Unit 4 The Global Economy

Question 1

Globalisation

Answer 1

The growing integration and interdependence of the world economy I.e the increased international movement of output, financial capital, foreign direct investment (multinational production) and the harmonisation of consumer tastes.

Causes: improved transport and communications, reduction in trade barriers and removal of exchange controls.

Question 2

Comparative advantage (C/A)

Answer 2

The producer with the lowest opportunity cost of production (or highest output per factor of production) for a particular product.

If persons or national economies specialise in production of a good they have a comparative advantage in, all can gain from trade.

Question 3

Absolute advantage (A/A)

Answer 3

The producer with the ability to make the largest amount of a particular product using its factors of production.

Having absolute advantage in production of a product does not mean specialisation in it will lead to gains from trade; a producer can have absolute advantage in several products.

Question 4

Multinational companies MNC)

Answer 4

Large company with production based in several different countries. E.g. General Motors.

Question 5

Foreign direct investment (FDI)

Answer 5

Spending by firms on productive capacity in other countries.

E.g. the purchase of a foreign company or the setting up of a production plant abroad. It generates employment there and often involves technology transfer which has spin-off benefits for other local firms, boosting economic growth. FTI contrasts with portfolio investment (buying shares) because managerial control is exercised over the newly owned plant.

Question 6

Protectionism

Answer 6

The raising of trade barriers against imports.

This protects domestic industry from more competitive foreign firms by the raising of tariffs, quotas or bureaucratic barriers; it is rational to respond to projectionist measures in kind, but it causes deadweight welfare losses (especially by raising consumer prices) compared to global free trade.

Question 7

Infant industry argument

Answer 7

Rationale for protecting domestic firms from foreign competition until they have grown large enough to achieve the economies of scale to match rival foreign firms.

Tariff protection enables them to establish themselves through internal growth but foreign competition is needed later to help deliver the cost reductions to keep prices down or deadweight loss will arise.

Question 8

Common external tariff

Answer 8

A tax on products imported into a customs union.

Method of protection used by a customs union to keep down imports from non-members; the tariff is designed to raise the import price to the same level in each member country.

Question 9

(Import) Quota

Answer 9

A limit on the number of imported goods allowed into a country over a period of time.

A barrier to trade which leads to deadweight losses and higher consumer prices (but without a tariff’s advantage as a revenue raiser for government); their effect is more certain than tariffs, which depend on elasticities.

Question 10

Non tariff barriers

Answer 10

Methods to prevent the sale of imports apart from tariffs or quotas.

E.g. product quality controls designed to favour domestic firms, preferential buying from domestic firms by public sector.

Question 11

Dumping

Answer 11

Practice of selling exports in foreign markets at a low cost (or below selling price in domestic market).

A form of protectionism which damages foreign suppliers who cannot sell profitably in their domestic market; dumping firms may do this to keep up domestic prices (reducing supply at home e.g CAP) or to capture the foreign market before raising price. WTO allows a victim of dumping to retaliate (e.g. by raising tariffs) if it can prove damage to its domestic industry.

Question 12

World trade organisation (WTO)

Answer 12

Organisation to promote free trade and coordinate (and police) reduction in barriers to trade.

Set up in 1995 to replace GATT (General Agreement on Tariffs and Trade).

Question 13

Free trade area (FTA)

Answer 13

A group of countries which coordinate a reduction of trade barriers between themselves but do not erect a common external tariff.

Often progresses to customs union because each country has different tariff against non-members (hence lowest tariff forms gateway to goods from outside, benefiting import-export firms in that nation).

Question 14

Customs union

Answer 14

A group of countries with reduced trade barriers (tariffs + quotas) between members but a common external tariff against imports from outside.

This leads to trade creation (benefits) but trade diversion (cost), the latter also imposing costs on non-members, who may respond with trade barriers against the customs union.

Question 15

Common market

Answer 15

The stage of economic integration between states when barriers to capital (e.g. exchange controls) and labour mobility (e.g. visas) are removed.

Common market enables efficiency gains since firms can draw on labour supply from entire union (less labour shortages build up requiring increased wage rates) and firms can borrow money more cheaply, tapping into the savings of the entire union.

Question 16

Economic and monetary union (EMU)

Answer 16

When a group of countries in a common market abolish national currencies to share a single currency (and therefore operate a single monetary policy for the whole union).

Arguments for: reduced costs, stable currency, anti-inflationary.

Arguments against: loss of macro policy independence (interest rates, fiscal constraints) to deal with asymmetric shocks – labour must be flexible to cope.

Question 17

Convergence criteria

Answer 17

Macro economic conditions which must be met before a country is allowed to join an Economic and Monetary Union.

Covered: low inflation (below 2.7%), low government budget deficit (maximum 3% GDP), low national debt (maximum 60% GDP), low long-term interest rate (below 7.8%) and exchange rate stability (for two years) against other EMU currencies; meeting these criteria should indicate that an economy is ready for EMU membership e.g. it won’t need exchange rate depreciation to rescue its export sector due to excessive domestic inflation.

Question 18

Stability and growth pact

Answer 18

Limit placed on government budget deficit for countries belonging to the European single currency.

Agreed by member countries, budget deficit should not exceed 3% GDP in any one year, or risk the imposition of fines; Its rationale? To prevent individual countries creating inflationary pressure by running a budget deficit (one governments fiscal laxity could raise EU inflation, bringing European Central bank interest rate rises which would slow down the entire EMU economy).

Question 19

Trading bloc

Answer 19

A group of countries who form a free trade area, customs union or common market as a way to reduce trade barriers between them and raise barriers to non-members. E.g. European Union.

Question 20

Trade creation

Answer 20

The welfare gains from joining a customs union.

These derive from having reduced trade barriers with customs union members e.g. lower tariffs will enable countries to specialise more in what they have a comparative advantage in, gaining the 2 triangles of deadweight loss in the standard textbook tariff diagram.

Question 21

Trade diversion

Answer 21

The welfare losses to a country from joining a customs union.

These derive from having to adopt a common external tariff which may raise the price of imports from low-cost producers outside the customs union e.g. rise in price of New Zealand butter when UK joined EEC in 1973.

Question 22

EU enlargement

Answer 22

Process whereby the established 15 members of the European Union is widening its membership to new European (accession) countries.

In May 2004, 10 new countries joined (Poland, Hungary, Czech Republic, Slovakia, Slovenia, Estonia, Latvia, Lithuania, Republic of Cyprus, Malta); in January 2007, Bulgaria and Romania joined; candidates for future enlargement include Croatia and, controversially, Turkey; EU membership requires a country to fulfil conditions of political and economic development before entry.

Question 23

Competitiveness

Answer 23

The ability of domestic firms to sell their output in the global market (domestic + foreign).

Firms need to stay competitive to survive and contribute to GDP and preserve jobs; this implies being competitive on price or non-price (product quality, branding etc) former helped by fall in exchange rate, non-inflationary wage settlements, higher productivity (e.g. lower unit labour costs); the latter by supplied side policies (e.g. highly skilled).

Question 24

Unit labour costs (ULC)

Answer 24

Labour costs per unit of output.

Crudely: wage bill divided by total output; this is a key indicator of a country’s competitiveness if output growth can outpace growth in the total wage bill then you unit labour cost (ULC) will fall; this should enable the goods to get more price competitive, provided the exchange rate does not strengthen; increased labour productivity won’t result in lower ULC if wages rise at a faster rate.

Question 25

New deal (ND)

Answer 25

New Labour's policy to combat the long-term unemployment: after a period of assisted job search, and unemployed person is guaranteed some form of paid work (involuntary work or subsidised employment) or training. New Deal is a supply-side policy to make labour market more flexible.

Question 26

Social chapter

Answer 26

Section of the Maastricht Treaty which commits European Union countries to guarantee certain legal rights of workers in the labour market. Create a level playing field within EU where all workers get protection, helping labour mobility, and firms can't relocate to source cheaper labour; but institutionalises higher labour costs, making workers less flexible.

Question 27

Working time directive (WTD)

Answer 27

Regulation setting a maximum number of hours per week and employer can insist his employees work. E.g. in UK 48 hours a week, although workers can sign away this right and not all workers are covered e.g. doctors.

Question 28

Exchange rate system

Answer 28

The rules which determine how a country the exchange rate is set. Either: floating, dirty (semi) floating, semi fixed (e.g. Exchange Rate Mechanism), fixed or EMU.

Question 29

Floating exchange rate system

Answer 29

Exchange rate is freely determined by market forces (without government intervention targeting E.R). Trade deficit causes depreciation of currency, this softens job losses in short run; despite being subject to fluctuation, in this system a currency should be in immune from major speculative attack (e.g. George Soros on Stirling 1992).

Question 30

Fixed exchange rate system

Answer 30

Exchange rate is maintained at a target level by government interventions in the currency market. Advantages: anti-inflationary (discipline on wages: devaluation cannot come to rescue of uncompetitive firms).

Question 31

Devaluation

Answer 31

Fall in value of exchange rate, usually announced by the government when part of a fixed exchange rate system (notes: 'appreciation' fall in exchange rate when in floating regime). Effects are to raise import prices and decrease export prices (for in terms of trade), which gives the initial impetus to export sector (though wage-price spirals can undo competitiveness); effect on balance of payments current account is only positive if Marshall Lerner condition holds.

Question 32

Marshall Lerner Condition

Answer 32

The sum of elasticity of demand for exports and imports must exceed one. This guarantees that a devaluation of currency will improve the trade balance on balance of payments current account. N.b. surprisingly, if each elasticity is 0.6 (inelastic) the trade balance still improves! In short run, J curve reflect low elasticities.

Question 33

J curve Effect

Answer 33

The short term fall in balance of payments current account following a devaluation of the exchange rate before long run elastic demand for imports and exports leads to rise. Measures balance of payments current account (vertical axis) against time; in short run firms don't sell more exports because existing contracts reflect previous exchange rate therefore same volume of exports and earns less as price has fallen (same for imports, in reverse).

Question 34

Hot money

Answer 34

Money in search of the highest short-term rates of return available internationally. Such sums are moved by large financial investors into economies where rates of interest are increasing relative to others (so long as the nominal exchange rate is not depreciating at a greater rate); this adds volatility to exchange rate movements since e.g. rises in UK interest rate creates hot money inflows which drive up demand for Sterling… Until UK interest rates fall relatively, when the hot money flows out leading to sterling falls; unlike foreign direct investment, these flows are short term, like currency speculation.

Question 35

Dutch Disease

Answer 35

Where the strength of one sector of the economy drives up the exchange rate to a point where its other sectors lose competitiveness. Arguably one of the factors causing the UK Manufacturing recession in 1980-82, when North Sea oil created massive demand for sterling which drove up the currency so far that other export sectors, like steel and cars suffered a major loss of price competitiveness abroad.

Question 36

Real exchange rate

Answer 36

The price of the country's goods relative to those produced abroad when expressed in a common currency. Measures international competitiveness (combines movements in normal exchange rate and relative information). When UK's real exchange rate rises UK exports become more expensive for foreigners relative to bond produced substitutes: i.e. less price competitive; this can occur for 2 reasons: 1) U.K.'s inflation is relatively higher than abroad. 2) U.K.'s nominal exchange rate rises.

Question 37

Effective exchange rate

Answer 37

The exchange rate of the country's currency measured against a week on average of the currencies of its major trending partners. This gives a general picture of whether the nominal exchange rate movements of, say, Sterling against or other currencies have made exports relatively more expensive for foreigners; the weights used reflect the percentage trade with each country; trend in effective exchange rate is given in index number form.

Question 38

Balance of payments disequilibrium

Answer 38

Where balance of payments current account has a large, persistent and rising deficit (or surplus) over time. In the long run such a deficit can only be supported by matching inflows on the capital/financial accounts (e.g. from sale of assets or borrowing) which is unsustainable.

Question 39

Development

Answer 39

Broad notion of progress in social and economic conditions within a society covering improved material standards of living, self esteem and expanded opportunities for all individuals. Normative concepts; implies that national income statistics are insufficient: development requires more than just improved material standards of living; measured by HDI.

Question 40

Less economically developed countries (LEDC)

Answer 40

Term referring to those countries with relatively low per capita income. E.g poor countries.

Question 41

Newly industrialised countries (NICs)

Answer 41

Countries which have rapidly industrialised since 1950.

Question 42

Infrastructure

Answer 42

The capital making up society's transport and communications networks, its supply of basic amenities and key public services. E.g. road, rail and telephone network. Sometimes called 'social overhead capital'; its absence is a major impediment for a region's economic development.

Question 43

Subsistence

Answer 43

Where farming families produce food for their own consumption. It forms part of the unrecorded or informal sector so official per capita income/GDP understates standards of living.

Question 44

Cash crop

Answer 44

Agricultural crop which is produced for the export market. The danger is that export earnings from cash crops go largely to the elite who run the industry, leaving the workers on small incomes; farmland can be tied up with the cash crop leaving locals to face food shortage.

Question 45

Brain drain

Answer 45

The emigration of highly skilled workers (domestically trained) who are able to earn far higher salaries abroad. However social ties limit time spent abroad and money sent home offsets this.

Question 46

Debt crisis

Answer 46

Constraint on economic growth facing LEDCs due to growing proportion of their national income needed to service the debt to richer economies.

Question 47

Capital flight

Answer 47

The withdrawal of funds from a country due to poor economic conditions, hastened by a speculative fear of currency devaluation. This actually pushes the domestic exchange rate down further, which usually requires government steps to support the exchange rate, like raising interest rates, to guard against inflation.

Question 48

Rural-Urban migration

Answer 48

Relocation of people from villages to cities.

Question 49

Corruption

Answer 49

Where government officials allow law-breaking in exchange for illegal payments.

Question 50

Demographic transition

Answer 50

Model where population grows according to 4 phases as a country develops economically. 1) high birth and death rates (deaths per population, per year) – traditional subsistence society (steady population). 2) death rate falls – industrialisation (population grows). 3) birth rate falls (population growth slows). 4) low birth and death rates – post-industrial society (steady population).

Question 51

Industrialisation

Answer 51

Early stage of economic development where proportion of national output from manufacturing grows rapidly as agricultural's share declines.

Question 52

Deindustrialisation

Answer 52

Later stage of economic development where proportion of national output from manufacturing declines steadily as the share from the service sector rises. For UK, this process has been especially marked since 1989: share of GDP taken by manufacturing has fallen from about 23% to 15% (2008), although in absolute terms manufacturing output has been rising very slowly (up 5% over this period); by contrast Germany's manufacturing share has hardly fallen over 1997-2008 (still around 23% of GDP).

Question 53

Harrod-Domar Growth Model

Answer 53

Model asserting national economic growth depends on increases in its savings rate and decreases in its capital-output.

Question 54

Prebisch-Singer Hypothesis

Answer 54

Hypothesis that countries which specialise in primary products will suffer falling terms of trade over time. Often a problem facing less developed countries; demand for these exports are price and income inelastic, hence primary product prices plummet when technological advances dries up supply or invents a synthetic substitute, and price of manufactured goods rises relatively faster when world income rises.

Question 55

Terms of Trade

Answer 55

Ratio of an index of a country's export prices to an index of its import prices. An 'improvement' in terms of trade means export prices rise relative to import prices (which reduces a country's price competitiveness); however, it means less exports have to be sold to buy a given quantity of import; LEDCs who rely on exporting primary product face terms of trade 'deterioration' over time as such necessity commodities are often income inelastic e.g. tea (Sri Lanka).

Question 56

Trickle Down Effect

Answer 56

Belief that when the rich get richer, the poor will experience some improvement in their incomes as an indirect result. The extra income to the average is spent on domestically produced goods and services which generates job opportunities and extra income for the less rich (as part of the multiplier effect).

Question 57

Import substitution

Answer 57

Strategy used by LEDC governments to replace imports of manufactured goods with domestic production. Popular in 1960s in countries like India; typically involved tariffs to keep imports uncompetitive.

Question 58

OECD

Answer 58

Organisation for economic co-operation and development. An organisation to promote economic growth amongst over 20 of the richest economies e.g. G8, Hungary, Mexico, Turkey, Australia and New Zealand; also aims to helps LEDCs.

Question 59

International Monetary Fund (IMF)

Answer 59

Institution designed to stabilise the world financial system, stepping in when exchange rates move dramatically and where countries experience severe balance of payment problems. IMF lends to governments whose exchange rates are falling fast or whose balance of payments current account is in growing deficit. Recipient nations must accept conditions which enforce tighter monetary and fiscal policy and supply-side measures like privatisation (stabilisation program), which target low inflation; such neo-classical 'shock therapy' can create short term unemployment and cause reduced growth, which worsen the LEDC's plight.

Question 60

Stabilisation programme

Answer 60

Conditions attached to loans from the IMF designed to strengthen macro economic performance. Typically includes momentary and fiscal contraction and it supply-side measures like trade liberalisation (removing tariffs etc); designed to reduce inflation and support the exchange rate in the long term; but it often hits poorest hard and exposes domestic firms to greater risk of bankruptcy.

Question 61

World bank (IRBD)

Answer 61

International financial institution which provides funds for development projects.

Question 62

Structural adjustment programme

Answer 62

Conditions attached to loans from the World Bank designed to strengthen microeconomic performance by encouraging market friendly institutions.

Question 63

Non government organisations (NGOs)

Answer 63

Private sector organisations (like charities) involved in providing financial and technical assistance to LEDCs. Complements the aid offered by rich economy governments, but without serving overtly political aims. Thus, it is argued that NGOs provide more reliable, better targeted aid.

Question 64

Intermediate technology

Answer 64

Technology appropriate to the needs of a LEDC. Therefore it enables Improvements in labour productivity without being so capital intensive that jobs are lost; it is less sophisticated than that used in richer economies eg: spades rathe than combined harvesters (for which lack of spare parts may prove a further difficulty).

Question 65

Aid

Answer 65

Transfer of resources to LEDCs on concessional terms which aim to promote economic development. Can be grants, soft loans, technical assistance or transfers of commodities (eg: famine-relieving food); bilateral if from one country or multilateral if through international agency like EU or World Bank).

Question 66

Tied aid

Answer 66

Aid provided by a rich economy on condition that the recipient uses the funds to buy products from the donor country. Form of bilateral aid, which may be less useful thN unconditional aid since recipients cannot freely buy the best hep available.

Question 67

Soft loan

Answer 67

Loan which Is provided to a LEDC at concessionary rates. Eg: with interest repayment rates at least 25% lower than market rates! or with very long repayments periods.

Question 68

Debt for equity swap

Answer 68

Mechanism where indebted LEDCs exchange foreign debt for shares in domestic firms. Helps break the vicious circle of rising indebtedness in a way which protects rich economy lenders from having to write it off; more generous to LEDCs is debt for nature swaps, where foreign debt is exchanged for LEDCs' commitments to conserve the environment.

Question 69

Micro finance

Answer 69

Small loans provided to poorest households in LEDCs not traditionally available from large indigenous banks. Recently recognised as a critical ingredient of helping the poorest families making a living and grow a small business (eg: Grameen bank in Bangladesh).

Question 70

Fair trade

Answer 70

A worldwide movement to alleviate poverty in poor countries based on sale of their certified exports at a fair (higher) price.

Question 71

Horizontal equity

Answer 71

The equal treatment of people in the same circumstances. Eg: government charging same income tax to all people earning the same income; uncontroversial.

Question 72

Vertical equity

Answer 72

The notion which can be used to justify taxing richer people more to bring about greater 'fairness'.

Question 73

Lorenz Curve

Answer 73

Graphical representation of inequality: cumulative shares of (eg) income are plotted against cumulative shares of the population. Eg: the share of total income earned by the poorest 10% is plotted as a point; more curved = more unequal distribution.

Question 74

Gini Coefficient

Answer 74

A statistical measure of inequality; on Lorenz curve diagram, Gini coefficient = area between line of equality and Lorenz curve/whole area under line of equality. Values: 0 = perfect equality, 1 = maximum inequality; Gini coefficients have been rising since 1979 in UK for income and wealth inequality.

Question 75

Decile

Answer 75

10% of the population of a group. Usually used for (UK) income distribution: the lowest decile is the poorest 10% (in UK).

Question 76

Quintile

Answer 76

20% of the population of a group. Usually used for (UK) income distribution: the lowest quintile is the poorest 20% (in UK).

Question 77

Absolute poverty

Answer 77

A state where a household or person is unable to purchase the basic necessities to sustain civilised life.

Question 78

Relative poverty

Answer 78

A state where a household or person is significantly poorer than the average for the rest of society. Usually set a t less than 50% (or 40%) of median earnings. Eradicating it is achievable with enough redistribution of income (so that the poorest are all between 50-100% of median earnings) but it is considered less serious than absolute poverty. But feelings of alienation from society may lead to unhappiness, illness and crime.

Question 79

Poverty trap

Answer 79

The disincentive to work when someone on benefits faces a very high effective marginal rate of tax if they work harder. This an arise when starting income tax is relatively high and benefits are suddenly withdrawn when someone starts work or earns more in work. Recent UK government policy eg: Working Families Tax Credit has been aimed at removing poverty traps as part of supply side policy.

Question 80

Replacement ratio

Answer 80

The ratio of unemployment benefits to average earnings. If the replacement ratio is high, this reduces the incentive to take up paid employment eg: if the replacement ratio is close to or above 100% this acts as an unemployment trap; reducing the replacement ratio is therefore a supply side policy which has been followed in UK since 1980.

Question 81

Means tested benefits

Answer 81

Benefits which are only paid to households who can prove they are poor.

Question 82

Direct tax

Answer 82

Tax levied on an individual or company on their income or wealth. Eg: UK income tax, corporation tax, council tax, capital gains tax; usually progressive but unlike indirect taxes can reduces incentives to work.

Question 83

Indirect tax

Answer 83

Tax levied on expenditure. Eg: in UK: VAT, tobacco duty, fuel duty.

Question 84

Progressive tax

Answer 84

A tax which takes a higher proportion of income as income rises. Essential for tackling inequality ('fairer') eg: UK income tax, since poorest pay very little (tax free allowance + lower marginal rates of tax until get richer).

Question 85

Regressive tax

Answer 85

A tax which takes a lower proportion of income as income rises. Eg: ( despite zero rated goods ) or tobacco duty since poor spend more of their income than the rich; shift to indirect taxation since 1979 in UK ( advantage: better for incentives to work; disadvantages: regressive + inflationary).

Question 86

Marginal rare of tax (MRT)

Answer 86

The proportion of an additional pound of income which goes in tax. = change in tax paid/change in money come; eg: top rate income tax has MRT of 40% in UK; cuts in MRT should stimulate AD (via C) and AS ( higher incentive to work).

Question 87

Automatic stabiliser

Answer 87

A feature of the government's public finance which helps keep aggregate demand stable in the face of 'booms' and 'busts' ( the business cycle) without a deliberate attempt by government to adjust AD.

Question 88

Discretionary fiscal policy

Answer 88

Alterations to fiscal (government spending and taxation) deliberately made by government to modify aggregate demand in pursuit of its macroeconomic policy aims (low inflation, high growth etc). Also known as 'fine tuning'; in contrast some fiscal factors work automatically eg: entering recession leads to lower tax withdrawals and higher benefit payments ( thereby stimulating AD when it is needed most) via these 'automatic stabilisers'.

Question 89

Demographic timebomb

Answer 89

The negative effects of the ageing of the populations in the industrialised world. Causes: 1) falling birth rates; 2) increased life expectancy; 3) early retirement. Effects: rising dependency ratio ( = population of non working age/population of working age) leading to increased pension spending by government. Possible solutions: raise taxes on workers, reduce pension rates, raise retirement age, move from taxpayer funded to private or (stock market) funded pensions.

Question 90

Public sector net cash requirement (PSNCR)

Answer 90

Government spending minus revenue (per year). Also known as budget deficit. Result of reflationary fiscal policy designed to raise AD (and employment etc); needs financing by either borrowing from banks ( inflationary) or selling bonds to general public (raises interest rates - offsetting some of the boost to AD).

Question 91

Deflationary policy

Answer 91

Government policies to reduce aggregate demand. 3 measures: 1) increase interest rates (monetary policy) 2) cut government spending (fiscal policy) 3) raise taxes (fiscal policy) Aims to reduce inflation (or trade deficit/boost £ exchange rate) but trade off is lower growth and higher unemployment ( unless AS is vertical).

Question 92

Fiscal drag

Answer 92

The effect of inflation (or even real earnings growth) which increases the tax burden in a progressive income tax system without government raising rates because people move into higher tax brackets. This would enable government to raise the relative size of the public sector by stealth; it's effect is to reduce AD (more T, less C) unless government spends the extra tax revenue; each Budget, the Chancellor must raise tax threshold by the rate of inflation ( or real earnings growth) to remove fiscal drag.

Question 93

Fiscal boost

Answer 93

The effect of inflation to reduce the real burden of unit taxes over time unless government indexes unit taxes or moves them in line with inflation. In UK this affects the duties on tobacco, alcohol and petrol eg: if inflation is 10% and petrol duty kept at 50p per litre (when full price is £1), tax burden falls from 50/100 to 50/110; effect is to raise AD (less T, more C in real terms).

Question 94

Income effect (and Supply of Labour)

Answer 94

The increased demand for leisure (fall in supply of labour) by an individual worker as wage rates rise because workers regard leisure as a normal good to be enjoyed more as they earn more. This effect causes 'backward bend' in the supply curve of labour of an individual worker (once wage rises above a critical level); hence any cut in marginal tax rate here will reduce hours worked (contrary to the government's expectations of this 'supply policy'); however, most workers don't hit their 'backward bend' until wages rise as far above market levels (exceptions: GAP year students, the very rich?).

Question 95

Substitution effect (and supply of labour)

Answer 95

The fall in demand for leisure ( increased in supply of labour) by an individual worker as wage rates rise because leisure becomes more expensive in terms of opportunity cost (wage foregone). This effect dominated the income effect for most workers, producing the upward sloping supply curve for the individual worker; it's dominance ensures that cutting marginal tax rate is an effective supply side policy, since workers respond to the higher inventive to work.

Question 96

Laffer curve

Answer 96

The relationship between average rate of income tax and tax revenue: at low tax rates, raising tax rates will increase revenue but after a point revenue falls as workers lose the incentive to work.

Question 97

National debt

Answer 97

Outstanding debt of a national government at a point in time.

Question 98

Golden rule

Answer 98

UK government must only borrow for investment projects: all current spending (non-durable items, like wages) must be paid for from current year tax receipts. Adopted by Chancellor Gordon Brown in 1998 to ensure 'fiscal prudence' and put downward pressure on public spending. Increases in public spending must be accompanied by tax rises unless benefiting future generations, which justifies borrowing so raising the repayment burden on those generations.

Question 99

Sustainable investment rule

Answer 99

UK government must ensure national (I.e public sector) debt never exceeds 40% of national income. Adopted by Chancellor Gordon Brown in 1998 to erasure it's creditors ( buyers of government bonds) that it will be able to repay its debts (fiscal prudence) whilst government can always raise funds by taxation.

Question 100

Phillips curve (PC)

Answer 100

Inverse relationship between rate of wage inflation and unemployment in the macro economy. Empirically based; the short run relationship reflects shifts in AD as economy slides up/down (upward sloping) short run AS curve; in long run, Classical Economists believe the economy will settle at a 'natural rate of unemployment' (NAIRU) consistent with those voluntary unemployed: attempts to reflate and drive unemployment below this natural rate will simply raise inflation and only reduce unemployment so long as the 'money illusion' lasts.

Question 101

Monetarism

Answer 101

The belief that monetary policy is the only way for government to effectively run the macro economy. The underlying belief is that in aggregate demand from expansionary monetary or fiscal policy will only ever boost real output in the short run once people fully anticipate inflation; also that inflation control requires monetary contraction via the Quantity Theory.

Question 102

Keynesianism

Answer 102

The belief that the macro economy can reCh an equilibrium even with unemployment and that then expansionary fiscal policy is a more effective solution than monetary policy. Hence the Keynesian AS curve is upward sloping but not vertical; implies that wages are 'sticky' downwards in a recession, causing demand deficient unemployment; fiscal stimulus ( like increased spending on public works) raises AD via the multiplier whereas interest rate cuts may just be saved instead, especially if there is deflation.

Question 103

Deflation

Answer 103

Situation of persistent negative inflation. A climate of falling average prices means consumption is deferred in expectation of lower prices, which reduces real growth via a downward multiplier; interest rate cuts may become ineffective once nominal interest rate reaches zero (with falling prices this implies a positive and rising real interest rate, which deters recovery of AD).