Unit 4 - The Macroeconomy Flashcards
How is the level of activity in the economy determined?
The interaction of aggregate demand and supply (AD AS)
Define
Aggregate Demand
The total demand for final goods and services in the economy at a given time and price level
The amount of goods and services that will be purchased at all possible price level
Equation
Aggregate Demand
and what does each represent
AD = C + I + G + (X-M)
Consumption/Consumer Expenditure
Investment - spending by the private sector on capital goods
Government Spending
Net export = Exports - Imports
Why can’t you explain the downward slope of Ad with the same reasons as an individual demand curve?
A change in price level implies that many prices are changing, including wages paid to workers therefore incomes are changing,(C=a+bY) and consequently it is not possible to assume prices and incomes remain constant
Three reasons for a downward-sloping AD curve
- Wealth effect
- Interest rate effect
- Net exports effect
Explain
The Wealth effect on AD
the AD curve works under the assumption that the governments supply of money/economy’s wealth is held constant. As the price level rises the wealth of a country declines as the purchasing power of the currency falls. so if buyers become less wealthy they can not buy as much as they used to
Describe
The Interest effect on AD
As the price level rises, consumers requre more money to handle they transactions, however the supply of money is still fixed. increased demand for a fixed supply of money leads to increased interest rates
Describe
Net exports’ effect on AD
if the price of domestic price levels increases, demand increases for imports and because domestic goods have a higher price level, demand for exports fall as the goods are now expensive to foreigners
Define
Aggregate Supply
The total output that firms in a economy are willing and able to supply at diffrent price levels in a given period of time
Define
SRAS
short run aggregate supply
output which will be supplied at different price levels in a period of time when the factors of production remain unchanged or fixed
Describe
Why SRAS and Price level have a direct relationship?
higher price enables firms to meet extra costs and enjoy higer profit margins and producers are more willing and able to supply more goods
State
Reasons for SRAS and Price levels’ positive relationship
- Profit effect
- Cost effect
- Misinterpretation effect
Describe
Profit effect on SRAS
price level increses with the price of factor of production held constant, the gap between output and input prices widens therefore profit increases
Describe
Cost effect on SRAS
Average cost may rise as output increases, even though the rates and raw materials stay constant eg overtime and the miscellaneous costs must be paid. To compensate producers will require higher prices
What are *Reflationary Monetary policies *
When government reduces the interest rates and increases the money supply in the economy
What are Reflationary Fiscal Policies ?
Governments reduce taxes,
increased government expenditure ( subsidies)
Define
Inflation
A persistent increase in the general price level that leads to a fall in the value of money
What are the main economic problems?
Price stability
Exchange rate Stability
Unemployment
Equity
Balance of payment stability
Economic growth and development
What are some qualities of inflation?
Price increase must be on a wide range of items
Must be sustained over a period of time
If low and steady it allows businesses to plan with confidence
What are the three main causes of inflation?
Cost push
Demand pull
Monetarist
What are the three degrees of inflation?
Creeping/gradual inflation - <10
Strato-inflation - high but fluctuating rate of inflation >10
Hyperinflation - short lived, over 50%
What are the two types of inflation?
Suppressed inflation - caused by government prices that prevent the price mechanism from working
Stagflation/slumpflation - during periods of recession and can be attributed to economic stagnation
Describe
Cost Push inflation
Supply side inflation , due to changes in the aggregate supply factors leading to rises in cost of production and therefore price level
Bad inflation
What are the causes of cost push inflation?
Wage cost
Oil prices
Currency depreciation
Imported inflation
Profit margins and indirect tax
Explain
Effect of wage cost
Wages and salaries account for a large portion of national income,
and increase the cost of production when wages increase. When it is persistent it causes cost push inflation
As price level increases workers, demand more money, which increases price level, causing a wage spiral
Explain
Effect of Oil prices on cost push
Oil is used directly and indirectly, especially in transport and as a raw material, and when oil prices rise, inflation
Explain
Currency depreciation effect on cost push
Loses its value or purchasing power heavily affecting countries that rely heavily on imported materials
Explain
The effect of imported inflation on cost push
If a country relies heavily on imported raw materials, inflation from the country of import can cause increase in cost of production and therefore an increase in price level.
Explain
The effect of profit margins and indirect tax on cost push
In an attempt to meet their profit targets and are likely to increase prices especially if demand is inelastic, which will increase price level as consumers continue to buy and prices continue to rise
Describe
Demand Pull Inflation
Demand side inflation due to changes in factors affecting aggregate demand pulling price level up by the price mechanism
Good inflation
What are the causes of demand pull inflation?
Reflationary polices by government
Increased consumer spending
Explain
Effect of Reflationary fiscal and Reflationary monetary policy on demand pull
Fiscal - government reduces taxes leaving consumers with more disposable income allowing them effective demand for more goods. They can also increase government expenditure leading to a multiplier effect leading to a further increase in AD
Explain
Effect increased consumer spending
Aggregate Demand increases when there is greater consumer confidence due to economic and political stability increasing propensity to consume
State
Fishers equation
MV=PT
Money supply
Velocity of circulation
Price level
Number of transactions
What does the quantity theory of money show?
How the reckless printing of money to pay debts back or finance campaigns, can result in an increase in general price level and lead to inflation that devalues the money
state
Possible benefits of inflation
Stimulating output - optimism about the future
Reduce debt burdens - nominal interest rates do not adjust to inflation
Prevent some unemployment -
Factors affecting the consequences of inflation
- The cause of the inflation - Demand pull is good; cost push is bad
- The rate of inflation - high inflation causes more damage
- Whether the inflation rate is accelerating or stable - firms need time to adapt
- Whether the inflation rate is anticipated or not - uncertainty reduces expenditure
- How the inflation rate compares to other countries - other suffer more; your goods are still competitive
Describe
The misinterpretation effect on SRAS
Producers confuse the increase in price level with popularity of their good and may be encouraged to produce more which will reduce profits in the long run
Define
LRAS
Long run aggregate supply
The output that firms will produce after the price level and factor prices have fully adjusted after any shift in AD
Maximum potential output possible with given resources and technology at full employment
Describe
The shapes at each point of the Keynesians LRAS and what they mean
Initially it is perfectly elastic so output can be increased without raising the prices, for example the existence of spare capacity.
Eventually firms begin to experience shortages and due to the large demand, workers require more wages (elastic).
Eventually they reach maximum output and full employment and price level increases from there and the graph is perfectly inelastic
Why is the Neo-Classical LRAS Curve perfectly inelastic?
They believe that in the long run labour market will be in equilibrium and economy will always be operating at full capacity where AD=AS at full employment
What is the cause of a shift in the LRAS?
A change in quantity and or quality of resources (factor productivity)
What are the causes of of an increase in quantity of resources in the long run?
Net Immigration
Increased retirement age
More Women in the labour force
Net investment
Discovery new of resources
Land reclamation
What are the causes of an increase in quality of factors of production in the long run?
Improvement in education
Advancements in Technology
State
Consequences of inflation
- A reduction in net exports - goods are less competitive in international markets
- Unplanned redistribution of income
- Menus costs - changing prices
- Shoe leather costs - costs of moving between asset types
- Fiscal drag - (bracket creep) individuals and firms are dragged into higher tax brackets
- Inflationary noise - higher price level confused for more demand for goods
- Inflationary spiral
- Discouragement of investment
Define
Deflation
Sustained fall in the price level that leads to a rise in the value of money
Define
Disinflation
A fall in the rate of inflation
There is still inflation but the rate of increase falls
State
Causes of deflation
Good deflation (AS) - advancements in technology, lower cost of production
Bad deflation (AD) - fall in demand, more unemployment
Positive consequences of deflation(AS)
Lenders receive more money - increased real value
Increased employment
Negative consequences of deflation (AD)
Consumers may delay their purchases for times when prices are even lower. Firms see low demand and are unlikely to reinvest, increase unemployment, further reducing demand causing a deflationary spiral
How to measure CPI and RPI
a) Selecting the base year
- this base year is given an index of 100
b) Selecting the “basket” of goods - is determined by family expenditure survey in which about 7000 households provide an annual record of their spending over a fortnight.
c)
Attach weights to the different categories of goods
d) Calculations of price relatives for goods involved in the “basket” - this is done by calculating the percentage changes in the base date prices.
e) Determining the weight of goods and services - the weights are determined by the relative expenditure on the various goods and services by the households
Problems of using CPI/RPI
- Time factor - changes in taste and new goods are not accounted for properly
- Quality changes - increases in price accompanied by better quality are interpreted as inflation
- Taxes and benefit - changes in tax and tax allowances are not considered
- High rates of inflation- difficult to measure annual rate
- Political implications - data may be changed by institutions as the state of an economy is liked with their success. Assists and pensions will have to be index linked
- Statistical errors
Equation
Rate of inflation
Current year index - Base year Index
Equation
Base year index
Sum of indices / sum of items
Should equal 100
Equation
Weighted index
Weight x index
Equation
Subsequent years index
Sum of weighted index / sum of weights
