Unit 2.1 Flashcards
Macroeconomics
looks at whole economies or groups of economies such as the EU or the eurozone. Sometimes macroeconomics will look at the whole world ( global economy)
Economy
The state of a country/region in terms of the production and consumption of goods and services. The state of an economy is measured by GDP
GDP
Gross Domestic Product measures the total value of natural output of goods and services produced in a given time period. It estimates the size of and growth in the economy.
How is GDP calculated- Expenditure
-Consumption (C)
-Government Spending (G)
-Investment Spending (I)
-Changes in value of stocks
-Exports (X)
-(minus) Imports (M)
=GDP (aka Aggregate Demand)
AD=C+I+G+X-M
How is GDP calculated- Factor Incomes
- Income from wages and salaries
-Profits of private and public sector businesses
-Rental income from the ownership of land
(NOTE: Transfer payments such as welfare benefits are excluded from GDP)
How is GDP calculated- Value of output
-Value added from each of the main sectors.
These are:
-Primary (e.g. farming, forestry and mining)
-Construction
-Manufacturing
-Tertiary (e.g. tourism and healthcare)
- Quaternary ( e.g. Business Consultancy)
Manufacturing
Manufacturing is the business of producing tangible goods in factories such as new vehicles or smart phones. In March 2023, the manufacturing sector accounted for 95% of total uk economic output. It accounted for 8% of employment in the same period.
EXAMPLES OF SERVICE INDUSTRIES
- Services are part of the tertiary sector
- Examples include services such as accountancy, health and social care, hospitality, education, and tourism.
- Service industries accounted for 80% of total UK economic output
(Gross Value Added) and 82% of employment in 2022 - Many manufacturing jobs depend on the demand for and output in service industries - for example, factories that make coffee machines, train services that require manufacturing of new carriages, signalling and track.
EXAMPLES OF MANUFACTURING INDUSTRIES
Automotive: The UK has a significant automotive industry, with major car manufacturers such as Jaguar Land Rover, Mini, and Rolls-Royce
* Aerospace: The UK is home to major aerospace companies, including Airbus, BAE Systems, and Rolls-Royce.
* Chemical and pharmaceuticals: The UK has a large chemical industry, producing a range of products including plastics, paints, and detergents. The country is also home to major pharmaceutical companies, such as AstraZeneca and GlaxoSmithKline.
* Food and drink: The UK have a diverse food and drink industry, producing a range of products including beer, whisky, chocolate, and processed foods. A large percentage of food and drink production is exported.
Gross Value By sector UK
In the UK in 2022, Real Estate had a £270,093 Million Gross Value giving it the largest value along with Wholesale and Retail which had a £238,068 Million Gross Value
What economic information is used to measure the level of and changes in average living standards within an economy?
-Baseline indicator is real national income per capita (GDP or GNI)
-This is real GDP divided by the population = Income per head
-Real means that the income data has been adjusted for the effects of price inflation
-PPP – a purchasing power parity adjustment is made when comparing and contrasting standards of living across countries.
GDP per capita
Measures the average economic output per person in a country. It’s a useful metric for understanding the average standard of living or income level within a given nation. Per capita GDP provides a way to compare the economic performance of different countries while considering their population sizes. Per Capita GDP = Total GDP / Population.
GNI
Gross national income is an alternative to GDP as a measure of wealth. It calculates income instead of output.
GNI= GDP+ Net primary income+ Net secondary income
Qatar has high GNI
Net Primary income
This includes wages, salaries and other income earned by a country’s residents working abroad, as well as earnings from foreign investments such as dividends and interest.
Net secondary income
Refers to transfer of money between countries, such as remittances from foreign workers to their families in their home countries or international aid. Usually negative as leaving country
Countries with GNI higher than their GDP
-Countries with High Remittances e.g. Mexico, Guatemala
-Countries with Foreign Aid e.g. Gambia, South Sudan
-Countries with Expatriate communities
PPF in macro economics
A macro PPF is likely to be labelled consumer goods and capital goods, or goods and services.
Purchasing Power Parity
Purchasing power parity (PPP) is the idea that items should cost the same in different countries, based on the exchange rate at that time. PPP measures how many units of one country’s currency are needed to buy the same basket of goods and services as can be bought with a given amount of another currency.
In countries where the relative cost of living is high such as Norway and Switzerland, there will be a downward adjustment to a nation’s PPP-adjusted GNI per capita.
In nations where the relative cost of living is low such as India, the real purchasing power of $1,000 will be higher and this leads to these countries seeing their PPP-adjusted GNI per capita incomes rising in global league tables.
Big Mac Index
The Big Mac Index measures each currency against a common standard – the hamburger sold by McDonald’s all over the world - manufactured in a standardized size, composition and quality.
PPP is calculated by comparing the price of a basket of comparable goods and services in different countries
By converting the average national Big Mac prices to United States dollars, the same goods can be compared.
This can tell us something about whether a currency is under or overvalued in foreign exchange markets.
BigMac Index January 2023:
Switzerland- Over 7 dollars
Venezuela- Under 2 dollars
What is real national output (real GDP)
Real GDP stands for Real Gross Domestic Product.
It’s called “real” because it considers inflation, which can distort the value of goods and services produced in an economy over time.
Real GDP is adjusted for changes in prices, providing a more accurate measure of an economy’s actual growth.
Real GDP is usually expressed “at constant prices”
What is nominal (money) national output?
Nominal GDP measures the total value of all goods and services produced within a country’s borders during a specific time period, but it doesn’t account for the changes in prices that may occur during that time.
Nominal (or money) GDP is expressed at current prices.
Nominal GDP in a given time period = Quantity of Goods and Services Produced × Current Prices
Converting money GDP into real GDP
In one year, an economy had a nominal GDP of £12 billion
During that year, inflation was 6%.
Calculate the value of real GDP compared to the previous year:
Real value in current year = (Nominal value in current year / price index in current year) * 100
Real value in current year = (£12bn / 106) x 100
Real value in current year = £11.32 billion (at constant prices)
Improving standard of living
-Improving human capital
-Getting more people into properly-paid work
-A living wage can help to lift labour productivity
-Accessible and high-quality public services
-Better / affordable housing to rent & buy
-Wealth generated from successful businesses
MOVING BEYOND INCOME PER HEAD
Income per head is a guide to living standards but many economists argue that we should move beyond it as a simple indicator:
Look at disposable income rather than gross income (not least because the burden of taxes varies between nations)
Focusing on income per head can ignore deep-rooted inequality
Median disposable income might be a better measure of living standards for people in the middle of the income distribution
Income per capita is not always a reliable guide to well-being
WHAT IS DISPOSABLE INCOME?
Disposable income is the amount of money households have available for spending and saving after direct taxes such as income tax and national insurance contributions have been accounted for.
It includes earnings from employment, private pensions and investments as well as cash benefits provided by the state.
Mean disposable income in UK in 2019 was £39,328
Median disponible income in UK in 2022 was £32,349
LIMITATIONS OF DATA ON INCOME PER HEAD
Changes in the distribution of income (known as relative poverty)
Official data on incomes can be inaccurate – existence of shadow economy where income is earned but not registered for taxation
Regional and local variations in per capita income + rural/urban gaps
Changes in length of working hours and job conditions & security
Problems in accurately measuring a nation’s GDP and price inflation – makes it harder to assess real incomes
WHY IS GDP A FLAWED GUIDE TO LIVING STANDARDS?
Ignores the distribution of income and wealth
Need to consider changing working hours / work-life balance
Does not include the value of non-marketed output and unpaid work such as family care and voluntary activities
Rising real GDP may not be sustainable – risk of lost natural capital
Defensive spending such as cleaning up the effect of pollution & waste and crime prevention add to GDP but hurt welfare (reactive instead of proactive)
May not capture value of free services including digital economy
What is economic well-being ?
Economic well-being refers to the overall quality of life and material prosperity enjoyed by individuals and households.
It encompasses various aspects, including income, consumption, access to basic needs and services, wealth accumulation, job security, social safety nets, and overall life satisfaction.
Measuring economic well-being is crucial for understanding how individuals are faring within the broader economic context and for evaluating the effectiveness of economic policies.
Economic growth
The sustained growth of real GDP over time
Contributes to rising average living standards (GNI per capita)
Long-run increase in a country’s productive capacity
Economic welfare
A broader measure of well-being (social and economic)
Many aspects of well-being are not material aspects of our daily lives
Wellbeing measure might include the level of inequality + median incomes
Economic growth vs welfare
Economic growth- The sustained growth of real GDP over time
Contributes to rising average living standards (GNI per capita)
Long run increase in a country’s productive capacity
Economic welfare - A broader measure of well-being (social and economic)
Many aspects of well-being are not material aspects of our daily lives
Wellbeing measure might include the level of inequality + median incomes
HOW MIGHT WELL-BEING BE MEASURED?
Median Household Income and Real Income Growth:
Income Inequality: Gini coefficient or other measures of income distribution
Wealth and Assets: Including financial assets, property, and investments
Percentage living below a defined poverty line, often based on income thresholds.
Underemployment and job security
Healthy Life Expectancy
Education: Literacy rates, school enrollment, and attainment levels.
Surveys that ask individuals about their overall happiness and satisfaction with their lives.
Inter-Generational Mobility: The extent to which children’s economic outcomes (such as income or education) are related to those of their parents.
Air and Water Quality: Measures of pollution and cleanliness that impact well-being.
WHAT IS SUBJECTIVE HAPPINESS?
Subjective happiness refers to self-reported levels of happiness with one’s life, usually determined using questionnaires.
Measuring subjective happiness usually involves considering emotions, rather than asking about material well- being
Factors that tend to affect your happiness include: your personality and genetics, social influences (including a network of close friends), income and wealth (to a smaller degree than you might expect), health, and ability to enjoy leisure time.
WHAT IS THE EASTERLIN PARADOX?
The Easterlin Paradox concerns whether we are happier and more contented as our real living standards improve
Within a society, richer people tend to be happier than poor people.
Richard Easterlin argued that life satisfaction does rise with average incomes but only up to a point.
Beyond that the marginal gain in happiness declines (there are diminishing returns)
One of his conclusions was that someone’s relative income can weigh heavily on people’s minds.
Several papers have contested the findings of the Easterlin Paradox
Well being budget
The New Zealand government announced the world’s first well-being budget in 2019. Their fiscal budget is now based on wellbeing priorities such as improving mental health, addressing child poverty and sexual violence and improving access to affordable housing.
THE HAPPY PLANET INDEX
The Happy Planet Index measures life expectancy, experienced well-being, inequality of outcomes, and ecological footprint in order to determine the countries that can deliver the longest and happiest, but also most sustainable lives to their residents.
The Index works to measure efficiency by ranking countries relative to how they offer their people long and happy lives, for each unit of environmental output.
Most sustainable countries, Happy Planet Index for 2021- Costa Rica- 62.1
Least sustainable countries, Happy Planet Index for 2021- Qatar- 24.3
Under employment
Refers to a situation where an individual is working but the job does not fully utilise their skills or ability, and/or does not provide sufficient hours or pay to meet their needs. Under employment can occur for a variety of reasons and can take many forms such as:
-Looking for an extra job or actively searching for a new job with longer hours to replace their current (main) job
-They prefer to work longer hours in their present job
-Under-employment also means that workers are under-utilized in terms of their ability, formal qualifications and experience.
Under-employment can be rising even though unemployment is declining.
The existence of under-employment tends to make the official unemployment figure look better than it truly is.
Cyclical unemployment
When unemployment rate rises during an economic downturn and falls during a recovery. It’s caused by fluctuation in the business cycle. Involuntary unemployment due to lack of aggregate demand for goods and services. Also known as Keynesian unemployment or demand-deficient unemployment.
Causes of cyclical unemployment
When an economy is booming, demand for goods and services increases leading to more hiring. The employment rate rises as real GDP expands.
When economy slows and goes into a recession, demand decreases and companies lay off workers
Keynesian economic places lots of emphasis on the role of aggregate demand in influencing unemployment. Keynes argued during economic downturns, aggregate demand increases and firms reduce their production and lay off workers. This can lead to a negative multiplier effect.
Structural unemployment
Caused by changes in the economy, like the decline of certain industries or rise of automation. Happens when there is a mismatch between skills of workers and needs of employers. Often people stay unemployed because of disincentive effects from the tax and welfare system also because of disincentive effects including the unemployment trap . Often happens because of other barriers to people finding work such as unaffordable housing, high cost of childcare and expensive transport services. Links closely to the concept of occupational immobility of labour.
Causes of Structural unemployment
New jobs often require new skills – cost of training
Unaffordable housing ( both to buy and rent)
Employer discrimination against some groups
Erosion of skills from long-term unemployment
Impact of automation on certain occupations
Effect of welfare system on work incentives
Frictional Unemployment
Short-term unemployment caused by people transitioning between jobs, moving to a new location or re entering the workforce after a break. Can be reduced by making information in jobs more available and making job search more affordable via cheaper transport or subsides. Always a level of frictional unemployment in labour market, helps provide pool of labour for employers .
Causes of Frictional Unemployment
School and college leavers entering labour market
People searching for work following a career change
Early retired, coming back to the labour market
Mothers returning to active job search
Incomplete information could hamper job search
People on short-term contracts
Effects of unemployment
Loss of income – declining, living standards, decline in spending power
Loss of national output – workers can’t contribute to economy, working within PPF
Decrease in consumer spending – loss of disposable income
Reduce tax revenue – less paying a more receiving benefit
Increased government spending in social welfare programs
Reduced investment, firms less confident in economy so less likely to invest in projects
Increase relative poverty – unable to meet basic needs so require government support
Balance of payments
Summarises all transactions between residents of a nation and non-residence during a period. Includes value of trade flows investment incomes and other financial transactions across national borders.
There are three parts of balance payments:
The current account (Records payments for trade in goods and services plus net flows of primary and secondary income)
Capital account
Financial account
Unemployment
To be counted as unemployed, someone must be of working age, willing and able to work and actively seeking work but cannot find a job.
Ways of measuring unemployment
Labour Force Survey- This survey asks households to self-classify as being employed, unemployed (using the International Labour Organisation definition) ( someone who is out of work, but is willing and able to work .can start a job in the next two weeks) or economically inactive. Survey carried out quarterly, 44,000 households surveyed
It provides a broader and more comprehensive picture of unemployment, including those not eligible for benefits.
Claimant Count-
The claimant count is a measure of unemployment based on the number of people who are claiming unemployment-related benefits, this counts the total number of recipients of Job Seeker’s Allowance (JSA) added to those looking for work to claim Universal Credit (UC).
It provides a narrow definition of unemployment, as it only includes those actively seeking and receiving government benefits
National Rate of unemployment can hide:
-Regional variations
-Local variations
-Variations in unemployment by age, gender, ethnicity and other social backgrounds.
-It doesn’t tell us about how long people have been out of work (duration of joblessness)
Long term unemployment
Long-term unemployment refers to people who have been unemployed for 12 months or more.
The longer someone is unemployed, often the harder they find it to get another paid job as The longer someone is without a job, the harder it is for them to find their way back into paid employment.
One reason is that people’s skills worsen due to economic inactivity. Motivation to search for a job suffers the longer someone is out of work.
Employers often favour people with a consistent record of being in work rather than those who have gaps in their CV.
This is a structural supply-side problem in the UK labour market.
Mass Unemployment
Mass unemployment exists when officially one person in ten in the labour force is out of work.
In practice, the true level of unemployment might be significantly higher than this.
Youth Unemployment
This is the measured unemployment rate (the proportion of the economically active population who are unemployed) for all 16–24-year-olds
Why is youth unemployment relatively high
-Lack of experience: Young people may have fewer work experiences making it harder for them to find jobs. (They have weaker human capital)
-Lack of education or training: Some young people may not have the skills or qualifications needed for the jobs available.
-Age discrimination: Employers may be less likely to hire young people, who are perceived as being less reliable or motivated than older workers.
-Economic downturns: When the economy is struggling, young people are often the first to be laid off or have their hours reduced.
-Automation and technological advancements: As technology advances, jobs are being replaced by machines, especially retail.
Discouraged workers
Discouraged workers constitute one group of inactive work-seekers. These are persons who have ceased to seek work because they believe there are no suitable available jobs. Included in hidden unemployment
Hidden unemployment
Hidden unemployment is also known as disguised unemployment. The number of people who do not have work but who are not counted in government reports, for example, people who have stopped looking for a job and people who work less than they want to.
Causes of hidden unemployment
not counted in unemployment even though, under utilised in the labour market
-Many long-term unemployed give up the active search for work and then become economically inactive
-A large cohort of people are sidelined onto disability benefits with one or more chronic illnesses- this has risen in the uk since the pandemic
- A growing number of people are non employed because they must care for elderly relatives- they may have to switch from full to part time work
- There also has been a rise in self-employment, people working on zero hour contracts and agency work as part of the Gig economy
Are unemployment figures accurate
-LFS is intended to be representative of the entire population of the UK, but there is always scope for sample error (but sample size is high)
-Unemployment is not the same as under-employment (i.e. people working part-time but who would prefer a full-time job)
-In all countries there is disguised “hidden “ unemployment with many people working in informal labour markets
-Measured unemployment excludes the economically inactive- there are often complex reasons for people not searching for work.
Gig economy
The gig economy is a work arrangement where people perform short-term, flexible, and often freelance work, typically through online platforms or apps.
Instead of having a traditional full-time job, people in the gig economy often work on a project-by-project basis, sometimes for multiple clients at once.
Some examples of gigs include rideshare drivers, freelance writers, virtual assistants, and food delivery workers.
The gig economy has grown in popularity due to the rise of technology, the desire for flexibility, and the shift away from traditional employment.
It is linked to zero hour contracts - employment arrangements where workers are hired without a guarantee of work hours.
seasonal unemployemnt
Seasonal workers might be without paid jobs due to the time of the year when there are seasonal changes in demand, production and employment season, but then let go after the holidays. e.g farming, tourism, retailing, hospitality.
Reasons for high levels of job vacancies in the UK economy
-Brexit: Brexit has made it harder to recruit workers from the EU cruising shortages of workers in sectors, such as hospitality, social care and construction
-Skills gaps and low pay: skill shortages such as in engineering and IT allied to relatively low pay in some industries causing problems of recruitment and retention.
Cyclical unemployment in a recession
Cyclical unemployment is due to a lack of demand for goods and services.
In a recession, many firms reduce employment to cut their costs – this is called “labour shedding” or “down-sizing”
In a recession, real national output contracts and this then leads to an increase in spare productive capacity. Firms then cut their workforce and cyclical unemployment rises.
Real Wage unemployment
Classical real wage unemployment is a concept that comes from the classical school of economic thought. It’s the idea that unemployment is causes by wages being too high relative to the productivity of workers. In other words, employers are unwilling to hire workers at the current wage level because they believe that workers aren’t worth that much. This can occur when labour supply exceeds labour demand, or when there is a surplus of workers in a particular industry. Classical economists believe that if real wages were allowed to adjust downward, unemployment would disappear because works would be willing to work for less.
The Unemployment Trap
The unemployment trap is a frustrating cycle that can make it difficult for people who are unemployed to find work. Being unemployed can lead to a loss of skills and experience, which can make it harder to get a job. It can also lead to a loss of confidence and motivation, which can further hinder a person’s job search.
Additionally, employers may be less likely to hire someone who has been unemployed for a long time, as they may view them as having lower productivity.
The tax and welfare system can also contribute to the unemployment trap especially in relatively low-paid jobs
Human capital
Human capital refers to the knowledge, skills, and abilities that people have that enable them to produce goods and services.
It’s basically the intellectual and behavioural assets that people have that enable them to be productive and contribute to economic growth.
This can include things like education, training, experience, and personal qualities like creativity, problem-solving abilities, and emotional intelligence.
The more human capital a person has, the more valuable they are to an employer, and the more productive they are likely to be.
Improving human capital is critical to reducing structural unemployment.
Real wage rigidity
wage rigidity happens when workers are reluctant to see their real wages fall during an economic downturn.
Real wages drop when nominal wages don’t rise as fast as prices
Keynesians argue that wages can be “sticky” or slow to adjust downward because of long-term labour contracts, trade union collective bargaining agreements, and social norms about fair pay.
Workers and employers may be reluctant to renegotiate contracts or reduce wages during economic downturns, leading to persistent real wage levels that are too high relative to the demand for labour.
Policies to reduce unemployment
Reducing Occupational immobility: Immobility is a cause of structural unemployment, Policies like apprenticeships schemes can provide new skills people need to find fresh employment and improve incentives to find work. The poor quality of workplace training has been a concern with evidence of a persistent skills gap in the UK.
Benefit and tax reforms: To some, a policy that reduces real value of welfare benefits might increase incentives for unemployed to take a job Targeted measures to improve people’s incentives might include linking welfare benefits to participation in work experience programmes or lower marginal tax rates for people on low incomes.
Employment subsidies and/or employment tax cuts:
- Government subsides for businesses that take on long term unemployed
-Lower taxes on businesses that employ more workers might be effective
Changing participation age- Increase the amount of time young people have to spend in education- 2015 young people have to stay in education until 18.
Reducing the geographical immobility of labour: People may have the right skills but high house prices and rents may make. it impossible to change location to get a new job. Low level of house building in a major factor in this.
Boosting aggregate demand- might include increases in state investment spending or lower taxes to boost disposable income
Both are a fiscal stimulus. Many governments have turned to fiscal policy as a way of creating new jobs, typically involving construction projects that are labour intensive
The hope is that extra spending on new roads, housing and other infrastructure projects will lead to a strong positive multiplier effect on output, incomes and jobs.
Consequences of unemployment
- Loss of income- leads to a decline unemployed living standards as well as a decline in spending power and rise of falling into debt problems.
-Negative multiplier effects- one person’s spending is another’s income so to lose well paid jobs in an area, such as if a large factory closed down, can lead to a drop in demand for local services downward pressure on house prices and ‘second-round employment effects’ for businesses supplying the factory.
-Loss of national output- leads to a loss of potential national output (ie GDP operating below potential) and is a waste of scarce resources. Unemployment can damage economies growth potential. When high there will be an increase in spare capacity - the output gap will become negative and ca have deflationary forces on prices, profits and output
-Fiscal costs- Government looses out because of fall in tax revneue and higher spending on welfare payments, can lead to an increase in the budget deficit which then increases the risk that the govt will have to raise taxes , or scale back plans for public spending.
-Social costs- Unemployed linked to social deprivation, e.g. relationship with crime and social dislocation including increased divorce rates, worsening health and lower life expectancy. Regions that suffer from persistently high long term unemployment see falling real incomes and widening inequality of income and wealth.
Economic inactivity
The economically inactive are people of working age but not in work who have not been looking for a job within the last 4 weeks
Main reasons for economic inactivity:
-Students remaining in full-time education / on training courses
-Looking after family or home including caring for elderly parents
-Long-term sickness which prevents people from working
-Retired people including the early retired
-Discouraged workers who have given up an active search for work
The pandemic may have caused a rise in economic inactivity particularly among those in their fifties.
8.7 million people aged 16-64 were economically inactive, and the inactivity rate was 21.0% in spring of 2023.
Government is concerned that persistently high levels of labour market inactivity is holding back economic growth and recovery from the pandemic.
Policies to reduce economic inactivity
-Improving financial incentives: Key is to make work pay and lower some of the barriers to people actively looking for a job. Supply-side policies such as tax-free childcare, a higher minimum wage, cheaper transport costs, reforms to rented housing, reforms to pensions.
-Investment in human capital and labour market flexibility: Employer or government-funded skills programmes such as degree apprenticeships, T-levels, STEM education. Measures to encourage part-time work, job sharing, or remote work options. (But fewer than 3% of 16 year olds enroll in T-Levels, with almost a third of those enrolled in 2022 giving up)
Inflation
Inflation is a sustained rise in an economy’s general price level. This means that, on average, the prices of goods and services are going up over time. It’s a normal part of a healthy economy, but if inflation gets too high it can cause serious problems. When inflation happens peoples money is worth less in real terms, which means they must spend more to get the same goods and services. In extreme cases it can lead to hyper inflation.
How inflation is calculated
CPI is a price index that measures the price changes in a basket of goods that are consumer faces. RPI is a price index that uses the same principles of CPI, but ultimately use a different/broader basket of goods/services to measure inflation, and the average is calculated in a different way. RPI tends to produce a higher inflation rate than CPI because it includes housing costs and uses a different formula.
Internal causes of inflation
Large surge in property prices.
Higher wages/labour costs.
Boom in credit/money supply
Rise in business taxes, for example VAT
External causes of inflation
Increase in world oil/gas prices
Inflation in global commodity prices
Depreciation of the exchange rates
Higher inflation in other countries
Effects of inflation
Causes problems for consumers as they find their money doesn’t go as far as it used to.
Effective business is because it can lead to uncertainty and instability, E.G.businesses may have a hard time planning for the future and making long-term investment when inflation is high.
When inflation, high central bank usually raises interest rates in attempt to curve inflation
Cost of borrowing – inflation leads to higher interest rates for businesses and consumers with debts
Reduced demand for country exports
Effects of inflation on the government
Pressure on government to raise value of state welfare benefits, including the state pension or out of work benefits to help control poverty.
High inflation can cause real GDP growth to slow – can lead to lower tax revenues and the government, then having to borrow more money
Can lead to increase in market interest rates, making borrowing more expensive when they issue new bonds
High relative inflation can lead to worsening of international competitiveness causing fall in exports which can threaten jobs and GDP growth.
Hyper inflation
Hyper inflation is a phase of extremely rapid inflation nearly always the result of mass money printing by the government with money as an asset ending up as worthless. It is also associated with economies where there has been a collapse in real output/ supply.
Deflation
Deflation is a sustained period when the general price level for goods and services is falling. This means that a weighted basket of goods and services is becoming less expensive over time. The annual rate of inflation is negative.
Disinflation
Disinflation is a fall in the rate of inflation but not sufficient to bring about price deflation. During a period of disinflation, consumer prices are still rising but at a slower rate, for example a drop in the annual inflation rate from 7% to 2%.
Inflation expectations
Inflation expectations describes what people and businesses expect to happen to consumer prices in the future (usually one year ahead). Once a high rate of inflation becomes established it can be difficult to remove. If people expect higher prices, this can then feed through to higher wage claims and rising costs. This is known as a wage-price spiral.
Stagflation
Stagflation refers to an unfortunate and costly combination of stagnant (slow) economic growth, rising unemployment and high and rising inflation.
Consumer Price index
A Consumer Price Index (CPI) is a measure that tracks changes in the average price level of a basket of goods and services purchased by a typical household over time.
It is a widely used economic indicator for assessing inflation and cost of living adjustments.
CPI is calculated by comparing the current prices of the items in the basket to the prices of the same items in a base year or period.
The percentage change in this comparison reflects the inflation or deflation rate.
Consumer Price index- weights
The consumer price index is a weighted price index
These weights are based on the spending patterns of households on a wide range of goods and services
In the UK, housing and household services account for 30% of the inflation calculation
Food and non-alcoholic drink is now less than 10% of the index
The weights are altered periodically to take account of changing spending patterns
CPIH is the CPI including housing
calculating inflation using a price index
,Calculating the consumer price index for 2023
1.Select prices in 2022 as the base year for the calculation, the index = 100
2.Multiply 2023 price index data for each category by their individual weighting
3.Sum of, price x weights = 102,000
4.Then divide this number by the sum of the weights (1,000)
5.This gives a price index for 2023 of 102
6.The rate of inflation in 2023 in this example was therefore 2%
limitations of the uk consumer price index
-The CPI basket is not fully representative of all consumers - it will be inaccurate for non-typical households, for example - 10% of CPI index covers motoring costs – inapplicable for non-car owners. Single people will spend differently from those with children
-Errors / inaccuracies in data such as sampling errors from surveys.
-Many of the services in the digital economy do not have a price such as Google searches, WhatsApp and Instagram feeds
-Changing quality of goods and services: a rise in the quality of products may not be easily reflected in the prices we pay
-Time lags: The CPI is slow to respond to new products in markets – the CPI basket is changed each year but only by a little.
challenges in measuring inflation (overview)
-Basket of goods and services: Consumer preferences evolve over time, and the basket may not always accurately reflect what people are buying.
-Substitution bias: Consumers tend to adjust their spending patterns in response to price changes. When the price of a particular item rises significantly, people may switch to cheaper alternatives.
-Quality adjustments: The CPI must make quality adjustments to account for quality changes, which can be subjective and challenging to quantify accurately.
-Geographic variation: The CPI is typically a national measure and may not capture regional variations in prices effectively.
-Subgroups and demographics: CPI represents an average consumer, and the inflation experience can vary among groups, such as age, incomes, or urban vs. rural populations.
Consumer price inflation in the UK
The Uks official inflation target is 2%. This is the target that the Bank of England, the UK’s central bank, is trying to achieve. The bank of England uses various tools to try to keep inflation at this level, including setting interest rates. When inflation is above the target, the Bank of England typically raises interest rates to try to slow down the economy and bring inflation back down.
Main causes of inflation
Money & credit boom
Higher wage costs
Increased energy bills
falling exchange rates
higher indirect taxes- tax on goods and services
economic boom
Cost-push inflation
Cost-push inflation occurs when businesses respond to rising unit costs by increasing prices to protect their profit margins. Cost push inflation can come about from both domestic and external sources including a fall in the external value of the exchange rate which then leads to a rise in prices of imported products.
Causes of cost push inflation
1.Rising labour costs perhaps due to an increased minimum wage
2.Higher global prices for components and raw materials including imported energy (oil and gas) and foodstuffs
3.A depreciation in the external value of the exchange rate which then causes a rise in import prices – many imports are priced in US $s
4.An increase in indirect taxes such as higher VAT or environmental taxes such as a carbon tax
Key point: Inflation from cost-push factors can be difficult to control, since the central bank has little control over the factors that cause it.
demand- pull inflation
Demand-pull inflation is a phase of accelerating inflation which arises from a rapid growth in aggregate demand. It occurs when economic growth is too fast. Businesses can take advantage of high demand by raising their prices to widen (increase) profit margins. Typically, demand-pull inflation is associated with an economic boom.
Causes of demand pull inflation
-Demand-pull inflation happens when the economy is growing too quickly, and aggregate demand for goods and services outstrips supply.
-When this happens, prices for everything start to rise, because consumers are willing to pay more to get the things they want.
-This can be caused by several things, including economic growth, low interest rates, and an increase in the money supply.
-If the government engages in excessive fiscal stimulus, like cutting taxes or increasing spending, it can boost demand and lead to inflation.
-This kind of inflation is often seen as a sign that the economy is “overheating” and that corrective measures need to be taken
note: fiscal = taxes + government spending. e.g. national insurance or NHS spending
Milton Friedman
Milton Friedman was one of the most influential economists of the 20th century, and he was a leading advocate of monetarism.
He was an American economist and statistician who taught at the University of Chicago for many years.
In 1976, he won the Nobel Prize in Economics for his work on consumption analysis, monetary history, and the relationships between inflation and unemployment.
He’s well known for his strong support of free-market policies and opposition to government intervention in the economy. His ideas were hugely influential during the 1980s and 90s.
Basics of Monetarism
Monetarism suggests that the amount of money in an economy plays a crucial role in determining the overall price level, or inflation.
If the central bank increases the money supply too rapidly, it can lead to inflation because there is “too much money chasing too few goods.”
Monetarists are often critical of using fiscal policy (government spending and taxation) to manage the economy. They argue that fiscal policies can be unpredictable and lead to economic instability.
Monetarists also believe in the concept of long-run neutrality of money. This means that in the long term, changes in the money supply do not affect real variables like employment and output but primarily impact nominal variables like prices.
causes of the surge in uk inflation in 2022-23
11.1% October 2022
-Pandemic-related supply shortages: As the world economy recovered from the pandemic, demand for these supplies and materials increased, but the supply couldn’t keep up. This led to higher prices for raw materials and products, which pushed up inflation.
-Conflict in Ukraine: The conflict has caused a spike in energy prices, as Russia is a major exporter of natural gas and other fuels. Higher energy prices have pushed up the cost of production for many businesses.
-Labour shortages: These have been a big problem in the UK, especially in sectors, like healthcare and logistics. A lack of workers has made it difficult for businesses to operate, and it’s pushed up wages for those workers who are available
Greedflation
Greedflation is also known as price gouging
Price gouging refers to the practice of charging excessive or unreasonable prices for goods or services in response to a situation of increased demand or limited supply, such as during a natural disaster, pandemic, or other emergency.
In such situations, demand for certain goods or services may increase dramatically, and the supply may be constrained, leading to scarcity and higher prices.
Price gouging occurs when sellers take advantage of this situation by charging prices that are much higher than what would be considered reasonable under normal market conditions.
Growth of money supply as inflation cause
The growth of the money supply can be a cause of inflation when it outpaces the growth of real economic output (goods
and services produced).
This concept is often described by the Quantity Theory of Money, which states that the price level in an economy is
directly related to the money supply and the velocity of money (how quickly money circulates in the economy) relative to the quantity of goods and services produced.
inflationary effects of rising money supply
As the money supply grows, individuals and businesses have more to spend. If the supply of goods and services in the economy does not increase at the same rate (or if it decreases), the demand for these goods and services can exceed their supply.
When demand exceeds supply, sellers can increase their prices to capture more of the available money.
Expectations of future inflation can further exacerbate the problem. If people anticipate that prices will continue to rise, they may make purchases sooner rather than later, which can fuel additional demand and price increases.
Rising prices can lead to demands for higher wages as workers seek to maintain their real purchasing power.
Shrinkflation
refers to practise of companies reducing the size or quantity of a product while keeping the price the same or even raising it. This allows companies to keep prices stable or even increase them, without consumers noticing as much. It’s a form of hidden inflation that can be difficult to detect. Companies may shrink the size of products, reduce amount of product in a container or even reduce the quality of the product. Assymmetric info
importance of the relative inflation rate
-A country’s relative inflation rate matters because it can affect its competitiveness in international trade.
-If one country has high inflation, while another country has low inflation, that can lead to an imbalance in trade.
-The country with high inflation will see its exports decline, while the country with low inflation will see its exports increase.
-This can lead to imbalances in the balance of trade, and it can also cause problems for the country with high inflation, since it will become less competitive in the global marketplace.
-In extreme cases, this can lead to problems like capital flight and debt crises
high inflation and the risk of capital flight
-When a country experiences high inflation, investors may start to worry about the stability of the economy.
-They may fear that the high inflation will lead to a decline in the value of the country’s currency.
-To protect their assets, these investors may decide to move their money out of the country, in a process known as “capital flight”.
-They might do this by selling their assets in the country, like stocks or real estate, and then moving the proceeds to a different country, like one with a more stable currency.
consequences of a high rate of inflation
-The main reason economists view inflation as damaging is because it erodes the value of money.
-This can cause problems for consumers, who find that their money doesn’t go as far as it used to.
-It also affects businesses, because it can lead to uncertainty and instability. For example, businesses may have a harder time planning for the future and making long-term investments when inflation is high.
-When inflation is high, the central bank will often raise interest rates in an attempt to curb inflation
high inflation & yields on government bonds
-When a government issues new bonds, it has to offer a certain interest rate, known as the “yield”, to attract investors.
-If inflation is high, the government will have to offer a higher yield on its bonds to entice investors to lend it money.
-This is because investors will want to be compensated for the risk of inflation eroding the value of their investment. In other words, they’ll want to earn enough interest to offset the effects of inflation.
-High inflation leads to higher interest rates on government bonds.
-When governments must pay higher interest rates on their bonds, they ultimately increase taxes to pay off the interest
economic costs of high inflation
-Inequality: Inflation has a regressive effect on lower-income families in developed & developing countries – most of their wealth is held in cash
-Falling real incomes – if wage rises lag price increases each year
-Negative real interest rates: If the interest rate on savings is lower than inflation
-Cost of borrowing: High inflation may also lead to higher interest rates for businesses and consumers with debts (perhaps via rising mortgage rates)
-International competitiveness: A high relative rate of inflation can reduce competitiveness which will lower demand for the country’s exports
-Business uncertainty: High and volatile inflation is not good for confidence because businesses cannot be sure of what costs will be – this might hold back investment
Winners and losers of Inflation
Winners:
Workers with strong wage bargaining power (perhaps those workers who belong to trade unions)
Debtors if real interest rates on loans become negative (when the nominal interest rate is less than inflation)
Producers if their prices continue to rise faster than costs (leading to higher profits)
Losers:
Retired people relying on fixed incomes/ pensions
Lenders if real interest rates on loans are negative
Savers if real returns on their savings deposits are negative
Workers in low paid jobs with little or no bargaining power- perhaps those with no union representation
Economic costs from deflation
1/ Falling wages – businesses need to cut their costs to maintain profits – they may decide to reduce jobs
2/ Real value of debt goes up – makes it harder to repay that debt (including mortgages & government bonds)
3/ Consumers might hold back their spending – expecting price falls – lower C leads to fall in AD
4/ Investment may slump (fall in C) & diversion overseas
5/ Real interest rate on debt / savings will rise
Example: Nominal interest on loan = 2%
Inflation = -2%, real interest rate = 2% - (-) 2% = +4%
Economic / business opportunities from a period of deflation
1/ Fall in general prices - might increase real incomes of poorer families (perhaps due to strong currency)
2/ Rise in demand for “value products” – business must offer value for money
3/ Asset prices falling can improve housing affordability – important for first time buyers
Asset price deflation
When the valuations of assets such as bonds, housing and equities fall over a sustained period. This often happens at the end of a financial bubble.
Economic impact of a period of deflation
-Real interest rates rise
-Real level of debt rises
-Pressure for lower wages
-Declining business profits
-Rise in cyclical unemployment
-Improved price competitiveness
Consequences of price deflation- overview
-Holding back on spending: Consumers may postpone demand if they expect prices to fall
-Debts increase: Real value of debt rises with deflation - can be a drag on consumer confidence
-Real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices.
-Lower profit margins: Lower prices can mean reduced revenues & profits for businesses - this can then lead to higher unemployment as firms seek to reduce costs by shedding labour.
-Confidence and saving: Falling asset prices such as price deflation in the housing market hits personal sector wealth and confidence
-Income distribution: Deflation leads to a redistribution of income from debtors to creditors – but debtors may default on loans
-Deflation can make exporters more competitive eventually – but this often comes at a cost such as. higher unemployment and weaker economic growth in the short term
What macroeconomic policies might be used to tackle / prevent deflation?
- Low interest rates and quantitative easing
-In some countries, policy interest rates have become negative (Switzerland)
-Expanding the supply of credit in banking system
-QE used by many central banks including BoE and European Central Bank - Fiscal stimulus measures
-Higher government spending (capital infrastructure projects)
-A rise in government borrowing to inject demand into the circular flow
-Lower direct taxes to increase disposable income and spending - Other measures to stimulate aggregate demand
-Attempts to lower the value of the exchange rate (perhaps via central bank intervention to sell their own currency in the FOREX market)
-Higher taxes on savings to encourage consumption of goods and services
Benefits of high inflation for a government
-Higher inflation can lead to fiscal drag- this happens when peoples wages/ incomes are rising in nominal terms which causes them to pay more in direct and indirect taxation.
-High inflation can cause a reduction in the real value of the governments existing/ outstanding debt
Wage price spiral
A situation where workers bid for higher wages because they have seen their real income eroded by fast rising prices. This can lead to a further burst of cost push inflation in an economy.
Wage price spiral - cycle
Rising inflation -> Falling real incomes -> Workers bid for improved wages-> leads to high labour costs -> Firms raise their prices -> (repeat)
Balance of payments
The balance of payments is an important economic indicator that measures a country’s transactions with the rest of the world. In essence it’s a record of all the money coming into and going out of a country, including payments for goods, services and financial transactions. There are 3 parts of the balance of payments: the current account, the capital account and the financial account.
These 3 parts must balance out in the end.
Current account of the BoP
the current account records payments for trade in goods and services plus net flows of primary and secondary income. The current account is the sum of these 4 separate balances:
1. Net balance of trade in goods
2. Net balance of trade in services
3. Net primary income
4. Net secondary income
Primary income (in context of BoP)
Measures the monetary flows generated from the owning of cross border financial assets, known as investment income. It represents the yields (returns) from the UK investments abroad and that of foreign owned investment in the UK. Primary income also includes pay from cross border workers such as migrants.
Secondary income (in context of BoP)
Current transfers between residents and non-residents- examples of secondary income transfers include foreign aid, and contributions to international organisations such as the UN and the EU- which the UK has now left.
Remittances
Remittances are typically categorised as a credit item in the current account , contributing positively to the current account balance. In many lower income countries, remittances can offset trade deficits or other current account deficits, helping to achieve or maintain a current account surplus.
E.g.s of Loire income countries that receive remittances- Tonga, Gambia, Haiti
which money flows appear in secondary?
This category includes a variety of transfers, such as:
-Remittances: Money sent by foreign workers (migrant workers) back to their home countries.
-Foreign Aid: Grants, concessional loans, and other forms of assistance provided by one country to another for developmental, humanitarian, or other purposes.
-Diaspora Contributions: Contributions made by a country’s diaspora to support projects or family members in their home country.
-Payments made to international institutions: When the UK was a member of the European Union, the UK was a net contributor to the EU budget. These payments were treated as a negative on the secondary income account.
which income flows appear in primary?
-Income on Direct Investment: This includes profits, dividends, and interest earned by residents from their direct investments in foreign companies and vice versa.
-Income on Portfolio Investment: This is income such as dividends and interest earned by residents from portfolio investments in foreign securities and vice versa.
-Compensation of Employees: This represents wages, salaries, and other compensation earned by foreign workers employed in a country and by residents working abroad.
-Taxes on Income and Wealth: This includes taxes on income and wealth paid to foreign governments and taxes paid by foreign residents to the domestic government.
index number
Index numbers are a useful way of expressing economic data time series and comparing / contrasting information. An index number is a figure reflecting price or quantity compared with a base value (e.g. base year) . The base value always has an index number of 100.
Policies to help control inflation
Policies to control inflation should focus on the underlying causes:
These might include the following:
Demand-pull inflation:
-Increases in interest rates and a tightening of the supply of credit
-Contractionary fiscal policy – higher taxes and cuts in state spending
Cost-push inflation:
-Supply-side policies to increase productivity
-Labour market reforms to increase labour supply
Supply Side policies to help control inflation
-Expansion of the worker-visa programme to encourage more skilled workers into the UK from the EU and beyond
-Policies to encourage increased house-building to address chronic shortages and rent inflation
-Investment in human capital to improve labour productivity and lower unit labour costs
-Investment tax allowances to drive investment in and scale of renewable energy and gas storage
-Infrastructure investment to help lower business costs in the long run (improved transport networks, telecoms)
How Higher interest rates can control inflation
-Increase in interest rates is a tightening of monetary policy
-Should, in theory, lead to slower growth of aggregate demand
-Helps to control demand-pull inflation by closing the output gap
-Can also lead to a stronger exchange rate (increased demand for currency)
-This leads to a drop in the prices (costs) of imports
How higher taxes can control inflation
-Increase in direct tax is a deflationary fiscal policy
-Higher taxes cause a drop in household disposable income
-Consumers see a drop in their spending power
-This feeds through to weaker aggregate demand
-Which in turn, causes a fall in demand-pull inflationary pressure
Reasons why inflation is hard to control
-Global Economic Factors: Fluctuations in global commodity prices, exchange rates, and international trade can affect the cost of imports and, consequently, domestic prices.
-Supply-Side Shocks: Supply-side factors, such as natural disasters, geopolitical conflicts, or supply chain disruptions, can lead to sudden and unexpected increases in production costs.
-Built-In Inflation: In countries with a history of high inflation, there may be built-in inflationary expectations. Workers may demand higher wages to keep up with expected price increases, and businesses may increase prices in anticipation of rising costs. This wage-price spiral can be self-reinforcing and challenging to break.
-Monetary Policy Lag: The impact of higher interest rates, may not be felt immediately. There can be a lag between the time a policy change is implemented and when it affects the economy. Household spending may be resistant to changes in interest rates.
