MacroEconomics Flashcards
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What is the circular flow of income?
A simple economic model which describes the reciprocal circulation of income between producers and consumers
What are factors of production?
Land, labour, enterprise and capital
What are the assumptions made for the closed economic model of the circular flow of income?
- No government sector (tax or capital injections)
- No exports or imports
- All money earned is spent (none saved)
What is national output?
Economic output produced by firms
What is economic output?
quantity of goods or services produced in a given time period, by a firm, industry, or country
What is National Income?
The total income received by people in the economy.
What is National expenditure?
Total amount spent on goods and services
Give examples of ‘injections’ into the circular flow of income
- Capital produced through exports
- Private investment
- Public spending
What are capital injections?
Spending that puts money into the circular flow
What are withdrawals/leakages?
Items that take money out of the circular flow
Examples of withdrawals/leakages?
- Savings
- Imports from abroad
- Taxes
What are commercial banks?
Banks such as Barcalys, Natwest etc. that hold money for masses of people
What is the current bank rate?
The interest rate
What is a base rate?
The interest rate
What is quantitive easing?
Injecting more money (liquidity) into the economy by buying assets
Effects of quantitive easing?
- More money for people to spend= better economy
- Inflation
What does the Bank of England do?
- Holds money for the government
- Holds money from commercial banks
What is the effect of the independence of the Bank of England?
The B of E sets it own monetary policy for the good of the country rather than the good of an individual party
Methods of measuring an economy’s wealth
- National Income
- National output
- Expenditure method
What is GDP?
‘Gross domestic product’- The value of goods & services produced over a given time, usually 1 year
How can resources be described?
Scarce or Finite
How are human wants described?
Infinite
What is the economic problem between ‘human wants’ and ‘resources’
Human wants are infinite but resources are finite
Give the 3 economic problems of production
- What to produce
- How to produce
- Whom to produce to
Name the 4 main economic resources and what they are rewarded with
Land – Rent
Capital – Interest
Labour – Wages
Enterprise – Profit
What is Land?
Natural resources
What is Labour?
Human resources
What is capital?
Man made good used to produce Goods + services
What is enterprise?
Ability to combine other inputs (capital, labour, land)
What are households?
People in an economic system
What are firms?
Factories/businesses/anything that provides goods/services
What is investment?
Money invested by firms into purchasing capital stock
What is macroeconomic equilibrium?
When injections=withdrawals
What is disposable income?
The amount of money households have for spending after income tax
Whats are factors of production?
Land
Labour
Capital
Enterprise
What is a closed economic system?
When firms and households are the only components in the system and there are no external factors
What is an open economic system?
When external factors such as investment, govt spending, tax, imports/exports etc. are involved in an economic system
What are injections:
Money added to an economic system externally eg. exports, govt spending, investment etc
What are withdrawals/leakages:
Money taken out of an economic system through tax, imports and savings
In regards to injections and withdrawals, how can GDP be increased?
If total injections > total withdrawals
In regards to injections and withdrawals, how can GDP be decreased?
If total withdrawals > total injections
When GDP increases, how does it return to equilibrium?
Households spend more money abroad = imports = increased leakages
Taxes increase = more leakages
people save more money = more leakages
All this continues until injections = leakages
When GDP decreases, how does it return to equilibrium?
People pay less taxes = Less leakages
Firms lower costs so more exports = more injections
Govt try to stimulate economy by spending = more injections
People spend less abroad = less leakages
All this continues until injections = leakages
3 ways to measure a country’s wealth
National income
National output
National expenditure
What is national income?
The combined amount that a country’s people earn as income, in a given time
What is national ouput?
The value of the goods and services produced by a country, in a given time
What is national expenditure?
The combined amount that a country’s people spend
What are the macroeconomic objectives?
- Full employment
- Price stability
- Sustainable economic growth
- Balance of payments in equilibrium
- Low levels of inequality
- Concern for the environment and sustainability
What is the value added?
The amount by which the value of an article is increased at each stage of its production, exclusive of initial costs.
The advantages of index numbers
- Shows data in a simplified form
- Makes it easier to compare prices between years
Calculating index number
100 x GDP (specific year) ÷ GDP (base year)
Nominal GDP
THe value of national output at current prices
What is quantitative easing?
An unconventional monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective
What is the asymmetric inflation target?
The 1% boundary eitherside of the target inflation rate
Examples of economic indicators
- Output growth:growth in real national output
- Price levels and inflation
- Levels and types of unemployment
- Balance of payments
Independant policies
Monetary policies that aren’t controlled by political parties and instead are for the economy
What is short run growth
Output measured as annual changes in real GDP and is typically recorded as %rate of change
What is the economic (business) cycle?
The annual fluctations in GDP over a period of time
What is recession
A decline in national output (output fall for two consecutive quarters)
What is recovery?
When upward movement of national output is restored, reducing the negative output gap between actual and capacity of production
What is full employment?
When national output reaches its potential or capacity level
What is a boom?
The overheating of an economy, representing an inability of supply capacity to meet high levels of demand
Symptoms of a boom
-A rise in inflation
-An increase in imports
A positive output gap may occur if output is temporarily over its capacity level
Measuring long term growth
Measured by averaging annual growth rates over longer periods of time (5~10 years)
Problems with measuring economic growth (4)
- The volume of data includes degrees of inaccuracy and omissions
- Omissions relate to non-marketed activities
- Non marketed government services need to be valued
- Omissions related to activity within so-called informal or hidden economy (black market)
The benefits of economic growth (6)
- Increased consumption and investment. This leads to increased material living standards
- Increased employment opportunities
- Strong economic growth contributes to business confidence
- Increased trade competitiveness
- Increases tax revenue for the government
- Decreases risk of inflation from overheating
Costs of economic growth (3)
- GDP statistics fail to take full account of the externalities involved in production, especially external costs caused by a negative environmental impact
- Growth of GDP gives no indication of the distribution of this rising income
- A ‘consumer society’ gives rise to social problems that detract from social well being but are not taken into account in GDP statistics
What is sustainable economic growth?
Economic growth achieved in a manner that does not threaten to reduce future economic welfare
What are transfer payments?
Transfers from tax-payers to benefit recipients through the working of the social security system.
What does ‘at constant prices’ mean?
Current price deflated by price index of goods and services
Bare facts about income distribution and redistribution (3)
- Income distribution encourages economic growth and visa versa
- Correct level of income inequality is when income growth is maximized for the least well off in society
- The tax and benefit system is used to redistribute income towards the less well off
Sources of LR economic growth (4)
- New natural resources
- New technology
- Increase in quality of labor
- Innovation
Sources of SR economic growth (3)
- Increase in aggregate demand
- Increase in aggregate supply
- Increased employment
Consequences of recession
- Fall in demand
- Rise in unemployment
What is a slump?
The bottom of the business cycle which represents a period of serious economic decline
Consequences of a slump (3)
- Low inflation
- Low business confidence
- high rate of bankruptcy and unemployment
What are the 4 macroeconomic indicators?
- Inflation
- Unemployment
- Economic Growth
- Balance of Payments
All of these are equally weighted
Why has their been an increased number of women entering the labour force (3)?
- Increasing, and changing types, of jobs
- Increased and improved childcare facilities
- Changing social attitudes
What are some of the benefits of having women in the workforce? (2)
- Increased labour force leads to an increased output and an increase in economic growth
- Increased income tax for the government
What is the benefit of unemployment for the worker?
Gives them time to search for a more rewarding job
What is the benefit of unemployment to firms?
Makes it easier for expanding firms to find workers at low wages
What is the benefit of unemployment to the economy?
- Decreases cost-push inflation as workers are less likely to risk their jobs for higher wages
- Decreases demand-pull inflation as workers are less likely to spend lots in fear of unemployment and those who are unemployed do not spend lots
How can low unemployment lead to inflation?
Demand for workers is greater than supply so firms have to pay more money keeping their workers for competition and stealing the best workers from other firms, leading to cost push inflation.
What is hysteresis?
Long term unemployment
What is classed as long term unemployment?
Unemployment for 6 months or longer
What are the problems associated with hysteresis (2)?
- Firms can be less likely to employ workers who have been out of work for a long time as they’re afraid their skills may have become outdated or that they are bad workers
- Workers can become discouraged and be less likely to apply for work
What are the problems for Britain with high unemployment in foreign countries (2)?
- Unemployed workers from abroad may come to Britain to look for work that is not in fact available, and add strains to the current resources in Britain, as well as adding to unemployment (TAKING OUR FUCKING JOBS)
- Leads to decreased foreign demand for British exports which leads to a decrease in aggregate demand, resulting in greater unemployment in the UK
What is underemployment?
A lack of paid work for an individual. Eg. When a part-time worker would like full time work
What is a flexible market?
One where skills and hours of work can be distributed and shared between many jobs
Does England have a flexible market?
Yes, one of the most flexible markets.
What is derived demand?
Demand for something that is dependent on demand of an external factor
Explain why is demand for labour is derived demand?
Demand for labour is dependent on demand for the good or service that the labour produces
How do changes in interest rates affect income?
Increased interest rates increase mortgages, which decreases DISCRETIONAL income
How to combat technological unemployment?
Create a highly skilled workforce
What can occupational immobility lead to?
A greater demand for workers, yet increased unemployment as there is a mismatch between skills needed for a job and skills of the workers
How to combat occupational immobility?
Create a more highly skilled workforce with more transferable skills
What are ‘Key workers’?
Social workers, teachers, nurses etc.
Why is there a lack of key workers in big cities, such as London?
They cant afford the high house prices in the big cities
Who qualifies as the labour force?
People between the age of 16 and 65 who are employed, unemployed and are economically active.
Economically inactive
People of working age who are neither employed or unemployed. These include those with terminal illnesses, full-time students and those who retire early (discouraged workers)
Claimant count
The number of people eligible for Job Seekers Allowance (JSA)
Are we measuring unemployment accurately?
- Official statistics miss out the hidden unemployed
- Some of the labour force is economically inactive due to other reasons (e.g. They need to look after family, people who have retired early)
- Underemployment leads to inaccurate information
Acronym for the determinants of Aggregate demand
W-ealth and assets
R-ates of interest
I-ncone
C-redit availability
D-emographic
I-nflation
E-xpectations
S-avings encouragement (ISA’s)
What demographic are net savers?
Over 45’s
Under 45’s have a higher propensity to consume
What percentage of Aggregate Demand does consumer expenditure make up?
75%
What is the acronym for the determinants of investment on Aggregate Demand?
G-overnment policy R-ates of interest A-dvancements in technology P-rofits of investors E-xpectations
What is the acronym for the determinants of Government spending in Aggregate Demand?
C-cycles of business (recession or boom)
G-rowth in the economy/less benefits/more tax
P-olitics and beliefs
What is the acronym for exports and imports in Aggregate Demand?
C-omparative productivity to foreign countries
E-xchange rate
E-conomic cycle (domestic)
F-oreign economic cycle
Why does the figure of GVT EXP significantly undervalues public spending?
Transfer payments are not included, and they make up the majority of government spending
Will an increase in disposable income have greater effects on spending levels of those on lower and higher incomes?
Lower incomes would experience a greater effect as they need more expenditure to meet their basic needs whereas higher income households already have enough and thus will save more
How can it be that there is a greater increase in expenditure than in disposable income?
Increases in disposable income make households more optimistic which encourages them to borrow more money and spend more than they actually get
What is the acronym for the effect on imports and exports from the exchange rate?
SPICED:
Stronger Pound Imports Cheaper Exports Dearer
What are the two ways high inflation can affect consumer expenditure?
Increase consumer expenditure: Makes people want to buy more as they fear future prices will increase
Decrease consumer expenditure: People save more to maintain the real value of their incomes and hope for the prices to fall again
What is the multiplier of income?
Finds total income when when consumption has been passed down the whole economic chain
eg. if the multiplier is 10, a £1 increase in Aggregate demand will lead to a £10 total increase in income
What is the equation to find the multiplier of income?
1/MPS
MPS=Marginal Propensity to Save
What are the two factors that affect long run aggregate supply?
QUALITY & QUANTITY of FACTORS OF PRODUCTION
What is Yfe?
Income at full employment: when there is full productive capacity
Where on a graph would you put Yfe?
On the X-axis of a graph under where full productive capacity has been achieved
What is the main determinant of long run aggregate supply?
Investment
Investment affects the quality & quantity of factors of production
What is macroeconomic equilibrium? (3)
When aggregate demand = aggregate supply
When injections = withdrawals
E+G+I = M+S+Tax
In terms of the macroeconomic equilibrium, what happens when injections do not equal withdrawals?
If spending on consumption (G+E+I) exceeds withdrawals so there would be an excess of demand over supply, and thus macroeconomic equilibrium is not met
If spending on supply (M+S+Tax) exceeds injections, there would be an excess of supply over demand, and thus macroeconomic equilibrium is not met
What are the determinants of short run Aggregate Demand and short run Aggregate Supply?
Injections and withdrawals eg:
G,I,Tax,S,M,E
What is “stagflation”?
When there is an increase in prices but no growth in the economy
Eg. When the LRAS curve becomes perfectly inelastic
What are the two ways that the government can stop “stagflation”?
- Increasing LRAS (eg. Through greater investment)
- Decreasing aggregate demand, known as ‘Demand Management’ (eg. Increasing interest rates)
What is contractionary economic policy?
Policy that slows down the money supply and public spending
When is contractionary economic policy implemented?
When there is a period of inflation
What methods are used to implement contractionary economic policy?
- increased interest rates
- Banks made to hold more cash to restrict the money supply
- increased interest on bonds encourage investors to buy them
What are bonds?
When an investor buys a bond, they pay a certain amount of money to the bank, and receive more money than they paid but some time later
Eg. John buys a £300 bond from the bank. He cannot use any of this money until…6 months later, the bank pays him £350
What is the effect of bonds
- in the short term, they reduce the money supply in the economy
- in the long term, they increase the money supply in the economy
What is expansionary economic policy?
Policy that seeks to expand the money supply and to encourage economic growth
When is expansionary economic policy used?
During a recession, or when there is low aggregate demand
What policies are implemented in expansionary economic policy?
- decreasing interest rates
- tax cuts
- increased government spending
What is the difference between marginal and average propensity to consume?
MPC- the proportion of a change in income that is spent
APC- the proportion of total income that is spent
Explain if it possible for an economy to have an Marginal propensity to consume that is greater than one?
Yes, it is possible as consumption can rise by a greater amount than income
- Consumption can be based on borrowing or savings
- if shares or house prices increase in value, households may consume more due to the wealth effect
What is consumption?
Total planned household spending on goods and services
Determinants of consumer expenditure: credit availability
Increased competition in financial markets has allowed households to access credit (debts)
Determinant of consumer expenditure: inflation
Households will save to maintain the real value of the money
Determinant of consumer expenditure: consumer expectation
Sustained periods of economic growth may raise expectations of a rise in incomes so households will spend more
Determinant of consumer expenditure: age distribution of population
Post 45 aged people are net savers while young people have a high propensity to consume. So if there is a greater ratio of these age groups in the population, there will be an increase in consumption
Determinant of consumer expenditure: channels for saving
The incentive given to Savers by schemes such as ISAs encourage consumption. However, people argue these schemes merely alter the saving pattern of households
What is wealth?
The value of household assets, such as their house, shares or bonds
What is investment?
The addition to the capital stock made by firms
What is physical capital?
New factories or raw materials, for example
Contrast of human capital
What is the accelerator theory?
That if output levels were falling, then investment would also fall
If there is foreign economic growth, what affect will this have on UK exports?
Increased demand for UK exports as foreign countries are wealthier and therefore will spend more
If technological change increases productivity, will this increase or decrease new investment?
Increase:
-As new investment will be more productive, it will raise the return on investment and make investment more attractive.
Define marginal efficiency of capital?
The rate of return on an investment project
What is working capital?
Spending on stocks of raw materials or finished goods before they are sold
Consequences of unemployment
- Productive potential is lost
- Reduction in income due to unemployment causes a reduction in taxation and and increase in social security spending
- Social costs (crime) and individual costs (illness) increase economic costs (polis cost)
- Hysteresis
Disequilibrium unemployment
Unemployment resulting from real wage rates in the economy being above the equilibrium level.
Structural unemployment
Unemployment resulting from industrial reorganization, typically due to technological change, rather than fluctuations in supply or demand.
Sectoral unemployment
Cyclical unemployment that occurs when the unemployment rate moves in the opposite direction as the GDP growth rate. So when GDP growth is small (or negative) unemployment is high.
Regional unemployment
Structural unemployment occurring in specific regions of the country.
Seasonal unemployment
Unemployment that is expected to occur at certain parts of the year
Frictional unemployment
Unemployment which exists in any economy due to people being in the process of moving from one job to another.
Structure of the current account of the balance of payments
- Trade in goods and services
- Investment income
- Current transfers
- Current account balance = 1+2+3
International Investment Position
Records the total external assets and liabilities of the UK economy
Notes on structure of the current account
- The monthly current account is normally referred to the balance of payments
- The current account deficit or surplus is termed the balance of payments disequilibrium
External equilibrium
When the current account of outflows and inflows match
Problems with a persistent balance of payments deficit
Foreign money in the form of investment is beneficial but an increase in oversea borrowing increases external debt
This in turn means more has to be spent to export due to interest rates
Determinants of the demand for sterling
- Trade in UK exports that require sterling to be purchased
- Oversea investments in the UK requiring foreign investors to buy sterling
- Rate of interest. High interest makes saving in sterling more attractive
- Speculation. Speculators will hold a currency whose value is expected to rise
Impact of exchange rate changes (Appreciation)
Fall in price of imports
Fall in inflation
Increase in oversea price of UK exports causing a loss in competitiveness
Reduction in net exports
Fall in AD
A depreciation in the currency will cause the opposite
Consequences of exchange rate instability
- Uncertainty. This hinders businesses as they cannot plan ahead due to uncertain production costs. Often firms agree to buy currency’s at a fixed price at a particular time but this is costly
- Too high exchange rates lead to uncompetitiveness
- Too low exchange rates put pressure on domestic prices and wages, thus eroding the competitiveness
How to improve land resources?
- Use land more efficiently
- find new uses of land (eg. Recently fracking)
How to improve labour?
- more workers eg. Migration
- get more of the elderly working
- get more women in work
- more people on benefits working (carrot & stick)
- more training/education
How to improve capital?
- decrease corporation tax and subsidies
- decrease tax write off period
- guarantee loans
How to improve enterprise?
- encourage enterprising culture
- training courses
- increased grants
What are the factors influencing short run aggregate supply and aggregate demand?
C+I+G+(X-M)
What are the factors influencing consumption? (5)
- Income and tax rate
- interest rates (cost of credit)
- house prices (wealth effect)
- consumer confidence
- new products on the market
What are the factors influencing government spending? (5)
- government revenue
- state of economy (unemployment)
- political beliefs (labour vs conservatives)
- external factors- events
- demographics
Factors influencing Investment? (5)
- profits, tax rate
- business confidence
- interest rates
- new technology
- costs of capital goods
Factors influencing X-M (5)
- exchange rates
- quality of reputation
- competitiveness
- tastes and fashion
- income levels at home and abroad (foreign growth in GDP)
What is the difference between short run and aggregate supply?
- In the short run, at least one factor is fixed
- In the long run, all and any factors can change
Aggregate demand
The total demand for an economy’s goods and services at a given price level and time period
Equation for Aggregate Demand
C + I + G + (X-M) C=consumption I=investment G=government spending X=exports M=imports
Determinants of consumer expenditure: Income
The amount of disposable income that is available to the consumer is important as the more there is, the more they will spend of it. The marginal propensity to consume shows how much a consumer will spend in relation to a change in income.
Determinants of consumer expenditure: Personal wealth
Wealth takes into account the long term income earning capacity of assets
e.g. if house prices rise, people will spend more as they believe they have more
Determinants of consumer expenditure: Interest rates
A fall in the interest rates will cause an increase in consumption as consumers are discouraged from saving their money due to poor interest rates
Give the exact definition of the multiplier
When an increase in an injection results in a larger increase in AD
What is the difference between actual and potential growth?
- if a new equilibrium is created, there is actual growth
- if there is not a new equilibrium created, it is only potential growth
What are the components of the current account?
- Trade account
- Income account
- Transfers account
What are the components of the trade account?
- trade in goods = visible trade
- trade in services = invisible trade
Are the UK in a surplus or deficit in regards to the current account
Deficit on trade in goods
Surplus in trade in services
What are the components of the income account?
- Earned income: income from jobs abroad / wages earned from abroad
- Unearned income: income from shares / properties abroad
What are the components of the transfers account?
-payments made for non-economic benefits eg. Foreign aid, EU payments, charities
What is the result of an increase in the balance of payments deficit?
- leads to a devaluation of the nation’s currency
- leads to increased level of debts
What is the effect of a rise in the balance of payments surplus?
- leads to a stronger currency
- decreased levels of debt
What is the key factor on the extent to which balance of payments effects the economy?
- depends on the proportion of GDP that the balance of payments make up
- If the balance of payments exceed 5% of GDP, it becomes a serious issue for the government
What are factor incomes.
Things given in exchange for factors of production:
The factor incomes are rent, wages, interest and profits
What is the equation for the value added?
Value added = value of an industry’s output - value of that industry’s material inputs
Equation to work out real GDP from the nominal
(Nominal figure x price index number of chosen year) / price index number of the initial year
Indirect tax will affect who more?
Indirect tax will affect less wealthy consumers as the tax value is fixed so the same tax will leave the less wealthy family with less disposable income
What is debt
The accumulated liability of a government
How taxation is adjusted
Taxation will change according to SR economic growth. Where there is a positive output gap, taxations will rise as consumers have more income. This phenomenon is referred to as the fiscal drag
What is fiscal policy?
The use of government spending and taxation to control aggregate demand and aggregate supply and thus control the economy
What policy does a government use during recession?
Expansionary fiscal policy to increase AD
What policy does a government use if the economy is overheating?
Contractionary fiscal policy to lower AD
What is a fiscal position?
The level of government spending in regards to taxation
How does Government spending lead to increased AD?
The multiplier effect
What are the different policies that affect the economy?
- Fiscal Policy
- Monetary Policy
- Exchange rate Policy
What are the features expansionary fiscal policy?
- Increased Gvt spending
- Decreased taxes
What are the features of contractionary fiscal policy?
- Decreased govt spending
- Increased taxes
What are the features of expansionary monetary policy?
- Lower interest rates
- Higher availability of credit
- Decreased interest on bonds
What are the features of contractionary monetary policy?
- Higher interest rates
- Lower availability of credit
- Increased interest on bonds
What effect will a decrease in income tax have on AS?
-A decrease in income tax could be an incentive for people to work less as they get more income
OR
-A decrease in income tax could encourage people to work more to make as much money as possible
What is discretional fiscal policy?
Deliberate changes in taxation and gvt spending
What are automatic stabilisers? Give examples of Automatic Stabilisers during recession and booms
Forms of government spending and taxation that change automatically to offset fluctuations in the economic cycle
eg. If unemployment increases, more money has to be spent on welfare & un. benefits (G increases) and there is less income tax revenue (T decreases) - this is an example of expansionary fiscal policy during recession!
If unemployment decreases, Less is spent on welfare & un. benefits (G decreases) and more is gained through income tax revenue (T increases) - this is an example of contractionary fiscal policy during a boom!
What are the monetary policy goals?
- Maintain a low and stable rate of inflation at around 2%
- Controlling the money stock by setting interest rates (current base rate is 0.5%
- Recently, monetary policy has had the responsibility of managing unemployment and economic growth
What will a low rate of inflation lead to?
Confidence in
- Consumers regarding spending decisions
- Firms regarding investment decisions
- Workers regarding wage decisions
What is the base rate?
The interest rate the bank of england charges other banks for loans
Factors that affect the deciding of the interest rate
GDP Unemployment Exchange rates House prices Level of investment by firms Relative GDP growth in other countries
What things can the bank of england manipulate?
Interest rates
Quatitive easing
What are the problems with fiscal policy?
Recognition lags: It takes time for policy makers to recognise the need to make changes in fiscal policy
Imperfect information: Key data on the economy is often delayed, old, incorrect or subject to revision
Response lags: It takes time for a certain policy to take effect and create a response in the market
How long does it take discretionary fiscal policy to effect the economy?
-Roughly 18 months for it to completely filter through to the economy
How long does it take for automatic stabilisers to effect the economy?
-They take effect and gain a response almost immediately
What is a budget deficit?
-The annual amount that the government has to borrow to meet the shortfall between the money gained through tax receipts and the level of government spending
It occurs when the government spends more than they receive through tax receipts
What is a cyclical budget deficit?
A cyclical budget deficit takes into account fluctuations in tax revenue and spending due to the economic cycle
Eg. when in a recession, tax revenue falls and spending on unemployment increases
What is structural budget deficit?
This is the level of the deficit, even when the economy is at full employment
What is ‘Crowding out’?
- When expansionary fiscal policy (G>T) leads to the gvt running a budget deficit
- As the government is running a deficit, it needs to borrow money from firms and households
- To encourage firms and households to lend, the interest rate is increased so lenders get a bigger return
- However, higher interest rates increase the cost of borrowing so firms borrow less and less investment is undertaken by firms
What is ‘Crowding in’?
- When expansionary fiscal policy stimulates economic activity by encouraging private sector firms to increase their investments
- Increased gvt spending has an upward multiplier effect as the industries invested in by the government will thus invest more
- Decreased gvt taxation also means that consumers will spend more, so firms have more income to invest- thus leading to long run economic growth
How can an increase in income sometimes not affect AD or help to boost the economy?
If additional income is spent on imports then it will decrease the balance of payments on the current account and will improve foreign economies rather than our own
Why are fiscal policy and monetary policy sometimes referred to as demand side policies?
Because they both seek to influence AD
What are the four sectors of government spending?
Capital expenditure
Current spending
Transfer payments
Debt interest payments
What are the five most important areas of government spending in the UK?
Social protection Health care Education Defence Debt interest
What factors affect proportion of spending on social protection?
Depends on benefit rates and economic activity
Increases during high unemployment
What factors affect proportion of spending on health and education?
Government priorities/policies
Age distribution of population
Expectation of advancements made in treatment
Factors affect proportion of spending on defence
Involvement in oversea conflicts (e.g. Iraq Afghanistan)
What factors influence government spending?
Market failure
Economic activity
Elections
Corruption
What are the aims of transfer payments?
The aim of transfer payments is to provide a basic floor of living for low income households
What is current government spending?
Spending on merit goods and public goods
Types of tax
Income tax VAT Excise duty (alcohol, tobacco) Capital gains tax (increase in value of shares) Corporation tax Inheritance tax
Factors affecting the effectiveness of fiscal policy
Size of the multiplier
Depends on the state of the economy
Depends on other factors such as interest rates
Bond yields
Whether a country has the borrowing power to finacne fiscal policy
What is the difference between budget deficit and public debt?
The budget deficit is the deficit that arises from too much government spending for example. This can be corrected by borrowing capital. The accumulation of budget deficit is called debt
How can an increase in government spending reduce unemployment?
Introduction of training programs will reduce structural unemployment
Lowering of taxation will encourage firms to invest and households to spend
Low interest rates will increase consumption
What is the primary target of monetary policy?
Maintain a low rate of inflation
What is the bank of England responsible for concerning monetary policy?
The bank of England are responsible for setting interest rates and controlling the money supply
Recently, the BoE has become involved in stimulating economic growth and employment
How does monetary policy work?
The MPC decide on a interest rate every month
To arrive at this deicision, they ocnsider many macroeconomic variables
The MPC will use interest rates or quantitive easing
How will the BoE react to higher growth and inflation?
They will tend to increase interest rates
Loose monetary policy
If the BoE anticipates inflation falling below the inflation target, they are likely to cut interest rates to encourage savers to spend
Tight inflationary pressure
If the BoE feels the economy is growing too quickly and inflation is predicted to exceed the target rate, they will increase interest rates to reduce growth
How are interest rates and exchange rates linked?
Global investors will seek to find banks with the best interest rates
By investing their money in a different currency from what their money originally was supply of the previous currency increases while the demand for the newer currency increases
This will change the exchange rates of both currencies
Thus, the higher the interest rates, the more that the currency appreciates
Other monetary tools
Printing money
Rules on bank lending and credit agreements
Quantitive easing
Affecting the exchange rates
How does printing money encourage spending?
By increasing the supply of notes, households will have more money to spend as wages increase
However, this depreciates the currency and will lead to cost-push inflation if not monitored correctly
How does influencing bank lending and credit agreements change government spending?
If the BoE decide to tighten the rules on how much credit and loan funds banks can make available, this will have an effect on constraining investment and consumption
How does quantitive easing affect government spending?
QE involves creating money electronically to buy assets
This increases available liquidity for banks
What is a liquidity trap?
A liquidity trap occurs when cutting interest rates fails to boost economic activity
This is due to banks being reluctant to lend or consumers being reluctant to borrow
What is a liquidity trap?
A liquidity trap occurs when cutting interest rates fails to boost economic activity
This is due to banks being reluctant to lend or consumers being reluctant to borrow
What is the ‘Paradox of thrift’?
Despite their being low interest rates, households choose to save rather than to consume, due to fear over job security
What are the causes of the liquidity trap?
- Banks are afraid that creditors will not be able to pay back
- Risk was not worth the rewards as profits they made from interest rates did not cover the cost of defaulting loans
- Households and firms have low confidence in the economy
- Feared a future increase in interest rates and that they thus wouldn’t be able to pay
- Banks sometimes overcharged borrowers above the base rate in fear of losing profits
When is a depreciated currency not useful in improving the current account balance?
- If PED of imports is inelastic, then the demand for imports will not decrease, but more money will have to be spent on them, worsening the current account
- For inelastic raw materials (eg oil), more money is spent on them if the currency depreciates, leading to cost-push inflation, termed ‘Imported Inflation’
How can credit availability affect investment and consumption?
- The lower the credit availability, the higher the constraints on investment and consumption as there is less money available to borrow
- Called ‘Tight Credit Regulation’
When is quantitive easing used?
- When the economy is experiencing the liquidity trap
- By increasing liquidity, banks will be more inclined to lend money as they have less constraints in terms of cash (liquidity)
What are transmission mechanisms?
How monetary or fiscal policy filters through and effects the economy
What are the limitations of Monetary Policy? (5)
- The liquidity trap can occur
- Difficult to control many macroeconomic objectives with one tool
- changing interest rates may negatively effect the exchange rate through the effect of hot money
- Interest rates may affect one part of the economy but not another part
- Time lag: it takes time for monetary policy to filter through to the economy
What are supply side policies?
Policies that seek to improve the long run productive potential of the economy
How can the effects of supply side policies be shown on a PPC curve?
By shifting the country’s production possibility frontier outwards to the right
What are the supply side policies? (14)
Privatisation Deregulation Reducing income tax Increased education and tax Reducing the power of trade unions Reducing state welfare benefits Providing better information (jobs) Deregulate financial markets Lower tariff barriers Removing unneccessary red tape and bureaucracy Improving transport and infrastructure Deregulate labour market Investment grants Regional policy
How does privatisation improve long run productive potential of an economy?
By selling state owned assets to the private sector, as the private sector is generally more efficient in running business as they have the prospect of increased profit so will try and provide services as cost efficiently as possible
How does deregulation improve long run productive potential of an economy?
This involves reducing barriers to entry in order to make the market more competitive.
Getting rid of trade monopoly’s by the introduction of newer firms is an example of deregulation
This competition tends to lower prices and provides a better quality of goods and services
How does reducing income taxes improve long run productive potential of an economy?
It is said that lower taxes increases the incentives for people to work harder thus leading to greater output.
However this is not always the case as income effects may be diminished due to substitution effects (e.g. inflation)
How does increasing spending on education on training improve long run economic growth?
Better education can improve labour productivity and increases AS
There is usually market failure concerning the under provision of education so governments may choose to subsidise these services
However government intervention is time consuming and costly
How does reducing the power of trade unions improve long run economic growth?
This ought to increase productive efficiency (less time lost to striking) Reduce unemployment (If labour markets are competitive)
How does a reduction in state welfare benefits imrpove long run economic growth?
This may encourage the unemployed to take jobs
How does providing better information abour jobs imrpove long run economic growth?
This may help to reduce frictional unemployment
How does deregulating financial markets improve long run economic growth?
This allows for more competition and lower borrowing costs for consumers and firms
How do lower tariff barriers improve long run economic growth?
This increases trade as trading becomes cheaper
How do investment grants improve LR economic growth?
Investment grants offers incentives to invest in capital
However, investment grants are not abundant so the governement must choose what projects to invest in
How does regional policy improve LR economic growth?
Regional policy provides incentives for firms to set up in depressed regions to make them more economically active
How can supply side policies occur independently of the government?
If businesses are feeling confident about the future, they may choose to increase output and investment
Also if firms believe the economy is likely to grow, they may invest in order to meet future demand
In markets where competition is intense, innovation is often driven by a desire to gain a market share
What does the balance of payments consist of?
Trade in goods and services
Investment income
Current transfers
How do supplyside policies aim to increase LRAS?
By increasing competitiveness
Promoting greater competition in markets
Providing incentives
incentives
How can a high technology sector in industry be developed?
Investment in research and development
Investment in human capital (education)
Investment in physical infrastructure (transport links)
How can the current account of the balance of payments be improved in the short run?
By implementing demand side policies to decrease household expenditure on foreign imports
By improving an uncompetitive exchange rate
What are the limitations of using demand side policies to improve the current account deficits in the short run?
Reduced growth and output
Increased unemployment
This approach does not solve the underlying problem of a poor trade performance
What are the limitations of exchange rate depreciation to improve the current account deficit in the short run?
This is only a short term solution as the high price of imports causes inflationary pressure, that erodes the temporary competitiveness
What supply side policies are appropriate for improving a long term current account deficit?
Promoting investment in research and development
Promoting capital investment in the high technology sector
Promoting investment in human capital (education)
What is the limitation of promoting economic growth and employment using demand and supply side policies?
This takes time to implement and so the impact is minimal
Competition and deregulation has negative aspects
What are the limitations of promoting full employmentusing demand and supply side policies?
Risk of inflation
Uncertainty
Time lags
What are the limitations of using demand and supply side policies to control inflation?
Demand: risk of trade off involving output gap and higher unemployment
Strong exchange rate: unless inflation falls, exchange rate becomes uncompetitive
Supply: may increase income inequality
What,is a trade off?
When a policy success to improve an aspect in one area but worsens an aspect in another
How can a country have a comparative advantage over others in producing a particular good?
Access to particular resources
Access to particular technology
The availability of economies of scale
What can countries gain from trade?
Reduced costs in countries lead to lower global prices
Lower prices lead to increased domestic consumption
Consumers are subject to a wider choice of products
Trade is said to improve relations between countries but only if trading terms are equal
Why can countries benefit from trading in a free market?
In a free market, the gains from trade are maximised due to the lack of restrictions from accessing products from low cost sources
What is protectionism?
Refers to the policies designed to restrict free trade in the interests of protecting domestic producers
What methods of protectionism are there?
Tariffs Quotas Subsidies Exchange controls Voluntary export restraints (VER's) Red tape
What is a tariff?
A tax imposed on imported products by raising the market price and decreasing the quantity of imports
What are quotas?
A restriction on the level of permitted imports (does not generate any government revenue)
What are exchange controls?
The process by which access to foreign currency is controlled to influence the demand for imports
What are VER’s?
Voluntary agreements whereby the exporting countries agrees to a limit on the quantity of its products entering another market
What are the reasons for protectionism?
To protect infant industries
To prevent dumping
Protection of declining domestic industries
To eliminate a balance of payments deficit
To encounter unfair competition from overseas
What is the argument against protecting infant industries?
Although it sounds correct, in practise it may give less incentive for developing countries to ever become efficient
What is dumping?
Refers to the act if selling goods below the cost of production often resulting from the over use of subsidies
Evaluation of protecting against dumping
As dumping can result from an excess of subsidies, the WTO deems this as unfair competition so importing countries are encouraged to place tariffs in retaliation
Evaluation of the protectionism of declining domestic industries
If the decision is time limited, it may buy time to reconstruct the industry
However, usually this results in job losses as workers are made redundant so firms cam become more competitive
Supplyside policies concerning reeducating the work force is more effective
Evaluation of eliminating the balance of payments using protectionsism
Other countries can retaliate by implementing protectionism reversing the initial effect of the improvement of the balance of payments or even worsening it
Evaluation of using protectionsism to counter unfair competition
Lower wages overseas do not mean there is unfair competition as countries may be relying on possessing a comparative advantage over others in labour intensiveness
What is red tape?
Time delaying customs procedures that can be used to discourage imports due to the opportunity cost of filling in complex custom forms
Definition of Cost-push inflation?
When firms increase their prices in order to protect profit margins, as a result of increasing costs of production
When does cost-push inflation occur? (4)
- Can result from an increase in the cost of raw materials
- If an economy’s exchange rate weakens, foreign raw materials become more expensive
- If wages rise at a higher rate than productivity
- When indirect taxation leads to an increased cost of production
When is cost-push inflation most likely to occur?
When the economy is near full employment (perfectly inelastic part of the curve) as the shortage of labour means that wages have to increase in order for firms to maintain or attract the highest skilled workers available
What effect does Cost-push inflation of the aggregate supply and demand curves?
-It causes a shift inwards in SHORT-RUN aggregate supply
When will an increase in the costs of production not lead to cost push inflation?
- If firms do not decide to ‘push’ the costs onto the consumers through increasing the price of the product, and attempt to cut costs elsewhere in the business
- For example, if the goods has elastic demand then firms would loose significant revenue by shifting the costs onto the consumer
- Despite this, the inflation rate tends to increase at roughly a proportiante level to the rate of wage increases
What is the actual definition of structural unemployment?
- When there is a mismatch between the skills that workers have and the actual skills needed for the job
- This can come as a result of increased technology used within industry
- It can be combatted through producing a more highly skilled workforce (supply side policies)
