Shoe-Leather Costs – Consumers and firms spend more time managing money to avoid devaluation (e.g., shopping around, investing in inflation-protected assets). 3. Loss of International Competitiveness – High domestic inflation makes exports more expensive, reducing demand for them. 4. Wage-Price Spirals – High inflation can become self-perpetuating if expectations remain high. 5. Higher Interest Rates – Central banks may raise rates to control inflation, slowing investment and growth.

Question 26

What are the consequences of deflation?

Answer 26

For Individuals 1. Increased Debt Burden – The real value of debt rises, making repayments harder. 2. Unemployment – Falling demand leads to lower production and job losses. 3. Delayed Spending – Consumers postpone purchases, expecting lower future prices, worsening economic slowdowns. For the Economy 1. Lower Consumption and Investment – Firms delay investment due to falling prices and profits. 2. Debt Deflation – Real debt burdens increase, causing financial distress for households and businesses. 3. Higher Real Interest Rates – Even with low nominal rates, deflation increases the real interest rate, discouraging borrowing. 4. Recessionary Pressures – Falling demand leads to lower GDP and economic stagnation (as seen in Japan’s “Lost Decade”).

Question 27

How changes in world commodity prices affect domestic inflation?

Answer 27

1. Cost-Push Inflation Higher commodity prices increase input costs for firms, leading to higher prices for goods and services. Example: A rise in oil prices increases transport and energy costs, pushing up prices across various industries. 2. Imported Inflation If the UK imports commodities, a global price rise leads to higher import costs, increasing inflation. Example: A surge in global wheat prices raises UK bread and food prices. 3. Exchange Rate Effects A weaker pound makes imported commodities more expensive, increasing inflation. A stronger pound makes imports cheaper, reducing inflationary pressures. 4. Deflationary Effects (when commodity prices fall) Lower commodity prices reduce production costs, leading to lower prices (deflationary pressure). Example: Falling oil prices in 2015 led to lower transport costs and lower overall inflation in many economies.

Question 28

How changes in other economies affect inflation in the UK?

Answer 28

1. Global Demand and Supply Shocks Strong global economic growth → Increased demand for UK exports → Higher aggregate demand (AD) → Demand-pull inflation. Weak global growth (e.g., recession in key trade partners) → Lower demand for UK exports → Reduced inflationary pressure. 2. Exchange Rate Movements If major economies (e.g., the US or EU) experience inflation, the Bank of England may raise interest rates to stabilize the pound, affecting UK inflation. A weak pound increases import prices, causing imported inflation. A strong pound lowers import costs, reducing inflation. 3. Supply Chain Disruptions Global crises (e.g., COVID-19, Ukraine war, Suez Canal blockage) can disrupt supply chains, reducing supply and increasing inflation in the UK. Example: The global semiconductor shortage raised car and electronics prices. 4. Energy Prices and Geopolitical Events The UK relies on imported gas and oil; global energy price hikes (e.g., OPEC production cuts) raise UK inflation. Example: The 2022 energy crisis significantly increased UK inflation due to soaring gas and electricity prices.

Question 29

How negative and positive output gaps relate to unemployment and inflationary pressures?

Answer 29

1. Negative Output Gap (Recessionary Gap) Actual output < potential output → Economy is underperforming. High unemployment → Firms produce less, so they hire fewer workers. Low inflationary pressures → Weak demand keeps wages and prices low. Example: 2008 Financial Crisis – High unemployment and low inflation/deflation in many economies. 2. Positive Output Gap (Inflationary Gap) Actual output > potential output → Economy is overheating. Low unemployment → Firms struggle to find workers, pushing up wages. High inflationary pressures → Excess demand raises prices (demand-pull inflation). Example: Late 1980s UK – Rapid growth led to rising inflation and low unemployment.

Question 30

What is Philips curve?

Answer 30

The Phillips Curve illustrates the inverse relationship between inflation and unemployment in the short run. 1. Short-Run Phillips Curve (SRPC) Shows that lower unemployment leads to higher inflation, and vice versa. When AD rises, unemployment falls, but inflation increases due to higher wages. Policy dilemma: Reducing unemployment often leads to rising inflation. 2. Long-Run Phillips Curve (LRPC) – L-Shaped Curve (Monetarist View) In the long run, there is no trade-off between inflation and unemployment. The economy returns to its natural rate of unemployment (NRU), regardless of inflation. High inflation expectations shift SRPC outward, leading to stagflation (high inflation and high unemployment).

Question 31

What is the implications of the short run Philips curve and the long run, L - shaped Philips curve for economic policy?

Answer 31

1. Short-Run Phillips Curve (SRPC) – Policy Trade-Off Governments face a trade-off between inflation and unemployment. Expansionary policies (lower interest rates, higher government spending) can reduce unemployment but cause higher inflation. Example: 1970s UK and US – Policies to reduce unemployment led to rising inflation. 2. Long-Run Phillips Curve (LRPC) – No Trade-Off In the long run, the economy adjusts, and unemployment returns to its natural rate (NRU). If policymakers keep trying to reduce unemployment, inflation rises without reducing unemployment, leading to stagflation (high inflation and high unemployment). Monetarist View: Controlling inflation expectations is key to long-term stability.

Question 32

How economic policies may be used to try to reconcile possible policy conflicts both in the short run?

Answer 32

Short-Run Policies (Managing Inflation vs. Unemployment) Monetary Policy (Central Bank Actions) To reduce unemployment → Lower interest rates, QE (but risks inflation). To reduce inflation → Raise interest rates (but may slow growth and increase unemployment). Fiscal Policy (Government Spending & Taxation) To reduce unemployment → Increase government spending, cut taxes (stimulates demand). To reduce inflation → Reduce spending, increase taxes (slows demand but may reduce growth). Wage & Price Controls Governments may try to cap wage increases to control inflation (but can lead to labor disputes).

Question 33

How economic policies may be used to try to reconcile possible policy conflicts both in the long run?

Answer 33

Long-Run Policies (Reducing Natural Unemployment & Controlling Inflation) Supply-Side Policies (To lower NRU without causing inflation) Education & training → Improves labor market flexibility. Reducing benefits & job search incentives → Encourages employment. Infrastructure investment → Improves productivity. Monetary Rules (Inflation Targeting) Central banks set inflation targets (e.g., UK’s 2% CPI target) to manage expectations. Structural Reforms Labor market reforms (e.g., reducing trade union power) help control wage inflation.

Question 34

What are Keynesian vs monetarist/ supply side approaches on policy conflicts

Answer 34

Keynesian (demand side) Short run trade off exists Use fiscal & monetary policy to manage AD in the short run Can lead to inflation if fiscal & monetary policies are overused in the long run Monetarist (supply side) No long run trade off Focus on inflation control, avoid excessive demand stimulus in the short run Natural rate of unemployment means unemployment cannot be permanently reduced with demand policies Supply side economists Improve efficiency and productivity Reduce unemployment through structural policies Inflation and low unemployment can coexist if LRAS shifts outward

Question 35

What are deflationary policies?

Answer 35

Deflationary policies are government or central bank actions aimed at reducing inflation and slowing down excessive economic growth. These policies work by reducing aggregate demand (AD) and can be used when an economy is experiencing high inflation, asset bubbles, or an overheating economy.

Question 36

What types of deflationary policies are implemented by central banks?

Answer 36

1. Monetary Policy (Central Bank Actions) - Raising Interest Rates Higher interest rates make borrowing more expensive, discouraging spending and investment. Encourages saving, reducing consumer demand. Slows down house price growth, reducing the wealth effect. Example: UK (2022-2023) – The Bank of England raised interest rates to combat high inflation. - Reducing Money Supply (Tight Monetary Policy) Quantitative tightening (QT) → Central banks sell government bonds to absorb excess liquidity. Restricting bank lending reduces credit availability.

Question 37

What types of deflationary policies are implemented by government?

Answer 37

2. Fiscal Policy (Government Spending & Taxation) - Increasing Taxes (Contractionary Fiscal Policy) Higher income tax reduces disposable income, lowering consumer spending. - Higher corporate tax discourages business investment. - Reducing Government Spending Cuts in public services, infrastructure, or social benefits reduce overall demand. Example: UK Austerity (2010s) – Government spending cuts were used to reduce debt but also slowed growth.

Question 38

What types of deflationary policies are implemented by supply side measures?

Answer 38

3. Supply-Side Measures (To Control Inflation Without Stifling Growth) Wage Controls – Governments may cap wage increases to prevent cost-push inflation. Deregulation & Competition Policies – Encouraging market competition can reduce monopoly power and lower prices. Improving Productivity – Long-term investments in education, infrastructure, and technology can help control inflation without shrinking the economy.

Question 39

What polices may used to reduce cyclical unemployment?

Answer 39

Expansionary Monetary Policy Lower interest rates to encourage borrowing, spending, and investment. Quantitative easing (QE) to increase liquidity and stimulate demand. Example: US Federal Reserve (2008 Financial Crisis) → Cut interest rates to near zero to boost employment. Expansionary Fiscal Policy Increase government spending (e.g., infrastructure projects to create jobs). Cut taxes to boost disposable income and spending. Example: UK (2020 COVID-19 response) → Furlough scheme to prevent mass unemployment.

Question 40

What policies can be used to reduce structural unemployment?

Answer 40

Supply-Side Policies Education & training → Upskill workers to match modern job requirements. Apprenticeships & vocational training → Help transition workers into growing industries. Example: Germany’s vocational training system reduces structural unemployment. Geographic Mobility Policies Relocation subsidies → Help workers move to regions with more job opportunities. Infrastructure investment → Improve transport links to connect workers to jobs. Industry Support & Innovation Policies Encouraging R&D and innovation → Create new industries to absorb displaced workers. Example: South Korea’s investment in high-tech industries after industrial shifts.

Question 41

What policies may used to reduce frictional unemployment?

Answer 41

Improving Job Market Efficiency Better job-matching services (e.g., improved job centers, career guidance). Online job portals to connect employers and workers faster. Example: Scandinavian countries with highly efficient labor markets. Reducing Unemployment Benefits Encourages quicker job-seeking but can increase financial hardship. Balanced approach needed to avoid worsening poverty.

Question 42

What policies may used to reduce seasonal unemployment?

Answer 42

Diversifying Local Economies Encourage development of year-round industries in affected areas. Encouraging Off-Season Employment Retraining workers for temporary jobs in other sectors.

Question 43

What policies may used to reduce real wage unemployment?

Answer 43

Labor Market Reforms Reducing trade union power (to allow flexible wages). Lowering minimum wage in some sectors (controversial, as it may increase poverty). Subsidizing Employment Government wage subsidies for firms to hire workers at lower costs

Question 44

What policies may used to reduce voluntary unemployment?

Answer 44

Reforming Benefits System Reduce unemployment benefits or make them conditional on job-seeking. Introduce workfare programs (requiring work/training for benefits). Incentives to Work Lowering income tax to make work more rewarding. Flexible working arrangements to attract those hesitant to work full-time.

Question 45

How does excessive growth in credit and debt causes cyclical instability? Cyclical instability refers to large fluctuations in economic activity, where periods of rapid growth are followed by recessions. These fluctuations can be caused by various financial and behavioral factors that amplify booms and busts.

Answer 45

During economic booms, banks and financial institutions increase lending, leading to excessive borrowing by households and businesses. High levels of consumer and corporate debt fuel spending and investment, artificially boosting growth. However, when interest rates rise or confidence falls, borrowers struggle to repay debt, leading to defaults, reduced consumption, and a downturn. 2008 Global Financial Crisis → Cheap credit and risky mortgage lending in the US created a housing bubble. When house prices fell, mass defaults led to a global recession. Policies may use: Tighter financial regulation to prevent risky lending. Prudent monetary policy to avoid excessively low interest rates.

Question 46

How does asset price bubbles causes cyclical instability?

Answer 46

A speculative increase in house prices, stock markets, or cryptocurrencies leads to unsustainable booms. Investors buy assets expecting prices to keep rising, leading to excessive optimism. When the bubble bursts, asset values collapse, causing a loss of wealth, panic selling, and reduced consumer confidence. Dot-com Bubble (2000) → Investors overvalued internet companies, leading to a stock market crash. China’s Stock Market Crash (2015) → Government-driven speculation led to overinflated stock prices before a sharp collapse. Policy Solutions: Regulating speculative investments to prevent unsustainable price rises. Macroprudential policies like higher capital requirements for banks to prevent excessive risk-taking.

Question 47

How does destabilising speculation causes cyclical instability?

Answer 47

Speculators bet on future price movements in currency, stock, and commodity markets. Herd behavior can lead to rapid swings in financial markets, exacerbating economic fluctuations. Speculation distorts price signals, making investment decisions irrational and leading to over-investment or sudden capital flight. 1997 Asian Financial Crisis → Speculative attacks on Asian currencies led to sharp devaluations and financial chaos. 2021 GameStop Stock Surge → Speculative trading driven by social media led to extreme volatility. Policy Solutions: Stronger financial oversight to prevent manipulation. Transaction taxes on speculative trading to discourage excessive short-term speculation.

Question 48

How does animal spirits and herding behaviour causes cyclical instability?

Answer 48

“Animal spirits” (Keynesian concept) → Economic decisions are influenced by psychological factors rather than pure logic. In booms, optimism fuels excessive spending and investment. In downturns, pessimism leads to panic, hoarding money, and reduced investment, worsening recessions. Herding behavior occurs when investors follow the crowd rather than making rational decisions, amplifying booms and busts. Great Depression (1929) → A stock market crash led to a crisis of confidence, worsening the economic downturn. 2008 Crisis → Panic selling by banks and investors accelerated the collapse of financial markets. Policy Solutions: Counter-cyclical policies → Governments and central banks should stabilize confidence by adjusting interest rates, fiscal stimulus, and communication strategies. Improved financial education → Reducing irrational decision-making in markets.