MACRO Flashcards
Characteristics of Money
- durable
- portable
- divisible
- Hard to counterfeit
- Must be accepted by the population
- valuable
- scarce
Functions of Money
- Medium of exchange-allows goods and services to be traded without the need for a barter system.
- Store of value- any assets who’s ‘value’ can be used now or in the future.
- Measure of value- value of something that is expressed in an undesirable way.
- Standard of deferred payment- expressing the value of debt.
money supply
-The Bank of England makes sure it creates enough banknotes to meet the demand for them.
M0-notes and coins plus central bank reserves
M2M- notes and coins plus all sights deposits held by the non-bank private factor.
M2- notes and coins plus all retail deposits held by non bank private sector.
M4- notes and coins deposits, certificates of deposits, securities with a maturity of less than 5 years held by non bank private sectors.
Narrow Money
Is a measure of the value of coins and notes in circulation and other money equivalents that are easily converted into cash, such as short term deposits in the banking system.
Broad Money
Measure of the total amount of money held by households and companies in the economy-made up mainly of commercial banks.
Motives for money
- Transaction motive–to pay for goods and services
- Precautionary motive–investment that rarely loses value
- Speculative motive-provide a return to their holder.
Gresham’s Law
Bad money drives out good money.
coins composed of the cheaper metal will be used for payment, while those made of more expensive metal will be hoarded or exported and tend to disappear from circulation
Factors affecting Supply of money
- open market operations- (same as quantitative Easing) the Central Bank buys government Bonds effectively creating money.
- The reserve requirement imposed on banks- % of deposits made by customers at the bank that the bank must keep a hold of rather than lend out.
- the policy interest rate set by the bank of England- rate of interest will influence how many households and businesses are willing and able to borrow
Factors affecting demand of money
- rate of interest on loans.
- number/value of monetary transactions that we expect to carry out
- the extent to which we want to hold other financial assets (e.g. bonds, property, saving) known as speculative motive for holding money.
- change in GDP
- extent to which it is possible to use debit cards/credit cards
- extent to which we might have to pay out large unexpected payments
- rate of anticipated inflation
Money markets
Money for short term loan finance for businesses and households
- money borrowed and lent for 12 months
- includes internal bank lending
- includes short term govt borrowing to help fund govt budget deficit.
Capital markets
markets for medium-longer term loan finance
- markets where securities such as shares and bonds are issued to raise medium to log term financing
- raising finance to fund govt budget deficit through issues of bonds.
govt bonds
a promise to pay periodic interest payments and to repay the face value on the maturity date.
where hot money goes
- bank accounts
- shares
- property
- currency
- bonds/debentures
- antiques
Foreign Exchange markets
market where currencies are traded-no single currency market made of thousands of trading floors
- spot exchange rate is the price of a currency to be delivered now
- forward exchange rate is a fixed price given for buying a currency today to be delivered in the future.
Role of financial markets
- to facilitate saving by businesses and households.
- to lend to businesses and households
- to facilitate exchange of goods and service
- provide forward markets to currencies and commodities.
- to provide a market for equities (shares)
sources of business finance
long term
- share capital
- retained profits
- venture capital
- mortgages
- long term bank loans
medium term
- bank loans
- leasing
- hire purchase
- govt grants
short term
- bank overdraft
- trade creditors
- short term bank loans
- factoring
Debt finance
borrowing money from an outside source with promise of paying back borrowed amount, plus interest, at a later date.
Bank Loans
- loans provided over a fixed period
- timing and amount of loans repayments are set by the lender.
- unsecured loans pay higher interest rates because of risks
Benefits -greater certainty of funding, provided terms of loan complied with it -lower interest rate than bank overdraft -appropriate method of financing fixed assets. Risks -requires security -interest paid on full amount -harder to arrange -startups and small businesses excluded.
bank overdraft
short term facility-banks let business “owe it money” when bank balance goes below 0.
Helps businesses handle seasonal fluctuations in cash flow or when business run s short term cash flow problems.
Equity
equity finance
sales of shares don’t have to be paid back, only pay dividends
raising capita; by selling shares of the business to investors
Advantages/ disadvantages of equity finance
advant
- equity is risk capital and doesn’t offer a fixed return-business has some control over when to pay a dividend to investor.
- gives businesses more flexibility
disadvant
- dilution of ownership for the original founders
- equity require higher return than debt as it is risk capital.
- growing expectations overtime that dividends will be paid.
Public sector debt
owed by central and local govt and by public corporations
Private sector debt
owed by private businesses and households.
- companies borrowed finance for investment
- households have loans such as credit card debts and mortgages on properties.
Benefits/disadvantages of bank overdraft
advant.
- easy to arrange
- flexible
- interest, only pay amount borrowed under facility
disadvant.
- withdrawn at short notice
- interest charge varies with change in interest rate
- higher interest rate than bank loans.
Advantanges/disadvantages of debt finances
advantages
1. less capital required to be invested by the shareholders
2. debt can be a relatively cheap source of finance compared with dividends
3. easy to pay interest if profits and cash flows are strong
Disadvantages
1. Business may be vulnerable to unexpected changes in interest rates
2. Businesses have less control of events if they are highly geared
Primary markets
secondary markets
govt issue bonds
reselling he bonds for higher prices
how commercial banks make profit
take deposits, lend them put at a higher rates then pay back a small amount and keep the rest to make profits.
they also charge fees.
Limits to profits made by commercial banks
- market forces- the scale pf profitable lending opportunities
- regulatory policy
- behaviour of consumers and businesses
- monetary policy
Liquidity risk
- banks attract short term deposits
- lend for longer periods of time
- so banks can’t repay all deposits if savers withdraw funds
- to reduce liquidity risk banks will try to attract long term deposits and hold some liquid assets as capital reserves.
Credit risk
- risk to bank of lending to borrowers who can’t repay loans
- can be controlled by safeguards/ worthiness of the borrowers
- controlled through regulations-e.g. size of reserves banks should hold back in case of bad debts.
Financial Policy committee of the bank of England
- FPC’s role is to identify, monitor and take action to remove or reduce risk that threaten resilience of UK financial system.
- publish financial stability report to identify key threats to stability
- have the power to instruct banks to change capital buffers
- increasing capital buffers help absorb unexpected losses on assets.
Uk Potential Regulation Authority (PRA)
Part of BoE, responsible for prudential regulations and supervision of around 1,700 banks, building societies, credit unions, major investment firms.
Finacial Market Failure (moral hazards)
exist in markets where individuals or organisations take more risks than they should because they know they are covered by insurance or govt will protect them from damage incurred by those risks.
Financial Market Failure (monopoly)
the abuse of a power resulting from a concentrated market.
e.g. when a small number of firms in the market choose to work together to increase their joint profits and exploit consumers.
Financial Market Failure (speculation)
risky action in which a person or organisation/ organisation tries to predict what will happen to the price of an asset and buys/ sells accordingly to make profit. — a speculator takes advantage of fluctuations in the market.
Financial market failure (externalities)
negative externality exists when a market transaction has a negative consequence on a 3rd party.
positive externality exists when a market transaction has a positive consequence on a 3rd party.
network externalities are when there are knock-on effects of organisations working together—-this is a synergy if the effects are positive and a discord if the effects are negative.
Moral Hazard –banking instability
when an agent is given implicit support guarantee in the event of making a loss.
in commercial banking- the govt absorb the losses.–banks take more risks since they believe they receive private benefits from the risk taking.
guaranteeing the deposits of savers may mean that banks can attract deposits by offering lower rates of interest.
Systematic risk
the possibility that an event at the micro level of an individual bank or an insurance company could then trigger severe instability or collapse an entire industry or economy.—if the financial world is interconnected.
Financial Conduct Authority (FCA)
funded by firms it regulates
3 aims:
1. secure an appropriate degree of protection for consumers
2. protect and enhance the integrity of the UK Financial system.
3. promote effective competition in the interest of consumers
Asymmetric info
type of market failure that exists when one individual or party has much more info than another individual or party and uses it to exploit other parties.
Speculative bubble
exists when the price of something is driven well above what it should be, usually due to the behaviour of consumers.
principle agent problems
when one person is able to make decisions on behalf f another person but the principle is unable to adequately supervise the agent. Agent can act to their own interest rather than interest of principle.
Incomplete markets
exists when the available level of supply is not enough to meet the needs and wants of consumers
Financial instability and real economy
Instability and confidence-
- negative impact on business investment
- increased saving and lower demand
- high levels of debt and falling asset prices hit consumer wealth and spending.
Instability and loss of trust-
- people have less trust in banks and other institutions
- high interest rates on loans to businesses.
- credit harder to get for small and medium sized enterprises and start ups.
instability and inequality-
-poorer communities and families are more vulnerable during periods of financial recesion.
GDP-gross domestic product
the total value of output of goods and services produced within an economy in a given time period.- an increase in the productive capacity of the economy from one year to the next
Economic growth
usually calculated in real terms (adjusted for inflation) in order to net out the effect of inflation on the prices of goods and service produced.
GNP-gross national product
measures the final value of output or expenditure by UK owned factors of production whether they are located in the UK or overseas.
GNP=GDP+Net property incomes from abroad (net income flows).
-once calculated it is converted to US dollars and divided by the countries population to give GNP per head.
net income flows
net balance of interest, profits and dividends coming into the UK from UK assets owned overseas matched against the flow of profits and other income from foreign owned assets located in the UK.
problems with GDP
- cost of living is different in different countries
- distribution of wealth is different in different countries
- patterns of expenditure are different.
- quality of life
- non market activities-hidden markets (such as house wives)
- environmental factors
- happiness and well being
- the shadow economy
other issues-
-statistical inaccuracies
-income is not distributed on a per capita basis
Standard of living
refers to the amount of goods and services consumed by households in one year
standard of living= real national income/population
-high standard of living means households consume large number of good and services.
PPP-purchasing power parity
measures how many units of one countries currency are needed to buy exactly the same basket of goods as can be bought with a given amount of another countries currency.
-used
Human Development Index
focuses on basic education, minimal income and life expectancy
- knowledge (takes into account mean years and expected yrs of school)
- Long and healthy life (calculated using minimum value of life expectancy of 5 and max of 85)
- Standard of living (GNI adjusted for PPP standard).
-fails to take into account of qualitative factors, such as cultural identity and political freedoms (human security, gender opportunities and respect of human rights).
GCI-Good Country Index
- science + technology
- cultural
- internal peace and security
- world order
- planet and climate
- prosperity and equality
- health and wellbeing
Benefits of economic growth
- Boosts living standards through higher real GDP per head (reduces absolute poverty)
- increased output generates new jobs and reduces unemployment-as labour has derived demand.
- increased tax revenue can be used to fund extra spending on public and merit goods and services.
- improved business confidence -attractive o foreign investment inflows.
- higher consumption leads to induced increases in investment spending-accelerator mechanism
- growth acts as spur to introduce new technology which spurs innovation.
risks of economic growth
- environmental impacts-fast growth may create negative externalities
- depletion of non-renewable resources causing ‘resource poverty’
- increased pollution/waste/congestion
- energy crisis
- concerns about sustainability of growth for future generations.
increased inequalities in income and wealth
- widening gap between rich and poor
- higher levels of relative poverty
renewable resources being depleted because of over consumption.
- destruction of rain forests
- permanent loss of natural habitats through construction of roads, retail malls and industrial estates.
growth and environmental threats
- depletion of natural resources and impact of global warming
- over-population putting increased pressure on scarce land
- pollution of the environment both by produces and consumers.
could economic growth improve the environment?
- per capita income rises-new wealth can be used to buy cleaner fuels like natural gas.
- richer countries have resources to research and develop cleaner and less resource-intensive production tech.
- higher real income associated with lower fertility rates reduces natural rate of pollution growth.
Supply-side policies
-privatisation
- selling government owned assets to the private sector could increase competition. Firms will want to reduce their costs through innovation so agg demand will increase.
- disadv; this process could lead to a monopoly situation and consumers could lose out through higher prices
- disadv; once a business is sold it is sold.
Deregulation
-form of privatisation
would enable greater competition would lead to profit maximisers increasing supply as prices would lower.
Encourage enterprise and business investment
- cut bureaucracy (red tape) to make life easier for firms and help them cut costs. May gove money to new businesses .
- more small businesses
- by giving grants and reducing coorporation tax the govt can encourage competition and efficiency. As productivity improves it will produce more with a given amount of resources and increase LRAS.
Trade unions
trade unions try to push wages above the market equilibrium- govt try to reduce their power which makes labour markets more flexible and efficient with more workers not striking there is increased productive potential.
Spending on education and training
- if the work force is better trained and has more skills then it will be more productive and our AS will increase. So govt can invest in training schemes such as apprenticeships.
- depend on the level of youth unemployment.
- depend on the quality if training.
- disadv; opportunity cost.
- adv; creates jobs in the training market.
Lower income tax
- cutting income tax will give workers a higher disposable income and should make working more attractive e.g. doing more overtime.
- disadv; could reduce govt revenue.
- BUT may increase govt revenue as more people may end up working as a result.
- Success depends on the size of the tax cut.
- success depends on the duration of the tax cut.
cut welfare benefits
- cutting benefits can act as an incentive to take up work. It reduces the opportunity cost of working. So the active labour force increases.
- Adv; reduces govt spending, money can be spent elsewhere.
- disadv; hits the poor the most
- success depends on the size of the cut.
Unemployment
those people able, available and willing to work who can’t find a job despite an active search to work.
- scares human resources are not being used to produce the goods and services that help to meet people’s changing needs and wants.
- high levels of unemployment have damaging scarring consequences for an economy causing economic costs and social costs.
claimant count
number of people officially claiming unemployment benefits- must be actively seeking work.
Labour force survey
labour force
- all those actively seeking and available for work whether or not they are claiming benefits
- the number of people of working age who are able, available and willing to take work.
seasonal adjustment
- agg demand for labour varies at different times of the year due to seasonal changes in the number of jobs on offer.
- purpose of seasonal adjustment is to remove the variations associated with the time of the year.
Types of unemployment
- Seasonal- regular seasonal changes in employment/ labour demand.
- Structural- when there is a mis-match between the skills of those unemployed an the skills that new jobs require- linked to labour immobility.
- Frictional- unemployment related to the process of changing jobs, which may involve a period of time out of work.
- cyclical- category of unemployment whose number varies according to business or economic cycle.
- Real wage- when a rise in real wages above the market clearing level causes a contraction in labour demand and an extension in labour supply.
- Hidden- unemployment which is known to exist but is not included in official govt figures.
economic and social effects of high unemployment.
economic costs-
- lost output, the economy is inside the ppf (lost efficiency)
- fall in real incomes and lower living standards for those affected
- drop in tax revenues and higher welfare- budget deficit.
- possible decline in labour supply as unemployed move overseas.
social costs
- increase in relative poverty and benefit dependency
- extra demand on NHS- due to stress
Beneficial effects
- reduced risk of inflation= lower wage claims and price discounts.
- unemployed available for growing businesses
- rise in self-employment start ups as alternative to being unemployed.
Labour scarring effects from high unemployment.
loss of work experience
- reduced employability from depreciation of skill.
- gaps in CVs may influence potential employers
- decline in quality of human capital.
loss of current and future income
- vulnerability to consumer debt at high interest rates.
- decline in physical health and increase in stress.
Changing patterns of jobs in the economy
- new jobs in recovery stage are diff from lost jobs.
- structural unemployment–occupational immobility makes it hard for people to get jobs.
youth unemployment
young people out of work risk fall in their expected lifetime earnings from work.
- skills gap= employers not willing to employ people who lack ability to read or write
- reluctant employers= prefer older more experienced workers.
- falling retirement rates= caused by decline in pension incomes leads to fewer jobs for youths
- weak macro fundamentals= e.g. low real GDP growth and business confidence.
policies to reduce unemployment–labour demand
macro stimulus policies (+multiplier effect)
- low interest rates and policies to increase business lending
- depreciation in exchange rates
- infrastructure investments projects.
cutting the costs of employing workers
- reduction in the national insurance contribution tax
- financial support for apprenticeship programmes
- extra funding for regional policy-business grants.
competitiveness policies
- reduction in corporation tax to increase investment
- tax incentives for research/ innovation spending.
- Enterprise policies to lift rate of new business start-ups.
policies to reduce unemployment–labour supply
reducing occupational immobility
- better funding for and more effective training
- teaching new skills
- expansion of apprenticeships/ internship
improving geographical immobility
- rise in housing building will help to keep property prices lower and encourage affordable rents.
- active regional policy to create new jobs/businesses.
stimulate stringer work incentives
- higher minimum wage or living wage.
- reductions in income tax/ national insurance.
- welfare reforms to reduce the risk of the poverty trap
key barriers to lowering unemployment
- high levels of long term structural unemployment in the UK.
- pockets of exceptionally high unemployment and low economic activity rates , high youth unemployment.
- hard to overcome the disincentive effects of :
- a complex welfare benefit and tax system
- unaffordable housing sector
- low-paid jobs that keep families in relative poverty
- high costs and uneven availability of quality child care
- high rates if public sector dependency
- many people are under-employed and stuck in part time jobs.
- skills shortages, creaking infrastructure and variations in educational performance and opportunities
- weak demand in domestic and export markets.
benefit of fall in unemployment
- increased employment-boosts real GDP, helps lift living standards and demand.
- more people in work- creates extra tax revenue for the govt either to lower deficit/ increase spending.
- social costs of high unemployment are severe.
disadvantage of falling unemployment
- extra spending from expanding labour market might worsen the current account.
- risks of an acceleration in demand pull and cost push inflationary pressures if unemployment falls rapidly.
- fewer spare labour will mean a rise in unfilled vacancies labour shortages might put off some inward investment.
Natural rate of unemployment
involuntary unemployment–when there are too few goods in the economy at existing wage rates, and those who are actively searching for a job can’t find one.
voluntary unemployment– those who chose to to reject employment as they search for position with, for example, better pay or benefits.
Factors affecting size of natural unemployment
- level of welfare benefits
If welfare benefits are high compared to wages then the opportunity cost of work is also high. With high benefits there is less incentive to work-people may remain voluntarily unemployed.
Level of income tax in the economy
Low income tax acts as an incentive for people to find work as the opportunity cost of staying unemployed will be higher, so natural rate of unemployment will fall.
Trade unions power and military
If trade union are powerful they could push up wage rates encouraging more people into work. However, also above firms may find it expensive to take on more work.
Level of wage controls
If wages are set at a minimal level then more people will be encouraged to find work. NRU will be low–at this rate employers may offer less jobs and increase part time.
Degree of labour immobility
If labour is mobile then NRU will be low– refers to occupational, geographical and industrial immobility.
Rate of change in the economy and ability of workers to adapt to changes
If there is a fast rate of change in the economy and if workers are able to change and be skilled then NRU will be low.
Social attitudes and institutions
Stigmas that prevent people taking jobs e.g. working at McDonald’s. If the occupation is looked down on then many may choose to not take up the job.
Inflation
general rise in the average price from one year to the next—a fall in the value of the pound.
Deflation
A reduction in the average price level from one year to the next.
Causes of Demand pull inflation
most likely to occur when there is little spare capacity in the economy
- Increase in money supply
- depreciation in the exchange rate
- reduction in tax both direct and indirect
- increase in house prices
- booms in the economies of trading partners.
Wealth effect
As the value of your house increases, your wealth increases and so security increases–able to borrow more and buy more.
Cost push inflation
Caused by the economy–when there is a wide increase in production costs
- external costs e.g. a rise in the price of imported materials–imported inflation
- rising labour costs
- higher indirect taxes–one off
- wage prices spiral
- depreciation of exchange rates–artificial reasons
Quantity Theory of Money
Theory that states that inflation is caused by a prior increase in money supply (monetary).
Fisher’s equation of exchange
money supply (stock of money) x Velocity of circulation of money = Price level x standard of transactions
or MV=PT
Consequences of inflation
uncertainty
inflation affects prices and costs to businesses making it difficult to plan for the future.
extent depends on
1. how much our raw materials are domestic/foreign
2. may matter less for products with an inelastic demand, as increased costs can be passed onto price
3. how much of our raw materials are brought in advance on a contracted basis.
Saving are eroded
Money put in banks or loaned out loses its value
extend depends on
1. interest rates relative to inflation
2. made worse if there is a disincentive to save and AD further increases
3. less money in banks available for investment
People on fixed incomes lose purchasing power
Prices rise while incomes don’t.
extent depends on
1. amount of people on fixed incomes
2. may act as an incentive to take up work to reduce unemployment.
Possibility of a wage-price spiral
Higher prices may lead to workers demanding higher wages as they don’t want their real standards of living falling.
extent depends on
1. trade union power
2. skills of workforce
Loss of international competitiveness
the economy will become internationally uncompetitive if other countries don’t experience inflation at a lower rate. Exports will become relatively expensive and import relatively cheap.; balance of trade will deteriorate
extent depends on
1. economies reliance on exports-size of export market
2. inflation in other countries.
3. price elasticity of exports (few substitutes, necessities ect).
Breakdown of the price mechanism
- prices act as signals to allocate resources.
- price goes up, supply expands and demand contracts.
- The higher prices act as signal to producers to increase production in areas which are more profitable.
- though if there is inflation, higher prices don’t make profit.
Menu costs and shoe leather costs
this is the need to change the prices of goods and services known as menu costs.
- there is a need to hold less cash because cash by nature will be losing value if held and therefore consumers will have to go to the cash dispenser more often in order to hold smaller amounts of money-shoe leather costs.
BUT
prices are bar-coded and menus can be reproduced cheaply and cash payment is outmoded, so not significant for a policy maker.
Instability
higher rates discourage investment -real value of the profit will be smaller and normal interest rates will be too high before inflation is taken into account.
Benefits of inflation
Differentials
-It is easier to give someone a pay increase below inflation and decrease their wage in real terms.
Unemployment
- Some believe there is a trade off between unemployment and inflation as shown in Phillips curve. As inflation approaches 0 there must be an increase in unemployment.
- inflation caused by too much spending– govt increases tax on workers to reduce spending–firms cut back on workers as they can’t sell goods.
Sustainable rate
economy growing t sustainable rate means that productivity is growing with output so a certain amount of inflation can be tolerated.
why cost push is worse than demand pull
- AD is easier to influence than SRAS.
- AD is less elastic
- cost push may lead to job loss.
- cost push may be due to imported cost increases, which are difficult to avoid.
Monetary Policy
aimed to stimulate or dampen AD.
- -to stimulate AD.
1. The cost of borrowing, if reduced, could be expected to boost consumer spending and investment spending for firms. Expected to reduce savings and spur consumer spending even further as opportunity cost of spending is low.
- Exchange rates may be expected to fall, boosting overseas demand for out exports and making imports more expensive. This might encourage UK residents to switch to domestically produced goods and services reducing and giving a further boost to consumer spending and investment.
- Lowering interest rates are expected to increase share prices and other financial assets. Rather than putting money into bank accounts, people might prefer to invest spare cash or savings in shares to get higher returns than the banks.– people with shares will get wealthier and may consume more goods and services increasing consumer spending.
Depends on
Time lags
Normally interest rates change can take up to 2 years to have an impact on AD.
Previous interest rate levels
Some consumers existing loans or savings will be guaranteed so change in interest rates won’t affect them as much If interest rates have been low for a long time consumers may be near their credit limit so further cut in rates won’t stimulate much more AD.
Excess capacity in industry
During a recession cutting rates to increase AD will be successful because the economy has room to expand. -Though during a boom this will lead to inflation when there is excess capacity, so less incentive for firms to expand.
- though lower rates allow business to invest in extra capacity so this is less of a problem
interest rates of goods and services
effectiveness of increases in interest rate to reduce AD depends on the goods interest rates elasticity.
-Depends on the factors affecting elasticity such as proportion of income spent, necessity value. Not all sectors of the economy will see an increase in demand.
Uncertainty
- Certain events are unpredictable and this can affect the success of monetary policy.
Reality of economic data
The success of any policy is only as great as the data of monetary policy.
Proving links between economic variables
it is difficult to know how much is only as great as the data upon which it is based is reliable.
Judging success
Is inflation at the cost of employment considered a success.
Free floating exchange rate
where the external value of a currency is determined on demand for and supply of that currency
Monetarism and the quantity theory of money
monetarists believe that an increase in AD is influenced entirely by the amount of money in the economy (money supply)–inflation is caused by money supply and therefore the spending power of population exceeding the capacity of the country to produce goods and services.
-argue that policies that increase money supply will have short term effects on real output but generate inflation.
Role of the budget deficit.
identified as main cause of inflation. If govt spending exceeds govt revenue printing more money or borrowing are inevitable.
Monetarists suggest that by complementing strict control of money supply with supply side policies aimed at providing incentive for firms and workers to become more efficient situations of excess AD wouldn’t happen. The higher the level of AS that results from supply side policies can support higher level of demand without inflation.
Stagflation
this is the result of inflation and unemployment
Benign Deflation
Falling pries falling from technological advances across the economy.
Malevolent deflation
falling prices resulting from a significant downturn in economic activity.
Fiscal policy
can make us buy more or less or change our pattern of spending.
why do we have taxes?
- to raise revenue to finance spending on goods and services by central and local govt.
- when managing the level of AD output and prices use taxation. When demand is perceived as being too strong the govt can increase direct taxes to reduce the level of real disposable income (discretional income) and house hold spending.
- progressive system of taxation can be utilised to achieve greater equality i income and wealth between individuals and households.
Principles of taxation
Canon of taxation is the characteristics of a good tax. Taxes should be economical, equitable convenient and certain.
economical=fair (though who decides what is fair)–smith claimed on ability to pay.
convenient= easy for it to be paid–(pay as you earn).
certain= you know what you will pay.
efficient= does it do what it is supposed to do.
Flexible=changing or adapting taxes overtime to suit new changes.
Hypothecation
When taxes are intended for a specific purpose. If polluters pay tax then it internalises the externality.
The Laffer Curve
Shows that as tax rate increases then tax revenue will increase, up to a point where the government may charge a little bit more and then the revenue will start to fall.
Marginal propensity to consume
a change in consumption / change in disposable income
Direct taxes
- Equitable as it shortens the gap between the rich and the poor.
- Certain as everyone knows what they will pay
- Affects levels of spending.
Indirect taxes
- equal
- affect pattern of spending
advantages-
- influences spending patterns
- incentive effects
- flexibility
- freedom of choice
- correcting externalities.
disadvantages
- inflationary effects
- crimes (blackmarket)
- lack of announcement effects
- not based on ability to pay
Direct vs Indirect taxes
- -indirect taxes create less of an incentive to work than direct taxes as workers get to keep more of what they earn than if they were paying high income tax.–opportunity cost of leisure becomes higher–if they were working less hours they would be giving up more money.
- Added advantage that theoretically if income tax was reduced enough then more people would work more often and long run output potential of economy would increase,putting downward pressure on prices. SRAs would shift right.
–Indirect taxes are an incentive to save–make goods more expensive and we would delay consumption slightly–argument less important when–the good is a necessity, when inflation is high so goods are brought now, when interest rates are low.
–indirect taxes used to correct market failure as witnessed in environmental damage–can be placed on a product as a way of internalising the externality.
–taxes on spending are cheaper to administrate than indirect taxes are they are only collected from businesses–though income taxes have to be collected from businesses and individuals.
–indirect taxation gives govt more control over its use of fiscal policy–indirect taxes can be changed between budgets without parliamentary approval–direct taxes can only be changed in the annual budget.
How taxes cause market imperfections
VAT– causes a fall in demand and supply
- causes a shift to the left of the supply curve, meaning in a perfect market output would be greater.
- VAT argued as inflationary. Depends on price elasticity of the product taxed (inelastic goods means VAT is more inflationary)
- Diverts resources away from their most efficient use to where they may only be used second best. Though only most inefficient resources moved first, revenue raised compensates for inefficiency.
- -Income tax
1. could lead to a fall in demand and supply
2. could act as a disincentive to work esp. if opportunity cost of working is harder. - -Corporation tax
1. could reduce the supply of entrepreneurs/investors leading to a reduction in LRAS.
–Govt spending to generate a min price for inefficient products also causes imperfections.
Automatic Stabilisers
Fiscal policy-
recession- there is high unemployment and spare capacity so govt spending on benefits is high, while taxation will fall (business profits will fall so corporation tax will fall)– with govt spending high and taxation low AD will eventually rise.
boom- govt spending on benefits is low and people in work meaning tax will be high and the govt will increase revenue (take back what they gave during recession). Firms have high revenue and profits so corporation tax is high. In a boom people are likely to save esp. if interest rates are high– in a boom money may be spent on imports and so it won’t affect our economy.
-the automatic stabiliser reduces fluctuation and allows taxation to be smooth.
Growing government debt.
View is that rapid growth in govt spending or borrowing may cause a transfer of scarce productive resources from the private sector to the public sector where productivity might be lower.
The Role of the Budget Responsibility
- Economic and fiscal forecast- produce detailed 5 year forecasts for the economy and public finances twice a year. Details of the forecast are set out by the EFO
- Evaluating performance against targets– use public finance forecasts to judge the govt performances against its fiscal targets and targets for welfare spending.
- Sustainability and balance sheet analysis– assess the long term sustainability of the public finances, sets out long term projections for different categories of spending, revenue and financial transactions.
- Evaluation of fiscal risk–EFO and FSR include discussion of the risks to those forecasts and projections and provide further info on specific fiscal risks.
- Scrutinising tax and welfare policy costing– scrutinise govt costing of individual tax and welfare spending measures at each budget and autumn statement. Govt provide draft costings in the run up to each statement and we subject these to detail scrutiny and challenge.
buyers market
when there’s fewer sellers than buyers
sellers market
when there’s fewer buyers than sellers.
comparative advantages
- the relative opportunity cost of production is lower than in another country.
- A country is relatively more productively efficient than another.
Factor Endowment
- the concept that countries have different factors of production in different quantities and different qualities due to; weather, location, population and their skills, education levels.
if a person, firm or country specialises enough in the production of a good or service it normally leads to the creation of a surplus in that good or service.
-the existence of a surplus leads to trade. So countries surplus in one production for the surplus of another countries products.
Absolute advantage
A country can produce more of a good or service than another country
Comparative advantage
A country can produce a good or service at a lower cost than another country
Exchange rates
The rate at which one country’s currency can be exchanged for other currencies in the foreign exchange market.
Effective exchange rate
The weighted index of sterling’s value against a basket of currencies the weights are based on the importance of trade between the UK and each country.
Classification of the currency system
The choice of exchange rate regime is one of the most important that a country can make as part of a monetary policy.
Main options are:
- A free-floating currency where the external value of a currency depends wholly on market forces of supply and demand.
- A managed floating currency when the central bank may choose to intervene in the foreign exchange market to affect the value of a currency to meet specific macro economics objectives.
- A fixed exchange rate system e.g. a currency peg either as part of a currency board system or membership of the ERM for countries intending to join the Euro.
What factors determine currency value
- In a floating exchange rate system, the external value of a currency is determined by market demand and supply.
- Much currency dealing is speculative but trade and investment flows also have a key role to play.
- Factors mentioned in the graphic will usually lead to a currency appreciation i.e. rising external value.
How trade balances determine a currency value?
countries that have strong trade and current account surpluses tend to see their currencies appreciate as money flows into the circular flow from exports of goods and services and investment income.
How foreign direct investment (FDI) determine a currency value?
an economy that attracts high net inflows of capital investment from overseas will see an increase in currency demand and a rising exchange rate.
How Portfolio investment determine a currency value?
strong inflows of portfolio investment into equities and bonds from overseas can cause a currency to appreciate.
How Interest rate differentials determine a currency value?
countries with relatively high interest rates can expect to see ‘hot money’ flowing across the currency markets and causing an appreciation of the exchange rate.
what is the central bank
the monetary authority and major regulator bank in a country. Its functions include issuing and managing the countries currency.
Central bank intervention
when a central bank enters the foreign exchange market to buy or sell currency in order to influence exchange rates.
Base rate
the rate of interest set by the Bank of England, being in effect the lowest rate that lenders will charge interest at.
Base money
currency in circulation plus minimum reserves credit institutions are required.
Bond Market
The market for interest bearing securities that companies and governments issue to raise capital for investment.
financial stability
The condition in which the financial system- comprising financial intermediates, markets and market infrastructures- is capable of withstanding shocks and the unravelling of financial imbalances.
Cases for floating exchange rates
- less need for currency reserves for use in intervention
- fixed exchange rates can becomes vulnerable to speculative attack.
- useful instrument of macroeconomic adjustment
- lower currency can stimulate aggregate demand
- sterling depreciation in 2002-09 may have helped limit scale of recession.
- appreciation against the US dollar in 2007 was helpful when world oil prices were very high.
-provides partial automatic correction for a trade deficit by changing the relative prices of exports and imports.
- freedom for domestic monetary policy.
- allows countries greater freedom to set interest rates for domestic economic aims
- it gives policy makers another tool of policy which can be useful especially if other instruments of policy are not working as well as hoped.
Cases for fixed exchange rates
- stability and certainty- helpful for trade and capital investment.
- some flexibility i.e. occasional devaluation or revaluation of the currency.
- reduction in cost of currency hedging for businesses.
- fixed rate provides a discipline on domestic producers to keeps costs and prices down and o become more productive.
- reinforces gains in comparative advantage:
- if one country has a fixed rate with another, then differences in relative costs will quite easily be reflected in changes in the rate of growth of exports and imports
what are 9 Major Limitations of National Income Accounts?
-The ‘black economy’ distorts the figures. This is the name given to work that is not reported to the authorities.
A rise in national income may not mean a rise in living standards. This is because the rise may occur as a result of increased spending on items such as defence, which do not improving living standards. Similarly, an increase in national income may be accompanied by a rise in undesirable externalities, such as pollution, or a fall in the quality of goods.
The accounts only measure paid activities. They, therefore, exclude do-it-yourself activities and the work of housewives. If over a period of years there is a rise in such activities, then this will not be shown in the official figures and comparisons over several years will be inaccurate.
In most countries of Africa and Asia, women collect water and wood, people build their own houses and live off food that they have grown. If these unpaid activities are not counted, then the figures will greatly underestimate the level of GNP in these countries.
National income often rises in time of war, or the threat of war, because money is spent on weapons. This will push up GNP, but the people may be acutely short of goods to buy.
-When making comparisons with the past, adjustments have to be made to allow for inflation. Hence it is important when looking at the figures to see whether they are in nominal terms, i.e., the actual figures not adjusted to remove the effects of inflation.
The extent of inflation can be calculated fairly accurately over a short period, such as one year, but it is much more difficult to do so over a long period. One reason is that new products appear and existing ones become obsolete, so it is impossible to measure price rises accurately.
- Another adjustment that has to be made when making comparisons with the past is that the figures have to be adjusted to allow for population changes. If national income has risen by 10%, but population has also risen by 10%, the average person is no better- off.
- Many factors affect the quality of life but are excluded from GNP. Over the last few decades, people have come to enjoy more leisure, largely because they work fewer days. The national accounts take no note of this. Similarly, the quality of many products has improved— a modern TV is far superior to one made many years ago.
On the other hand, economic growth may be accompanied by increased pollution, overcrowded cities and a frenetic lifestyle—factors ignored by statisticians. The national income accounts measure some of the quantitative factors affecting life, but they ignore many features of the quality of life.
Finally, the figures say nothing about the distribution of income within a country. In some countries a small elite has a large share of the economic cake; in such countries figures showing a high average income per head may give the wrong impression of typical living standards.
what is nominal national income?
Nominal income measures income at current prices with no adjustment for the effects of inflation
what does real gdp measure?
Real GDP measures the volume of output. An increase in real output means that AD has risen faster than the rate of inflation and therefore the economy is experiencing positive growth.
How do we calculate national income?
income methods: wages-labour rent-land interest=capital profit/ dividents=enterprise
expenditure methods consumption investment spending government spending net exports
output methods primary secondary tertiary quarternary
What are injections and withdrawls into the circular flow?
AD= C+I+G+(X-M) injections include: -government speanding -banks loans, e.g. for investment -exports
withdraws include:
- savings
- taxation
- imports
what are the affecting the circular flow of income?
Households.
The primary economic function of households is to supply domestic firms with needed factors of production - land, human capital, real capital and enterprise. The factors are supplied by factor owners in return for a reward. Land is supplied by landowners, human capital by labour, real capital by capital owners (capitalists) and enterprise is provided by entrepreneurs. Entrepreneurs combine the other three factors, and bear the risks associated with production.
what are the affecting the circular flow of income?
Firms
The function of firms is to supply private goods and services to domestic households and firms, and to households and firms abroad. To do this they use factors and pay for their services.
what are the affecting the circular flow of income?
Factor incomes
Factors of production earn an income which contributes to national income. Land receives rent, human capital receives a wage, real capital receives a rate of return, and enterprise receives a profit.
Members of households pay for goods and services they consume with the income they receive from selling their factor in the relevant market.
what are the affecting the circular flow of income?
The Circular flow of income
Income (Y) in an economy flows from one part to another whenever a transaction takes place. New spending (C) generates new income (Y), which generates further new spending (C), and further new income (Y), and so on. Spending and income continue to circulate around the macro economy in what is referred to as the circular flow of income.
The circular flow of income forms the basis for all models of the macro-economy, and understanding the circular flow process is key to explaining how national income, output and expenditure is created over time.
what are the affecting the circular flow of income?
Injections and withdrawals
The circular flow will adjust following new injections into it or new withdrawals from it. An injection of new spending will increase the flow. A net injection relates to the overall effect of injections in relation to withdrawals following a change in an economic variable.
what are the affecting the circular flow of income?
Savings and investment
The simple circular flow is, therefore, adjusted to take into account withdrawals and injections. Households may choose to save (S) some of their income (Y) rather than spend it (C), and this reduces the circular flow of income. Marginal decisions to save reduce the flow of income in the economy because saving is a withdrawal out of the circular flow. However, firms also purchase capital goods, such as machinery, from other firms, and this spending is an injection into the circular flow. This process, called investment (I), occurs because existing machinery wears out and because firms may wish to increase their capacity to produce.
what are the affecting the circular flow of income?
The public sector
In a mixed economy with a government, the simple model must be adjusted to include the public sector. Therefore, as well as save, households are also likely to pay taxes (T) to the government (G), and further income is withdrawn out of the circular flow of income.
Government injects income back into the economy by spending (G) on public and merit goods like defence and policing, education, and healthcare, and also on support for the poor and those unable to work.
what are the affecting the circular flow of income?
international trade
Finally, the model must be adjusted to include international trade. Countries that trade are called ‘open’ economies, the households of an open economy will spend some of their income on goods from abroad, called imports (M), and this is withdrawn from the circular flow.
Foreign consumers and firms will, however, also wish to buy domestic products, called exports (X), and this is an injection into the circular flow.
What is aggregate demand?
the total level of planned real expenditure on UK produced goods and services.
What are the factors affecting the components of aggregate demand?
consumer spending
consumer spending:
-consumer confidence such as job security.
- tax rates-higher taxes the less they have to spend.
- stages of the economic cycle-in a boom they spend more, in a recession they spend less.
- interest rates- the higher the interest rates the more they save.
- inflation expectations- if they expect prices to rise they will buy more now making ad rise.7
- self fulfilling prophecy- a situation that a financial crisis is not directly caused by the unhealthy economic fundamental conditions or improper government policies, but a consequence of pessimistic expectations of investors- so if prices are expected to rise, people go out buy more, leads to prices rising (inflation).
What are the factors affecting the components of aggregate demand?
Investment
Investment spending:
- interest rates- the higher the interest rates the less they spend, the more they save
- spare capacity- when the economy is going through a recession, firms not able to use all factories of production because there is not enough demand; as economy recovers there is more AD and so more space needed as more workers employed and more goods demanded, less spare capacity available
- business confidence- the more confident in an investment, prices of an investment going up, if the business has higher prospects, the more they invest.
- stages of economic cycle- in a boom they invest more, in a recession they invest less.
- profit levels- the ore profit they have the more they invest.
What are the factors affecting the components of aggregate demand?
government spending
government spending:
-stages of the economic cycle- in a boom they gain more tax revenue as more people are in work, in a recession they have to spend more on welfare benefits
-size of the public sector which is run by the government– the more people out of work the more they spend on benefits.
What are the factors affecting the components of aggregate demand?
exports and imports
exports and imports:
-exchange rates– weaker pound exports cheaper imports dearer– strong pound imports cheaper exports dearer
- stages of the economic cycle overseas (exports), in the UK (imports)
- tariffs
- for imports- foreign govt regulation that affects the good imported in the UK.
what is short run aggregate supply?
this is how much output the economy can generate in the short term at each price level
- a rise in the price level should stimulate an expansion in supply
- when prices are falling production may contract
Factors affecting short run aggregate supply?
wage costs:
- minimum wage
- impact of migration workers on wages.
raw materials and component prices
subsidies
- taxes:
- VAT
- import tariffs or other protectionist measures
labour productivity
what is the multiplier process?
this is the idea the final impact on national impact of an injection into the circular flow will be greater than the size of the original injection.
what is the accelerator effect?
when an increase in national income results in a proportionately larger rise in investment.
- firms respond to demand by expanding production and making use of existing productive capacity, also by running down their stocks of finished products.
- if they feel high levels of demand are sustained they may choose to increase spending on capital goods, e.g machinery or factories, and increase capacity– if this investment goes beyond what is needed, to replace worn out or depreciated machinery, then capital stock will become larger
- demand for capital stock is being driven by demand for products that the firm is supplying to the market– gives rise to the accelerator affect.
example;
a surge in capital investment in wind turbines due to the super-high level of oil and gas prices and a rising market demand for renewable energy.
what is the capital output ratio
-The accelerator model works on the basis of fixed capital to output ratio
What does the LRAS curve represent and what factors affect it?
The LRAS curve represents the full long run productive capacity of the economy e.g where we are producing just about as much as our factors of production will allow.
Factors affecting the LRAS:
- an increase in the quantity and quality of capital equipment (machinery,tools ect)
- a more highly skilled workforce
- innovation and improvements in productive processes e.g better ways of producing goods and services, improved R&D, improved productivity
- factor mobility e.g geographical/ occupational
- improved attitudes of entrepreneurship
- encourage more people to join the labour supply (immigration, raise the retirement age, lower the school leaving age, lower benefits,lower income taxes)
what are Demand-side shocks
Demand-side shocks affect one or more of the components of aggregate demand - examples of such shocks might include:
- Economic downturn in a major trading partner
- Unexpected tax increases or cuts to welfare benefits
- Financial crisis causing bank lending /credit to fall
- Bigger than expected rise in unemployment rates
A negative demand-side shock can also bring about negative multiplier effects and also a negative accelerator effect on the level of investment spending.
what are Supply-side shocks?
Supply-side shocks affect short run aggregate supply and can also affect a country’s long-run productive potential. Examples of such shocks might include:
- Steep rise in oil and gas prices or other commodities
- Political turmoil / strikes
- Natural disasters causing sharp fall in production
- Unexpected breakthroughs in production technology
Macroeconomic policy can often respond to the effects of external shocks. For example, if there is a deflationary demand-side shock, then a nation’s central bank might decide to lower their main policy interest rates or use some other form of expansionary monetary policy.
The effects of external shocks depend in part on what type of exchange rate system a country has chosen to use.
What is marginal propensity to consume (MPC)?
The marginal propensity to consume (MPC) is the proportion of an aggregate raise in pay that a consumer spends on the consumption of goods and services, as opposed to saving it. Marginal propensity to consume is a component of Keynesian macroeconomic theory and is calculated as the change in consumption divided by the change in income.
Given data on household income and household spending, economists can calculate households’ MPC by income level. This calculation is important because MPC is not constant; it varies by income level. Typically, the higher the income, the lower the MPC, because as wealth increases, so does the ability to satisfy needs and wants, so each additional dollar is less likely to go toward additional spending.
How dos the Keynesian Diagram show marginal propensity to consume?
According to Keynesian theory, an increase in production increases consumers’ income, and they will then spend more. If we know what their marginal propensity to consume is, then we can calculate how much an increase in production will affect spending. This additional spending will generate additional production, creating a continuous cycle. The higher the MPC, the higher the multiplier—the more the increase in consumption from the increase in investment.
How does marginal propensity to consume help to calculate the size of the multiplier?
The multiplier effect states that an injection into the circular flow (e.g. government spending or investment) can lead to a bigger final increase in real GDP. This is because the initial injection leads to knock on effects and further rounds of spending.
The marginal propensity to consume will determine the size of the multiplier. The higher the MPC, the greater the multiplier effect will be. If the marginal propensity to consume is 0, there will be no multiplier effect.
-if the government pursues expansionary fiscal policy (higher G) but consumer confidence is very low, then there will be a high propensity to save and a low marginal propensity to consume; this will limit the effectiveness of fiscal policy because the injection will lead to only limited increases in spending and aggregate demand.
what is marginal propensity to save?
Marginal propensity to save (MPS) refers to the proportion of any extra income that is saved by consumers.
-For an individual, the marginal propensity to save will reflect how much they want to put extra income into different forms of saving.
-
Factors that influence the marginal propensity to save MPS?
Income levels. At low-income levels, consumers will be buying all the necessities of life. An increase in income, will probably all be spent. At higher income levels, with all necessities bought, saving becomes an affordable extra.
The diminishing marginal utility of income. As income levels rise, extra income has a diminishing utility and so consumers may not know what to spend the money on and therefore spend an increasing percentage.
The Keynesian consumption function shows that the marginal propensity to consume falls at higher incomes – meaning the marginal propensity to save rises.
Life-cycle hypothesis. Theories of life-cycle spending assume individuals wish to smooth out their consumption over a period of time. During a period of studying, marginal propensity to save will be zero (student probably will borrow. As they get a better-paid job and pay off their debts, they will be in a position to increase savings. During their mid-working life, individuals will tend to have a higher propensity to save – as they put money aside for retirement.
Individual preferences. Not all individuals are rational. Approx 25% of individuals do not follow the life-cycle hypothesis models and may fail to save, when rational utility maximisation may suggest they should. Some individuals are more prone to present-income bias. This means individuals place a higher weighting on consumption in present moment, than saving for future.
Risk averse – risk loving. Some individuals are risk-averse, and therefore are more likely to save extra income – planning for unemployment e.t.c. Risk-loving individuals may not wish to save.
Factors that determine the marginal propensity to consume?
Income levels. At low-income levels, an increase in income is likely to see a high marginal propensity to consume; this is because people on low incomes have many goods/services they need to buy. However, at higher income levels, people tend to have a greater preference to save because they have most goods they need already.
Temporary/permanent. If people receive a bonus, then they may be more inclined to save this temporary rise in income. However, if they gain a permanent increase in income, they may have greater confidence to spend it.
Interest rates. A higher interest rate may encourage saving rather than consumption; however, the effect is fairly limited because higher interest rates also increase income from saving, reducing the need to save.
Consumer confidence. If confidence is high, this will encourage people to spend. If people are pessimistic (e.g. expect unemployment/recession) then they will tend to delay spending decisions and there will be a low MPC.
What are the risks of a falling currency?
- Inflationary effects from higher import prices (cost-push):
- higher import prices for raw materials, food, energy
- imported capital technology becomes more expensive
- possible second round effects on wages
- weaker currency increases import prices and thus worsens terms of trade - Weak currency may deter foreign investors
- Harder for the govt to find foreign purchases of sovereign debt
- may require higher bond yields, increases cost of serving debt.
- Greater risk of capital flight - Risk for those who have borrowed in a foreign currency
- good examples here are consumers in countries such as Hungary - Low elasticity of demand may limit the impact of currency depreciation on the trade balance and export volumes
- Currency devaluation does not turn around what might be long term supply-side weaknesses in the economy.
What is free trade?
this is trade without the introduction of artificial barriers.
What are artificial barriers?
these include tariffs, quotas and the law (legislation)
tariffs-a tax or duty to be paid on a particular class of imports or exports.
quotas-A quota is a government-imposed trade restriction that limits the number, or monetary value, of goods that can be imported or exported during a particular period.
What are exchange rates?
- exchange rates are foreign money for travel and tourism, for buying goods and services to invest overseas
- the government can increase value by reducing supply or decrease value by increasing supply but have agreed not to intervene.
evaluation for exchange rates changes
- The existence of transport costs which may also change and offset any gains or losses from exchange rate fluctuations
- the existence of import duties/ tariffs
- the size of the currency conversion- how much you exchange
- contractual obligations= a firm may agree on a fixed price, 6 months in advance or goods being delivered and so won’t be exchange rate changes.
- The share of a countries trade with there countries- e.g the pound may appreciate against the currency but depreciate against another currency at the same time.
- The J curve
- relative prices of competing goods
Four Factors that affect exchange rates?
- demand for UK goods and services (c+i+g+x-m)
- relative interest rates
- Foreign Direct Investment (building factories)
- Speculation- buying while cheap and selling at higher prices.
What is the balance of payments?
this is a record of all the financial transactions between this country and overseas, this includes:
- inflows of foreign currency
- outflows of a foreign currency
- current accounts- balance of trade in goods and services and net primary income such as interest, profits/ dividents or migrant remittances.
- net secondary income= contribution to EU, military or overseas aids.
- capital account= sales/ transfers of patents, copyrights or franchise and transfer of ownership fiscal assets
- financial account= transactions that result in a change of ownership of financial assets and liabilities between UK residents and non-Uk residents– incl. net balance of foreign direct investment flows; net balance of portfolio flows (HOT money); balance of banking flows.
what are net current transfers?
this is money sent between two countries.
Methods the government can use to reduce a balance of payments deficit?
- devaluation of the currency= weaker pound, imports dearer, exports cheaper.
- reduce aggregate demand= monetary or fiscal policy to reduce consumer spending and so reduce imports.
- protectionism= use tariffs, quotas or subsidies.
What are the potential advantages of free trade?
- increased competition for producers:
- by putting pressure on suppliers to keep prices down
- dilution of monopoly power in domestic markets
- reduce price discrimination
- improved allocative and productive efficiency - Better use of scarce resources
- exploitation of the comparative advantage
- trade is a source of economic development - Dynamic efficiency gains
- trade tends to speed up the pace of technological progress and innovation across many different industries - economies of scale
- increasing returns to scale - a stimulant to economic growth
- exports which is and injection of AD
- boosts to exports will have multiplier and accelerator effects on national income
- supply-side improvements from investment an greater factor mobility between countries.
what are arguments against free trade ?
to diversify the economy
Many developing countries rely on producing primary products in which
they currently have a comparative advantage. However, relying on agricultural products has several disadvantages
Prices can fluctuate due to environmental factors
Goods have a low-income elasticity of demand. Therefore with economic growth demand will only increase a little
what are arguments against free trade ?
what are arguments against free trade
If developing countries have industries that are relatively new, then at the moment these industry’s would struggle against international competition. However, if they invested in the industry then in the future they may be able to gain comparative advantage.
This shows that comparative advantage can change over time
Therefore protection would allow them to progress and gain experience to enable them to be able to compete in the future.
more on infant industry argument
what is comparative advantage?
A country has a comparative advantage if it can produce a good at a lower opportunity cost than another country. A lower opportunity cost means it has to forego less of other goods in order to produce it.
If each country now specialises in one producing good then assuming constant returns to scale, the output will double
Therefore the output of both goods has increased illustrating the gains from comparative advantage.
Therefore, specialising in the good where there is a comparative advantage has led to an increase in economic welfare.
what are arguments against free trade?
The Senile industry argument
If industries are declining and inefficient they may require significant investment to make them efficient again. Protection for these industries would act as an incentive to for firms to invest and reinvent themselves. However, protectionism could also be an excuse for protecting inefficient firms.
what are arguments against free trade?
Raise revenue for the government.
Import taxes can be used to raise money for the government – however, this will only be a relatively small amount of money
what are arguments against free trade?
Help the Balance of Payments
Reducing imports can help the current account as it restricts imports. However, in the long-term, this is likely to lead to retaliation and also cause lower exports so it might soon prove counter-productive.
what are arguments against free trade?
Cultural Identity
This is not really an economic argument but more political and cultural. Many countries wish to protect their countries from what they see as an Americanisation or commercialisation of their countries
what are arguments against free trade?
Protection against dumping
Dumping occurs when a country has excess stock and so it sells below cost on global markets causing other producers to become unprofitable. The EU sold a lot of its food surplus from the CAP at very low prices on the world market; this caused problems for world farmers because they saw a big fall in their market prices. Other examples include allegations that China has been dumping excess supply of steel on global markets causing other firms to go out of business.
what are arguments against free trade?
Environmental
It is argued that free trade can harm the environment because LDC may use up natural reserves of raw materials to export. Also, countries with strict pollution controls may find consumers import the goods from other countries where legislation is lax and pollution allowed.
However, supporters of free trade would argue that it is up to individual countries to create environmental legislation
the self correcting mechanism?
this occurs when pound weakens so exports become cheaper, so our good oversea cheaper so other countries may import more goods as consumers overseas increase demand for our cheaper goods, this increases demand for our currency and so the value of our currency increases again.
what are common external tariffs?
these are tariffs placed on any goods imported from countries outside the European union.
what occurs in a single market?
in a single market all facts of production, land labour capital and enterprise (services) are free moving.
what are trading blocs?
Trading blocs are usually groups of countries in specific regions that manage and promote trade activities. Trading blocs lead to trade liberalisation (the freeing of trade from protectionist measures) and trade creation between members, since they are treated favourably in comparison to non-members.
The World Trade Organisation (WTO) permits the existence of trading blocs, provided that they result in lower protection against outside countries than existed before the creation of the trading bloc .
What are examples of trading blocs?
European Union (EU) – a customs union, a single market and now with a single currency
European Free Trade Area (EFTA)
North American Free Trade Agreement (NAFTA) between the USA, Canada and Mexico
What are the dynamic effects of migration?
migration can have long term effects on a country’s overall macro-economics performance.
- in the labour market there will be an increase in active labour supply which might cause lower unit labour costs for a host country.
- the fiscal effects of immigration include inward migration increasing pressure on government spending but can also lead to rising tax revenue.
- migration can increase the population in size, so rising demand for public services, and if housing stock is fixed this can lead to higher prices and rising rents
- human capital helps to generate ideas and production, as many migrants start businesses and possibly export there will be knowledge spillovers.
What are the arguments for Brexit?
Free trade arguments
- Britain could negotiate new trade agreements with EU trading partners and any emerging countries
- Britain could free itself from many of the EU’s complex and expensive laws and regulations.
Savings and prices arguments
- leaving the EU would cut contributions to EU budget
- food prices would possibly be lower if we left the common agricultural policy (CAP)
other gains
- Europe needs the UK as a favoured trade partner.
- UK would retain greater control over fiscal and monetary policy and freedom over labour markets, competition and environmental policies.
What are the arguments for staying in the EU?
Free trade arguments
- multinationals might reconsider their FDI into the UK
- Adopting a Norwegian approach would mean UK accepting many EU rules without any say in policies
Open market arguments
- UK will lose tariff-free access to largest export markets
- Pan-European trade agreements have benefitted the UK.
- Outside the EU, the UK would be more exposed to low cost competition.
other risks
- high costs for businesses adjusting to new laws.
- UK’s net EU contribution is <1%of GDP
- Moves to limit free movement of labour with Brexit might worsen skill shortages for UK businesses.
what does net contributer mean?
this means when the money put into the EU exceeds the money we get out of the EU
What are the main characteristics of the EU single market?
- free trade of goods and services
- mobility of labour
- free movement (people)
Impact of Brexit on developing countries?
- Brexit is likely to have effects on developing countries:
- slower UK growth and weaker pound
- would lead to contraction in exports to UK from developing nations
- would lead to countries such as Bangladesh and Kenya affected. - migration flows are uncertain
- may be a short term rise in migration
- would lead to a fall in external value of the pound would reduce the value of remittances - the UK aid was £18.7bn in 2015–a fall in the value cuts the real value
- 10% of UK aid flows through the EU
- the key is whether the UK maintains 0.7% of GNI aid taker after Brexit.
What are the micro impacts of the UK leaving the EU?
- The Eu is a customs union and leaving it may lead to higher import tariffs on EU exports.
- Higher import tariff costs increase costs of firms who experience lower profits
- Leaving the EU might cause delays at borders as UK firms comply with the EU rate.
- products cross boarders several times- and JUST IN TIME deliveries require minimal delays in boarders, so costs will be high.
- most UK exporters comply with EU regulations, post Brexits the UK will have to deal with less tape.
what is meant by globalisation?
this is an increase in interconnectedness and interdependence of economic activity and social relation.
what are the characteristics of globalisation?
its involves:
- the expansion of traded goods and services between countries
- an increase in transfers of financial capital across national boundaries including foreign direct investments by multinational companies and investments by sovereign wealth funds
- the internationalisation of products and services and the development of global brands
- shifting the production and consumption e.g. the outsourcing and offshoring of production and support services
- increased levels of labour migration
- the entry of countries into the global trading system incl China and former countries of the soviet bloc.
Globalisation has involved:
Greater free trade.
Greater movement of labour.
Increased capital flows.
The growth of multi-national companies.
Increased integration of global trade cycle.
Increased communication and improved transport, effectively reducing barriers between countries.
what does sovereign wealth funds mean?
this is a state-owned investment fund.
what are the main drivers of globalisation?
Containerisation – the costs of ocean shipping have come down, due to containerization, bulk shipping, and other efficiencies. The lower cost of shipping products around the global economy helps to bring prices in the country of manufacture closer to prices in the export market, and makes markets more contestable in an international sense.
Technological change – reducing the cost of transmitting and communicating information – sometimes known as “the death of distance” – a key factor behind trade in knowledge products using web technology
Economies of scale: Many economists believe that there has been an increase in the minimum efficient scale (MES) associated with particular industries. If the MES is rising, a domestic market may be regarded as too small to satisfy the selling needs of these industries.
Opening up of global financial markets: This has included the removal of capital controls in many countries facilitating foreign direct investment.
Differences in tax systems: The desire of corporations to benefit from lower unit labour costs and other favourable factor endowments abroad and develop and exploit fresh comparative advantages in production has encouraged countries to adjust their tax systems to attract foreign direct investment (FDI)
Less protectionism - old forms of non-tariff protection such as import licencing and foreign exchange controls have gradually been dismantled. Borders have opened and average tariff levels have fallen – that said in the last few years there has been a rise in protectionism as countries have struggled to achieve growth after the global financial crisis.
what are the Benefits of globalisation?
- Free trade
- Free trade Free trade is a way for countries to exchange goods and resources. This means countries can specialise in producing goods where they have a comparative advantage (this means they can produce goods at a lower opportunity cost). When countries specialise there will be several gains from trade:
Lower prices for consumers
Greater choice of goods, e.g food imports enable a more extensive diet.
Bigger export markets for domestic manufacturers
Economies of scale through being able to specialise in certain goods
Greater competition
what are the Benefits of globalisation?
- Free movement of labour
Increased labour migration gives advantages to both workers and recipient countries. If a country experiences high unemployment, there are increased opportunities to look for work elsewhere. This process of labour migration also helps reduce geographical inequality. This has been quite effective in the EU, with many Eastern European workers migrating west.
Also, it helps countries with labour shortages fill important posts. For example, the UK needed to recruit nurses from the far east to fill shortages.
However, this issue is also quite controversial. Some are concerned that free movement of labour can cause excess pressure on housing and social services in some countries. Countries like the US have responded to this process by actively trying to prevent migrants from other countries.
what are the Benefits of globalisation?
- Increased economies of scale
Production is increasingly specialised. Globalisation enables goods to be produced in different parts of the world. This greater specialisation enables lower average costs and lower prices for consumers.
what are the Benefits of globalisation?
- Greater competition
Domestic monopolies used to be protected by a lack of competition. However, globalisation means that firms face greater competition from foreign firms.
what are the Benefits of globalisation?
- Increased investment
Globalisation has also enabled increased levels of investment. It has made it easier for countries to attract short-term and long-term investment. Investment by multinational companies can play a big role in improving the economies of developing countries.
What are the Costs of globalisation?
- Free trade can harm developing economies.
Developing countries often struggle to compete with developed countries, therefore it is argued free trade benefits developed countries more. There is an infant industry argument which says industries in developing countries need protection from free trade to be able to develop. However, developing countries are often harmed by tariff protection, that western economies have on agriculture.
What are the Costs of globalisation?
- Environmental costs
One problem of globalisation is that it has increased the use of non-renewable resources. It has also contributed to increased pollution and global warming. Firms can also outsource production to where environmental standards are less strict. However, arguably the problem is not so much globalisation as a failure to set satisfactory environmental standards.
What are the Costs of globalisation?
- Labour drain
Globalisation enables workers to move more freely. Therefore, some countries find it difficult to hold onto their best-skilled workers, who are attracted by higher wages elsewhere.
What are the Costs of globalisation?
- Less cultural diversity
Globalisation has led to increased economic and cultural hegemony. With globalisation there is arguably less cultural diversity; however, it is also led to more options for some people.
What are the Costs of globalisation?
- Tax competition and tax avoidance
Multinational companies like Amazon and Google, can set up offices in countries like Bermuda and Luxembourg with very low rates of corporation tax and then funnel their profits through these subsidiaries. This means they pay very little tax in the countries where they do most of their business. This means governments have to increase taxes on VAT and income tax. It is also seen as unfair competition for domestic firms who don’t use same tax avoidance measures.
The greater mobility of capital means that countries have sought to encourage inward investment by offering the lowest corporation tax. (e.g. Ireland offers very low tax rate). This has encouraged lower corporation tax, which leads to higher forms of other tax. (see: Tax competition)
What are the impact of globalisation on the UK economy?
Growth
Assuming the UK maintains its competitiveness, globalisation is likely to increase UK growth in the long term because aggregate demand (AD) is likely to increase through increased exports (X), and aggregate supply (AS) is likely to increase because of higher levels of investment, both domestic and foreign direct investment (FDI). However, growth in the short term may become more unstable as the global economy becomes increasingly interconnected. The recent credit crunch is evidence that unstable growth is a possible consequence of globalisation. Some economists have also argued that globalisation has increased the process of deindustrialisation in the developed countries, including the UK.
Employment
Long term, jobs may be destroyed in the manufacturing sector and created in the service sector, hence creating structural unemployment, which could widen the income gap within countries. The net effect of the impact on employment depends upon the speed of labour market adjustment, which itself depends upon mobility and flexibility. Improvements in labour productivity may be needed to close the productivity gap.– not only this but globalisation has lifted hundreds of millions of people out of absolute poverty around the world
Prices
Increased competition is likely to reduce the price level, for traded manufactures. Because UK firms can source from around the world costs may be held down, and this may be passed on in terms of reduced domestic and export prices.
Trade
The volume of both imports and exports is likely to increase, with trade representing an increasing proportion of GDP. The effect on the balance of payments is uncertain and depends upon relative growth rates, inflation, competitiveness, and the exchange rate.– opportunities for UK businesses to trade and invest overseas.
What is the role of Multinational corporations in globalisation?
Globalisation refers to the integration of markets within the world economy, which consequently increases the interconnectedness of national economies. Multinational corporations are a function of this interconnectedness, as they can form and utilise the connections between national economies, to operate within multiple countries. The operation of a multinational corporation within these countries will require significant investments, often called foreign direct investment, which will act as an injection into the host economy. With the operation of multiple multinational corporations in one nation, each investing in the region, for example, Maharashtra in India which receives significant foreign direct investment, the economy will be boosted, given that investment is a primary component of the aggregate demand of a nation. These global financial flows between economies epitomise the interconnectedness and thus globalisation of the world economy.
The production of goods in one nation, and the sale of those goods to another nation also epitomises the increasing interconnectedness of economies that can be achieved through the operation of multinational corporations. Additionally, multinational corporations may also outsource their production processes, often to lesser developed nations to reduce costs. This means that economies must remain highly interconnected in order to smoothly import and export goods produced between different stages of the production line, which often operates across multiple countries. This represents the flows of physical goods between economies, such as raw materials, energy, food, parts and consumption goods. Flows of information are also vital in connecting economies, as the effective communication between operating centres in different nations is a prerequisite for a successful multinational corporation. Such flows combine to form a global economic network, which is comprised of multiple national economies.
what is Fiscal policy?
Fiscal policy involves the government changing the levels of taxation and government spending in order to influence Aggregate Demand (AD) and the level of economic activity.
what is the purpose of a fiscal policy?
- Stimulate economic growth in a period of a recession.
- Keep inflation low (UK government has a target of 2%)
- Fiscal policy aims to stabilise economic growth, avoiding a boom and bust economic cycle.
what is an expansionary (or loose) Fiscal Policy?
- This involves increasing AD.
- Therefore the government will increase spending (G) and cut taxes (T). Lower taxes will increase consumers spending because they have more disposable income (C)
- This will tend to worsen the government budget deficit, and the government will need to increase borrowing.
what is a deflationary Fiscal Policy?
- This involves decreasing AD.
- Therefore the government will cut government spending (G) and/or increase taxes. Higher taxes will reduce consumer spending (C)
- Tight fiscal policy will tend to cause an improvement in the government budget deficit.
what is a discretionary fiscal stabilisers?
This is a deliberate attempt by the government to affect AD and stabilise the economy, e.g. in a boom the government will increase taxes to reduce inflation.
what are Criticism of fiscal policy?
- The government may have poor information about the state of the economy and struggle to have the best information about what the economy needs.
- Time lags. To increase government spending will take time. It could take several months for a government decision to filter through into the economy and actually affect AD. By then it may be too late.
- Crowding out. Some economists argue that expansionary fiscal policy (higher government spending) will not increase AD because the higher government spending will crowd out the private sector. This is because the government have to borrow from the private sector who will then have lower funds for private investment.
- Government spending is inefficient. Free market economists argue that higher government spending will tend to be wasted on inefficient spending projects. Also, it can then be difficult to reduce spending in the future because interest groups put political pressure on maintaining stimulus spending as permanent.
–Higher borrowing costs. Under certain conditions, expansionary fiscal policy can lead to higher bond yields, increasing the cost of debt repayments.
what are Evaluation of fiscal policy?
-
-It depends on the size of the multiplier. If the multiplier effect is large, then changes in government spending will have a bigger effect on overall demand.
- It depends on the state of the economy. Fiscal policy is most effective in a deep recession where monetary policy is insufficient to boost demand. In a deep recession (liquidity trap). Higher government spending will not cause crowding out because the private sector saving has increased substantially.
- It depends on other factors in the economy. For example, if the government pursue expansionary fiscal policy, but interest rates rise, and the global economy is in a recession, it may be insufficient to boost demand.
- Bond yields. If there is concern over the state of government finances, the government may not be able to borrow to finance fiscal policy. Countries in the Eurozone experienced this problem in the 2008-13 recession.
what are the drawbacks of globalisation on UK economy?
- risks of increase in structural unemployment in industries/ regions that lose demand to lower cost competition from overseas.
- Globalisation may lead to rising income an wealth inequality
- increase in global trade output has an environmental effect– increased use of non-renewable resources and CO2 emissions
- Globalisation of brands-perhaps a loss of cultural diversity
- UK government has less control-economy may become more vulnerable to external shocks
- surge in inward migration of labour has brought economic and social tensions
- globalisation contributed to the sharp fall in interest rates and widening trade imbalances that were part of the root cause of credit crunch
- high food and fuel price inflation has hurt lower income families most.
what are other drives to globalisation?
- rising living standards
- less protectionism
- lower transport costs
- digital communication
- market liberalism
- diverging consumer cultures.
what does the Laffer curve state?
- The Laffer Curve is a (supposed) relationship between economic activity and the rate of taxation which suggests there is an optimum tax rate which maximises total tax revenue.
- The Laffer Curve concept infers that a tax rate cut could lead to an increase in tax revenue, or a decrease in tax revenue, depending whether you have already passed the ‘optimal tax rate’
Why might total tax revenues fall if the tax rate increases?
- Increased rates of tax avoidance – greater incentive to seek out tax relief, make max use of tax allowances
- Greater incentive to evade taxes (illegal) – i.e. non–declaration of income and wealth
- Possible disincentive effects in the labour market – depending on which taxes have been increased
- Possible “brain drain” effects – loss of highly skilled, high income taxpayers
Evaluating the Laffer Curve
-Supporters of the Laffer Curve are often those pushing for lower tax rates on higher income earners
-Lower top rate taxes might increase income inequality
Little strong evidence that top rate income tax is a major barrier to inward migration of skilled labour
- Many people are on fixed hours / zero hours contracts so tax rates have little bearing on work incentives
- Tax rates not the only factor affecting work incentives – we must also consider the impact of the benefits system
- For some people, tax cuts will cause them to take more leisure time instead of work – a backward bending labour supply curve effect – especially at higher wages/ earnings
- There is a solid Keynesian explanation for some aspects of the Laffer Curve – cuts in direct and indirect taxes increase real disposable income and therefore lead to higher consumer spending and aggregate demand
