Theme 2: The UK economy – performance and policies Flashcards
What is GDP
value of all newly produced final goods and services produced in an economy within a given time period
How is economic growth measured by rates
It is measured by rates of change of real GDP
What is a real value
a value without the effect of inflation
What is a nominal value
A value with the effect of inflation
What is the difference between total and per capital values
total is the total some
per capita is total/population
How can real and nominal values be described as
Real values can be described as the volume of national income i.e. the size of the basket of goods
nominal values represent the value of the national income i.e. the monetary cost of this basket of goods
What is GNI (Gross National Income)
GDP + net overseas intrest payments/ dividends
adds what a country earns from overseas investments and subtracts what foreigners earn in a country and send back home from the GDP
How do we make comparisons about growth over time and between countries
Data is compared to other countries to put figures in context while using real,per capita figure
What is Purchasing Power Parities (PPP)
the measurement of prices in different countries that uses the prices of specific goods to compare the absolute purchasing power of the countries’ currencies.
e.g. the exchange rate needed for say $100 to buy the same quantity of products in each country
What is PPP useful for
Comparing countries as it takes into account the cost of living
For example, in Kenya £2 a day in their own currency is enough to survive on, whilst it isn’t in the UK.
What are some of the problems of using GDP to compare standard of living
- inaccuracy of data; inaccuracy of collecting data, diifferent methods, black market
- Inequality; growth in gdp doesnt equal higher living standards
- Quality of g/s; may cause lower price
- different currencies
- Spending: some types of expenditure such as defence doesn’t increase standard of living but will increase GDP
What is the Easterlin Paradox
if you are poor and your income increases, you will be happier, but higher levels of income aren’t associated with increases in happiness
How does income and happiness depend on the people around you
if you are the richest out of everyone you associate yourself with, then you will be happier than someone who has the exact same income but is the poorest out of everyone they associate with
What is inflation
general progressive increase in prices of goods and services in an economy
What is deflation
decrease in the general price level of goods and services
What is disinflation
decrease in the rate of inflation – a slowdown in the rate of increase of the general price level of goods and services in a nation’s gross domestic product over time
What measure is used in the UK to measure inflation
Consumer Price Index (CPI)
How is the CPI calculated
- A representative shopping basket is created each year
- government officials collect 120,000 separate price quotations in 141 locations of around 600 products
- average household spending is worked out through the Living Costs and Food Survey, where around 5,500 families keep diaries of what they spend over a fortnight.
- the weighted price changes are then totalled to calculate the inflation rate
What are the limitations of the CPI
- not fully representative
- doesnt include housing
- overstimation as improved quality of goods led to price increase
- Hard to respond to new products
How is the RPI different to the CPI
● RPI includes housing costs such as mortgage and interest payments and council tax
● CPI takes into account the fact that when prices rise people will switch to product that has gone up by less. Therefore, the CPI is generally lower than the RPI.
● RPI excludes the top 4% of income earners and low income pensioners as they are not ‘average’ households whilst CPI covers all households and all incomes.
How is the RPI different to the CPI
● RPI includes housing costs such as mortgage and interest payments and council tax
● CPI takes into account the fact that when prices rise people will switch to product that has gone up by less. Therefore, the CPI is generally lower than the RPI.
● RPI excludes the top 4% of income earners and low income pensioners as they are not ‘average’ households whilst CPI covers all households and all incomes.
What are the 4 main causes of inflation
- cost push inflation
-
demand pull inflation
-
growth of money inflation
expectations
-
growth of money inflation
Draw a diagram (using AD-AS) for the growth of an economy
- expansion of AS and AD
- Leads to expansion of LAS
What is cost push inflation and draw a diagram
When businesses find their costs have risen (decrease in AS) , they will put up prices to maintain their profit margins
caused by anything that reduces AS e.g. increase in tax, depreciation in exchange rate, rising wages
What is demand pull inflation
caused by an unsustainable rate of increase in aggregate demand (AD) leading to a positive output gap (actual GDP> potential)
when the economy is close to full capacity
What is growth of money supply inflation
there being too much money in the economy. If people have access to money they will want to spend it but if there is no increase in the amount of goods and services supplied, then prices will have to rise.
What is the effect of inflation on consumers
- Less to spend = fall in living standards
- Those in debt will be able to pay it off cheaper, but inverse for those who are owed. Consumers who have saved will see their money is worth less
- Psychological effects on consumers of price rising
What is the effect of inflation on firms
- If inflation in Britain is higher than other countries, British goods will be more expensive and less competitive
- Have to calculate new prices
What is the effect of inflation on governments
- If government fails to change excise taxes in line with inflation then government real revenue will fall
- However, if they fail to change personal income tax allowances (the amount a worker can earn tax free) then real government income will increase and taxpayers will have less money
How does inflation effect workers
- If workers do not recieve yearly pay rises of inflation
How can some effects of inflation be anticipated
indecation - wages increased in line with predicted inflation
however this can make it difficult to control inflation by the government
What are the demand-side causes of deflation
-
Deep fall in AD causing a persistent recession / depression
- Large negative output gap – i.e. high level of spare capacity
What are the supply-side causes of deflation
- Improved productivity
- Technological advances
-
Significant fall in wage rates
- High exchange rate causing import prices to fall
What are the consequences of price deflation
- Holding back on consumer spending
- real value of debt rises with deflation
- The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices.
- Lower profit margin so reduced revenue
- Deflation can make exporters more competitive
What are the economic policies to avoid deflation
Low interest rates and quantitative easing
-
Other measures to stimulate aggregate demand
- Attempts to lower the value of the exchange rate (perhaps via central bank intervention to sell their currency in the market)
- Higher taxes on savings to encourage consumption
What are the main measures of unemployment
- Claimant count
- the International Labour Organisation (ILO) and the UK Labour Force Survey
What is the claimant count
number of people receiving benefits for being unemployed provided on a monthly basis
What is the labour force survey (LFS)
sample of people living in households and asking questions about personal circumstances to class people as employed, unemployed, or inactive according to the ILO definitions
What are the comparisons between the LFS and the Claimant Count
- some people arent elligble for benefits but are classed as unemplyoed so LFS is typically higher
- both seen as underestimating as they don’t recognise the hidden unemployed
What is the hidden unemployed
- working part time but would like to work full time
- on government training schemes who would prefer employment
- classed as sick or disabled
- who aren’t actively looking for jobs but would take a job if offered or are in education because they can’t get a job
What is unemployment and employment rate
employment rate is the percentage of the population of working age who are employed, and the unemployment rate is the percentage of the economically active who are unemployed.
What are the activity and inactivity rates
activity/participation rate is the percentage of the population of working age who are economically active whilst the inactivity rate is percentage of the population of working age who are inactive
What is under-employment
- underemployed are those who are in part time or zero hour contracts when they would prefer to be full time and people who are self-employed but would rather be employees.
- It also includes those who are in jobs which do not reflect their skill level
What is the effect of changes in inactivity
● Increases in inactivity will decrease the size of the labour force, therefore causing a fall in productive potential of the country . There will be a lower GDP and lower tax revenues as less people are working.
● However, decreases in inactivity could just result in more people being unemployed if there are no jobs available to them.
What is Frictional Unemployment
- People moving between jobs
- Isn’t serious and mostly short term
What is seasonal unemployment and what can be done to prevent it?
- Employment that is strongly seasonal in demand, requiring large numbers of people at specific times
-
Little can be done to prevent this in a free market economy
*
What is cyclical unemployment
- Unemployment due to a general lack of demand, also known as a Keynesian ‘demand deficient’ unemploymenyt
- Falls in demand, lowers profits and forces business to cut unemployment in order to control costs
What is real wage inflexibility
- Unemployment due to real wages being above their market clearing level which creates an excess supply of labour
- Caused by minimum wages and unemplyed workers refusing to take low paid jobs because of welfare benefits
What is structural unemployment
a mismatch of skills between the unemployed and available jobs
What are some causes of structural unemployment
- Decline of manufacturing….loss of skilled jobs (e.g. car industry in Birmingham)
- Occupational immobility…people with a lifetime of skills in the shipbuilding industry would find it difficult learning computer skills.
- Geographical immobility….people may be unable to move due to housing costs or unwilling due to family ties.
- Long term regional decline…certain parts of Britain have experienced decline (e.g. South Wales)
-
Foreign competition – rising imports
- Outsourcing of production overseas…relocation of the textile industry from Yorkshire to the Far East.
What are the 3 types of structural unemployment
- Regional unemployment is where certain areas of a country suffer from very low levels of employment due to industry closures
- Sectoral unemployment is where one sector (primary, secondary and tertiary) suffers a dramatic fall in employment.
- Technological unemployment is where an improvement in technology means that jobs are replaced.
What are some labour scarring effects from high unemployment
- Loss of work experience
-
Loss of current/future income
- changing pattern of jobs in the economy
What are some policies to increase demand for jobs
- Infastructure investment projects
- Financial support for apprenticeships
- Entreprise policies to life the rate of new business start ups
How to reduce occupational immobility
- Funding apprenticeships and training programmes
- improving interregional links
How to reduce geographical immobility
- Rise in house-building will help to keep property prices lower and encourage more affordable rents
- Active regional policy to create new jobs and businesses
- enterprise zones
What is the impact of unemployment on Firms
● There will tend to be a decrease in demand for their goods (but this depends on the YED) and so this could lead to a fall in profit.
● Long term unemployment can lead to loss of skills and reduce employability of workers, so firms have a smaller pool of skilled people to employ.
● They can offer low wages as people will take the job anyway because they know there is a lack of jobs so have few options.
What is the effect of unemployment on consumers
● Consumers suffer from less choice. The quality of goods may also decrease.
● The unemployed consumers lose out as they have less available to spend.
● However, firms may lower prices and put on sales in order to increase demand for their product.
What is the effect of unemployment on the government
● The reduced income results in a fall in tax revenues and higher spending on welfare payments for families with people out of work, incurring an opportunity cost as the money could be better spent elsewhere.
● This will result in an increase in the budget deficit. It will be likely that the government will have to raise taxation or scale back plans for public spending on public and merit goods, such as the NHS or education. They may need to increase borrowing.
What is the effect of unemployment on society as a whole
● Rising unemployment is linked to social deprivation. There is a relationship with crime and social dislocation
● It results in a loss of potential national output and represents an inefficient use of scarce resources. If people chose to leave the labour market permanently, then this will have a negative effect on LRAS
.● Taxpayers paying money to the unemployed is not a loss for the economy as it is a transfer payment but the economy is affected because there is a fall in national output and the social costs of the unemployed e.g. violence and crime.
What is the effect of unemployment on society as a whole
● Rising unemployment is linked to social deprivation. There is a relationship with crime and social dislocation
● It results in a loss of potential national output and represents an inefficient use of scarce resources. If people chose to leave the labour market permanently, then this will have a negative effect on LRAS
.● Taxpayers paying money to the unemployed is not a loss for the economy as it is a transfer payment but the economy is affected because there is a fall in national output and the social costs of the unemployed e.g. violence and crime.
What is the effect of migration on jobs
- Leads to increased jobs due to a circular flow of income
- Also leads to lower wages due to higher competition; people with low motivation and low skill are most affected
- Fill in shortages where skilled labour is needed
What are the 4 components of the Balance of Payments Accounts
- Current Account
- Financial Account
- Capital Account
- Balancing Item
What is the current account made up of
- Balance of trade in goods
- Balance of trade in services
- Net primary income (interest, profits, dividends and migrant remittances)
- Net secondary income (transfers i.e. contributions to EU, military aid, overseas aid)
What is the capital account
- Sale/transfer of patents, copyrights, franchises, leases and other transferable contracts (example would be international buying and selling of land by businesses)
- Debt forgiveness/cancellation (forgiving debt counted as a negative)
- Capital transfers of ownership of fixed assets (i.e. international death duties)
What is the financial account
- includes transactions that result in a change of ownership of financial assets and liabilities between UK residents and non-residents
- Net balance of foreign direct investment flows (FDI)
- Net balance of portfolio investment flows (e.g. inflows/outflows of debt and equity)
- Balance of banking flows (e.g. hot money flowing in/out of banking system)
- Changes to the value of reserves of gold and foreign currency
What is the balancing item
it gets rid of estimated errors and omissions to get the BOP=0
In a floating exchange rate what is the demand for curreny and BOP equivalent to
- demand = supply for currency
- BOP=0
Why is the BOP=0
- If there is a deficit on the current account there will be a surplus on the financial account
If there was an increase in interest rates this would cause hot money flows to enter the UK
What are key causes of Current Account Defecit
- Poor price and non-price competitiveness
- Strong exchange rate affecting demand for exports and imports
- High currency value increases prices of exports
- Appreciating currency also makes imports cheaper
- Recession in one or more major trade partner countries
- Volatile global prices (e.g. soft and hard commodities)
Conseqeuences of a current account defecit
- Loss of aggregate demand if there is a trade deficit (M>X) which causes weaker real GDP
- cause the currency to depreciate
- a loss of investor confidence, leading to capital flight
- Need to cut spending in the future. For example, during 2012-16, many countries in the Eurozone sought to reduce their budget deficit to comply with EU rules.
- Opportunity cost of debt interest payments.
- Potential rise in bond yields. may struggle to attract sufficient investors to buy bonds. If this happens, bond yields will rise causing the deficit to be more expensive to finance.
Reasons to not worry about current account defecit
- If financed by long-term capital inflows, it can increase the productive capacity
- In globalisation, it is easy to attract sufficient capital flows
- If defecit gets too large it will cause a devaluation which helps reduce the defecit
- Provides an outlet for domestic demand and prevent inflation
How can a current account defecit be financed
The financing of a deficit is achieved by:
- Selling reserves ( gold/ forex )
- Borrowing
- FDI
- Hot Money Flows
What are the causes of a current account surplus
- A large and persistent surplus of savings (S) over investment (I) for households, firms and the government.
- A large gap between exports (X) and imports (M), when net income balance and net transfers are small
- An export surplus may be the result of very high prices for exports of commodities such as oil and gas.
Consequences of a Current Account Surplus
- A surplus on the current account would allow a deficit to be run on the capital account e.g. surplus foreign currency can be used to fund investment in assets located overseas
- Current account surplus countries nearly always have fairly strong exchange rates as a result
What is the defintion of AD
Total level of planned real expenditure on the goods and services produced within a country
What are the components of Aggregate Demand
AD = C + I + G + (X-M)
What are the 4 reasons why the AD slopes downwards
- The Wealth Effect
- The Interest-Rate Effect
- The Exchange Rate Effect
- Real Balance Effect
What is the Wealth Effect
Price Level falls –> purchasing power increases –> higher consumption –> higher AD
What is the Interest-Rate Effect
Price Level falls –> More disposable income –> rise in loanable funds supply –> fall in interest rates –> lower cost of borrowing –> more investment in economy
(price of loanable funds is the real IR)
What is the Exchange-Rate Effect
fall in price level –> domestic goods cheaper –> more exports and less imports –> (X-M) increases so AD increases
What is the Real Balance Effect
Rise in prices –> savings have less value –> savings offer less security –> People will want to save more –> Fall in consumption so fall in AD
What is the difference between a shift in AD and a movement along AD
- Movement along the AD is caused by a change in prices (inflation/deflation)
- A shift of the AD is caused by any other variable independent of the price level
What is the marginal propsenity to consume
how much an increase in income affect consumption
Is MPC higher among the rich or poor
Poor tend to have a higher MPC
What is the relationship between savings and consumption
- Savings is what is not spent out of income
- An increase is consumption decreases savings
What are the 5 main influences on consumption
- Interest Rates
- Consumer Confidence
- Wealth Effects
- Distribution of Income
- Tastes and attitudes
How do interest rates influence consumer spending
- Major expenditures are bought on credit
- Interest rates affect the cost of credit
- High IR increase mortgage repayments
- Also decreases value of shares; as the MES compared to Treasury is smaller
How does consumer confidence influence consumer spending
- Confidence in the future increases spending.
- Lack of confidence increases savings
- Consumers might also expect higher prices and rush stores or factor in higher taxation (Ricardian Equivalence)
What is the Ricardian Equivalence
consumers anticipate the future so if they receive a tax cut financed by government borrowing they anticipate future taxes will rise. Therefore, their lifetime income remains unchanged and so consumer spending remains unchanged.
What are the problems with the Ricardian Equivalence
- Consumers are not rational
- Consumers do spend at least some of the tax cuts
- Tax cuts can boost growth and diminish borrowing requirements for governments
- Multiplier Effect
What are the problems with the Ricardian Equivalence
- Consumers are not rational
- Consumers do spend at least some of the tax cuts
- Tax cuts can boost growth and diminish borrowing requirements for governments
- Multiplier Effect
How do wealth effects affect consumer spending
Greater wealth improves a consumer’s confidence and thus leads to greater spending
e.g. a higher house prices means a consumer can borrow more on the house. higher share prices mean some can be sold
How does the distribution of income affect consumer spending
If money is moved from the rich to the poor, consumption is likely to increase as the poor have a higher MPC.
How do tastes and attitudes affect consumer spending
a strong materialistic drive that encourages people to have the newest and the best and therefore spending can be very high, in some cases even above income. If people were less materialistic, consumption would decrease.
Define investment
the addition of capital stock to the economy
What is the difference between net and gross investment
Gross Investment - amount of investment carried out and ignores the level of depreciation
Net Investment - Gross Investment minus the value of the depreciation
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What are the 6 main influences on investment
- Rate of economic growth
- Business expectations and confidence
- Interest Rates
- Access to Credit
- Retained profit
- Technological Change
How does the rate of economic growth influence investment
- A growing economy spurs on confidence hence investment
What is Investment a derived demand of
Confidence
How does Animal Spirits affect investment
Confidence makes Buisnesses want to preapre for the future
How do Interest Rates affect investment
- High IR increase the cost of borrowing
- Therefore the marginal efficiency of capital needs to be more attractive
What does Keynes’ Marginal Efficiency of Captial graph show
displays the expected rate of return from an investment at a particular given time. If interest rate is at 10% then firms need an expected rate of return which is at least equal to 10% to make it worthwhile.
How does access to credit affect investment
- High Risk investments mean less access to credit
- Recessions can make credit harder to acces with a risk awareness premium
How does retained profit affect investment
- Higher retained profit makes investment more attractive due to the opportunity cost of keeping it
What is the evaluation for the factors that affect investment
- Time Lags
If a firm has started a project a rise in IR is unlikley to change the decisions but can impact future projects and decisions
- Magnitude of Other Factors
IR can be outweighed by economic conditions
e.g. 2009 IR 5% –> 0.5% but investment still fell because of the deep recession and unwillingnes to lend (liquidity trap)
What is the accelerator effect
Suggests that capital investment is a function of output
An increase in demand and output, investment will rise to meet the expected demand
What are the 3 main influences on government spending
- The Trade Cycle
- Fiscal Policy
- Age distribution of the population
How does the trade cycle influence government spending
- Decisions made to manage AD and thus regulate trade cycle
- Automatic stabilisers cause Government spending to rise in recession
What are automatic stabilisers
An automatic way to blunt off the worst extremes in the economic cycles and buy time for discretionary government policy
What are 2 examples of automatic stabilisers
- Welfare Benefits
In Recession Government spending automatically increases through transfer payments, this increases AD
- Progressive Income Tax
in a Boom, Higher incomes makes workers be pushed into another tax band so tax regulates AD
How does fiscal policy influence government spending
- Level of government spending is dependent on what is laid out in the fiscal policy
How does the age distribution of the population affect government spending
- An ageing population leads to increased government expenditure on pensions, social care
- A young population leades to an increased spending on education
What is crowding out
a process where an increase in government spending
leads to a fall in private sector spending.
What is financial crowding out
If the government increases it’s spending – say through selling bonds – The demand for money will increase, which, ceteris paribus, raises interest rates.
At higher interest rates, both consumer spending and investment spending are likely to fall.
The aggregate effect on the economy is that financial resources are diverted from private firms to be used by the public sector.
How does financial crowding out lead to a fall in GDP
Initially, via a multiplier effect, national income increases, but as a result of the government selling securities in the financial markets, the demand for scarce loanable funds increases.
This drives up interest rates, which causes a contraction in the demand by the
private sector for investment goods (capital) as well as reducing the demand for
consumer goods. This, in turn, leads to a fall in GDP.
What is crowding out in relation to the labour market
a relative increase in the public sector may push up wages in order to attract workers from the private sector.
The increased demand for labour reduces unemployment and ‘tightens’ the labour market, leading to possible shortages of labour available for the private sector use as well causing upward pressure on wage levels across the economy.
What fundamental financial fact drives crowding out
that financial and real resources are ultimately scarce, and if one sector of the economy increases its use of these resources, fewer are available for use in other sectors.
What is the Ricardian Equivalence
This means that attempts to stimulate an economy by increasing debt-financed government spending will not be effective because investors and consumers understand that the debt will eventually have to be paid for in the form of future taxes.
The theory argues that people will save based on their expectation of
increased future taxes to be levied in order to pay off the debt, and that this will offset the increase in aggregate demand from the increased government spending.
What did Barro say to support the Ricardian Equivalence
an increase in government spending will lead individuals and organisations to expect interest rates to rise in the future, they will save more in order to pay higher interest rates.
What is the evaluation of crowding out
it may be a weak effect, this depends on the various elasticities that exist in the relevant markets.
if the supply of loanable funds is elastic and the demand for capital is inelastic, the impact of higher interest will be relatively small.
What evidence did Enrice Moretti from MIT find about federal spending to oppose the ‘crowding out’ theory
Government spending leads to an increase in private spending; a ‘crowding in’ effect
What are 3 reasons for the crowding in effect
- Frontier technology projects have extremely high fixed costs so by letting the public
sector fund the research, it allows the private sector to realise higher
profits. -
“Spillover effects”, where new technologies find different applications
in the private sector. GPS, for instance, was first developed to help
missiles find their targets -
Credit constraints on the private sector, where a project is difficult to
fund without government support due to, say, an economic downturn.
Why does frontier/speculative funding have a crowding in effect
the potential outcomes from speculative research and development are inherently unknowable, which makes a new project impossible to justify commercially.
What is net trade
Total exports - total imports
What are the 6 main influences on the net trade balance
- Real Income
- Exchange Rates
- State of the World Economy
- Degree of Protectionism
- Non-Price Factors
- Prices
How does real income influence the net trade balance
- Imports are YED positive so net trade decreases
How do exchange rates influence the net trade balance
- A strong pound makes imports cheaper and exports more expensive
- However this is dependent on elasticity; if both import and exportts are elastic then there will be fall in net trade
How does that state of the world economy influence the net trade balance
If the Uk’s main export country is doing well then UK exports will rise and so will the net trade balance
How does the degree of protectionism affect the trade balance
If there is high protectionism on UK exports in other countries, exports will decrease as it will be harder for UK firms to sell their goods in other countries.
If there is high protectionism on imports into the UK, imports will decrease but other countries are likely to retaliate and therefore exports are likely to decrease.
Free trade means that net trade will be a more significant part of AD, whether this be in a positive or negative sense.
How does the degree of protectionism affect the trade balance
If there is high protectionism on UK exports in other countries, exports will decrease as it will be harder for UK firms to sell their goods in other countries.
If there is high protectionism on imports into the UK, imports will decrease but other countries are likely to retaliate and therefore exports are likely to decrease.
Free trade means that net trade will be a more significant part of AD, whether this be in a positive or negative sense.
How do non-price factors affect the trade balance
higher quality and design, exports will be high as foreign demand for UK goods will increase and imports will decrease as people will buy the British goods instead of foreign goods so net trade will increase.
If UK goods are well marketed, people will have a stronger desire to buy British goods so exports will increase and imports will decrease, so net trade will increase.
Strong quality/design and marketing will mean that British exports are likely to be more inelastic.
How do non-price factors affect the trade balance
higher quality and design, exports will be high as foreign demand for UK goods will increase and imports will decrease as people will buy the British goods instead of foreign goods so net trade will increase.
If UK goods are well marketed, people will have a stronger desire to buy British goods so exports will increase and imports will decrease, so net trade will increase.
Strong quality/design and marketing will mean that British exports are likely to be more inelastic.
How do prices affect the net trade balance
- High prices of UK goods will mean that the goods are less competitive compared to international goods since people make decisions partly based on price.
- Prices are affected by the inflation rate: if the UK inflation rate is higher than other countries, prices will rise faster
- The effects of changing prices on the value of imports and exports depends on the price elasticity of demand. If PED is elastic, then higher prices will lead to a fall in net trade
What is aggregate supply
the volume of goods and services produced within the economy at a given price level.
the costs of production
Why is AS upwards sloping
Firms are willing to supply more at a higher price
Is Short-Run AS likely to be inelastic or elastic
likely to be elastic as an increase in output by firms is likely to lead to an increase in costs which leads to a rise in prices as they pass these costs onto consumers.
What is fixed in the Short-Run AS
money wage rates, factor prices and the state of technology are fixed and can’t change; a change in these results in a shift of the curve.
What 3 factors cause a hift in SRAS (Production costs)
- Changes in costs of raw materials and energy
- Changes in exchange rates
- Changes in tax rates
What is the classical LRAS
AS is independent of price level and instead determined by the potential production
What view does the classical LRAS reflect
Markets tend to correct themselves fairly quickly and move back to the LRAS
In the short Run can the AS exceed the LRAS
- In the short run it is possible for an economy to exceed the maximum potential LRAS by allowing factors of production to work overtime or not allow time for maintenance of machinery etc.
Draw the Keynesian LRAS
What does the Keynsian LRAS agree with at point B
It is vertical as with the classical view; this is the PPF
Why does the Keynsian LRAS not stay vertical
If it stayed vertical it would imply that when unemployment exists, wages and price falls which makes it worthwhile to employ again and employment comes back
But Keynes thought wages are sticky downwards
Why did Keynes believe wages were sticky downwards
- union power
- businesses are unwilling to risk demotivation
- workers are unwilling to work for too low
- the minimum wage means wages cannot fall below a certain level
When there is high unemployment (anything under A) what do firms do
They do have to offer high wages to attract staff as the LRAS is perfectly elastic at this point
What happens between points A and B on the Keynsian LRAS
Labour becomes scarcer so firms have to offer higher wages
These higher wages lead to a higher average price level.
Output becomes more price inelastic until it reaches point B, where an increase in prices no longer affects output as the PPF has been reached.
What are 6 main factors that influence LRAS
- Technological Advance
- Changes in relative productivity
- Changes in education and skill
- Changes in Government Regulation
- Demographic Changes and migration
- Competition Policy
How do technological advances influence LRAS
- More machines means more goods can be produced or more efficiectly
- Increasing the LRAS
How do changes in relative productivity influence LRAS
- Higher productivity increases the production possibility
- if the UK is more productive than other countries it will encourage production of that good in the UK, so investment will be increased, and this will increase LRAS
How do changes in education and skills influence the LRAS
- A more skilled workforce will be more efficient which will shift the LRAS
- Education can reduce occupational immobility which decreases structural immobility so resources are used efficiently
How do changes in government regulation influence the LRAS
-
Increase the size of the workforce by encouraging people to get back in (benefits and working age reduced)
2.Increase research and development ; offer tax breaks to fund
3.Increase incentives to set up businesses; entrepreneurial zones and lower coporation tax
How do demographic changes and migration influence the LRAS
- The more migration the higher the LRAS
- The more of that migration is working age the better
How does competition policy influence LRAS
- Competition pushes buisness to both improve efficiency and quality of their products so LRAS will increase
- Less competition however can encourage investment and innovation (copyright laws and patents)
What is the difference between wealth and income
Wealth is a stock of assets whilst income is a flow
Countries with high levels of wealth tend to have high levels of income and vice versa but there is not a perfect correlation between wealth and income.
What causes economic growth
An increase in quality or quantity of one of the four factors of production
land, labour, capital or enterprise
How will an increase in LRAS contribute to economic growth
- An increase in LRAS will increase the productive capacity of the economy along with economic growth
How does Land contribute to economic growth
The discovery of new resources e.g. oil will increase economic growth.
most potent effect in developing countries
eval: Dutch Disease
What is Dutch Disease
the problems associated with a rapid increase in the production of raw materials (like oil and gas) causing a decline in other sectors of the economy. When the raw materials run out, the economy can be in a worse position than before.
What are the effects of Dutch Disease
- **Appreciation in currency. **
- Decline in competitiveness. The problem of this appreciation in the exchange rate is that other trade-able sectors of the economy will become uncompetitive.
- **Growth in luxury imports. **
- Growth in real wages. causing another problem for manufacturing firms as they have to increase real wages to retain workers. This will further decrease the competitiveness of manufacturing exports.
- Indirect-deindustrialisation.
- Income inequality.
- Tax revenue. the government will often cut other taxes and come to rely on oil tax revenues.
How does an increase in the size of the workforce contribute to economic growth
A change in the age profile of the population i.e. the amount of people of working age will affect economic growth: the more people of working age there are, the more growth there will be.
How could the gov. increase the number of working people
- Raise the retirement age
- Provide free childcare
- Encourage immigration
How does the quality of the workforce contribute to economic growth
- Education makes workers more efficient
- Less likely to suffer structural unemployment so reduce NRU and increase LRAS
How does capital contribute to economic growth
- Sustained investment allows access to new techhnology to improve productivity
- More machines –> more goods
How does enterprise contribute to economic growth
If the government offers tax benefits and grants, they will encourage the development of business, creating jobs and meaning more goods and services are produced, which will increase economic growth
How does excessive wealth distribution affect incentives for enterpirse
If there is too much wealth distribution (i.e. too high taxes and benefits), there will be little incentive to work hard as the rich know a lot of their money will be taken away and the poor know that there is no need to work as benefits will give them just as much money as a job on minimum wage.
This lack of incentive will mean that businesses won’t invest and so there will be little to no economic growth.
What is actual growth
actual growth is the percentage change in GDP
What is percentage growth
Potential growth is the change in productive potential of the economy over time, so the LRAS or PPF curve shifts.
What is percentage growth
Potential growth is the change in productive potential of the economy over time, so the LRAS or PPF curve shifts.
How does export-led growth affect LRAS
Intially increased exports affect AD but sustained high ecports force investment and increased demand for labour
What are the advantages of export-led growth
- Injection into Circular Flow causes rise in AD
- Growing GDP causes accelerator effect
- Compplementary industries benefit; Rotterdam in Netherlands
What are disadvantages of export-led growth
- Overdepndence on trading partner
- Production capacity allocated to supply goods and services for export cannot be put to use meeting domestic needs and wants.
- Export-led growth might be unsustainable if it contributes extraction of natural resources beyond what is required for long-term balanced growth to be maintained.
What is the long run trend rate of growth
average sustainable rate of economic growth over a period of time. It is what tends to happen over a long period of time
What is an output gap
An output gap is the difference between the actual level of GDP and the estimated long-term value for GDP
What is a positive output gap
Actual GDP> long run trend rate
What is a negative output gap
Long run trend rate> Actual GDP
Why are output gaps difficult to measure
- Position of LRAS is unkown and intial estimates of GDP are often inaccurate
Portray +ve and -ve output gaps using a classical LRAS diagram
In the diagram, there is an equilibrium where AD=SRAS=LRAS. However, at AD1 , there is a negative output gap because the SRAS equilibrium is less than the LRAS equilibrium, so the full capacity of the economy is not being met. At AD2 , there is a positive output gap as SRAS is higher than LRAS.
How would a classical economist argue these output gaps would be fixed
Classical economists would argue that this positive output gap would be filled by long-run economic growth moving the LRAS curve, a recession which would decrease AD or a rise in the costs of production which would decrease SRAS. They would also argue that the negative output gap would be brought back to equilibrium by rising AD or a fall in SRAS due to lower costs of production.
What does this diagram show
The economy returns to Yf (full employment/equilibrium) following a period of deflation. There was no need to intervene justifying a laissez faire approach.
What is a paradox of thrift
Keynes argued in a recession, people responded to the threat of unemployment by increasing saving and reducing their spending. This was a rational choice, but it contributes to an even bigger decline in AD and GDP. This is why government intervention may be needed. (Defies Says Law)
What is an example of a paradox of thrift
High savings ratio in 2008 contributed to recession
What are some criticisms of the paradox of thrift
- Higher saving increases bank balances and can lead to an increase in bank lending - and hence investment. (Banks may be unwilling to lead)
- A fall in demand from higher saving, will cause lower prices, which encourage demand to increase. This is related to Say’s Law which states supply creates its own demand.
- Higher domestic savings can lead to lower domestic inflation and therefore increase exports. Higher exports can boost demand.
What is Says Law
the production of goods creates its own demand.
production creates wages for workers and income for the businessman. Therefore, the production has increased wealth and leads to demand for other goods.
What are the implications of Says Law
- The economy should always be close to full employment. There shouldn’t be demand deficient unemployment.
- Economic downturns are not due to a ‘glut of supply’
- According to classical economists, any unemployment must be due to **wages being artificially kept above the equilibrium level **or structural factors, such as lack of skills in specific industries.
- To increase output, we should concentrate on increasing production rather than demand.
What are the criticisms of Say’s Law
- 1930 mass ue shows there can be insufficient aggregate demand for goods produced.
- Wages are sticky downwards
- **Paradox of Thrift **: Say himself criticised Ricardo for neglecting the possibility of hoarding if there are insufficient investment opportunities. Lack of confidence
- Liquidity Trap. In a liquidity trap, the demand to hold cash is greater than the demand to spend. Banks increase their reserves and the saving rate increases, this leads to a fall in aggregate demand.
- It may be very rational to ‘hoard’ money – especially in a period of deflation or anxiety.
- The balance sheet recession of 2008-12, illustrated an example of where banks, consumers and firms were keen to pay off their debts and not spend all their income. This led to a prolonged recession
Draw and explain effects of a positive output gap
· R.GDP is now above trend and this can occur because with the rising demand firms will offer overtime/stay open longer etc.
· However this puts upward pressure on the price level (demand pull) and cost push. WHY?
· The SRAS curve now shifts in as COP rises. (please draw SRAS2)
· The economy returns to YFE but now at a higher price level (inflation)
There may be an increase in inflationary expectations also (why?)
What does this diagram show
Fiscal Policy + Multiplier can lead to demand push inflation
What is the trade cycle
periodic but irregular up and down movements in economic activity
boom –> downturn –> recession (slump) –> recovery
What are the two main types of a trade cycle
two main types of trade cycle: a mild trade cycle where GDP does not fall
during recessions but instead doesn’t grow by as much as the trend, and a more
extreme one
What is charcteristic of a boom
- High national income
- Economy working above PPF (Positive Output Gap)
- Increase imports to meet demad
- Inflationary pressure
What is charcteristic of a boom
- High national income
- Economy working above PPF (Positive Output Gap)
- Increase imports to meet demad
- Inflationary pressure
What is characteristic of a downturn
- Output and income fall –> fall in C and I and tax rev.
- Payments for benefits increase
- Accept lower wages due to high unemployment –> fall in inflation + imports
What is characteristic of a recession
- High unemployment
- Causes low C,I,M
- Inflationary pressure will be low, may be deflation
- GDP -ve for 2 quarters
What is characteristic of a recovery
- National income and output begin to increase with unemployment falling
- C,I,M increasing
- Inflationary pressure grows
What is hystersis
Economies do not bounce back to their previous level of growth
e.g. some may take retirement, some lose their skills or become discouraged causing a loss in physical and human capital discouraging investment
What is an example of Hystersis in the UK
In the period 8 to 13 February 2022, based on adults aged 50 to 70 years in Great Britain (GB) who have left or lost their job since the start of the coronavirus (COVID-19) pandemic and not returned to work:
The majority (77%) of adults aged 50 to 59 years said they left their previous job sooner than expected compared with 57% of adults aged 60 years and over
What are the benefits of economic growth for consumers
- There will be an increase in demand for housing as people have more money and so are able to afford to buy properties, which will increase house prices.
- Shares to increase in value and lead to positive wealth effect.
- Improved productive efficiency due to better technology could lead to **lower prices or higher quality goods. **
What are some costs of economic growth for consumers
- Growth in Inequality
- Growth in inflation
What are some benefits of economic growth on Firms
-
Investment will increase since businesses are more successful.
* Business confidence will improve so higher I - increased investment means technology will improve which is likely to increase productive efficiency and lead to lower costs.
- The combination of higher demand and lower costs is likely to lead to higher profits.
- Economic growth also provides the opportunity for new firms to establish themselves and allows existing ones to make more profit.
What are some benefits of economic growth on Firms
-
Investment will increase since businesses are more successful.
* Business confidence will improve so higher I - increased investment means technology will improve which is likely to increase productive efficiency and lead to lower costs.
- The combination of higher demand and lower costs is likely to lead to higher profits.
- Economic growth also provides the opportunity for new firms to establish themselves and allows existing ones to make more profit.
- Easier to access finance due to lower IR and higher confidence
What are some costs to economic growth on Firms
- Firms who sell inferior goods may lose out
- Changing technology may cause markets to disappear/greater automation
What are some benefits to economic growth for living standards
- Economic growth will result in lower poverty levels .
- Increase in supply –> increased jobs –> higher wages
- There will be more goods and services, lowering prices and improvin access
- Housing standards and the quality of food increases –> health increases
- Increased government spending will lead to improved living standards
- people with higher incomes are able to buy cleaner fuels and richer countries can devote resources for research and development of cleaner resources and ‘greener’, more efficient technology
What are some costs to living standards due to economic growth
- ** increased inequalities **between rich and poor; rich might even exploit poor for growth
- exploitation of the environment A rise in income means more people have access to electricity etc. and use it more freely. This causes depletion of non-renewable resources, concern about sustainability of growth for future generations and increased levels of pollution/waste/congestion.
What are Growth Pessemists
What is the tragedy of commons
individuals could limit their use so that they don’t deplete the common resource. However, there is a free-rider problem. Where people rely on others to cut back their production. If everyone free-rides and maximises their use, then we get a situation of over-consumption.
What are policies to overcome the tragedy of the commons
- Voluntary agreements need sense of civic responsibility
- Government regulation can limit fish catches or size of fishnets to allow young fish to escape.
- Clearly defined property rights the private owner has a stronger incentive to manage the resource for optimum outcome. However, the problem of property rights
What is an example of overcoming the tragedy of the commons in fishing stocks through gov. regulation
Officials determined that the population of midAtlantic bluefish was at an unhealthy level in the late 1990s. To recover this valuable fishery, federal managers implemented a nine-year rebuilding plan, which reached its goal a year
ahead of schedule, leading officials to declare bluefish fully rebuilt in 2009.
What are the 4 key macroeconomic objectives
- Economic Growth - sustainable in the long-run
- Low Unemployment - as low as possible, 3% only frictional
- Low and stable inflation - 2% targetm
- Balance of Payments Equilibrium on the Current Account - sustainablity of current account to finance deficits; avoid current account
What are some other macroeconomic objectives
- Balanced government budget: This ensures the government keeps control of state borrowing, so the national debt does not escalate. This allows governments to borrow cheaply in the future should they need to and makes repayments easier.
- Protection of the environment: This aims to provide long run environmental stability. It ensures resources are used sustainability
- Greater income equality: This minimises the gap between the rich and poor. It is generally associated with a fairer society.
Is a deficit on the balance of payments
- a high level of imported goods provides consumers with a wider choice of goods, which may be of higher quality and lower prices
○ All of this enhances consumers standards of living and welfare - Firms may also benefits from cheaper or higher quality imported components or raw materials, which may reduce costs, either enhancing profits or lowering prices further for customers
- As a result, it is viewed by many economists that a deficit on the balance of trade overall, is not necessarily detrimental to the wider economy
What is monetary policy
Monetary policy is where the central bank or regulatory authority attempts to control the level of AD by altering base interest rates or the amount of money in the economy.
What is fiscal policy
Fiscal policy is use of borrowing, government spending and taxation to manipulate the level of aggregate demand and improve macroeconomic performance.
How does an rise in IR cause a fall in AD
increase the cost of borrowing for firms and consumers
It also makes savings more attractive, as the interest earnt on them will be higher
fall in demand for assets such as stocks, shares and government bonds. This leads to a fall in prices for these assets (negative wealth effect)
People will become less confident about borrowing and spending if interest rates rise.
value of the pound will rise . This means that imports
will be cheaper, and exports will be more expensive. This decreases net trade
therefore AD.
What are some problems with a rise in interest rates
- Such a significant fall that there is a BOP deficit
- Time lag takes 1-2 years effect
- Not all IR affected by repo rate
- Liquidity trap e.g. 2008
- High IR over time encourage discourage investment
How does QE increase AD and inflation to meet the target
Bank of England buys assets in exchange for money in order to increase money supply and get money moving around the economy during times of very low demand.
there is a rise in demand and so asset prices rise - positive wealth effect
money supply increase; increased money supply will mean that the price of money falls; interest rates are the price of money
Commercial banks may lower their interest rates
What are some issues with quantative easing
- Risky and could cause hyperinflation; 2020 QE –> 2022 inflation
- no guarantee that higher asset prices lead into higher consumption through the wealth effect, especially if confidence remains low.
- More expensive housing market, worsens inequality. It also led to rising share prices which increases inequality, since the rich grow richer whilst the poor see none of the gains.
Evaluate issues with fiscal policy
- Spending impacts LRAS
- Taxes and spending have an impact on inequality
- May have an impact on debt and expectations
- Ricardian Equivalence
- Poor information. Fiscal policy will suffer if the government has poor information
- Dependent on multiplier and confidence
- Size
- Conflicts with other objectives
- Political influence
Evaluate with demand-side policies as a whole
- Classical economist believe its just short-run disequilibrium, will return to LR equilibrium
- Impact of changes on economy depend on where they are in Keynsian Economy
- Significant time lag till full effect
*
Policy response in the UK to the Great Depression
- Contractionay Fiscal Policy
cut public sector wages and unemployment benefit by 10% and raised income tax from 22.5% to 25%; reduces AD - UK forced to leave gold standard, caused value of £ to fall by 25%,
- There was recovery in London and the South East but Wales, the north and Scotland
did not reach full employment until 1941.
What was the US policy response to the Great Depression
Expansionary Keynsian fiscal policy response
- New Deal which promised public sector investment, work schemes for the unemployed and fiscal stimulus.
- The USA reached full employment in 1943
What are automatic stabilisers
· Automatic stabilisers act in an automatic way to blunt off the worst extremes in the economic cycle.
· Automatic stabilisers ‘buy time’ for discretionary government policy..
What are the 2 tools of automatic stabilisers;
- Progressive Income Tax System
- Welfare Benefits (U Benefits)
Explain the function of automatic stabilisers in a boom and bust
BOOM (Cushion Demand)
- Higher Incomes –> Workers Pushed into higher tax bands –> Higher average rate of tax –> slow down increase in C
- U low –> Gov. Spending on Benefits reduces
Recession (support output)
1) Incomes Lower –> workers move into lower tax bands –> lower average rate of tax –> Prevents large decrease in C
U High –> Gov. Spending on benefits increase
What does MIT say about the crowding in effect of $1 public investment
$1 of additional public funds for R&D translates into $5 of extra R&D funded by the private sector at the mean values of public and private R&D.
What are the 3 reasons for the crowding in effect
- Frontier technology projects have extremely high fixed costs .
- “Spillover effects”, where new technologies find different applications e.g. GPS was public sector
- Credit constraints on the private sector, where a project is difficult to fund without government support due to, say, an economic downturn.
What is the liquidity trap
Occurs when the base rate falls so low that it no longer stimulates AD.
Following the credit crunch banks became nervous/very cautious about lending and limited the availability of credit as they sought to recoup losses.
What is forward guidance
· Forward guidance is when the Central Bank announces to markets that it intends to keep interest rates at a certain level until a fixed point in the future.
The aim of forward guidance is to influence long term interest rates and market expectations
What are the benefits of forward guidance
· Commercial banks feel the cut in base rates is temporary, they may not want to cut their long term rates.
· But, if the Central Bank confirms that it will keep base rates at 0.5% for a considerable time, then commercial banks may be more willing to reduce their long term rates because they know they will be able to borrow from the Central Bank at 0.5%.
· The hope is that this will encourage banks to cut rates, and increase overall lending in the economy.
How credible is forward guidance
· There is nothing to stop the Central Bank ignoring its own pledge
· Markets and banks know this and this could reduce the usefulness of the commitment, but it can still give an indication of how monetary policy will operate.
Markets do tend to place a lot of weight on Central Bank pronouncements.
How could forward guidance backfire
· Some economists suggest that a commitment to keep interest rates low for a long time, is an admission that the economy is deeply depressed and this could actually knock confidence and expectations
Therefore, rather than boosting lending and economic activity, forward guidance could be seen as an act of desperation and therefore not help
What is the funding for lending scheme
· The funding for lending scheme was launched in July 2012 to try and encourage banks to lend directly to the real economy
FLS works by Bank of England lends commercial banks funds at interest rates lower than market rates for an extended period.
· If commercial banks expand their lending, they get lower interest rates. However, if they reduce their lending, they have to pay higher interest rates.
· Because commercial banks find it cheaper and easier to borrow – this encourages them to lend to firms and consumers higher quantities and at lower interest rates.
What is the cash reserve ratio and how can it be used for monetary policy
Cash Reserve Ratio, it is the** percentage of deposits which commercial banks are required to keep as cash according to the directions of the central bank.
**
When the central bank wants to increase money supply in the economy, it lowers the reserve ratio. As a result, commercial banks have higher funds to disburse as loans, thereby increasing the money supply in an economy
Evaluate the effectiveness/limitations of monetary policy
- limited in addressing cost push inflation domestically
- limited supply-side effect
- Liquiditty trap
- Need more tools to control this many objectives
- Exports less competitive
- Time Lag- transmission mechanism
What are the arguments for using indirect taxation
· Changes in indirect taxes can change the pattern of demand by varying relative prices (e.g. an increase in the real duty on petrol)
· Indirect taxes can be used as a means of making the polluter pay and “internalizing the external costs” of production and consumption
· Indirect taxes are less likely to distort choices between work and leisure and have less of a negative effect on work incentives.
· Indirect taxes can be changed more easily than direct taxes – this gives policy-makers more flexibility.
· Indirect taxes are less easy to avoid
· Indirect taxes provide an incentive to save that help to provide finance for investment
What are the arguments against use of indirect taxation
· Many indirect taxes make the distribution of income more unequal because of their regressive effects
· Higher indirect taxes can** cause cost-push inflation** which can lead to a rise in inflation expectations
· If indirect taxes are too high – this creates an incentive to avoid taxes through “boot-legging”
· Revenue from indirect taxes can be uncertain particularly when inflation is low or there is a recession causing a fall in consumer spending
· There is a loss of welfare from duties e.g. loss of producer & consumer surplus
· Higher indirect taxes affect households on lower incomes who are least able to save
What is the supply-side effect of lower income tax
increase incentive to work this is because the opportunity cost of not working increases. The voluntary UE may now seek employment meaning the labour supply increase shifting out the LRAS.
· In addition those in work may now work harder as the potential rewards are greater.
Evaluate the effects of a lower income tax
· Given the state of current government finances, can it lower Y tax sufficiently to influence the voluntary Un to find employment. -Liz Truss
· Will those in work harder or just enjoy a post-tax pay rise? - backward bending supply curve
Have the voluntary Un actually got the skills to become employed without retraining?
What is the supply-side effect of decreasing coporation tax
This should create the incentive to invest. As well as influencing AD, the SRAS will be influenced through greater productivity and LRAS increases through increased productive capacity.
Evaluate the supply side effect of lowering coporation tax
· By lowering corporation tax there is no guarantee that firms will invest. They may lack confidence
* Firms may reward shareholders from the greater profits, benefitting AD (as long as the majority of shareholders reside domestically) but not influencing LRAS significantly.
e.g. 18.7 billion water company profit, 18.1 billion dividend
What is the supply-side effect of decreasing benefit payments
· This increases the opportunity cost of not working, in theory incentivising the voluntary Un to find work.
This increase in the labour supply means the NRU falls and the LRAS shifts out as productive capacity increases.
Evaluate the supply-side effects of decreasing benefit payments
· Is this fair? Could this increase inequality and poverty of the most vulnerable in society
· What about the skills gap? Individuals may want to work but are they employable. Is there sufficient demand in the economy?
Child poverty?
What is the supply-side effect of spending on training and education
Higher government spending on education and training, could increase long-term labour productivity and help the long-term trend rate of economic growth.
Evaluate the supply-side effect of spending on training and education
· But, also government spending could be inefficient and wasteful – it depends on what the government spends the extra spending on
e.g. Apprenticeships 44% dropout rate
* Time lag
What is fiscal drag
· This is where tax bands do not rise in line with inflation. Inflation and earnings growth may push more taxpayers into higher tax brackets. Therefore fiscal drag has the effect of raising government tax revenue without explicitly raising tax rates.
good example of an automatic stabiliser.
What is the Gordon Brown’s Golden Rule of borrowing and spending
Borrowing should only be used to finance expenditure on infrastructure which will benefit the UK in the longer term, and is not to be used to finance current spending/debt, as taxes should cover current spending.
What are the implications of Gordon Brrown’s golden rule of borrowing and spending
· The government needs to gain better control of the budgets.
· In the longer term, the increase in economic activity gained by the infrastructure investment should pay off the extra borrowing.
· The chancellor Gordon Brown also has a sustainable investment rule. This states national debt should always be less than 40% of GDP.
What is the Growth and Stability Pact in the EU
· Prudent fiscal policy rules to ensure stability
· Total Government debt must not be more than 60% of gross domestic product;
The Government deficit must not be more than 3% of GDP except in particular circumstances.
What is the Laffer Curve
The Laffer Curve states that if tax rates are increased above a certain level, then tax revenues can actually fall because higher tax rates discourage people from working.
Equally, the Laffer Curve states that cutting taxes could, in theory, lead to higher tax revenues.
Equally increasing tax rates could yield lower tax revenue due to decreased economic activity, incentives to evade and avoid, brain drain effect
Explain this diagram
Fiscal policy is cumbersome and can overshoot targets.
If the negative output gap is less than expected and or the multiplier stronger than expected a negative output gap could turn positive leading to inflationary expectations.
Monetarists believe that expansionary FP is essentially inflationary.
Why is context so key to fiscal policy
· A key issue of expansionary fiscal policy is the state of the economy. If expansionary fiscal policy is pursued when the economy is close to full capacity (e.g. AD3 to AD4), then the increased government borrowing is likely to cause crowding out and/or contribute to higher inflation – but little increase in real GDP.
In a deep recession, with spare capacity in the economy, expansionary fiscal policy won’t cause crowding out or inflation. (AD1 to AD2 causes real GDP to rise from Y1 to Y2.)
What is a balanced budget fiscal multiplier
attempt to increase aggregate demand through changing spending and taxation levels, whilst leaving the overall fiscal budget situation the same.
if you increase spending and taxes equally, the increased government spending has a bigger positive impact on economic growth than the negative impact of higher taxes.
How does Quantative easing affect different parts of society
Regressive:
QE does benefit members of society who already own shares and property
Younger people found it harder to buy their first homes and build up savings
QE driving up bond prices cab also make it much harder to provide pension schemes and bond prices are used to estimate the cost to provide pensions in the future
How has the BOfE used QE in the coronavirus pandemic
Coronavrius pandemic £895 bn in QE
Bank became first central bank among the G7 to begin selling bonds ; ‘quantitive tighetening ) 2nd Nov 2022
Unwinding of QE will make it more expensive for gov. to borrow
Bonds are being sold for less than what the Bank paid so it is making a loss which will be paid by the Treasury
What are supply side policies
government policies aimed at increasing the productive potential of the economy and moving the supply curve to the right
What are market and interventionist based supply-side policy
** Market based policies** are policies which are designed to remove anything that prevents the free market system working efficiently
Interventionist policies are policies designed to correct market failure
What are the benefits of supply-side policies
- Lower inflation.
-
Lower unemployment; help reduce structural,
frictional and real wage unemployment. - Improved economic growth.
- Improved trade and balance of payments. By making firms more
competitive, they will be able to export more.
What are some market orientated supply side policy
- Privatisation
- Deregulation
- Reducing taxes - income + coporation
- Reducing state welfare payments
- Reduced bureaucracy for firms - red tape
- Labour market reforms
What is the benefits of privatisation
- Improved efficiency
- Lack of political interference
- No Short term view
- Pressure from Shareholders
- Increased competition - royal mail compete w others
- Government will raise revenue from the sale
What are the costs of privatisation
- Natural monopoly - since privatisation water bills risen by 40%
- Public service - promit motive shouldn’t be primary obj.
- Government loses out on potential dividends.
- Problem of regulating private monopolies.
- Fragmentation of industries; lead to fragmentation of raiil industry and the Hatfield rail crash for no one taking responsibility of safety
- Short-termism of firms
Evaluate Privatisation
- It depends on the industry in question.
- It depends on the quality of regulation.
- Is the market contestable and competitive?
- Can you create incentives in a nationalised firm? For example, performance-related pay could replace the profit incentive.
What has been the net effect of UK privatisation according to a Florio study in 2002
“Privatisation has had no noticeable effects in terms of trends in productivity, employment and price levels… Our overall result…..[is]… that taxpayers suffered a loss of £14bn’
This was transfered to shareholders, making it regressive
What is deregulation
This involves reducing barriers to entry in order to make the market more competitive. Greater competition creates incentives to reduce prices and costs.
For example, UK telecoms markets are now more
competitive and this has helped reduce prices and increase efficiency.
What are the benefits of deregulation
- Increased competition –> lower costs and prices for consumers.
e.g. aeroplanes and telecoms - Government regulation often involves excessive costs of bureaucracy.
- Deregulation allows consumers greater choices
What are the costs of deregulation
- Natural monopoly –> no comp.
e.g. local bus industries don’t need comp. - Also, new private firms will seek to cherry-pick the most profitable routes and times and leave out the unprofitable off-peak services.
- Deregulation could lead to a compromise of public services with a** poorer quality of provision**. Private firms have an incentive to cut costs and provide a lower quality of service.
e.g. due to deregulation In the UK railway industry, the government had to take over a failing private firm on a number of occasions.
Evaluate the effects of a fall in the income/coporation tax
low income individuals and families are given the ‘stick’ to improve their incentives (via cuts in welfare benefits), the better-off are given the ‘carrot’ in the form of tax cuts.
· A number of studies have shown that cutting income tax does not make people work harder and longer; it has been found that lower taxes may encourage some employees to take more leisure time as they can now gain the same disposable income by working fewer hours
ScienceDirect: Lower coporation taxes have 0 effect on growth
What is the deregulation of labour markets/ making it more flexible
Labour markets can be deregulated through policies such as
- Make it easier to hire and fire workers. Abolish redundancy pay or right of appeal
- Reduce maximum working weeks and minimum holiday pay.
- Enable zero-hour contracts which allow firms to employ workers when demand is greater.
- ** Union Busting**
- Encourage immigration
What are the advantages of a deregulated labour market - a flexible labour market
- Firms will be more efficient and competitive
- Increased trade from lower labour costs
- Greater choice.
- Increased labour market participation rates; among females esp.
- May encourage inward investment from TNC’s (Kafala System)
- Lower rates of structural unemployment.
- Stabilises economic cycle.
What are the disadvantages of a deregulated labour market - a flexible labour market
- Lack of training. –> low prod. (prod puzzle)
- greater job insecurity –> lower morale and lower productivity for the firm in the long-run
- Rising inequality; created a bigger gap between those ‘insiders’ with secure job contracts, and those ‘outsiders’ without job contracts.
- Higher search costs for workers needing to find new jobs. Also, firms may have higher replacement costs for hiring more workers. Firms may end up paying a premium to employment agencies to help fill gaps in their workforce.
How has labour market flexibility increased in the UK since 1979
- Fall in Trade Union Membership
(33%–>25%) - Growth in Zero Hour Contracts
(2004: 100,000 —> 1.03 million 2022)
In recent decades the UK labour market has been characterised by
- Unexpectedly low unemployment. Unemployment has fallen faster – despite relatively weak economic recovery
- Poor productivity growth – Workers keener to employ workers but pay lower wage and less investment
- Low real wage growth.
- Increased inequality.
What are examples of interventionist supply side policies
- Increased education and training –> prod.
- Providing better information about avaliable jobs
- Improved transport and infastructure –> lower costs for firms
- More affordable homes
- Improved healthcare
What are the benefits of increased education and training
· An increase in MRP (marginal revenue product) of workers –>absorb inflationary pressures + more competitive
· A decrease in occupational immobility. –> lower UE
Evaluate the effects of increased education and training
- Time Lag; not an immediate fix for any macro issues
- Depends on money spent and direction, quality of TE
What are the effects of improving transport and infastructure
Transport has market failure of congestion and pollution. Gov spending can help reduce these
Improved transport –> reduces cost of transport –> encourage firms to invest
Transport bottlenecks on road, rail and air are often cited as a major stumbling block for the UK economy
EVALUATION@ UK is crowded so hard to increase transport capacity
What are the effects of building more affordable homes
Building affordable council homes in expensive areas can make it easier for workers to move and find jobs in expensive areas reducing geographical immobility.
Firms can suffer from labour shortages in areas that have become very expensive to live in
What are the effects of improved healthcare
Business can face substantial costs from time lost to ill health.
Improving nations health –> improve labour productivity
Taxes on cigarettes, alcohol and sugar can reduce health care costs associated with drunkenness, obesity and polluted environments
What are the general limitations of supply-side policy
- Productivity growth depends largely on private enterprise and trends in technological innovation
- Market Based: equity
- Can be counterproductive
e.g. Since 2009, UK has seen a fall in structural unemployment due to more flexible labour markets- but productivity is almost stagnant - In a recession, supply side policies cannot tackle the fundamental problem which is lack of aggregate demand
- Time. All supply side policies take a long time to have an effect e,g, education spending may not influence the economy for 20-30 years
- Expensive –> large opportunity cost
- Government failure due to assymetric information
What is the conflict between economic growth and protection of the enviroment
As the economy grows, we expect more resources to be used and we produce pollution and noise and destroy habitats.
e.g. Brazil’s president cut down rainforest to create prosperity.
In crises, becomes less important e.g. covid and plastics
Evaluate the policy conflict between economic growth and the enviroment
However in the long run economic growth may be a solution as it helps to drive the funding of technology to fix the problem which could mean a solution.
Schumpeter says creative destruction. Huge profit motive, individuals become more aware and consumers become more friendly
**2022 green energy investment at record levels of $1.1 trillion **
What is the policy conflict between economic growth vs Balance of Payments equilibrium
- Economic growth leads to larger income and thus larger demand for YED +ve imports, ceteris paribus, which increases the current account deficit
Therefore the UK might become dependent on foreign direct investment
- Conversely a government may feel it needs to reduce the budget deficit. This will require higher taxes and lower spending. However, this tightening of fiscal policy will lead to a fall in AD and lead to lower economic growth.
Evaluate the policy conflict between economic growth and BOP equilibrium
If policies to reduce a budget deficit lead to unemployment and lower growth, the government will need to pay more on benefits and will get lower tax receipts. Therefore the deficit may experience only a small reduction.
e.g. Eurozone dillema
However, it depends on how you reduce a budget deficit. For example, if you raised the retirement age and made it more difficult to get welfare benefits, then you can reduce government spending, but there is little negative impact on economic growth (in fact, people have to work longer, increasing LRAS)
What is the policy conflict between inflation and unemployment
Phillips found the existence of an empirical regularity, which said that the rate of change in money wages increased as the rate of unemployment fell. This was then generalised into a relationship
between unemployment and inflation
e.g. Lawson Boom, 1989 2.3% GDP Growth, 7.8% inflation
Evaluate the policy of inflation and unemployment
However, during the 1970s , we saw high levels of unemployment
and low inflation, called stagflation; short-run relationship not right
The Great Moderation 1993-2007, had a long period of economic expansion (36 consecutive quarters)
Relationship has returned to the long-run position
What is the policy conflict between economic growth vs inequality
- Economic growth leads to rising incomes and asset prices.
Positive wealth effect
This increases the Gini coefficient (mathematical measure of the Lorenz Curve).
- High income earns you savings in wealth which can earn you income in an interest rate
- Property; buying house increases wealth, renting increases income and wealth increases from inflation allowing you to buy another house
Evaluate the policy conflict between inequality and economic growth
- However, trickle-down theory where the investment and the consumption of the rich trickles down through society to redistribute income and wealth.
- Relies on high income earners to invest more of their wealth.
- If progressive taxation is too high it may actually cause a flat in tax revenues as there is an disincentive to earn
Evaluate the trickle-down effect with ref. to the 1980s tax cuts
IMF studies: ‘increasing the income share of poor + middle class, while a rising income share of the top 20% results in lower growth’
1980: US did tax cuts top1% have 8% share of total –> 2022 20% share
LSE: ‘1980s tax cuts for the rich have just increased income inequality’
What is the monetarist view of the Phillips curve
argue that in the long run there is no trade-off as Long Run AS is inelastic.
Monetarists argue that if there is an increase in aggregate demand, then workers demand higher nominal wages. When they receive higher nominal wages, they work longer hours because they feel real wages have increased.
but when they realise real wages are the same as last year, they change their price expectations, and no longer supply extra labour and the real output returns to its original level.
Therefore, unemployment remains unchanged, but we have a higher inflation rate. The short-run Phillips curve shifts upwards to SRPC 2
What do monetarists say about the causes of unemployment
Monetarists argue that unemployment is determined by the natural rate of unemployment
so it is a supply-side phenomenon
What do keynsians argue about unemployment
Keynesians argue there can be demand deficient unemployment, and during a recession, demand-side policies can reduce unemployment in the long term
