PRIORITY Flashcards
Disadvantages of inflation (6)
- Reduction in net export
- Price competitiveness decreases, demand by other countries decreases, export revenue decreases - Menu cost
- Fiscal drag
- Income and revenue increases (bonus payouts), push to higher tax brackets, income tax increases - Discouragement of investment
- Unanticipated investment causes uncertainty, firm is unable to plan long term production, hesitate to invest
- Business confidence decreases, because prices keep changing, cannot make decisions for prices - Inflationary noise
- Confusion over relative prices caused by inflation
- A rise in the price of a product may not mean that it has become more expensive relative to other products; the product may have risen in price by less than inflation and so may have become cheaper in real terms.
- Consumers and producers may make wrong decisions
- e.g. producers increase output because price increases, but price increase is due to inflation, this may cause misallocation of resources (overproduction) - Inflation causing inflation
- Workers demand higher wages, firm rises prices to cover expected higher costs.
Advantages of inflation (3)
A low and stable rate of inflation can bring advantages to the economy.\
1. Stimulating output
- Increasing demand may make firms feel optimistic about the future
- Price increase is more than cost increase, profits increase, investment increases
- Reduce debt burden
- Real interest rate may fall due to inflation
- Those who borrowed money to buy a house may experience fall in their mortgage interest payments.
- Debt decreases, consumption increases, output and employment increases - Prevent some unemployment
- With zero inflation, firms ma have to cut labour force
- Inflation enables firms to reduce reeal costs of labour either by keeping nominal wages constant or not raising them in line with inflation
- During inflation, workers with strong bargaining power are likely to resist cuts in real wages.
Factors affecting consequences of inflation (5)
- Cause of inflation
- Demand-pull inflation: output increases
- Cost-push inflation: output decreases - Rate of inflation
- High rate causes more damage - Accelerating or stable inflation rate
- Can cause uncertainty, investment decreases - Anticipated or unanticipated inflation
- Unanticipated inflation may cause firms and consumers to delay their investment and consumption
- If anticipated inflation, can take measures to adapt and avoid harmful effects - Inflation rate compared to other countries
- If inflation rate is below main competitors, goods and services price competitiveness increases
How to use fiscal and monetary policy to lower unemployment and its difficulties
- Increase AD
- Monetary: Decrease interest rate, increase money supply
- Fiscal: Decrease indirect taxes, increase government spending
- Difficulties: Higher inflation in short term, could increase national debt
How to use fiscal and monetary policy to lower rate of inflation and its difficulties
- Decrease AD
- Monetary: Increase interest rate, decrease money supply
- Fiscal: Increase direct taxes, decrease government spending
- Difficulties: Unemployment increase, output decreases
- Unpopular with voters (people get angry with GOV if interest rate increases)
How to use fiscal and monetary policy to solve current account deficit on BOP and its difficulties
- Decrease AD
- Monetary: Increase interest rate
- Fiscal: Increase taxation
- Difficulties: Effectiveness depends on PED for imports and export
Give some examples of supply-side policy. (8)
- Cutting corporate tax
- Cutting income tax
- Reduction in welfare payments
- Increase spending on education and training
- Increase spending on infrastructure
- Privatisation
- Deregulation
- Subsidies
Benefits of free trade (6)
- Competition created can lower prices and raise quality for consumers
- Allows people to access great range of products
- Firms have wider choice of raw materials and may reduce costs of production
- Firms have larger market, enable them to take greater advantage of economies of scale
- Allows efficient allocation of resources with countries being able to concentrate on producing products that they have comparative advantage.
- Allow countries to specialisem increases output, higher employment and ultimately improve living standards.
Causes of changes in terms of trade (4)
- Demand and supply of imports and exports
- If price of exports increase, ToT improves - Price level
- Inflation increases, export prices higher than import prices, ToT improves - Exchange rate
- Devaluation reduces export price
- Increases export price competitiveness
- ToT worsens - Prebisch
- In the long run, price of primary goods decreases in proportion to manufactured goods.
- ToT moves against primary producing countries
- Demand for manufactured goods increases more than demand for primary goods when income increases
- In recent years, relative price of agricultural products decreases, volatility in commodity prices increases
Explain favourable and unfavourable rise in ToT
- Favourable rise in ToT: If price of exports increases because of demand increase, overall export revenue increases (more domestic products sold)
- Unfavourable rise in ToT: If price of exports increases because cost of production increases, overall expot revenue decreases (demand for country’s products fall)
However, unfavourable rise in ToT may reduce current account deficit. If Marshall-Lerner condition is met, fall in export prices relative to import prices should increase export revenue relative to import expenditure.
Impacts of change in terms of trade (4)
- Living standards
- When ToT increases, country can buy more imports for any given quantity of exports.
- When ToT decreases, means more domestic output has to be exported to pay for imports. - Impact on BOP
- If price of exports increase because demand from trading partners increases, exports earnings increases, current account improves
- If price of exports increases because cost of production increases, exports’ price competitiveness decreases, exports earnings decreases
- If price of exports decreases because world demand decreases, can lead to current account deficit (export revenue decreases, amount of foreign currency flowing into the country decreases, country;s net exports decreases, current account balance decreases)
- Changes in import prices can cause improvement or worsening of the current account - Impact on inflation
- If ToT improves due to falling import prices, this could result in lower inflation because domestic producers may have to lower prices to compete with imports
- If ToT worsens, this could cause rising inflation as workers may seek pay increases due to increasing import prices, leading to an escalation of the wage price ‘spiral’. - Impact on growth and employment
- If ToT improves because export demand increases, growth and employment levels will be maintained or improved.
- But if ToT improves due to import prices decreasing or price of exports increase due to costs increase, it is likely that growth and employment decreases
Causes of current account deficit (4)
- Growing domestic economy
- Imported raw materials increases, output increases
- Likely to be short-term and self-correcting (output increases, exports increases) - Declining economic activity in trading partners
- Trading partners experience economic recession, imports decreases
- Also known as cyclical deficit
- Short-term and self-correcting - Structural problem
- Domestic firms are not internationally competitive becaue of overvalued exchange rate, relatively high inflation rate and low labour or capital productivity.
- Not self-correcting over time - For primary-producing countries:
- They need to import high prices of oil, raw materials and manufactured goods
- Export primary products: Agricultural where it has to continue to export in large quantity to get high revenue
Consequences of current account deficit (3)
- Country consumes more products than it produces (spend more on imported goods)
- Country has to finance the deficit by attracting investment into the country or by borrowing
- This will involve outflow of money in the future in the form of investment income. - Reduce AD
- Demand for domestic currrency decreases, depreciation happens, price of imports increases, price of exports decreases, demand for domestic goods decreases, demand for foreign goods increases
- Slow down economic growth
- Causes unemployment - Lenders might think borrowers are unable to repay the loan, stop lending
Consequences of current account surplus (2)
- Living standards decreases
- Demand increases, money supply increases, inflation increases - Cause friction between countries
- Deficit countries put pressure on surplus countries to change its policies
Advantages of floating exchange rate (2)
- Restore balance on current account in BOP
- If there is current account deficit:
- Demand for currency decreases, supply of currencyy increases which leads to depreciation
- Exports become cheaper, imports expensive
- In the long run, deficit moves towards surplus - Governments are assumed not to intervene in foreign exchange markets through their central banks
- Since GOV has no exchange rate target, it is free to pursue other policy objectives
- Independence in economic policy making