Steedsy Theme 2 Flashcards
3 ways of calculating economic activity
Expenditure method -how much is spent
Output method - total output produced by firms
Income method - total value of income for firms
Marginal propensity to consume definition
The marginal propensity to consume measures the change in consumer spending following a change in someone real disposable income
Why is the value of the marginal propensity to consume important?
When the government is considering cutting direct taxes - the aim of this might be to stimulate consumption to help drive economic recovery after a recession. The impact of the tax cut depends on the MPC. If it’s high, most of the extra disposable income will be spent rather than saved. However, if the marginal propensity to save is high, then a tax cut might be ineffective. This suggests that the government might do better to tell the tax reductions on low income families with a higher expected MPC.
Key factors influencing household saving
Real interest rate - high interest rates, high savings
Price expectations - if consumers expect prices to fall, they may choose to save more now
Availability of credit
Job security / unemployment - when unemployment is rising, people save more as a precaution as a job security declines
Consumer confidence - when consumer confidence is stronger than people are more willing to borrow and save less
Taxation of savings
Trust in savings institutions
Name, the seven government, economic objectives
GDP
Inflation rate
Borrowing costs /debt
Balance of payments - imports and exports
Unemployment rate
Sustainability
Inequality
Formula for aggregate demand and the percentage for each component
AD = C + I + G + (x - m)
Consumption = 65%
Investment by firms into machinery etc = 15%
Government spending = 25%
Exports - imports = -5%
Key factors influencing consumer spending
Real disposable income
Employment and job security
Availability and cost of consumer credit
Rate of interest
The wealth affect (increase in wealth leads to an increase in consumption)
Inflation
Expectations of future price changes
Consumer confidence
Level of savings
How do you calculate marginal propensity to consume?
Change in consumption / change in income
Marginal propensity to save definition
The proportion of an increase in income that is saved
Definition of marginal propensity to consume
The proportion of an increase in income that is spent
Consumption definition
Total expenditure on goods and services by individuals
What is the capital investment?
Spending on machinery, equipment, factories, technology, and infrastructure to create new capital goods
Factors affecting investment
- Interest rates
- Availability of credit (whether you can borrow money - lowering interest rates increases availability of credit)
- Expected profits and retained profits - more profit, more investment, but bad to use profits because of opportunity cost
- Actual and expected demand for goods and services - the accelerator affect - investment expenditure increases when either demand or income increases. An increase in GDP leads to an increase in the rate of investment ( accelerates )
- Business confidence, when confidence is low, you save more
- Rate of technological change influences the level of investment
- Price of the product of the risk related to it
Definition of budget deficit / fiscal deficit
Spending is greater than income for one year
Debt definition
Some of all deficits over the period of time expressed as a percentage of GDP
What are the three areas of government spending?
Welfare spending / transfer payments (e.g benefits)
Public services / recurring spending
State investment - investment projects ( capital expenditure)
How much did the government spend as a percentage of GDP?
45%
State the three multiplier formulas
1 / MPS
1 / (1- MPC)
1/ MPW
MPW = MPM (marginal propensity to import), MPT (marginal propensity for taxation), MPS
MPW = all the withdrawals on the circular flow of income
Factors affecting the multiplier value
- MPC - the higher, the MPC, the large in the multiplier
- Leakages - more leakages of taxes, savings and imports, means the multiplier will be smaller
- Degree of spare capacity (if operating to max capacity, the multiplier is limited)
Multiplier definition
Initial injection into the economy leads to a bigger increase in output (GDP)
Are the products we import highly elastic or inelastic
Inelastic
What are the three accounts measuring the balance of payments?
Current account
Capital account
Financial account
What makes up the current account
-Visible trade balance (e.g. cars) this is negative as we import more than we export
- Invisible trade balance (services) this is a surplus
What are the factors affecting exports of goods and services?
- Relative prices of exports in the world markets
- Non-price demand factors (e.g. design, and branding)
- Strength of aggregate demand in key export markets
- The exchange rate (a stronger currency, makes exports more expensive)
What are exchange rates?
The value of one currency against another
What is the acronym for whether a strong currency makes it more expensive or less expensive?
SPICED
Strong
Pound
Imports
Cheap
Exports
Dear (expensive)
What is the output gap
The difference between the actual level of GDP and its estimated potential level
What is meant by potential output
It represents the level of production an economy can achieve when all resources (CELL) are fully exploited without causing inflationary pressures.
What does a negative output gap often mean for employment
Higher unemployment
What is a positive output gap
When an economy’s actual output or GDP exceeds its potential output.
How can you achieve a positive output gap
Doing things like working overtime
What impacts would cause a fall in aggregate demand
- fall in net exports (x - m)
- cut in government spending
- higher interest rates
- decline in household wealth and confidence
What impacts would cause an increase in Aggregate demand
- depreciation of the exchange rate
- cuts in direct and indirect taxes
- increase in house prices (wealth affect)
- expansion of supply of credit (lowering interest rates)
What is an economic shock
When unexpected events cause changes in the level of demand, output and unemployment
What is aggregate supply
The total output of goods and services that firms in an economy are willing and able to supply at a given price level
What is long run aggregate supply
Represents a maximum output when all factors of production are fully and efficiently employed
Factors causing a shift in short run aggregate supply
- wage costs due to a change in minimum wage
- labour productivity (higher efficiency means lower costs)
- Key raw material prices
- business indirect and direct taxes
- cost of imported materials
- supply shocks
What can cause a change in potential GDP
(CELL)
- changes in the labour supply
- changes to the stock of natural resources
- improvements of productivity
- advances in the state of technology
- improvements in institutions such as banking
What does the Keynes graph show
3 situations of one where output is greater than aggregate expenditure, one where aggregate expenditure is equal to output and one where output is less than aggregate expenditure
What is the difference between the Keynesian model and the classical model
Keynes believe the government and economists should help the economy occasionally. The classical model involves economic growth in the long run while the Keynes model involves economic growth in the short run. The classical model shows the maximum total output level of just a straight line when the keynes model is a curve.
What are the three different types of taxes?
Progressive taxes - the marginal rate of tax rises as income rises
Proportional taxes - the marginal rate of taxes, constant average rate of tax
Regressive taxes - the rate of tax paid falls as income rises
Which fiscal policy aims at controlling inflation
The tight policy
What do the government do to control inflation
They will increase taxes and reduce government spending to reduce inflation ( tight policy )
What happens to the 7 government objectives, when the tight fiscal policy is introduced?
Unemployment : increases
Sustainability : improves
Balance of payments : decrease in imports, which COULD lead to an increase in exports if inflation reduces as the prices are more competitive
Economic growth : decreases
Debts : improves as government spending decreases and taxes increase
Inflation : decreases
Inequality : decreases
Which policy aimed at stimulating economic growth and what does it involve?
Loose policy - decreasing taxes and increasing government spending
What are the impacts on the 7 government objectives on introducing the loose fiscal policy
Potentially inflationary
Unemployment decreases
Inequality increases
Sustainability decreases
Balance of payments : import increase
Economic growth increases
Debt increases
Evaluate why the loose or tight fiscal policy might not have as big of an impact on the economy as people might think
The multiplier may not be as large due to consumer confidence, they could save, depends on the magnitude of the change in government spending and taxes, depends if consumers already have debt
Evaluate the expansionary policy (loose policy)
Higher market interest rates
And acceleration in the rate of price inflation
Marginal propensity to spend save of households
Marginal propensity to import
Change in business confidence
How does the fiscal policy attempt to reduce inequality?
Progressive tax (taxing more, the more you earn)
Public (state) pensions
Social housing (council houses)
Government investment in education and healthcare
Welfare state transfers e.g. benefits
What are automatic stabilisers?
Changes in tax revenues in the state spending arising automatically as the economy moves through the trade cycle
For example, when the economy is expanding tax revenues increase as more people working in the state spending decreases or stays the same
And when the economy is in a trough tax revenue will decrease as less people are working and spending and government spending increases to get the economy out of the trough
What are the four functions of money?
Medium of exchange
A unit of account to measure prices
Standard or deferred payment - e.g. using credit cards
A store of value
What is interest?
Interest is what you pay for borrowing money, and what banks pay you for saving money with them.
What are the five tools of the monetary policy?
Credit availability
Interest rates
Quantitive easing
Quantitive tightening
Exchange rates
What do higher interest rates mean for exchange rates?
Higher interest rates mean higher exchange rates as more foreign investment into the UK banks (hot money)
Who sets the interest rates for England?
The bank of England, or the monetary policy committee (MPC)
What factors are considered by the MPC when setting interest rates?
Economic growth
Bank, lending and consumer credit figures
House prices (the wealth effect)
Consumer and business confidence
Unemployment figures
Inflation
Expectations
What is the transmission mechanism of monetary policy?
There are several ways in which changes in interest rates influence, aggregate demand, output and prices. These are collectively known as the transmission mechanism of monetary policy.
How would you reduce inflation using the monetary policy?
Drop credit availability so less money is available to spend
Increase interest rates as this leads to an increase in saving and a decrease in borrowing which leads to a decrease in aggregate demand
After using the monetary policy to reduce inflation, evaluate the impact
The aggregate demand could reduce more due to a negative multiplier
And it can take between 12 to 24 months for the full effects on real GDP after a change in policy interest rates
Evaluate the effects of exchange rate changes
Time lags
Low price elasticity of demamd
Explain quantitative easing
When the economy is sluggish, the central bank (Bank of England) generates new money electronically and buys assets like government bonds from commercial banks (e.g Lloyds bank) and other financial institutions. More demand leads to higher prices for assets which rises the price of bonds which leads to a lower yield on bonds. Therefore the base interest rate drops.
What are the economic effects of higher interest rates
- Consumer spending decreases
- household saving increases
- less investment in new capital
- appreciation of pound
Evaluate quantitative easing
Time lags
Higher income groups can take advantage and invest instead of spend so doesn’t go round the circular flow of income
Depends on consumer and business confidence
Depends on personal debt
What is a liquidity trap
When interest rates are already low and they go lower it will have a limited effect on aggregate demand
Demand side causes of deflation
- deep fall in aggregate demand
- large negative output gap
Supply side causes of deflation
Things that cause higher supply:
- improved productivity
- technological advancements
- fall in wage rates
Why is deflation damaging
- people hold back on spending waiting for the price to go lower
- lower profit margins for businesses
- lower consumer confidence so more saving
- Less wealth effect, so gets even worse
What is the purpose of quantitative tightening and what does it involve
- deflationary monetary policy
Selling government bonds to banks. When banks buy bonds, this reduces liquidity (amount of credit available) as the bank will lend less - bond prices drop as the Bank of England is no longer a purchaser, causing the yield to increase, and so less spending and more saving
What were the demand side policies used in the Great Depression
Cut in interest rates ( UK 9% to 0.6%)
Uk chose to increase taxes but this actually worsened the depression
What were the demand side policies used in the financial crisis of 2008
Quantitative easing
Government spending on banks
Describe crowding out
The government increases spending
They have to borrow so they fund it by issuing bonds.
Consumers have less to spend as they buy the bonds
To attract more bond demand, they increase the yield
As bond interest rate goes up, other interest rates also go up so more save and less invest.
Advantages of using GDP to measure the living standards of a country
Easily comparable with other countries
Limitations of using GDP data to measure the standards of living of a country
Doesn’t measure quality of life
Population growth may account for this GDP growth
Spending on investment goods may raise future living standards at expense of the current
