Macroeconomics Semester 1 Flashcards
What is economics?
This is the study of how people interact with each other and with their natural surroundings in producing their livelihoods, and how this changes overtime.
What is the economy?
The economy is the real-world system that governs how we interact with each other and with our natural environments in producing goods and services on which we live.
Why do we use economic models?
We use economic models because we have to assume some factors will stay equal in order to make economic assumptions, often the interactions in an economy will be too complex to answer even simple questions, so we use Ceteris Paribus.
What is gross domestic product?
GDP will often aim to approximate the ideal of how much is produced and spent in a country in a given period of time.
What are the 3 ways of measuring GDP?
-Total spending on domestic products
-Total domestic production (based on value added)
-Total domestic income
What does value added mean?
This means that we only add to GDP the additional output of production above the price that was paid for the original raw materials. If we didn’t do this, we would be double counting output and the GDP value would be higher than it actually is.
What do we do about international transactions in GDP?
We will include exports, and exclude imports. This means that GDP will include value added, income from and the consumption of domestic products.
How does the government get included in GDP calculations?
-The government is treated as a producer in GDP, public services will be ‘bought’ by taxes.
-We assume the cost of production by the government captures the value added.
What are the main expenditure components of GDP?
-Consumption (expenditure on consumer goods and services)
-Investment (expenditure on newly produced capital goods, e.g equipment buildings and inventories i,e unsold output)
-Gov spending (excluding transfer payments)
-Net exports (exports - imports)
Y = C + I + G + (X-M)
What is the difference between nominal and real GDP?
Nominal GDP uses real prices, where as real GDP uses constant prices, which will be based off of a base year on an index.
What are purchasing power parities?
The price of goods will be different in different countries, so because of this we have to use PPP in order to get a true idea of living standards in different countries. We cannot use exchange rates alone to find PPP as living costs can also vary greatly, so instead we work it out by:
-Using a basket of goods (OECD-Eurostat)
-A homogeneous, specific good (Big Mac index)
Why is GDP per capita used when comparing welfare?
-It will give us a better measure of the material living standards of a country.
What are the alternatives to GDP when comparing welfare
-GNI: GDP minus the income earned by foreign companies and households, plus income earned by nationals abroad.
-Disposable income per capita: Wages, salaries, profit, rent, interest and transfer payments from the gov or others received, minus any transfers the individuals made to others (such as taxes).
-Consumption per capita: a measure of aggregate consumption in the country - one of the 5 components of GDP, which is believed to link more to welfare than other components, divided by the population.
When did GDP differences between countries first appear?
It wasn’t until the 19th century, as up until this point GDP was fairly constant. Britain led this with the Industrial Revolution, and many countries then followed in the 20th century.
What is economic growth?
Economic growth is the relative increase in GDP from one period to the next. It is calculated by actual - original/original.
What is economic growth?
Economic growth is the relative increase in GDP from one period to the next. It is calculated by actual - original/original.
What is the hockey stick model?
The hockey stick model shows how many countries experienced rapid growth, with GDP graphs forming the shape of a hockey stick. This occurred for Britain from 1650 onwards, but in 1870 in Japan. Many nations didn’t start to truly develop economically until they gained independence from their colonial rulers.
This isn’t always the case though, Latin America gained independence and still struggled to form true economic growth.
How did technology play a crucial role in economic growth?
Technology is the description of a process using a set of materials and other inputs, including the work of people and machines, to produce an output.
Technology could be a new, more efficient machine, but it can also change the organisation of production, like the division of labour, as explained by Adam Smiths Pin theory.
How did technology play a role in the Industrial Revolution?
It transformed Britain from an agricultural and crafts based economy into a commercial and industrial economy. The productivity of labour in producing light is now 1/2 million times greater than it by using a campfire.
What is the issue with economic growth?
-Economic growth comes with many negative externalities on the environment, this is because a lot of the newly developed technology often requires raw materials such as fossil fuels to function.
-As well as this, there will be negative externalities on people health is air pollution causes sickness.
What things aren’t included in GDP that probably should be?
-Environmental health
-Human health and QoL
-Security and community
-Household production.
What things aren’t included in GDP that probably should be?
-Environmental health
-Human health and QoL
-Security and community
-Household production.
What were the main reasons for the occurrence of the Industrial Revolution?
-A nascent domestic industry that was heavily protected by mercantilist rules
-A cheap supply of raw materials (cotton) thanks to the Empire (including slavery)
-Richness in natural resources
-An intellectual revolution which will encourage experimentation and innovation.
What are the main players in an economic model?
-The individuals
-Households (groups of individuals making decisions together)
-Firms (economic organisations in which private owners of capital goods hire and direct labour to produce goods and services.
-Governments (non-profitable organisations with powers to change laws and institutions).
What is a market?
This is the mean of transferring goods or services from one agent to another. All transfers are to outside of the household, voluntary for mutual benefit and directly reciprocated (unlike a gift).
Markets will be monitored by institutions, who will set laws and ‘rules’ to regulate the social interaction among people.
What is one key institution all markets require?
Private property. This means that the person possessing it has the right to exclude others from it, benefit from it and then also exchange it with others.
What is capitalism?
Capitalism is an economic system characterised by the prominence of markets and privately owned firms. These will be regulated by a government, and different capitalist markets will be different depending on the amount of government intervention into the free market.
Why do assume rationality in economic models?
We assume rationality in economic models because this means every individual aims to maximise utility/satisfaction based on the info available to them. Therefore in economic models:
-People don’t do random stuff
-People take opportunities when they arise
-People face issues or scarcity (finite resources)
-No ‘Dues ex Machina’ (a trend will continue to follow its path, and there will not be a sudden diversion from the path)
Why is it important economic models end in equilibrium?
This means that the outcome of the model is self perpetuating. The model will therefore not change unless an external force is introduced which alters the situation in the model.
However, assumptions matter for these models to reach equilibrium, and it is at this point economists tend to disagree.
What is an absolute advantage?
An absolute advantage will occur when one country/firm can produce a good more efficiently than another.
What is a comparative advantage?
This is when an agent is able to produce a good relatively more productively than another country, even if they don’t have an absolute advantage on that good.
What did David Ricardo say about comparative advantages?
David Ricardo said that if a country has comparative advantage, it should always aim to produce and trade with another country, as even if the country doesn’t have an absolute advantage, specialisation will still cause the quantity of output to increase, therefore benefiting both countries.
Will there only be one equilibria when trading with comparative advantages?
No, there will likely be a range. Any combination of goods which at least matches the previous quantities of both goods for both countries is a possible realistic equilibrium outcome of the trades which occur.
What is an isocost line? (lesson 2 slides)
An isocost line will represent and graph showing the cost of two production factor inputs (e.g coal and workers) for different technologies, and as a result this will show the constant different combinations of the two goods which will cost the same.
If wages become more expensive, the the isocost lines will change to represent the new number of workers (and output) which will be available, and by putting different isocost lines on the graph for different technologies, it will show which technology is most efficient for given raw prices/wages.
What is the benefit of new technology?
The first adopter of new tech is called an entrepreneur, and they will benefit from more profits (known as Schumpeteriam, or innovation, rent) until their competitors copy and adopt the new technology, which can be slowed through patents.
What is creative destruction?
This is the process by which old technologies and the firms that adapt them are swept away by the new, as they cannot compete in the market.
However, it is this destruction that causes economic growth.
How did labour costs help cause the British Industrial Revolution?
In the 17th century, British wages for coal started to rise compared to the likes of France, so this meant that an incentive came around for British workers to innovate technology, and reduce the need to hire workers. It was this incentive that prompted the revolution.
The same occurred in the textiles industry, causing the ‘spinning Jenny’ which massively improved textile’s efficiency, and was later implemented in a factory size, massively reducing reliance on human labour.
What is the Malthusian Trap model?
The Malthusian trap is when a small population growth would see farmers income rise, following which the farming families would have more children, so more could work on the farm. However, as the area of land available remains the same size, there would be diminishing returns to labour, and as a result families would now not be able to afford to feed the growing family, because wages would fall.
This would then cause the trap, as populations would shrink again and the process would start again.
What two assumptions made by Malthus cause many (including David Ricardo) to disagree with his theory?
-He assumed that there would be a geometric growth in population, and therefore each person would have two children, which isn’t true.
-Furthermore, not everyone in England was a farmer, but Malthus worked in a church and therefore was constantly facing people who experiences the issues of his theory.
-Another assumption was diminishing marginal returns in agriculture, which won’t necessarily be true should there be technological advance.
When did Britain escape Malthus’ theory?
In the 1800s, when technological advance was made, which allowed the wages curve to shift outwards, meaning even if population was going to fall before, the increase in wages meant that the families could now be provided for.
Since 1800, the UK has seen real wages and labour productivity rise side by side, with the only dip coming in 1920s when the universal suffrage occurred.
What is the OECD better life index?
The better life index was created by the OECD, which allows you to weight different economic and social factors depending on how important you feel they are to overall well-being.
Do economies grow in a straight line?
No, although over many years the overall growth trend will be positive, there will be bumps in the road caused by recessions, this could be due to many factors such as war (WW2), disease (Spanish flu in 1920) or economic crisis (such as in 2009).
Why have the business cycles in the UK become more regulated since the Industrial Revolution?
The agricultural society in Britain before the 1800s would of had far more volatility in output due to the reliance on weather, and as a result its growth rate varies much more than GDP does. However, industry and service sectors were far less volatile, as there were less external variables which these sectors were dependent on.
What is the definition of a recession?
When output is declining. A recession will be over when the economy begins to grow again.
It is officially defined as when the economy shrinks in at least two successive quarters.
Why are business cycle’s important?
Since the Industrial Revolution, specialisation and industrialisation has meant that much of the population depends on paid employment from firms rather than harvests.
As a result of this, periods of negative growth have become more significant because if the economy produces less, fewer people will be employed by the now more prominent firms. And as a knock on effect of this, more people will then be going without income.
What is Okun’s law?
Okuns law is the relationship between growth rate and unemployment. By plotting the data if countries, there is a clean trend that when GDP growth is high, the change unemployment rate is negative, and the opposite when GDP growth is low.
What is the definition of unemployment?
Unemployment is a person who is not working a present (not linked to a firm), wants to be employed and is ready to start working within two weeks, and has been looking for a job or is ready to start one soon.
People who aren’t working by choice are out of the labour force and not unemployed, they are considered to be economically inactive.
What are the two types of unemployment?
Short term: short spells due to temporary circumstances that resolve themselves quickly(usually less than a year)
Long term: long periods of unemployment, defined by the OECD as longer than a year. It is this unemployment which will rise during recessions, and has a massively negative impact on welfare.
Shocks drive business cycles, and as a result the fluctuations in GDP. What are the different types of economic shocks?
-Household shocks: if affects one particular household
-Economy shocks: It affects all households in the economy
-Industry shocks: affects a particular industry as well as the households linked to it.
Shocks can also be demand side (Taylor Swift’s Eras Tour causing a potential $5billion gain to the economy), or supply side (the Evergreen ship blocked the Suez Canal).
What two ways can households cope with shocks?
-Self insurance: saving and borrowing where other households aren’t involved.
-Co-insurance: support from social networks, social safety net or the government.
Co-insurance can also be informal, when you can borrow between family and friends and this relies on trust. However, if the shock is an economy shock and everyone is struggling for money, then this will not be a viable option.
What do the two strategies households use to cope with shocks reflect?
-They reflect the idea that people prefer smooth consumption. This means spending partially in the present (potentially through borrowing is current income is low), but they will also not increase consumption drastically when income does rise, as some of this will be needed to repay previous debt, and the rest will be important to save, incase of a unexpected shock or to spend in the future (during retirement).
-Tax payments also show households aren’t entirely selfish. They are willing to support each other to smooth the effects of good and bad fortune, with the knowledge they will then be supported should they find themselves in difficulty. Co-insurance is also evidence of altruism (acting selflessly to aid others for the concern of their well-being).
Which shocks do and don’t households respond to?
Households will change consumption based on long-term shocks, but will have very little acknowledgment of short term shocks on their consumption level.
What may consumption smoothing fail?
Households will make plans based under uncertainty about the future, and do their best based on the information they have. The more uncertainty, the more households may save and delay consumption.
Households may not follow through with plans due to:
-Credit constraints
-Time inconsistency
-Limited co-insurance
What are credit constraints?
If an individual cannot provide good evidence to a bank that they will be able to pay back what they wish to borrow in the future, they may not actually be able to borrow. This will then cause a binding restriction on the amount of current spending a household can make, known as credit constraint.
What is time inconsistency (weakness of will)?
This refers to the fact that we may fail to consider all the incentives we will have to face in the future when committing to a plan, so we don’t always save as we initially planned to.
This is not, however, actually a failure of rationality, it is just a product of discounting the future at different rates due to ‘present bias’.
How does limited co-insurance impact household consumption smoothing?
In many countries which have a lack of established social regulation, they will make social security such as:
-health insurance
-no insurance against natural disasters
-no unemployment insurance
-lack of basic social security transfers.
In many countries, this occurs purely because risks are uninsurable, and a market to insure against these risks don’t exist, since it isn’t profitable for firms to offer it.
How do firms investing differ from households consumption smoothing?
Firms don’t have as strong a preference for smoothing as households, as they will adjust their investment for both temporary and permanent shocks, to maximise their profits.
Firms will invest when demand is high, and when they have high expectations for future demand, so high demand -> high capacity utilisation-> investment-> even higher demand.
Why does business confidence matter?
Business confidence makes up a fairly large proportion of GDP, and therefore, as investment tends to follow business confidence, it is important business confidence remains stable to ensure investment remains constant.
We can see investment (and therefore business confidence) is crucial for GDP growth, so the government will often intervene with economic policy to help keep investment high and stable, by attempting to remove any uncertainty for firms.
What is more volatile, household consumption or investment?
Investment is more volatile than consumption, since investment adapts to both short and long term shocks, where as households will only adapt to short-term shocks.
How can we see the reason for a recession?
-If the recession is paired with high inflation, it will be caused by firms putting up prices, and hence lowering demand in the economy.
-If it is due to households, then it will cause inflation to fall because firms will lower prices in an effort to spike demand.
What the two main ways to measure inflation?
-CPI index: this uses a basket of goods based on a fortnightly survey of households (with more prominent goods weighting heavier in the basket), and measures the prices of these goods (excluding exports, but including imports and consumption taxes on goods).
-GDP deflator: this tracks the change in prices of all domestically produced final goods and services. However, instead of a basket of goods the GDP deflator tracks the price changes of components of domestic GDP (however, exports are excluded, and imports are included). It can also be expressed as the ratio of the nominal to real GDP, and is normally only used for a data purpose to change nominal GDP to real on a series.
What is a balance sheet?
A balance sheet is a record of assets, liabilities, and net worth of an economic actor such as a household, bank, firm or government.
What are liabilities?
Liabilities are anything of value that are owed.
What is net worth?
Net worth is assets minus liabilities.
Why doesn’t wealth or net worth change when you lend or borrow?
This is because a loan will create both an asset and a liability on your balance sheet. If you borrow money you will receive cash as an asset, and the debt will be an equally valued liability. Obviously, once interest has been added to a loan the liability will then increase in size.
What is a bank?
A bank is a firm that makes profits through its lending and borrowing activities. They create money in the form of bank deposits during the process of supplying credit.
What is base money?
Base money is cash held by households, firms, and banks, and the balances held by commercial banks in their accounts at the central bank, known as reserves. Base money is the liability of the central bank.
What is bank money?
Bank money is money in the form of bank deposits created by commercial banks when they extend credit to firms and households. Bank money is the liability of commercial banks.
What is broad money?
The amount of broad money in the economy is measured by the stock of money in circulation. This is defined as the sum of bank money and the base money that is in the hands of the non-bank public.
It is the amount of money in the hands of the non-bank public.
What is a legal tender?
This is a form of payment (notes and coins), which can legally be accepted as payment by law (cannot be rejected), where as bank deposits and cheques would not be a legal tender.
What is the central bank?
The central bank is the only bank that can create base money. Usually, but not always, this is part of the government. Commercial banks have accounts at this bank, holding base money.
For this reason, commercial bank reserves will always be equivalent to cash, so a commercial bank can withdraw thus from the central bank when necessary.
How do commercial banks make a profit?
Commercial banks make a profit by charging interest when a household or firm takes a loan out of the bank. This means when the loan is repaid, some additional money will also enter the banks assets, and this is called bank money, which will cause the banks net worth to rise.
How do commercial banks make a profit?
Commercial banks make a profit by charging interest when a household or firm takes a loan out of the bank. This means when the loan is repaid, some additional money will also enter the banks assets, and this is called bank money, which will cause the banks net worth to rise.
What is a maturity transformation (also known as a liquidity transaction)?
A maturity transformation is the practice of borrowing money-short term and then lending it long term. A bank accepts deposits, which it will promise to repay at short or no notice, and then makes long-term loans.
The lenders deposits will be liquid (can be withdrawn from the bank at any time), but the loans from banks to borrowers will be illiquid (cannot be immediately withdraw into legal tender).
What risks come with a maturity transformation?
The bank will be exposed to liquidity risk (the risk that an asset cannot be exchange rapidly enough for cash to prevent a financial loss), or a default risk (the risk that credit given as loans will not be repaid).
Why would all depositors wanting their funds at the same time be an issue?
If all depositors wanted their funds at the same time, the fact that many of the banks assets may be in an illiquid form means that they may not be able to repay all the demanded withdrawals of deposits. If a bank goes bankrupt and cannot honour its liabilities, this is known as a bank run.
What may occur if a bank goes bankrupt?
If a bank is heavily involved in the economy/financial system and is at risk of bankruptcy, the government may decide to provide funds to rescue them, as the failure of a bank could threaten livelihoods of people all throughout the economy, which is why the Bank of Scotland was rescued during the financial crisis.
What is the short-term interest rate?
The short-term interest rate is the price of borrowing base money.
How can commercial banks loan money?
There’s two main ways that a commercial bank can loan money. Either they can get the money from the central bank, which they would have to loan at the policy rate, or they can loan it from another bank, which they would have to do at the short term interest rate.
What determines the interest rate in the economy?
It works in terms of supply and demand.
-The demand for base money depends on how many transactions commercial banks have to make.
-The supply of base money is Simone a decision by the central bank.
What is the policy rate?
The policy rate is the interest rate which is set by the central bank. It applies to banks that borrow base money from each other, and also from the central bank.
What is the bank lending rate?
This is the average interest rate charged by commercial banks to firms and households. This rate will usually be above the policy rate, and the difference between the two is the spread (or markup) on commercial lending.
Why is the short-term interest rate and policy rate never too far apart?
This is because the short-term interest rate must be around the policy rate level, or one bank would never go to another bank to receive a loan because if the policy rate was much lower, they would simply be able to get the loan at a cheaper price because the central bank offers a lower interest. Therefore, the two rates always remain relatively similar.
What options do banks have to overcome the default risk?
-If a default means a bank is going to collapse, then they may be able to receive a loan or payment from the central bank to prevent this, and save a potential disaster for the financial market.
-They can also ask shareholders for money to raise equity, but this will only work if shareholders have a high level of trust that they will receive future profits on their shares.
-Banks can also put a claim on an asset of the individual they are loaning to, so should that player default on their loan, the asset becomes an asset of the bank, which would increase the banks net worth should they lose out on the loan repayment.
When will the gap between the policy and bank lending rate be greater?
In developing countries where there is a more uncertain economic environment. In 2014 Brazil had a policy rate of 11%, but the lending rate was 32%.
What is a government bond?
-This is a financial instrument issued by governments which promises to pay flows of money at specific intervals.
-Every bond will have a yield, which is the implied rate of return that the buyer gets on their money when they buy a bond at its market price. Essentially, it is the interest rate on the bond.
How does present value work?
The present value is the break-even price which you would pay for a contract which would make you indifferent between buying the contract and not buying it. It has to equal whatever the amount of money would give the price of the asset at the end of the contract, if you were to just put that money into the bank instead at the current interest rate.
The same concept still applies when the contract lasts for multiple years, and you get a payment from the contract year year. The present value will be the sum of the payment from the contract each year/(1 + interest rate)^the year of the contract.
What is net present value?
A firm will asses if it should make an investment on an asset depending on the difference of the present value and the costs of making the said investment. If this is possible (present value profits is greater than the cost), then it will be beneficial in the firm going for this investment.
How do bonds work?
A bond will last for a predetermined period of time, called the maturity of the bond. The lender of the bind receives two payments, the fixed payment every period, and the face value of the bond paid when the bond matures. We call these fixed payments coupons.
What is the price of a bond?
The price of a bond = discounted present value of coupons + discounted present value of the face value when it matures.
Or, for a bond with a maturity of T years:
Price = C/(1+i)^1 + …. + C/(1+i)^T + F/(1+i)^T
Why is the yield of a bond important?
-The yield of a bond is the (coupon/market price of the bond) x 100. Hence, the yield is important because it is the implied rate of return a buyer gets on their bond when bought at a market price.
-When the price of the bond falls, the yield will rise a vice versa.
-If the yield is the same as the interest rate, then buying a bond will have the same as saving that money in a bank at the current interest rate. For the equation of working out the price of a bond by yields, look at the week 4 slides.
-As a saver can choose between a bond and saving in a bank, the yield and the interest rate will often be very similar. If it wasn’t money would be switched very quickly from one asset to the other by traders until the rates equalised, a strategy known as arbitrage.
What costs and revenue does a bank face?
-Operational costs: These include the administration costs of making loans, such as wages and rents.
-Interest costs: The interest a bank must pay on a liability such as a deposit,
-Revenue: The repayment and interest on of the loans which the bank has extended to customers.
-Expected return: The return on the loans it provides, taking into account not all customers will repay their loans.
What does it mean is a bank is insolvent?
This means that the value of a banks assets is less than the value of a banks liabilities, it has negative equity.
What is the leverage ratio of a bank?
This is the total assets divided by their net worth (equity).
What is secured borrowing?
This is borrowing with collateral, using its financial assets, so it has positive default risk.
Collateral means something provided to a lender as a guarantee of repayment
How can the central bank impact the economy?
-By lowering the policy rate, people will receive lower mortgage repayments since the bank lending rate will also fall, and more disposable income will become available, increasing consumption.
-Furthermore, they can also afford to lend to more risky clients, as they can borrow more money from the money market to compensate incase of default.
-Finally, less interest is charged so risky borrowers are more willing to be accepted by a bank.
-Of course, higher policy rates will increase desire to save and reduce consumption, so this can help counter inflation in the economy.
How does the relationship between the lender and borrower suffer from the principle agent problem?
The ‘lender’ is the principle and the ‘borrower’ is the agent. It is often not possible for the lender to write a contract ensuring the loan will be repaid by the borrower. This is because it is impossible to ensure that the borrower will use the funds in a prudent way that will allow repayment according to the terms of the loan.
One solution of this is for the borrower to put some of her equity into the project, to ensure the interests of the two players are more closely aligned, since collateral forces the borrower to have an incentive to work hard, and it is a signal to the lender that the borrower is confident the project will succeed.
What is credit rationing?
This is when those with less wealth borrow on unfavourable terms, compared to those who have more wealth. This is proven by the fact that one in eight US families had their request for credit rejected, and the assets of these credit-constrained families were on average 63% lower than the unconstrained.
I’d an individual’s low wealth prevents a loan, this is known as credit-excluded, if they can still borrow, they are merely credit constrained.
What facts show the issues of credit-constraint?
-If the value of one’s house goes up by 10% in the Uk, the number of start up businesses rises by 5%.
-Asset poor families in the US often have to take payday loans p, which have an average annual interest rate of 486%.
Why does spending on invest tend to occur in clusters?
-Firms may adopt a new technology at the same time
-Firms may have similar beliefs about expected future demand.
How can we show how changed in current income will actually impact the AD?
One way to do this would be through the multiplier. The multiplier is how a rise in one persons income or firms investment then has a knock on effect on others spending.
-If the total increase in GDP is equal to the initial increase in spending, we say that the multiplier is equal to 1.
-If the total increase in GDP is greater or less than the initial increase in spending, then the multiplier is greater or less than 1.
What is the multiplier process?
This is a mechanism in which the direct and indirect effect of a change in autonomous spending effects aggregate output. The multiplier is 1/1-MPC
This is done by combining the very different behaviours of consumption-smoothing and non-smoothing households to represent consumption spending for the economy as a whole. This is the aggregate consumption function.
What is the aggregate consumption function?
This is an equation that shows how consumption spending in the economy as a whole depends on other variables. For example, in the multiplier model, the other variables are current disposable income and autonomous (would happen regardless of income) consumption.
What is autonomous consumption?
This is consumption that is independent of current income.
What is the equation for aggregate consumption?
Aggregate consumption = autonomous consumption + income dependent consumption.
C = C0 +C1(Y), where C1 is the effect of one addition unit of income, also known as the marginal propensity to consume. C0 is autonomous consumption.
The gradient of aggregate consumption will be equal to the MPC.
How will marginal propensity to consume differ for different households?
The value will be higher for credit constrained households.
Low wealth households have an average MPC of 0.8, but this is much lower for well-off households. Despite this, even in rich countries, 1 in 4 households are credit constrained.
How will marginal propensity to consume differ for different households?
The value will be higher for credit constrained households.
Low wealth households have an average MPC of 0.8, but this is much lower for well-off households. Despite this, even in rich countries, 1 in 4 households are credit constrained.
What did we see in spending by US households in the 2008 crisis?
Over the next year, consumer non-durables only fell by 3%, however durables fell in consumption by 10%. This will be because households were less confident in their future job security, as well as the risk of assets such as houses fall in price. This meant purchases of goods like cars and new fridges being postponed.
How can AD be worked out using the multiplier diagram?
There will be output (income) on the x-axis, and aggregate demand on the y-axis. As output equals aggregate demand, there will be a 45° line straight through the origin, representing where the two match in value.
When the multiplier line crosses this line, we can determine output/AD in the economy as being here.
What do we assume about investment within the multiplier?
We assume that investment is independent of income. It will instead depend on interest rates and business expectations.
What is the process of the multiplier on a fall in investment?
A cut in investment-> this lower spending will also then cause lower production and lower incomes -> firms will fire workers as a result of this -> this then leads to an even further decline in spending.
Diagrammatically, the multiplier curve will just shift downwards, since investment is independent of income, so not impacted by the MPC.
What do we assume in the multiplier concept?
We assume that there are under-utilised resources within the economy, and we also assume that wages are not impacted by the change in output.
Similarly, we also assume costs don’t rise output does, and firms will be happy to supply extra units of goods to meet new demands without adjusting prices.
If there wasn’t under-utilised resources, the multiplier would be smaller.
How will a fall in wealth cause consumption to change?
If a family has a mortgages on its house, and the price of the house falls, then a likely reaction for the family will be to save more. This is known as precautionary saving, and will usually take place when a situation occurs meaning a household falls below their target wealth, this occurred in 1929 after there was a fall in investment, and ended up resulting in the Great Depression.
What would be the difference in an increase of a households house price depending if credit constrained or not?
-If not constrained, then the improvement in your networth will cause raise your wealth relative to the target wealth. We would then predict that this would reduce your precautionary savings, and increase consumption.
-For constrained households, a rise in house price would lead to an increase in consumption spending as higher collateral means that you can borrow more.
What are the 4 choices firm owners have when making investments decisions with profits?
1) Dividends: Allocate the funds to managerial or employee salaries, or dividends for owners.
2) Savings, or paying off an existing debt
3)Invest abroad: build new capacity in another country
4) Invest at home: in the home country.
Choice 4 is invest in our multiplier model.
How does a firm decide what to do with profits?
-If the discount rate (p) is better than interest rate and return on investment, they will keep the funds and increase consumption spending.
-If r (interest is highest), they will repay a debt or buy a financial asset
-If return on investment (pi) is greatest, they will invest.
What is the equal for the multiplier model when governments and net exports are included?
When the government is included, we have also to include government spending, as well as income left after tax for consumers spending C1. Net exports will also be impacted by the marginal propensity to import. So the new equation for the multiplier model is:
AD = C0 + C1(1 -t)Y + I + G + X - mY, where M in the marginal propensity to import.
What does it mean that government spending is exogenous?
Much of government spending (excluding transfers) is on public services, health and education. This won’t change in a systematic way with changes in income, so is therefore referred to as exogenous.
What 3 ways can government spending and taxation dampen fluctuations in the economy?
1) It’s size, if the government spending (which is much more stable than private spending) makes up a large amount of GDP, this will help keep the economy from high volatility.
2) The government can help by providing unemployment benefits
3) They can intervene using fiscal policy
What is fiscal policy?
This is changes in taxes or government spending in order to stabilise the economy.
What 3 reasons cause the private market to fail?
-Correlated risk: A surge in insurance claims means a provider may not be able to pay everyone, Co-insurance within family and friends may be insufficient.
-Hidden actions: moral hazards can occur if a person is too well insured.
-Hidden attributes: Asymmetric information can cause issues, if for example you learn the firm you own is financial difficulty, but your insurer or bank lender does not.
What are automatic stabilisers?
These are the characteristics of the tax and transfer system in the economy that have the effect of offsetting an expansion or contraction of the economy. An example of this is the unemployment benefits system.
What is the paradox of thrift?
Is a single individual consumes less, her savings will increase. However, if everyone saves, the result may be lower rather than higher savings overall. The attempt to increase savings is thwarted if an increase in the saving rate is not matched by an increase in investment (or another source of AD). The lower level of output will mean savings do not actually increase, as employment and income will fall.
What is a fiscal stimulus?
This is the use by the government of fiscal policy (via tax cuts and spending increases) with the intention of increasing aggregate demand.
What is the budget balance?
This is the difference between government tax revenue and spending. When this is negative, there is a budget deficit, and when positive there is a budget surplus.
It is normal for a deficit to grow when stabilising in a recession, but if a government decides ro reduce a deficit, this might amplify the fluctuations in the economy. If a government cuts back on spending, this is known as austerity.
What is crowding out?
This is the effect of an increase in government spending in reducing private spending, as would be expected for example in an economy working at full capacity utilisation, or when fiscal expansion is associated with a rise in the interest rate (meaning private sector borrowing becomes more expensive).
For this reason, we would not normally expect a government to undertake fiscal expansion if unemployment is low, but in may in extreme circumstances such as war.
How does government policy impact the multiplier model?
If businesses have a high trust that the government will help an economy recovery in a recession, this will improve business confidence.
-If a household thinks that higher government spending will be followed by a rise in taxes, they may increase saving to make sure they can afford these extra taxes when they come.
Will the multiplier vary depending on position in the business cycle?
Yes, many economists would argue that the multiplier will be greater for economies who are in or exiting a recession, compared to those who are in a or at the beginning of a boom, because they will be closer to full capacity, and not have spare resources in the economy.
For example, US states hit more severely by the financial crisis in 2008 will have a higher multiplier than a less-affected state.
Why is the multiplier important when considering the impact of government fiscal methods?
-If the multiplier is negative (which could happen if a rising fiscal deficit caused a fall in confidence), then a stimulus package would cause GDP to fall, and an austerity policy would cause GDP to rise.
-If positive but less than 1, a fiscal stimulus would raise GDP but by less than government spending increase.
-If the multiplier is greater than 1, then a fiscal stimulus would raise GDP more than the increase in government spending, and a policy of austerity would reinforce the recession conditions.
A disagreement came during WW2, where some said the multiplier was around 0.8, and other economists argued it was close to zero, since during a war there is no idle resources.
What is government debt?
Government debt is the total amount of money owed by the government at a specific point in time.
What is the primary budget deficit?
G - T, where G is government spending and T is tax revenue - transfers. A budget deficit will worsen in a downturn of a business cycle, and recover when the downturn reverses.
A budget deficit will be funded by selling bonds to borrow, however, by selling these bonds, a government must add this to its debt until repaid. Foreigners can also buy these bonds, and are attractive to investors since they pay a fixed interest rate and are generally considered safe, as a government is unlikely to default.
What is a sovereign debt crisis?
This is when government bonds are considered too risky, this is rare to occur in developed countries, but not uncommon in developing and emerging countries. However, in 2010 there was a sharp increase in interest rates on bonds issued by Spain and Greek governments, which signalled a risk of default.
If a country has an untrusted government for buying bonds, austerity could be the only option for that nation.
What is a large percentage of debt to GDP an issue?
Like a household, a country has to pay interest on debt. And to pay this, taxes may have to increased. However, it is okay for a country to have debt at all times, since as some bonds mature, others will be issued, so the debt is simply rolled over.
An every increasing debt-to-GDP ratio is problematic, but no one knows at one point problems will occur.
UK government debt peaked at a percentage of GDP in 1947, at 250%
How can inflation help a nation to pay off its debt?
The face value of a government bond (level of debt) is denominated in nominal terms. So the value of the (say £1 million debt) in one year would be worth less 10 years later when it came to repaying the debt.
Why are foreign markets important?
-When the Chinese economy slowed (who accounted for 32% of Australian exports in 2013), this was transmitted straight to impact Australia.
-Imports will dampen fluctuations in the economy, since the marginal propensity to import shows part of a rise/fall in income will be the impact on imports.
Why will trade constrict the use of fiscal stimulus?
When France adopted a fiscal stimulus plan in 1981, the two years later saw Germany grow faster than France themselves, since the additional disposable income saw French imports rise, and this meant that the largest benefit came to France’s trade partners, rather than France themselves. It also forced France to revalue their currency.
