Theme 2 Flashcards
Closed economy
Where there is no foreign trade
Components of aggregate demand (AD)
Consumption (65%) + Investment (15%) + gov spending (25%) + (Imports - exports) (-5%)
AD = C + I + G + (x - m)
MPC (definition and equation)
Marginal propensity to consume
△C / △Y
MPS (definition and equation)
Marginal propensity to save
△S / △Y
Factors influencing AD
- disposable income
- the wealth effect (peoples wealth increases they spend more money)
- inflation (prices increase and consumption falls)
- expectations (buying before an expected price increase)
- interest rates (consumption decreases when rates increase)
- unemployment (increased unemployment decreases spending)
- availability of credit (more available to borrow increases spending)
Real (income)
Allowing for inflation
Net investment equation
Gross investment - capital depreciation
The accelerator theory
An increase in national income leads to a bigger increase in planned investment.
Factors influencing planned business investment
- interest rates / availability of credit
- expected profits and business taxes
- business confidence (greater confidence leads to larger investments)
- cost and number of substitutes
- risk of investment
Government spending
- transfer payments (benefits eg. Pensions)
- recurring spending (public services eg. Teacher wages)
- investment projects (state investment eg. Building schools)
The output gap
The difference between the actual level of GDP and its estimated potential level. Usually measured as a percentage of the level of total output.
Negative output gap
The economy’s output is below the full capacity. Often corresponds to higher unemployment and under utilised resources. Leads to disinflationary effects.
Net trade equation
(X - M)
Trade balance
The difference between the value of exports and the imports.
When the value of exports exceeds the value of imports = surplus
When the value of imports exceeds the value of exports = deficit
Factors influencing exports of goods and services
- relative prices of exports in world markets
- the exchange rate
- non price demand factors eg. Brand and design
- strength of aggregate demand in key export markets
Free floating exchange rates
Currency value is set by market forces (supply, demand)
Currency appreciates and depreciates
Benefits of a free floating exchange rate
- shock absorption
- reduced speculative attacks
Disadvantages of a free floating exchange rate
- exchange rate volatility
- currency risk
Fixed exchange rates
Central bank fixes the currency value - pegged to one or more currencies
Benefits of a fixed exchange rates
- price stability
- reduced exchange rate risk
Disadvantages of a fixed exchange rate
- lack of flexibility
- speculative attacks
Reasons for a fall in AD
- fall in net exports (m>x)
- cut in gov spending
- higher interest rates
- decline is household wealth and confidence
Reasons for an increase in AD
- depreciation of the exchange rate
- cuts in direct and indirect taxes
- increase in house prices
- expansion of supply of credit + lower interest rates
The multiplier effect definition
Happens when an initial change in spending, leads to a larger and more widespread final impact on an economies total output of income.
Positive multiplier effect
When an initial increase in injection leads to a greater final increase in the level of real GDP. Opposite for negative multiplier.
Multiplier formula
1 / marginal propensity to save
Or
1 / (1 - MPC)
When does a high or low multiplier effect occur
High multiplier value when:
- economy has plenty of spare capacity to meet higher AD
- MPM and tax is low
- high MPC extra income
Low multiplier effect when:
- economy is close to capacity during a boom phase
- propensity it import goods and services is high
- higher inflation causes rising interest rates which dampens AD
Long run aggregate supply (LRAS)
The maximum possible output. Represents output when all factors of production are fully utilised and efficiently employed.
Factors influencing long run aggregate supply
- higher productivity of labour and capital
- innovation and enterprise
- growing population and increased labour market participation
- capital investment
- stock of natural environmental resources
Macro economic objectives
- reduce unemployment
- economic growth
- reduce the debt
- sustainability
- reduce inequality
- control inflation
- balance of payments (increase exports)
Contractionary policy (fiscal)
Objective is to reduce AD
Increase taxation and reduce government spending
As a result:
- increased unemployment as demand is dropped
- increased sustainability as we produce less
- decrease in economic growth as output decreases
- increase in balance of payments as we do not import as much and exports are cheap
- decrease in the deficit as gov spending decreases
- reduction in inequality however number of people facing increases
How does tight policy lead to an appreciation of the £
An increased rate of interest causes demand for the £ to increase so the value of the pound increases due to the fixed amount in circulation. (Investors wants money in UK banks due to high return). This leads to an appreciation of the pound.
How does a strong pound impact the balance of payments
Strong Pound Imports Cheap Exports Dear
Loose monetary policy
Main objective is to stimulate economic growth
Reduces the rate of interest
Increases the amount available to borrow
As a result:
- causes a decrease in unemployment
- causes an increase in economic growth
- causes a decrease in sustainability
- deficit will lessen (more employed so more tax revenue)
How does loose policy lead to a depreciation of the £
A lower interest rate will decrease the demand for the £ so the value of the pound decreases due to investors not wanting money in UK banks due to the low return. This leads to a depreciation of the pound.
How does a weak £ impact the balance of payments
Weak Imports Dear Exports Cheap
Tight monetary policy
- increases the rate of interest
- reduces amount available to borrow
-main objective to control inflation
As a result
- causes an increase in unemployment
- causes an increase in sustainability
- deficit will worsen (less employed so less tax revenue)
Loose fiscal policy
- increases AD
- increase in gov spending and decrease in taxation
As a result
- decreased unemployment
- decrease in sustainability
- increase in inflation
- increased inequality gap
- decrease in balance of payments
- increase in the deficit
