Unit 2.C - Major Economic Issues

Question 1

How are the three key major economic issues connected?

Answer 1

All are ultimately founded on interactions of AS and AD:

Economic growth (being a measurement of changes in GDP): ultimately in short term, a measure of how much of AS is being paid for by AD, in long term, about a steady increase of AS coupled with successful management of AD.

Unemployment: when the level of AD/total spending is less than the full employment level of output, productive capacity of the economy.

Inflation: when the level of AD/total spending exceeds the full employment level of output: when the economy is producing as much as it can, adding more spending can only buy so much more production: effectively, this money is just excess: ‘too much money chasing too few goods’, OR when a left shift of AS interacts with the price level to produce a higher price level at equilibrium: bc an increase in costs of production mean profit-maximising businesses put prices up to remain profitable.

And often changes in one will affect AD and AS as to result in changes in another: e.g. a rise in inflation leads to a contraction in AD due to reduced investment as expectations of the future decline, and with a reduction in the level of total spending, short-term economic growth decreases (given that growth is measured by changes in GDP, and short-term growth is given by the level of spending) hence resulting in a widening of the GDP gap and in increase in the amount of cyclical unemployment.

Question 2

What is economic growth?

Answer 2

Economic growth measures changes in GDP: the final value of all market goods and services produced in an economy over time, adjusted for inflation, which represents the total amount of production in $ terms. Thus, economic growth is essentially an indicator of the level of production in an economy.

Economic growth can also be defined as an increase in the volume of goods and services an economy produces over a given period. It’s just that to measure this we need a common unit so we can discuss ‘volume’ of say services by a teacher or waiter in the same terms… We assign a dollar value to all things and this total value is GDP.

Question 3

What is GDP?

Answer 3

Gross Domestic Product (GDP) is the final value of all market goods and services produced in an economy over time, adjusted for GDP. It represents the total production (in $ terms).

Note: this doesn’t directly include raw goods and services and intermediary goods (which are included in final price): doesn’t count the value of the oranges that went into the juice; this is included in final market price. Also doesn’t include foreign ownership: ‘produced IN an economy’ and so not necessarily the same as income.

Question 4

Real vs nominal GDP?

Bonus: recent data for economic growth?

Answer 4

Real GDP: adjusted for inflation
Nominal GDP: not adjusted for inflation

Economic growth over the last few years has been approximately 2.5%. 2% would be considered low, and depending how far back you go, long term average growth would be about 3.5-4%, but at the moment the RBA + broader gov would be thrilled with 3-3.5%.

Question 5

How is economic growth calculated?

Answer 5

Economic growth (%) = (real GDP(cy) - real GDP(py)/real GDP(py) x 100

Thus economic growth is a percent change in GDP.

Question 6

Can we tell if there’s been economic growth in an economy by looking at the value of GDP per year over that time frame?

Answer 6

Yep! Economic growth essentially just means there’s been an increase in GDP, so we by looking at a table of GDP values over the time frame we can see that if GDP has been increasing then the economy is experiencing economic growth.

Question 7

Why is GDP given by AD demand in short term?

Answer 7

Assuming the economy isn’t operating at the full employment level of output, we assume that with an increase or reduction of spending, firms will supply an equal value of goods and services in response for this payment and so if AD falls, well, businesses won’t sell their goods for free… the vol. of goods and services sold will be equal to the level of spending. And until the full emp. level of output is surpassed then the same is true for an increase in spending: if the demand is there, then firms will try and capitalise on this by increasing supply however they can, using any idle resources, working a little harder, etc.

Question 8

Why is an increasing GDP considered important for an economy?

Answer 8

Increasing GDP implies that the level of production in an economy is rising, and if the level of production is rising then…

• With more production there is more employment as a result of more idle resources (inc. unemployed ppl) being utilised to make the new level of supply possible. Thus more efficient resource use, economy operating closer to full empl. level of output, reduced social issues of unempl, lower cost to gov, etc: see impacts of unemployment.
• More GDP means more taxes, so more gov. revenue (consider fiscal stance: if GDP is increasing then it’s probable that in short term gov. will be running contractionary fiscal policy) so increased long-term ability to provide more extensive/higher quality public services, and a greater ability to fund future deficits when future economic downturns occur.
• Higher GDP per capita means higher incomes per household on average… bc increasing production means a reduced GDP gap: more resources (labour) being utilised, so more people have a job/are working more hours, resulting in more money received as wages (returns on the production factor of labour): more employment. Thus, by increasing average household incomes increasing GDP has the potential to improve living standards as ppl have greater ability to pay for basic necessities and things that improve (short-term and long-term) welfare.
• Growth in GDP helps reduce debt without heavy service cuts/tax rises.
• Growth in GDP helps reduce poverty.
• Lower the GDP, lower the income, lower the average standards of living.

Question 9

What is the relation between GDP and living standards/welfare?

Answer 9

• Higher GDP per capita means higher incomes per household on average…

(bc increasing production means a reduced GDP gap: more resources (labour) being utilised, so more people have a job/are working more hours, resulting in more money received as wages (returns on the production factor of labour))…

So by increasing average household incomes, increasing GDP has the potential to improve living standards as ppl have greater ability to pay for basic necessities and things that improve (short-term and long-term) welfare inc. medicines, treatments, fresh food, education, sanitary goods, etc.

Yet. While a rising level of GDP is required to fund many things which improve the general welfare of a population (e.g. health, education) it does not strictly mean by itself that living standards will improve. It is first and foremost an indicator of production and should NOT be taken as an indicator of welfare. This being said, there is a definite correlation between rising GDP and rising living standards (given increasing average household incomes) hence is still considered a highly important indicator by economists for assessing the state of a society.

Question 10

What are some of the common criticisms of GDP?

Answer 10

• Doesn’t describe income distribution/inequalties (e.g. maybe there is a rise in GDP, but the returns only go to a few ppl)
• Devalues ‘caring’ duties (inc. paid and non-paid) which are very good for society but typically assigned a relatively low $ val; ppl are driven towards higher-paying jobs instead.
• Doesn’t account for the economic growth which may occur in the wake of a natural disaster e.g. rebuilding after an earthquake will temporarily boost production: GDP goes up but not for ‘good’ reasons.
• May be confused by some as an indicator of general state of society… some will criticise concept of GDP noting that it says nothing about general social cohesion, unrest, childhood mortality, life expectancy, happiness, work-life balances etc, but this was never what GDP was meant to directly measure. GDP an indicator of something else which may improve general wellbeing level but that’s not really the point.

Question 11

What are some alternatives to GDP as indicators of wellbeing?

Answer 11

• Human development index (HDI)
• Gross National Happiness
• Genuine Progress Index (GPI)

Question 12

Ecologically vs economically sustainable growth?

Answer 12

In ecological terms: ecologically sustainable economic growth is identified by the net impacts of aggregate supply on the environment: considers the methods used in production to achieve growth. Growth is ecologically sustainable IF it does not occur to the sacrifice of the environment so much that ultimately leads to a long-term decrease or stagnation in AS, remembering that AS is about the quality and quanity of resources and the success with which they are combined (e.g. as a result of pollution or soil erosion). Basically minimising the scenario where AS hurts itself via environmental degradation. (AD isn’t really considered.) Non-renewables: consider that we could have a high level of growth in the short term by fishing every fish in the sea but this would be a highly temporary and unsustainable increase in growth: the long term result is a decrease/left-shit in AS and inflation, and perhaps an unsustainable reliance on other industries.

In economic terms: sustainable economic growth in economic terms is characterised by successful short-term mgmt of AD to ensure that at any one point the (more volatile) level of total spending does not exceed the limits of productive capacity (resulting in inflation) while gradual improvements in productivity and market efficiency occur, resulting in an increase over time of AS. Essentially centres around AD increasing but not so much that it outstrips AS and causes inflation.

Question 13

Determinants of economic growth?

Answer 13

In the short term, economic growth (which is measured by changes in GDP, which represents level of production) is determined by the total level of spending in an economy, or the magnititude of AD, which is given by C + I + G + (X-M). However, in the long term, the level of production may only increase if there is a right-shift in AS (if there is an increase in quality and/or quantity of factors of production and the general success with which they are combined: any improvement in efficiency/productivity e.g. change in the state of tech, change to tax system + regulations, average level of education/training, etc.).

Question 14

Benefits of economic growth?

Answer 14

• Generates gov. revenue: greater ability to subsidise merit goods, provide public goods + services.
• Increasing average household incomes
• Allows for rising living standards without greater redistribution of income
• Helps address absolute poverty and may address income inequality by reducing the extreme lower end of the income range.
• More tax revenue (assuming a country has systems in place that redistribute income e.g. welfare system or progressive tax system) may help address relative poverty.
• Ec growth is needed to reduce unemployment (bc ec growth means increasing GDP, increasing GDP means a reduction in the GDP gap).
• Means more efficient use of resources + potentially less waste.
• Not necessarily just about ‘more’ but also ‘different’ and ‘better’.

Question 15

Costs of economic growth?

Answer 15

• Inflation
• Social (and economic) change
• External stability/geopoltics (e.g. by reducing imports)
• Environmental damages
• Higher income inequality

Question 16

What is the multiplier effect?

Answer 16

The multiplier effect is that any change in AD will result in a multiplied effect on GDP.

Question 17

What is the formula implied by the multiplier effect?

Answer 17

ΔY = k × ΔAD

Question 18

Why does the multiplier effect occur?

Answer 18

The changes in level of total spending has a multiplied impact on GDP because money spent doesn’t (usually) stop with the first recipient: it can be re-spent throughout the economy, because one person’s spending is another’s income. For example, Matt spends $100 at a restaurant. If we were to trace only 1 line of the funds… Say $15 dollars of this were paid as wages to the head waiter for contributing the production factor of his labour during this time, who spent the $15 on locally-grown produce. The farmer used $12 to buy lunch on his way home, where the cafe owner used $5 of this for a muffin at a rival cafe, which was finally paid to a bank as interest on a loan, etc. And so in this way we can add up the totals of money spent from each thread of the original $100 and see that the total money which was made available to spend as a result of the $100 transaction was actually much greater than the original sum.

Question 19

What determines the size of the multiplier k?

Answer 19

The size of the multiplier k is given by the average marginal propensity to save (mps) where k = 1/mps.

mps + mpc = 1… If you have mps = 0.8 therefore mpc = 0.2. This means that if you earn $1 you save 80c and spend 20c.

Question 20

How does economic growth reduce unemployment?

Answer 20

Economic growth means increasing GDP (which reflects increasing production) and if GDP is increasing then the GDP gap is decreasing; the economy is operating closer to the full emp. level of output because firms are responding to a higher level of total spending by producing a higher total output (an expansion along the AS curve). To make this increased production possible a greater quantity (+ quality) of resources (labour: unemployed pp) must be employed, so the demand for labour increases (basically more work to do so more people needed) and the underutilization of labour decreases and more people have a job/are working more hours, resulting in more money received as wages (returns on the production factor of labour).

Note: this is CYCLICAL unemployment being reduced: unemployment that’s due to the phase of the business cycle.

Question 21

What is unemployment?

Answer 21

A person is classed as unemployed if they work 1hour/week or less and are willing and able to work more. The unemployment rate is calculated as the fraction of unemployed people out of the labour force (where the labour force is the total number of employed people and unemployed people).

Question 21

What is unemployment?

Answer 21

A person is classed as unemployed if they work 1hour/week or less and are willing and able to work more. The unemployment rate is calculated as the fraction of unemployed people out of the labour force (where the labour force is the total number of employed people and unemployed people).

Question 22

How might the unemployment rate increase at the same time as the number of employed people?

Answer 22

The unemployment rate is based off the fraction of unemployed people out of the labour force, which is comprised of the total no. of unemployed people and the total no. of employed people. Thus, the unemployment rate doesn’t directly consider the number of discouraged jobseekers: people who work 1hr/week or less but are NOT willing and/or able to work more. If some of these discouraged jobseekers become willing and able to work then the no. of unemployed people will increase, increasing the unemployment rate. Thus, if the number of discouraged jobseekers becoming technically unemployed exceeds the no. of new jobs created the outlined effect will occur.

Question 23

What are the two types of unemployment?

Answer 23

Cyclical unemployment: unemployment that’s due to the phase of the business cycle.
E.g. a student works at a cafe, the cafe shuts down owing to a major economic collapse, the student becomes unemployed due to the phase of the business cycle (because AD was low).

Structural unemployment: the unemployment that remains when the economy is experiencing a boom and cyclical unemployment has been eliminated. Stems from a mismatch between skills possessed by workers and skills desired by employers. May be due to change in consumer behaviours or state of technology: consider that an increase in AS, (while benefitting the broader economy by increasing the full employment level of output/GDP and enabling long-term economic growth) may be driven by an improvement in technology where the cost is that it results in a number of workers becoming redundant (winners + losers).
E.g. a bricklayer can lay 100 bricks per hour, yet the company invests in a new machine that can lay 1000 per hour, at is much cheaper to run and maintain… the bricklayer becomes unemployed due to a change in the skills desired by employers relative to the skills that they possessed: structural unemployment.

Question 25

What is the participation rate?

Bonus: underutilisation rate?

Answer 25

The fraction of the working age population that the labour force represents.

Labour force/working age pop (×100)

Underutilisation rate: the fraction of the labour force that is willing and able to work more:
(#unemp + #emp)/labour force (x 100)

Question 26

What is full employment, or the natural rate of unemployment?

Answer 26

Full employment describes the level of unemployment when the business cycle nears its peak and the economy is operating at its productive capacity: the (primarily structural) unemployment that remains when cyclical unemployment is eliminated: NOT 0% unemployment.

Or, when anyone with desirable skills and qualifications can get a job.

May occur at 3-5% unemployment.

Any further attempt to reduce unemployment through stimulating the economy will only result in inflation.

Question 27

Why is it important to know the full employment level of output or the level of employment which is cyclical and the level which is structural?

Answer 27

It’s important to know what fraction of the unemployment rate is due to the phase of the business cycle so that economic decision-makers can best decide how to reduce this unemployment. If unemployment is cyclical in nature then the best way to address it is by stimulating aggregate demand, or the total spending in the economy, which is given by C + I + G + (X-M). If AD increases then more money is received by businesses so the total output increases in response, and to make this increase in GDP possible businesses must utilise more idle production factors including labour; they will employ more people and/or increase the hours worked of existing employees, thus reducing the unemployment rate. However, increasing AD demand will scarcely affect the level of structural unemployment because by definition this portion of unemployed workers lacks rather desirable skills and qualifications and so there is less reason for businesses to hire them. The level of structural unemployment may be harder to address (we can’t usually wind society backwards) but can be best addressed through retraining, and potentially provision of incentives to revitalise a dying industry.

Question 28

What are some of the ways in which the gig economy changes the labour market?

Answer 28

• Instead of working for one employer you’re working job-to-job: less obligation to any one company, greater mobility of labour between areas its needed
• No protections, no minimum wage

Question 29

What are some of the ways in which casualisation changes the labour market?

Answer 29

• Reduces the number of people who work full time: instead, many of these work casually.
• Workers paid more, yet more flexibly employed: the trade off of being paid more is greater security.
• Gives businesses more control + power: easier legally and logistically to sack people than people who are signed into a part-time/full-time contract.
• Possible changing definitions: in the future will casual workers get sick leave?

Question 30

How does automation affect the labour market?

Answer 30

• Reduces no. of people employed in factories, agricultural sector, paralegals.

Ag sector: something like 15 percent of the Aussie population in the early 1900s was employed in agriculture, but now that number is around 2.5% work in agriculture, forestry, and fisheries ALL UP.

Question 31

What is the trend for the level of unemployment over time?

Answer 31

Unemployment has more or less been decreasing.

Question 32

Is there more or less structural unemployment now or in the 80s?

Answer 32

• Less structural unemployment now than in the 80s.

Question 33

Since 1980, in which years have there been a significant recession?

Answer 33

• 1985
• 1990
• 2008

Question 34

Is the level of unemployment more or less volatile now than it was in the 1900s?

Answer 34

Less: with the introduction of growth targeting and improved budget management a stabilisation of the business cycle has corresponded to a reduction in fluctuations of unemployment level.

Question 35

What are the key impacts of unemployment?

Answer 35

• Resources not being used to full capacity
• Decline in labour market skills of long-term unemployed.
• Costs to gov.
• Reduced GDP
• Slower wage growth
• Social impacts

Question 36

How does unemployment mean that resources are not being used to full capacity and what are the results of this?

Answer 36

The incidence of unemployment reflects workers that could otherwise be contributing to AS, thus limiting the amount that productive capacity can respond to higher levels of total spending, reducing output. The economy is operating within the PPF.

Thus, the economic problem is not being addressed: we are not maximising the wants satisfied with our finite level of resources because not all resources are being used.

Thus, lower total output means lower total income: average household incomes will fall which leads to a decrease in consumption + contractionary cycle, coupled with the fact that a poor economic outlook may reduce investment, production, economic growth. As average household incomes reduce, living standards may fall, and employed people must contribute more of their tax to the provision of goods and services for unemployed ppl.

And of course given that income is the returns on the factors of production (inc. wages as return for labour) if people aren’t contributing their labour to anything they aren’t receiving income (only transfer payments).

Question 37

More info on decline in labour market skills for the long-term unemployed…

Answer 37

• Missed opportunities to increase experience, skills + networks.
• Decline in self-esteem, self-confidence, other social impacts of being unemployed (e.g. risk of abusing drugs, of being involved with chrime)
• Young people: may be particularly at risk of losing job skills as a result of being unemployed because they may have no prior experience and it may delay them entering the workforce just when they need to break into it most and they have the least experience: may become discouraged jobseekers, and may result in them never breaking into the workforce.
• Risk of these effects meaning that short-term unemployment becomes long-term unemployment as some may become less employable or unemployable due to impacts outlined above. Cyclical unemployment may become structural in this way.

Question 38

How does unemployment increase costs to gov.?

Answer 38

• Unemployed people receive welfare payments and financial assistance with some goods and services that must be paid for from the budget.
• A greater portion of income must be spent providing goods and services to reduce effects of income inequality.
• Costs of dealing with the social issues of unemp.
• Falling incomes means less tax, so reduced revenue: (unemp. people paying little or no taxes, while a decline in expenditure on businesses and reciprocal output also results in less income to business owners + workers: it’s not only the unemployed who have reduced incomes, but those who miss out on taking their money, and so many others will fall into lower tax brackets).

Question 39

How does unemployment result in lower wages growth?

Answer 39

Consider the market for labour: the greater the supply, the lower the equilibrium cost. If there is only so much demand for labour there will be an oversupply, and so long as there is an oversupply of labour it is easy for businesses to hire whoever’s willing to work for X wage: if person A starts kicking up a fuss about their wage, then it is all too easy to fire them and hire person B who has no problem working for this amount; workers have less bargaining power to increase their wages, then. Thus, high unemployment results in an excess of idle labour, giving businesses more power and less incentives to pay high prices for labour. The wages growth rate may be less than the inflation rate, which represents a significant loss for workers and increase in their living costs.

Question 40

How does unemployment connect to income inequality?

Answer 40

• Ability of workers to negotiate wage prices (to at least keep up with the rate of inflation)
• Increased unemployment more among lower income earners such as the young and the unskilled. B/c unemployment means a loss of income for these people they become relatively worse off compared to higher income earners, contributing to poverty + overall wider distribution of income.
• Increased risk of people from disadvantaged backgrounds being unemployed for social reasons or for a lack of relevant skills: a potential reinforcing of intergenerational low socio-economic status as kids from poorer households may experience secondhand impacts of their parents unemployment, or a person from an ethnic minority may not be hired for reasons of prejudice. This results in lower income and greater income inequality for these people too.

Question 41

What are some of the social issues that may occur as a result of unemployment?

Answer 41

• Decrease in physical and mental health outcomes, partially due to reduced incomes so less access to things that improve wellbeing e.g. medications, fresh food, support services, etc and added financial stressors.
• Increased levels of debt, financial hardship, and poverty.
• Increased levels of homelessness + housing issues.
• Increased levels of crime
• Increased boredom
• Risk of family breakdown
• Loss of routine
• Increased social isolation
• Reduced social cohesion
• Loss of work skills.
• Erosion of self-esteem + self-confidence
• Increased drug and alcohol abuse

These costs are ultimately costs to the whole community, bc more resources must be used directly to deal with these issues that could be otherwise used elsewhere: opportunity cost is other social issues that could be addressed. More public funds must be spent on welfare payments, health, social services, security measures, etc, rather than other community wants.

And bear in mind that different groups may be disproportionately affected by unemployment for various reasons, inc. young people, ppl in regional areas, older men, immigrants, indigenous communities.

Question 42

What is inflation?

Answer 42

Inflation is a sustained increase in the general price level over the whole economy, or an erosion of the purchasing power of money. A rise in the cost of living with no additional output gained.

Question 43

How is the rate of inflation calculated?

Answer 43

The rate of inflation is calculated as a percent change in the Consumer Price Index (CPI).

Question 44

What is the CPI?

Answer 44

The CPI is an expression of the total price of a weighted basket of goods + services, reflecting the average total spending of Australian households in capital cities.

Also a measurement of living costs: if the CPI is inflation it means the cost of paying for rent, food, entertainment, travel, etc. is increasing, and so you need more

Question 45

What is a general limitation of the CPI?

Answer 45

The CPI only measures the average household spending, and like any average, while it does a fairly good job of representing the whole, it may not describe the situation for any one household, or even any: consider that the average no. of children in an Australian household is 2.3. This means that the price of some goods and services may be increasing (or less commonly, decreasing) at a faster or slower rate than others. For example, the agricultural sector may have already been operating closer to its productive capacity when a boom occurs, so that it takes less to push it into being stretched and unable to respond to an increase in AD, so the price increases more rapidly, compared to the entertainment sector which already had much more spare capacity, and so inflation occurs much less readily because an increase in spending WILL result in a proportionate increase in output.

Question 46

Should we expect inflation when we’re not operating at capacity?

Answer 46

No.

Question 47

What are the two key types of inflation?

Answer 47

• Cost-push inflation

- Demand-pull inflation

Question 48

What is demand pull inflation?

Answer 48

Demand pull inflation is the inflation that occurs as a result of an increase in total spending (AD) past the limits of productive capacity; when the economy is not operating at capacity, businesses will match the level of spending with output of equal value, but past a certain point the ability of businesses to respond becomes limited. Given that AD = C + I + G + (X-M) this may occur when there is a significant increase in any of these factors. May be related to net exports but more typically it follows a sharp rise in consumption or investment, which account for a much larger portion of AD (combined, ~75%). Essentially, the result is that there is too much money chasing too few goods, or an excess of money relative to the value of output that can be reciprocated for this spending, to the limits of productive capacity, and so there is an erosion in purchasing power: $10 buys you less than it used to.

Ultimately, inflation occurring when some of those who have the money to demand are unable to do so due to an inability of suppliers to respond due to their already operating at capacity.

Can also occur when money is being printed.

Question 49

How is demand-pull inflation managed?

Answer 49

Demand-pull inflation can be prevented by managing AD carefully so that at any one point it doesn’t exceed the full employment level of output.

Question 50

What is cost-push inflation?

Answer 50

Cost-push inflation occurs when there is a widespread increase in business costs, e.g. wages increase due to installation of a price floor, petrol costs increase due to a geopolitical conflict. This means that firms will have to sell more to cover their additional costs or raise prices (resulting in a contraction of demand: fewer people willing and able to pay) and either way this results in fewer business remaining profitable, causing a decrease in AS and a reduction in the full employment level of output. This increased price level associated with a lower level of production is what results in a contraction of AD, and hence lower spending resulting in an equilibrium level of output, aka a lower level of GDP.

Aka costs of production increase, so fewer businesses profitable, so AS decreases, or the level of potential production is reduced, resulting in an increase in price level for any given level of output produced. Consequently, AD will contract, and given that in the short term the level of GDP is given by the level of total spending, this results in a reduction of GDP.

The result of all of that, is that although the population will be the same, although all resources still exist, the level of production will be lower, so,

Question 51

Cost-push vs demand-pull inflation?

Answer 51

Cost-push: 
Caused by a decrease in AS. 
results in a decrease in GDP and increase in general price level. 
No economic growth or negative growth. 
Widens GDP gap. 

Demand-pull:
Caused by an increase in AD.
Results in a stagnation of GDP at which point the general price level begins to rise.
Some economic growth attached.
GDP gap eliminated: economy operating at productive capacity.

Question 52

What is the possible demand-pull inflationary aspect of cost-push inflation?

Answer 52

ONLY IN THE EVENT THAT THE FULL EMPLOYMENT LEVEL OF OUTPUT DECREASES.
A sustained left-shift or decrease in AS MAY result in a decrease or left-shift of the full employment level of output. AD at the old level could exceed the new full employment level of output. The result of this is would be classic demand-pull inflation, where there is essentially too much money chasing too few goods.

Question 53

What makes cost-push inflation particularly naysty?

Answer 53

• Not only increases living costs for no additional output, but results in a decrease in GDP and negative or no economic growth. 2

Question 54

What are the effects of cost-push inflation on society?

Answer 54

• Increased living costs with no additional output
• Lower GDP: lower household incomes, some businesses will experience reduced revenue or fail, so unemployment will increase (with its related social consequences)
• Risk of inflationary spiral
• Impact on income inequality: a rise in price of a good or service reflects a larger portion of income for a lower income earner than for a higher income earner, they may also be less able to negotiate a wage increase to keep up with costs of living.
• Lenders/savers
• Certainty
• GDP, unemployment, average incomes
• Investment
• People with debt
• Costs of the remedy, which is higher official interest rates.

Question 55

What are the benefits of low and positive, moderate inflation?

Answer 55

• Acts as a buffer to reduce odds of negative inflation occurring.
• Helps overcome wage-price stickiness
• Moderately rising prices good for stimulating AS.
• Following a period of deflation due to low economic growth, may signal to consumers that the health of the economy is improving, thus increasing consumption relative to level of consumption in deflation, which will boost AD and have a multiplied effect on GDP, also indicates to businesses and investors that profits are increasing again (or at least it seems so) and encourages AS.

Question 56

Why is negative inflation bad?

Answer 56

Overcoming wage and price stickiness
- A low level of inflation helps prices (and wages) to change relative to each other. Businesses like to raise rather than lower prices, and workers like to receive wage increases. If prices and wages all stayed the same (no wage or price inflation at all), then the price signal would stop working and shortages and surpluses would be more likely. Low levels of inflation act like a lubricant- they help the price signal do its thing as some prices and wages go up more than others, but prices and wages don’t necessarily fall (in nominal terms).

Stimulating aggregate supply in the medium term
- A small amount of inflation helps to stimulate production. Aggregate Supply rises as inflation does, so slowly rising prices gives businesses the incentive they need to boost production. The thinking behind this is that businesses will respond to rising prices with rising production but because inflation is low, they don’t notice that all price.

Also RBA has an effective lower bound; can’t lower interest rates below a certain point (unless they delve into MMT) and so there’s a risk of deflation spiralling out of control.

Falling prices is bad for businesses: businesses try to maximise revenue usually through increasing prices, and so as prices fall, the level of production decreases, and businesses may try to lower wages to reduce operating costs, and some will shut, resulting in more unemployment, and lower household incomes, so people will spend less, (assuming their wages delfate faster than average price of goods) and because AD = C + I + G + (X-M) if consumption falls, this will reduce AD, which determines GDP and economic growth in the short term, which will experience a magnified effect. Because prices are falling, consumers will expect prices to keep falling, and because there is an inverse relationship between demand and price they will forego their consumption hoping to pay a lower price for the same good in the future, and so deflationary expectations ultimately will result in low or negative economic growth. Bad for people with debt: they will have lower incomes yet the size of the debt will be worth more in relative terms, resulting in it becoming harder to pay off. Assuming the RBA doesn’t flirt with modern monetary theory and put negative interest rates in place, interest rates will be at 0% to try and increase the monetary supply and have an expansionary effect on the economy, and lenders won’t lend at 0%, and although interest-free loans would stimulate investment by itself, if the economy is in the sort of poor state indicated by deflation, its not likely that businesses will be incentivised to expand, as surviving would be their primary concern.

Question 57

What is deflation?

Answer 57

Deflation: a growing supply of goods and services being chased by a constant or slower-growing supply of money. This means that deflation can be brought about either by an increase in the supply of goods and services or by a lack of increase (or decrease) in the supply of money and credit. In either case, if prices can adjust downward, then this results in a generally falling price level.

Question 58

What are the costs of high inflation?

Answer 58

• Uncertainty
• Risk of inflationary spiral
• Impact on lenders/savers
• Impact on income inequality
• Impact on GDP
• The costs of necessary cure (raising interest rates)

Question 59

Costs of low inflation?

Answer 59

• Too close to negative inflation
• Sends a bad signal to businesses, who like increasing prices which typically mean increasing revenue (unless goods have elastic demand) and so they will be less likely to be willing to pay for high operational costs, expansion, etc if profits appear to be decreasing. May result in wage prices decreasing, (particularly for lower income earners who may be viewed as more disposable and hence easier to pay less because if they kick up a fuss they’re easier to replace: impact on income inequality.
• Disrupts price mechanism.