Year 2 Trade Cycle and Inflation Flashcards
What assumptions are made so the SRAS curve is positively sloped
Firms are profit maximisers
The law of diminishing returns
What is the classical view of the LRAS
They think the LRAS is a vertical line
They think that changes to AD cause the prices of factors to change which causes the SRAS to shift to the previous GDP value
What is the policy implications of the classical view of LRAS
Governments are powerless to influence GDP to changes to AD
Boosting AD only boost GDP in the short run
In the long run, boosting AD causes inflation
Governments can cause economic growth in the long run by shifting the LRAS
What is the Keynesian view of LRAS
He belives that factor markets are slow to adjust to changes in market forces
This causes a reverse L looking LRAS curve
What is the classical approach to stabilising the economic cycle
That the economy should be left alone and that the government can’t affect the output level in the long run
The economy will self correct itself
What are the problems with stabilisation policy
Information problem about where the economy is on the cycle
The timing of policies and the time lag for policies to take effect
Difficulty measuring the multiplier
How does the macro economy self correct
When there is insufficient demand in the economy, surpluses of goods cause the prices to fall until consumers are willing to buy them. This causes AD to increase
When there is excessive demand, shortages of goods drive prices up until consumers start to consume less causing AD to decrease
What is the Keynesian approach to stabilising the economic cycle
They believe that the government need to intervene and adjust the economy as the economy won’t self correct itself
What do Keynesian economists need to have to run the economy
They need to have accurate data about how the economy is currently performing and how it will in the future (economic performance)
What are the main types of indicators of economic performance
Coincident indicators
Lagging indicators
Lead indicators
What are coincident indicators
These are current events that give an indication of the current economic performance
What are lagging indicators
These are current events that give an indication of the stage of the cycle that has already happened
What are lead indictors
These are current events that tell you about future economic activity
e.g. surveys
What are the most useful surveys for lead indicators
Consumer confidence survey
Purchasing Manager indices - asks businesses about their employment intentions and future orders
What are output gaps
They measure the difference between actual economic output an economy produces in the short run and potential economic output in the long run
What is a negative output gap
Its actual output is below the level of its potential output
What is a positive output gap
Its when an economy is currently performing at an actual output level greater than its potential output
How useful are output gaps
They are useful to interventionist governments
A negative output gap means the government know how much additional spending they need to close the gap
A positive output gap means that government knows how much to cut spending by
What is the problem with measuring actual economic output
There are disincentives to declare the real amount of money people have earned
There are black markets that are unrecorded
The GDP is so large that tiny errors are a lot of money
Whats the problem measuring potential economic output
Historical data has to be used and assumed that the growth rate hasn’t changed
What does potential economic growth rates depend on
Productivity rates of labour
Rate of change in technology
Immigration levels
The level of investment
What causes output gaps
Changes in actual GDP
Changes in potential GDP
What is hysteresis
It refers to the damaging effect on future (potential) output of a fall in current output
Why does hysteresis happen
When GDP falls it causes
A loss of entrepreneurs that won’t start another business
Unemployment where some people might not work again
What does hysteresis cause
It causes a shift in the LRAS curve to the left
What are the ideas that explain the trade cycle
The multiplier and accelerator
Speculative and herd behaviour
Asset market bubbles
Credit/debt cycles
What is the multiplier
It is a concept that says that an initial change in someones income causes a change their spending which affects other peoples income
What affects the size of the multiplier
The size of the leakage rate in the economy
the greater the leakage rate the smaller the multiplier
What are the 3 things that make up leakage rate
marginal propensity to save
marginal rate of tax
marginal propensity to import
What is the equation for the multiplier(k)
1/leakage rate
What is the marginal propensity to consume
It is the likelihood of spending a part of income
change in consumption / change in income
What is the marginal propensity to save
It is the likelihood of saving a part of income
change in savings/change in income
what is mps + mpc equal to
1
What does a simple economy mean
No international trade
No taxes
What is the equation for change in income
Change in AD x multiplier
What is the accelerator definition
It is a measure of the extent to which investment spending changes following a change in the rate of consumer spending
What is the accelerator an example of
derived demand
Whats the theory of the accelerator theory
In order to keep investment levels increasing each year, consumer spending must accelerate
What does the accelerator help to explain
the turning points in the trade cycle
What is the evaluation of the accelerator theory
If firms have spare capacity, then firms won’t need to invest
There may be lags between changes in demand and changes in capital
Firms may not invest because of business confidence
The accelerator applies more to the secondary industry
What are assets
Tangibles bought by investors not for their use but in hope that they will increase in value over time
How are assests moved around
They are traded in respective markets but are substitutes for one another for any speculators trying to store wealth
What are asset markets like
They are prone to volatile pricing activity with price surges (bubbles) followed by sharp downward correction (crashs)
How does a bubble form
It forms when asset prices are driven beyond the point where they reflect the underlying value of the asset
What are examples of asset market crashes
Bitcoin crash in 2020-21
The US houding bubble that caused the global recession of 2008-09
What explains the volatility of asset markets
Herd behaviour
information uncertainty
What are the stages of asset bubbles and crashes
The upswing - increase in value
The pop - the fall in value
The bounce - the recovery of price
What are the implication of asset markets in the real economy
Changes in asset prices effect the wealth of holders
The more or less wealthier people, the more or less confident they are
Wealth effect
What do credit markets allow to happen
It allows people to spend their future income in the present and then have to spend less in the future when paying it off
What are the effects of credit markets on the trade cycle
During periods of borrowing AD will be higher then it could be if everyone spend what they earned
When debts come to be repaid, AD falls as people spend less
What is the classical economists view of stabilising the macro-economy
Automatic self correction
Too much information failure to make effective changes
How does the economy self correct
In a economic downturn AD falls so firms will cut prices because of the lower demand
This causes lower demand for labour , which causes workers to accept lower wages
Falling prices causes consumer to start spending and firms to start hiring again
Business confidence returns and investment increases
AD rises
What is the classical view of interference by governments
It makes the economy worse and de-stabilises the recovery mechanism
Why does interference make the economy worse at recovering
Uncertainties about the output gap
Uncertainties about the size of the multiplier
Uncertainties about the time lags involved when implementing policies
Crowding out effects of government activity
What is the problem with output gaps
They are hard to accurately measure
Hard to measure actual output because of errors and black markets
Hard to measure potential output because of mass immigration, rapid technological change and changing productivity
What is the problem with the multiplier
Hard to measure as it isn’t constant
Need to predict future leakage rates
What is the problem with time lags
It means that policies don’t take effect instantly
What are examples of time lags
Interest rate cut by Bank of England indicates for commercial bank to cut rates
Banks need to inform customers on variable loans
Customers take time to react and adjust spending
Firms will take time to feel effect of sales
Firms take time to adjust output
Government takes time to measure changes to GDP
How long are time lags normally
18 months to 2 years
What the problem with crowding out
As governments try to spend more they replace who is doing the spending by crowding out the private sector through borrowing or higher taxation
What is the quantity Theory of Money
Theory of why money loses value
Money is devalued when its supply rises too quickly and this loss of value is shown as inflation
What is the relationship between quantity of money in circulation and the average price level
Direct relationship
Who developed the Quantity Theory
Irving Fisher
What is the Fisher identity or equation of exchange
Identity made from the Quantity Theory of Money
MV = PQ
M= Money supply
V = Velocity of circulation of money
P = Price Level
Q = Real Quantity of output
What is the velocity of circulation of money
The average number of times a unit of currency changes hands in a year
What 2 assumptions turn the Fisher identity into the monetarist theory
The velocity of circulation of money is stable
The volume of output produced in an economy is stable
What does the Monetarist theory suggest then
That the money supply is directly linked to the general price level
An increase in output in the short run will not cause a change in the price level as long as the money supply changes by the same amount
What were the policy implications of the monetarist theory
Governments who wanted to control the price level would restrict the change in money supply to match the short run growth of output
What are the challenges to the monetarist theory
- An increase in the velocity of circulation of money caused by inflationary expectations can cause inflation
- A fall in output but with constant money stock causes inflation e.g. wartime
- An increase in money supply could lead to an increase in output when there is a large output gap (Horizontal LRAS curve)
- A rise in the money supply could be neutralised by a fall in velocity of circulation e.g. lockdown
- Keynes argued that a price level rise causes the money supply to rise as the cost of living rises
What are the economic costs of inflation
1.Effect on UK competitiveness
2.Problem of the wage-price spiral
3.Redistribution of income from savers to borrowers
4.Consumers and businesses on fixed incomes lose out
5.Usually leads to higher nominal interest rates
6.Disrupt business planning
7.Distorts the operation of the price mechanism
8.Shoe leather cost/search costs
9.Menu costs
What is the effect of inflation on UK competitivness
Inflation causes a loss of price competitiveness in international markets
AD falls from falling exports
What is the evaluation of the effect on UK competitivness
Assumes a given exchange rate - depreciated exchange rate
Depends on relative inflation rate
Depends on the selling prices of UK goods
Source of inflation - Excess demand for exports won’t effect competitiveness
It will hurt open economies more
What is the wage price spiral
Price level rise can lead to higher wage demands
Higher wages causes unit labour costs to rise if above the increase in productivity
This causes firms to raise prices to maintain profit levels
Causing inflation
What is the evaluation of the wage price spiral
The second rise in inflation depends on how monopsonistic and monopolistic the labour market is
The more it is, the more likely wages will rise
What is the redistribution of income from savers to borrowers
Inflation causes a reduction in the real value of savings when real interest rates are negative
The real value of debt is diminished
How will consumers and businesses on fixed income lose out
Fixed pensions have their real value diminished
The state pension is normally adjusted for inflation each year
What is the evaluation of consumers and businesses on fixed incomes losing out
The CPI only takes into account the average spending patterns of consumers
Consumers with abnormal spending patterns like pensioners will have a different inflation rate
This means that there incomes are not adjusted for inflation
How can inflation disrupt business planning
It causes uncertainty about the future which makes planning hard
This may have a negative impact on the level of planned investment
How can inflation distort the operation of the price mechanism
Results in inefficient allocation of resources
When inflation is volatile, consumers and firms won’t have enough information to make good decisions
What is the evaluation of the disruption of business planning
The volatility of inflation is what makes planning hard as firms don’t know their future costs and revenue
Unanticipated inflation is worse as it can’t be planned for
What are shoe leather costs/ search costs
Inflation makes it harder for consumers to find the best deals and see relative prices
This extra brings opportunity costs
What is the evaluation of shoe leather costs
This is a very small impact of inflation
Price comparison websites reduces the search cost
What are menu costs
They are the extra costs to firms of changing price information
This is important to firms with bulky catalogues
When is inflation the worst
High, volatile and unanticipated
Open economies with large amounts of people on fixed incomes
Wage price spiral
What are the economic benefits of inflation
Encourage investment
Falling debt values
Rising Asset Values - Wealth Effect
Lack of inflation leads to low real output and employment
Money illusion
How does Inflation encourage investment
Profits may be eroded sitting in banks at negative real interest rates
Firms decide to invest the money instead
What is the money illusion
Inflation allows the government to increase nominal spending and reduce real spending
Allows the government to operate negative interest rates
What is deflation
A sustained fall in the general price over time
Negative Inflation
What are the 2 types of deflation
Benign
Malign
What is benign deflation
Supply side improvements - increase in supply
Causes increased output, employment and real living standards, rising real incomes
Caused by productivity, commodity prices, tech
Associated with long run supply side growth
What is malign deflation
Fall in the level of aggregate demand
Causes falls in output, employment and living standards
Hard to get rid of if deflationary expectations set in causing downward multiplier impact
What is deflationary expectations
Consumers and firms expect deflation so postpone their consumption and investment
Increasing savings ratio and reduces velocity of circulation of money
Less C+I reducing AD
What is the disadvantage of both deflations
It raises the real value of debt
This makes it more expensive for borrowers and causes increased opportunity costs in other spending areas
What is another disadvantage of both deflations
It makes monetary policy less effective
Deflation makes it impossible to achieve negative real interest rates
This makes it hard to stimulate the economy
What is the equation for real rate of interest
Nominal roi - inflation rate
What country has experienced malign deflation
Japan
What were the Prime Ministers 3 main economic policies to remove deflation
Negative central bank interest rate and QE
Expansionary Fiscal Policy
Supply side structural reforms making markets more efficient
What does Negative central bank interest rate do
Commercial banks are charged to hold money with the Bank of Japan
This incentives them to lend the money out
What is quantitative easing QE
The central bank pumping liquidity into the economy by buying bonds from existing holders
What is the short run Phillips curve
A inverse non-linear relationship between inflation rate and unemployment rate
Developed by AW Philips
Inflation y-axis
unemployment x-axis
What explains the short run Phillips curve relationship
Low unemployment means that there is a high average income so high consumption
It also means higher wages for workers as its harder to replace them - higher costs
High unemployment causes low average wages and low costs for firms
What did the short run Phillips curve mean for governments
It offered governments a trade off between inflation and unemployment
The non-linear relationship causes a greater opportunity cost as you try to reduce 1 variable closer to zero
What is the natural rate of unemployment
Unemployment when all labour markets were in equilibrium with all willing and able people in work
The unemployment was caused by frictional, structural or voluntary unemployment
What is the long run phillips curve
A vertical line positioned at the economies natural rate of unemployment
No trade-off between inflation and unemployment
How does the long run Phillips curve work
If a short run demand stimulus is added, inflation rises and unemployment falls
The position is held in the long run until the money illusion stops i.e. higher nominal wages but same real wages
Workers leave the market and unemployment falls back to original rate at LRPC but with higher inflation rate
What are the policy implications of the Long Run Phillips Curve
The natural rate of unemployment is immune to demand side policies
The natural rate of unemployment can only be affected by supply side policies
Successive attempts to boost the short run position will shorten its time in the long run
Whats the point of inflation targeting
It shows a commitment to keeping inflation under control
Achieving the target will reduce inflationary expectations
Does it matter if the inflation target is missed
Yes and NO
It anchor’s inflationary expectations but won’t be credible if broken lots
Though it wasn’t designed to be always 2%, shocks can disrupt the target
Why isn’t the inflation target 0%
2% isn’t inflationary if goods are improving 2% each year so there is a quality adjusted target rate of 0%
2% allows negative real interest rates and money illusion
Too high of an opportunity cost
Could easily fall into deflation which is hard to get rid of
