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Macro for business > Topic 4: Inflation, Unemployment & Economic Policy: Inflation > Flashcards

Topic 4: Inflation, Unemployment & Economic Policy: Inflation Flashcards

1
Q

What is inflation?

A

Inflation is a rise in the price level; deflation refers to a fall

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2
Q

What is the price level?

A

The average change in the price of goods and services in the economy

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3
Q

How do governements measure the rate of inflation? and example from UK

A

Price indices e.g. The Office for National Statistics (ONS) publishes a ‘consumer price index’ (CPI)

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4
Q

Explain the Consumer Price Index?

A

. Basket’ of 500-700 goods & services constructed for the ‘average household’ – but excludes housing costs

. Prices are used to calculate an ‘index’ - from this price inflation can be calculated every month & annually
. Items within basket change over time such as Smart Phone apps added and Sat Navs removed

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5
Q

How has the CPI changed for 2018?

A

CPIH =
CPI + housing costs (H)

Housing costs include council tax rates & rents paid in the private sector

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6
Q

What are the steps in creating the CPI?

A

Step 1: survey consumers to determine an average basket of goods
Step 2: find the price of each good in each year
Step 3: calculate the cost of the basket of goods in every year
Step 4: choose a base year & calculate consumer price index taking price changes while keeping quantity the same
Step 5: use the consumer prices index to compute the inflation rate as a percentage change

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7
Q

How is the inflation rate calcuated in the CPI?

A

((Index in current year - Index in previous year)/Index in previous year ) X 100

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8
Q

Who uses inflation measures?

A

. Bank of England: Since 1997 the Bank of England has been given a remit to meet a CPI target of 2% (± 1%) per annum-maintained by controlling the money supply

. Wage negotiations: employees interested in real wages & want to maintain their standard of living

. Business contracts, e.g. a construction contract to complete a project over a two-year horizon-to determine correct pricing of projects

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9
Q

Why is the government target for inflation at 2%?

A

To keep inflation low and stable, helping everyone plan for the future.

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10
Q

What are the main costs of inflation?

A

. Reduces real income – true since 2008!
. Menu Costs
. Uncertainty

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11
Q

Explain how inflation reduces real income

A

if you earn £25,000 per annum, then with 4% annual price inflation (& without a wage increase) your real income falls by £1,000 in one year

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12
Q

Explain Menu costs of inflation?

A

The costs of changing prices you advertise to customers uses up resources, e.g. re-tagging items, implementing new pricing strategies
. When firms incur more costs it is usually passed to consumers =more inflation

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13
Q

Explain the uncertainty costs of inflation

A

. Bank of England & European Central Bank (ECB) see it as the most important cost of inflation
. Higher inflation tends to be more volatile → future inflation rate is uncertain

. Firms find planning more difficult under inflation because they do not know by much costs increase in the future → investment & employment fall which reduces national income

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14
Q

Why is deflation bad?

A

. Bad for those with debt
. Consumers delay consumption
. May indicate very weak demand in the economy

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15
Q

Explain why deflation is bad for those with debt?

A

. Real value of debt increases → bad news for governments with large debts & weak tax revenue
e.g. A debt of £1,000 with -4% price becomes a real debt of £1040 with annual price inflation

. Lenders worry that governments cannot pay interest back on what they have already borrowed – increasing the cost of borrowing for government for future lending

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16
Q

Explain why deflation causes consumers to delay consumption?

A

Because they anticipate prices to fall → demand falls → prices fall further

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17
Q

Explain why delation potentially signalling weak demand in the economy is bad

A

Business will pessimistic about the future & postpone expansion plans

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18
Q

What does the aggregate demand curve show? and the slope

A

Shows by how much national output (GDP) will be demanded at each level of prices.
Negative relationship between AD and price levels

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19
Q

Why does the AD curve slope downwards?

A

. International substitution effect: consumers switch from domestic goods to imported goods (M above) for a price rise

. Real balance effect: household real savings falls in value, so save more & consume less (C above) for a price rise

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20
Q

What does the Aggregate Supply curve show? and slope

A

It shows the amount of goods & services that firms are willing to supply at any price level
A positive relationship between AS and price level

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21
Q

Why does the AS supply curve slope upwards?

A

. short-run: nominal wages are constant

.AS curve slopes upwards because firms find it profitable to expand output when the real wage falls (nominal wages not fully adjusted by the price level)

. firms also increase output because it is profitable to do so compared to their marginal costs (MC)

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22
Q

What is an example of a deflationary period?

A

Credit crunch led to a demand-led deflationary period

23
Q

What is demand-pull inflation?

A

Occurs when a rise in AD leads to an increase in overall prices and shifts the AD curve to the right

24
Q

What are some examples of demand-pull inflation?

A

. Reduction in income taxes → increases disposable income

. Increased government spending & improvements in consumer & company confidence

. Reduction in interest rates: increased lending by banks to households & companies

25
Q

What is cost-push inflation?

A

When a reduction in supply leads to an increase in overall prices due to rising costs causing AS curve to shift to the left.

26
Q

What are some examples of causes of cost-push inflation?

A

. Higher wages: trade unions negotiate real rises in wages

. Depreciation of the exchange rate, e.g. from £1=$2 to £1=$1 increases the cost of imported goods

. The weather, e.g. food costs rise due to a poor growing conditions or floods destroy equipment

27
Q

What is the BoE Monetary Policy in terms of inflation?

A

. Bank of England’s Monetary Policy Committee (MPC) will set interest rates every month to meet a 2% CPI inflation target

. The official bank rate is the main policy tool to meet this objective & is set by a committee of nine members

  • Governor of the Bank of England, Mark Carney, plus four others from the Bank of England
  • four external appointments from business & academia
28
Q

How does inflation targeting help firms and consumers?

A

. Price transparancy-helps consumers choose best products easier
. Drives competition between firms lowering prices
. Stable expectations of the economy improves business and consumer confidence

29
Q

What are the disadvantages of inflation targeting?

A

. Needs to be semi-flexible in case of a cost-push inflation would require interest rates to rise and GDP to fall further but with future restoration to the inflation target in mind

30
Q

How does the BoE accommodate for future inflation?

A

Bank of England’s monthly Inflation Report, November 2018 (published every 3 months) outlines its prediction of future inflation
. e.g. fan chart of the different possibilities or inflation levels till 2021

31
Q

What is the unemployment rate?

A

Unemployment rate is the percentage (%) of the economically active over the age of 16 who are available & looking for work (4 weeks) but not currently employed

32
Q

How is it measured in the UK?

A
  • Unemployment is measured by a survey – an internationally recognized measure
  • UK: Office of National Statistics (ONS), Labour Force Survey
33
Q

Who is excluded from being economically active? and criteria of employment ?

A
  • Employment defined as working one or more hours per week

* Unemployment level: corresponding number of unemployed

34
Q

What is the unemployment level?

A

Corresponding number of unemployed

35
Q

How has unemployment rate changed 1970-2018 in the UK

A
  • Low 70s
  • Fell to 70s level before 2008
  • Increased after 2008
  • now dropped off again after 10 years recovery
36
Q

Explain the AD for labour and slope

A
  • Aggregate demand for labour, ADL: the number of workers firms wish to employ at the given the wage rate
  • Why downward sloping? Labour costs fall as the real wage falls, so firms hire more workers → profitable to expand output & increase number of workers employed
37
Q

Explain the AS of labour and slope?

A
  • ASL: the number of workers willing to work at the given wage rate
  • upward sloping as opportunity cost of being inactive increases with the real wage
38
Q

What is the definition of classical unemployment?

A

Refers to when workers have priced themselves out of a job.

39
Q

Explain classical unemployment

A

• follows the ‘classical’ approach to economics which argued that markets are always in equilibrium with demand = supply

  • unemployment implies aggregate supply of labour > aggregate demand
  • Source: trade unions & minimum wage legislation push up real wages above equilibrium
40
Q

What is the solution to classical unemployment?

A

• ‘flexibility’ of wage settlements, e.g. fewer public sector workers (traditionally nationally agreed wage levels), non-unionized workforce or limiting strike action over pay

41
Q

What is the definition of Cyclical (Keynesian) unemployment?

A

• When workers lose their jobs because of downturns in the business cycle

42
Q

Explain cyclical unemployment

A

Keynes ) argued real wages are ‘sticky’ (i.e. not flexible) to move downwards during a downturn in the economy (e.g. in 2008):

  • efficiency wages: employers pay above equilibrium wages to keep workers motivated
  • wage contracts maintain real wage level

• a reduction in aggregate demand reduces the demand for labour by firms but real wages do not fall so firms let go of workers

43
Q

What is the solution to cyclical unemployment?

A

• increase demand for labour, e.g. increase government spending through fiscal policy

BUT not as bad as classical unemployment as once economy recovers unemployment expected to fall again

44
Q

Why are people not necessarily better off despite record-low unemployment?

A

Inflation above wage growth so real wages fall= lower standard of living

45
Q

What types of unemployment are there?

A
  • Classical
  • Cyclical
  • Frictional
  • Structural
46
Q

What is frictional unemployment?

A

• When a worker has quit a job and seeking a new one. Only temporary.

47
Q

What is structural unemployment?

A

Reflects a dynamic, changing economy where an industry moves into decline and those workers struggle to find new jobs that require different skill set.

48
Q

What can cause structural unemployment?

A
  • pattern of demand changes, e.g. away from fossil fuels (e.g. coal) towards renewable energy supplies → regional & sectoral unemployment e.g. mining towns
  • global competition, e.g. growth of Chinese exports in clothing & steel (effect on UK steel), growth of UK exports in financial services & cars
49
Q

What is the solution to structural unemployment?

A
  • tax incentives for companies to invest in worker training
    • housing policies: affordable housing by encouraging house building e.g. relocation of mining town to find new employment
    • improve information about job vacancies
50
Q

What does the Phillips curve show?

A

Indicates a trade-off between inflation & unemployment where lower unemployment has to be traded for higher inflation and vice versa.

51
Q

What does the Phillips curve look like in the Long run?

A
  • Phillips curve is vertical in the long-run → there is no trade-off between inflation & unemployment
  • Price expectations are represented by a series of short-run Phillips curves for different rates of price inflation
52
Q

Explain the Long-run Phillips curve

A

• workers predict the impact on inflation resulting from fiscal policy & adjust their price expectations accordingly

  • workers do not suffer from ‘money or price illusion’, the confusion between nominal & real wages
  • Long run GDP is fixed at max/potential GDP
  • Still some unemployment-mostly frictional
53
Q

Explain the process of unemployment readjusting to the long run Phillips curve

A
  • Unemployment falls with inflation
  • Workers negotiate higher nominal wage increase
  • Firms reduce employment back to natural rate of unemployment

Macro for business (6 decks)

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