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Questions and Answers
What is one effect of a decrease in aggregate supply on inflation and output?
What is one effect of a decrease in aggregate supply on inflation and output?
Which of the following can cause a decrease in aggregate supply?
Which of the following can cause a decrease in aggregate supply?
What happens to GDP when there is an increase in aggregate demand?
What happens to GDP when there is an increase in aggregate demand?
What could be a consequence of a richer population on the economy?
What could be a consequence of a richer population on the economy?
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Which event is NOT likely to cause a decrease in aggregate supply?
Which event is NOT likely to cause a decrease in aggregate supply?
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What was the average UK house price in 1968 in real terms?
What was the average UK house price in 1968 in real terms?
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What effect does inflation have on life savings?
What effect does inflation have on life savings?
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How does inflation impact wages?
How does inflation impact wages?
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Which of the following describes a consequence of inflation?
Which of the following describes a consequence of inflation?
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What happens during deflation according to economic principles?
What happens during deflation according to economic principles?
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How can inflation become a self-fulfilling prophecy?
How can inflation become a self-fulfilling prophecy?
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What is the primary method used by central banks to combat inflation?
What is the primary method used by central banks to combat inflation?
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What is a significant consequence of rising prices due to inflation?
What is a significant consequence of rising prices due to inflation?
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Why do central banks often face criticism when fighting inflation?
Why do central banks often face criticism when fighting inflation?
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What might politicians do in response to inflation-related issues?
What might politicians do in response to inflation-related issues?
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Which film holds the highest real domestic lifetime gross box-office takings?
Which film holds the highest real domestic lifetime gross box-office takings?
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What is the nominal domestic lifetime gross for 'Avengers: Endgame'?
What is the nominal domestic lifetime gross for 'Avengers: Endgame'?
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Which film was released in 2022 and had a nominal gross of 0.68 billion?
Which film was released in 2022 and had a nominal gross of 0.68 billion?
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What is the nominal domestic lifetime gross of the film 'Titanic'?
What is the nominal domestic lifetime gross of the film 'Titanic'?
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Which year did 'E.T. the Extra-Terrestrial' release?
Which year did 'E.T. the Extra-Terrestrial' release?
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Study Notes
Economic Principles Lecture 05: Steering Markets
- Lecture is on steering markets, part of Economic Principles course at University of Liverpool
- Lecturer is Dr. Tim Jackson; contact: [email protected]
- Midterm exam details:
- Starts 9:30 am, Friday, November 1st
- Online, on Canvas
- One-hour, 20 questions
- No penalty for incorrect answers
- Practice midterm available on Canvas
- Submit on time to avoid late penalties
Recap of Capitalism
- Capitalism requires freedom, property rights, and rule of law
- Markets allocate resources based on people's opinions, similar to democratic voting.
- Demand curve represents buyer opinions, and supply curve represents seller opinions.
- Market price and quantity depend on the average opinion of buyers and sellers.
Aggregates
- Individual goods/services are based on supply and demand (quantity and price).
- The whole economy involves many goods and services.
- The UK has approximately 53 million retail transactions daily (Retail Consortium 2023), not including commercial transactions or those done in cash.
- The macro-economy is a complex system.
- Economists use aggregates to understand the larger economy (total quantity and average price of goods/services).
- Aggregation is complex due to variability.
Output
- Aggregate output (Y) is the total value of all goods/services, equivalent to quantity in supply and demand diagrams.
- Aggregate output isn't as precisely defined as individual items.
- GDP is used to measure output in countries.
GDP
- GDP is a common way to measure output (Gross Domestic Product)
- It aims to show a country's sales, income generation, and spending on goods/services.
- GDP has different measurement methods (total value of goods/services produced and sold, total income earned, total value of all spending).
- The methods should ideally measure the same but often do not.
Growth
- Growth is the change in total output over time.
- A recession is a two-consecutive quarter drop in output.
- Growth indicates economic expansion (becoming richer) or contraction (becoming poorer).
- Continuing a standard of living necessitates growth, especially with rising populations and aging populations.
Average Price
- Price level is the average price of all goods/services.
- It is similar to the price in supply and demand graphs but more complicated due to variability.
- Economists use a basket of common goods to gauge average price.
- The basket's composition and quantities are fixed. The Office for National Statistics (ONS) data can indicate the composition.
Inflation and Growth
- Inflation is an increase in prices.
- Deflation is a decrease in prices.
- Disinflation is a decrease in the rate of inflation.
- Inflation measures how expensive items are becoming.
- Economists and governments are concerned with both inflation and growth.
- Inflation used to be less of a concern but recently has become more important.
Real vs Nominal
- Economists use "real" to indicate price changes, contrasting with "nominal" values in data.
- Nominal wages are the amount received, whereas real wages are the purchasing power based on the wage.
- When inflation is low, real and nominal values are basically the same (no significant distortions).
- When inflation surges, real values decrease, while nominal ones can stay the same.
- This occurs since price hikes outpace/outgrow wage increase.
Films and Box Office Records
- Current box office records are nominal (current money values).
- Historical records should be adjusted for real values (to make comparisons with earlier years possible).
- Real comparisons show that only a few movies have held up well against the test of time.
Real vs Nominal-continued
- Comparing values across time is crucial, especially regarding long periods of inflation.
- House prices (UK) were significantly lower in 1968, e.g., average at about £53,000 in real terms.
- Real-term values are corrected for inflation.
Inflation Erodes Savings
- Inflation reduces purchasing power over time.
- Severe inflation can wipe out savings.
- This is especially notable in hyperinflation situations.
- Extreme instances show savings can quickly lose value.
Inflation Introduces Distortions
- Inflation transfers wealth from savers to borrowers (debt).
- Inflation potentially encourages risk-taking.
- Inflation complicates wealth transfer between employees and their employers and impacts purchasing power.
- The price signal for resources becomes unclear, possibly hindering resource allocation.
- Noted measures (like "shoe leather" or "menu" costs) are now less relevant due to technological advancement.
Inflation and Inequality
- Inflation negatively impacts wages negatively.
- Those with stronger bargaining power (e.g., UK pensioners) are more likely to have their wages increase at rates as or above the inflation rate.
- Wage increases at or above inflation rate thus help maintain their purchasing power.
- Individuals with lower bargaining power could find their purchasing power decreasing.
- Workers, especially those on minimum wage, are very susceptible to loss of purchasing power due to inflation.
Deflation is Also Bad
- Deflation discourages consumers by delaying future purchases (they wait for further price drops).
- This hampers economic well-being, similar to a contractionary effect.
Inflation is a Spiral
- Inflation can cause further inflation.
- Unexpected price hikes make workers demand higher wages.
- High inflation makes investors seek better returns.
- This could cause interest rate increases and price hikes as well.
- Thus, inflation can perpetuate itself, becoming a hard-to-break problem.
Fighting Inflation is Costly
- Interest rate increases are among the primary tools for fighting inflation.
- But this practice can harm by increasing borrowing costs (i.e., debt burden on loans, mortgages, and rent) and potentially causing an economic slowdown.
- Central banks often face criticism and political pressure during such strategies.
- This is due to the potential for widespread negative impacts.
Inflation Makes You Poorer
- Inflation means things become more expensive, thereby reducing purchasing power and increasing the cost of living.
- While it can occur gradually, people may not realize the impact over time.
- Thus, the purchasing power declines despite not realizing what's happening.
Con-Artists and Scapegoats
- Inflation provides opportunities for con artists and scapegoating by politicians.
- Politicians may seek to blame groups or events for inflation causes when these are economic in nature (for example, a lack of sufficient goods supply or excess demand).
Aggregate Demand and Supply
- Aggregate supply is the total value of goods produced, consumed.
- Aggregate demand is the value of everything in the economy.
- This consists of household consumption, business investment, government spending, and external demand.
Equilibrium
- Equilibrium is where aggregate supply and demand intersect.
- Equilibrium output is what GDP measures.
- Equilibrium price level is determined by the basket of goods (or services).
What Causes Inflation and Growth?
- Changes in supply and demand affect prices and output, influencing inflation and growth.
- Supply or demand increases/decreases can be characterized by economists as such to gauge effects.
- These alterations can greatly impact the economy.
Decrease in Aggregate Supply
- Fewer goods supplied leads to price increases and lower output, representing a recession/contractionary phase.
- Factors that cause decreases in overall supply (e.g., supply chain disruptions or material scarcity) are among causes of recessions and contractions.
- Factors such as natural disasters, or shifts in production, could influence such decreases in aggregate supply drastically.
Some Causes of Supply Falls
- Weather and disease
- Political regime shifts
- Wars and embargoes
- Market power (e.g., OPEC)
- Trade issues (such as Brexit)
- Costs (i.e., labor or materials)
- Investments and financial instability (e.g., after a financial crisis).
Increase in Aggregate Demand
- Increased demand increases prices and boosts overall output (booming economy).
- Increased demand (due to factors like increased income levels or expansionary fiscal policies) can spur significant growth in output of the economy.
Some Causes of Demand Rises
- Overall income increases
- Productivity increase due to better technology
- Savings decline (such as due to improved social welfare or culture/ideology changes)
- Increased borrowing (due to lower interest rates or other favorable lending terms)
- Government intervention.
- Interventions that aim at boosting the overall economy (such as increased government spending) can make consumers spend more, boosting demand.
Summary
- Changes in demand or supply influence prices and thus inflation and economic growth.
- Inflation is caused by supply decreases or demand increases.
- Recessions are caused by supply decrease or demand decrease.
- Governments aim to avoid inflation and recessions.
Supply Side Policies
- Tax cuts (incentivizing labor and investment; often effective on high-marginal tax rates.
- Deregulation reduces bureaucratic barriers to doing business.
- Labor reforms increase flexibility (easier hiring/firing).
- Reduced minimum wage.
- Education/training funding.
- Infrastructure investment
- Research/Development funding.
- Trade liberalization (easier access to global markets; reduction of tariffs/quotas).
- Immigration promotion (potential benefits).
Problems with Supply Side Policies
- Supply-side policies while potent, may introduce distributional consequences.
- These need to consider fairness and need to be carefully managed when implemented.
- Such policies can be challenging and time-consuming to implement.
- Such delays can mean they lack the ability to timely counteract factors that negatively impact the economy.
Policies to Fight Inflation
- Reduced government spending (or increase in taxes) reduces aggregate demand (reduction in government expenditure or increase in taxation directly/indirectly reduces consumer demand).
- This is a fiscal policy.
- Increased interest rates increase borrowing costs, reducing aggregate demand, which is a monetary policy.
- Interest rates are a frequently useful tool to adjust money supply.
Contractionary Policies
- Reduced aggregate demand reduces prices, and output.
- Central Banks use these policies to deal with inflation.
Expansionary Policies
- Increased government spending/tax cuts reduce interest rates.
- This stimulation boosts aggregate demand and economic growth.
- Note that such policies may increase inflationary pressure.
Monetary Policy
- Central Banks adjust interest rates through Open Market Operations (OMO).
- Government bonds are one of the main ways investments are made.
- The bond yields act as a reference point for similar investments (set "floor" on interest rate).
- Raising bond rates increases borrowing costs for consumers/firms, reduction of spending.
- Inflation falls with decreased aggregate demand.
- The interest rate is an important tool for controlling the economy.
Government Bond Rate
- Central banks (through open market operations) control these interest rates (by buying/selling government bonds).
- This indirect method has tangible effects on the overall economy as interest rate changes affect investment and borrowing activity.
Contractionary OMO
- Central Bank reduces government borrowing (by selling bonds).
- This leads to higher bond interest rates and tighter conditions in the loan market.
Expansionary OMO
- Central Bank increases government borrowing (by buying bonds).
- This leads to lower bond interest rates and a looser funding environment.
Quantitative Easing (QE)
- QE is a massive OMO (open market operation) where central banks buy a great deal of bonds.
- The scale is typically in the trillions of dollars.
Taylor Rule
- Many central banks seem to follow a Taylor Rule, guided by inflation and output targets, to adjust interest rates.
- A higher-than-target inflation rate warrants interest rate increase.
- This aims to curb spending.
- Lower-than-target output necessitates interest rate reduction, to stimulate spending.
- The Taylor rule is a conceptual tool for how economic policies can balance out inflation and output of the economy.
Monetary Policy in Action
- Rate cuts in downturns, rate increases after inflation spikes.
Taylor Rule (continued)
- The Taylor Rule formula clarifies this relationship.
- It considers how the central bank should adjust interest rate by taking inflation and output (or GDP) into account.
- The formula has terms that quantify the relative importance given to inflation versus output.
Using the Taylor Rule
- Central banks use the Taylor Rule to adjust interest rates and aim at bringing inflation and output closer to the target.
- Central banks often have a greater focus on inflation as opposed to output.
- Inflation is a frequently cited, problematic aspect in the economy.
- The US Federal Reserve stands out, having a mandate that includes maximum employment.
Evidence for the Taylor Rule
- The Federal Reserve doesn't explicitly follow the Taylor Rule.
- However, the data suggest the Federal Reserve tends to follow the Taylor Rule.
What Should Central Bank Mandates Be?
- Central banks frequently employ Taylor Rule-like models in their interest rate setting decisions.
- These models incorporate factors such as inflation and GDP outputs to guide adjustments.
- This methodology reflects an attempt to consider numerous economic factors during the interest rate setting process.
Inflation Mandates
- Central banks' perceived trustworthiness in managing inflation.
- Public perception wields considerable influence over how potential investors in the financial sector view inflation risk, as demonstrated by recent instances of inflation, the inflation fears, and the inflation expectations on the market.
Central Bank Credibility
- Maintaining a reputation to fight inflation is crucial.
- A consistent policy (reputation) can encourage compliance with policy as well as potentially bring down overall inflation and inflation expectations.
- If stakeholders believe the central bank will pursue policies consistently, economic growth may also result from this confidence.
Summary (continued)
- Inflation and economic output are impacted by aggregate demand and supply.
- Central banks adjust interest rates to achieve acceptable inflation and output targets through the Taylor Rule (or similar models).
- Tough decisions by the central bank are critical to achieving its inflation objectives, and this is also dependent on perceptions and credibility in the market.
Bibliography
- Various sources (such as BIS, FRED, ONS, academic articles, etc.) supply data used for the Economic Principles lecture.
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Description
Explore the key concepts of market steering in this lecture, which is part of the Economic Principles course at the University of Liverpool. Dr. Tim Jackson discusses the foundations of capitalism, the roles of demand and supply curves, and how these factors shape market dynamics.
