Feb Test Flashcards
What is Wealth?
A stock of assets which can be used to generate a flow of production or income. for example, physical wealth such as factories and machines is used to make goods and services.
What will effect the size of the Multiplier?
Changes in the marginal propensities to consume, save, tax and import will change the value of the multiplier:
An increase in the MC (which must come about because of a fall in MPS, MPM, MPT) will lead to a rise int he value of the multiplier
A large rise in interest rates is likely to discourage consumption and encourage saving, leading to a fall in the MPC and a rise in the MPS. Consequently, this would cause a decrease in the value of the multiplier.
Equally, a rise in household wealth is raise the MPC and so lead to a rise in the value of the multiplier.
Government changes to taxes paid by households will effect the multiplier. A rise in taxes increases the income paid in tax at the margin, leading to an increase in MPT. Hence, the value of the multiplier will fall.
A fall in fall in marginal tax rates will lead to a rise in the value of the multiplier.
Any factor apart from income that changes imports will also change the value of the multiplier. For example, an improvement in the quality of imported goods would encourage households to but more imports, increasing the MPM and so reduce the value of the multiplier.
What is the issue with the Multiplier?
It is difficult to measure its exact size.
Sophisticated econometric models have been used which describe the workings of the economy. They are not completely accurate. Equally, changes can happen in an economy which can alter the size of the multiplier from one period to the next.
The multiplier effect is not instantaneous. It takes time for money to flow round the circular flow.
E.g. there are time lags between the increase in government spending and the final increase in national income.
Economists disagree about the exact size of the multiplier. However in general, it is considered to be relatively low in HICs like the UK and the USA at around 0.5.
What is Inflation?
A sustained increase in the general/average price level level over time.
It implies a falling value of money. As prices rise, the purchasing power of money decreases.
What is Deflation?
A sustained fall in the general/average price level over time.
What is Disinflation?
A fall in the rate of inflation; prices are still rising but at a slower rate.
What is Cost-Push Inflation?
Inflation caused by increases in the costs of production in the economy, which are passed on to consumers as higher prices.
What is Demand-Pull Inflation?
Inflation which is caused by excess demand in the economy.
Too much spending in the economy relative to limited production capacity bids up prices.
If AD increases and there is no increase in AS, then Demand-Pull inflation is likely to occur.
What is Hyperinflation?
When the prices of goods and services rise by over 50% a month.
What is the Price Level?
The average price of goods and services in the economy.
What is CPI?
Consumer Prices Index:
The CPI (consumer price index) is the official measure of inflation in the UK.
Although CPI includes 87% of the goods used in the calculation of the RPI, CPI also includes goods such as new cars, computer hardware and air fares.
In the last decade the prices of some of these products have fallen quite dramatically, explaining why the CPI measure of inflation is often lower than that of RPI and RPIX.
The CPI also excludes some housing costs such as mortgage interest payments and council tax which tends to lead to a lower figure than RPI.
What is RPI?
Retail Prices Index:
A measure of the price level which has been calculated in the UK for over 60-years and used in a variety of contexts such as by the government to index welfare benefits.
Although the RPI may not appear to be a contentious measure of inflation, one element of the Household Expenditure Survey can make it unreliable: mortgage interest payments.
Most mortgage payments are directly affected by changes in interest rates but the problem with this is that interest rates are often used to combat inflation.
If inflation rises, interest rates usually rise too. The difficulty with this is that the rise in interest rates automatically increases monthly mortgage interest payments so the RPI inevitably rises.
Therefore, the interest rate weapon (which is designed to reduce inflation) actually has the perverse effect of increasing inflation in the short run.
In order to solve this problem, a modified version of the RPI (which excludes mortgage interest payments) is calculated which is called RPIX.
What is Anticipated Inflation?
Increases in prices which economic actors are able to predict with accuracy.
What is Unanticipated Inflation?
Increases in prices which economic actors like consumers and firms fail to predict accurately and so their decisions are based on poor information.
What is Stagflation?
Stagflation is a period of rising inflation but falling output and rising unemployment.
Stagflation is often caused by a rise in the price of commodities, such as oil. Stagflation occurred in the 1970s following the tripling in the price of oil.
What are Deflationary Policies?
Policies pursued by governments designed to reduce the rate of economic growth and, if successful, they will almost certainly also reduce the rate of growth of inflation.
More on Demand-Pull Inflation
“Benign inflation” is a necessary side-effect of economic growth.
Scarcity is worse, causing rationing, which bids up prices, causing inflation.
There is more of an inflationary effect the AD curve approaches closer to Yfe as LRAS becomes perfectly inelastic.
More inflationary effect as the output gap shrinks:
- Means less spare capacity / slack.
- Particularly in the labour market.
What are causes of Demand-Pull Inflation?
Consumer Spending may rise excessively; Interest rates could be low and consumers are spending large amounts on their credit cards, or consumer confidence could be rising because house prices are rising.
Firms may substantially increase their spending on investment; this may be a response to large increases in demand from consumers and need extra capacity to satisfy demand.
The government might be increasing its spending substantially, or it could be cutting taxes.
World demand for UK exports may be rising because of a boom in the world economy.
A growth in the money-supply due to QE increases liquidity as banks increase lending to customers. Customers are then likely to spend money that they have borrowed, causing inflation.
What are the 4 Main Causes of Cost-Push Inflation?
Wages and salaries account for about 50% of national income and hence, increases in wages are normally the single most important cause of increases in COP.
Imports can cause a rise in price. A boom in the world economy, for example, may push up commodity prices such as oil, copper, and wheat. It will also push up the price of finished goods leading to higher import prices for the UK.
Profits can be increased by firms when they raise price to improve profit margins. The more price inelastic the demand for their goods, the less will such behaviour result in a fall in demand for their products.
Government can raise indirect tax rates or reduce subsidies, subsequently increasing prices.
What is the Cost of High Inflation (Growth and Unemployment)?
Unanticipated inflation makes it difficult, if not impossible, for consumers and firms to plan for the future.
Firms may reduce their investment because they are less willing to take risks in an unstable macroeconomic climate.
When households expect a rise in price levels (anticipated inflation) and a decline in ‘purchasing power’, they may react by increasing their ‘consumption’ before the increased inflation rate takes effect. This means that households will bring forward their planned purchases in order to make the most of current price levels, before they increase. In addition, as cash will only lose value, consumers may increase their expenditure on items that probably won’t lose value in the long-term.
This disrupts patterns of spending in the whole economy, making it difficult for firms to supply goods. Economic disruption is likely to lead to lower levels of output and spending than would otherwise be the case,
Lower economic growth or falling GDP then leads to higher unemployment.
What is the Cost of High Inflation (Competitiveness)?
High inflation can lead to a balance of payment effect.
If inflation rises faster in the UK than in other countries, and the value of the pound does not change on foreign currency markets, then exports will become less competitive and imports more competitiveness.
The result will be a loss of jobs in the domestic economy and lower growth.
What is the Cost of High Inflation (Psychological and political costs)?
Price increases are deeply unpopular. People feel that they are worse off, even if their incomes rise by more than the rate of inflation.
High rates of inflation, particularly if they are unexpected, disturb the distribution of income and wealth. Changes are revolution in the past have often accompanied periods of high inflation.
What is the Cost of High Inflation (Shoe-leather costs)?
If prices are stable, consumers and firms come to have some knowledge of what is a fair price for a product and which suppliers are likely to charge less than others.
At times of rising prices, consumers and firms will be less clear about what is a reasonable price. This will lead to more ‘shopping around”, which in itself is a cost.
High rates of inflation are also likely to lead to households and firms holding less cash and more interest-bearing deposits.
Inflation erodes the value of cash, but since interest rates tend to be higher than with stable prices, the opportunity cost of holding cash tend to be larger the higher the rate of inflation.
Households and firms are then forced to spend more time transferring money from one type of account to another or putting cash into an account to maximise the interest paid. This time is cost.
What is the Cost of High Inflation (Menu costs)?
If there is inflation, restaurants have to change their menus to show increased prices.
Similarly, shops have to change their price labels and firms have to calculate and issue new price lists.
Even more costly are changes to fixed capital, such as vending machines and parking meters, to take account of price increases.
What is Indexation?
Adjusting the value of economic variables such as wages or the rate of interest in line with inflation.
What are the pros and cons of Indexation?
Although it reduces many of the costs of inflation, some costs such as shoe leather costs and menu costs remain.
It reduces pressure on government to tackle the problem of inflation directly; indexation eases the pain of inflation but is not a direct cure for it.
Indexation may hinder government attempts to reduce inflation because indexation builds in further cost increases, such as real wage increases, which reflect past changes in prices.
If the government wants to reduce inflation to 2% a year and inflation has just been 10%, it will not be helped in achieving its target if workers are all awarded at least 10% wage increases because of indexation agreements.
What is a Price Index?
A measure of average prices in one period relative to average prices in another period.
It measures changes in the value of a basket of commonly consumed goods.
In the basket, goods are weighted to reflect the proportion of the basket their represent; the weight is the quantity consumed.
How do you construct a Weighted Price Index to measure inflation?
Inflation is a measure of the cost of a representative basket of goods for a typical UK household.
1) Select a base year
2) Calculate the value of the basket in the base year: multiply price by quantity for each good/service, then add up the values.
3) Using base year weights (base year quantities), calculate the value of baskets in late years
4) Price Index for each year: ((Value of Basket in Year X) / (Value of Basket in Base Year)) x 100
