Economics AS Level Macroeconomics Notes PDF

Economics AS Macroeconomics Notes Aggregate Demand – The total demand for a country’s goods and services at a given price level and in a given time period. Aggregate Demand Formula: AD = Aggregate Demand C = Consumption / Consumer Expenditure I = Investment G = Government Expenditure X = Expor...

Economics AS Macroeconomics Notes Aggregate Demand – The total demand for a country’s goods and services at a given price level and in a given time period. Aggregate Demand Formula: AD = Aggregate Demand C = Consumption / Consumer Expenditure I = Investment G = Government Expenditure X = Exports M = Imports AD = C + I + G + (X – M) Exports – Imports ≡ Net Trade ≡ Net Exports Consumption / Consumer Expenditure – Spending by households on consumer products – Consumption is the largest component of AD Investment – Spending on capital goods – Investment is the most volatile component of AD Government Expenditure – Spending by the central government and local government on goods and services – This is education, health care and the police service NOT including transfer payments (housing benefit, job seeker’s allowance and state pensions) / an increase in job seeker’s allowance would be reflected in consumption as the increase in benefits will create an increase in disposable income that would then be spent on goods and services. Transfer Payments – Money transferred from one person or group to another not in return for any good or service Job seeker’s allowance – A benefit paid by the government to those unemployed and trying to find a job Exports – Products sold abroad Imports – Products bought from abroad Trade Surplus – The value of exports exceeding the value of imports Trade Deficit - The value of imports exceeding the value of exports Real GDP - The country’s output measured in constant prices and so adjusted for inflation Gross Domestic Product (GDP) – The total output produced in a country 1 Created by K.Longe WII EU TIT (Consumption Determinants): W – Wealth – The more wealth people have (In the form of their home, savings account and shares), the more they are willing to spend  Increased Consumption. Ex. Wealth can be spent or used to borrow against. It also results in greater consumer confidence I – Income* – Main determinant on consumption. The larger the amount of income available the more disposable income available for use on spending.  Increased Consumption | The distribution of income is also a factor as the poor spend a larger proportion of income so govt. measures that redistribute income from the rich to the poor are likely to increase Consumption. I – Interest Rate – If interest rates fall, people get less return on their savings and can borrow money for less  Increased Consumption E – Expectations –If consumers are feeling optimistic about the future they are more likely to spend more  Increased Consumption. This is why an increase in income can lead to a higher proportion of income being spent as well, as higher income can increase consumer expectation / confidence. U – Unemployment – A decrease in unemployment means more people have more disposable income  Increased Consumption. T – Taxes – If taxes fall, disposable income rises  Increased Consumption I – Inflation – If inflation is high and people expect price to rise then they may spend more now  Increased Consumption | On the other hand if inflation is high people may instead increase their saving in order to maintain the real value of their saving. T – Technology – Nowadays consumers have a tendency to throw away the old and buy the latest stuff  Increased Consumption | E.g. New iPhone is released Wealth – A stock of assets E.g Property, shares and money held in a savings account Distribution of Income – How income is shared out between households in a country Inflation – A sustained rise in the general price level. Consumer Confidence – How optimistic consumers are about future economic prospects Interest Rate – The charge for borrowing money and the amount paid for lending money 2 Created by K.Longe GAFIIES(Savings Determinants(NOT A COMPONENT OF AD!)): G – Government Policy – A policy to introduce tax-free saving schemes will encourage people to save more. A policy to raise state pension on the other hand would reduce the incentive for people to save for retirement. A – Age Structure Of Population – Young people tend to save very little. Middle- Aged people tend to increase their saving. Elderly people tend to dissave in order to maintain living standards when they retire. On the other hand some pensioners continue to save in order to pay for care, medical treatment or just to leave inheritance money. I – Real Disposable Income – Whilst an increase in Real Disposable Income can increase spending it can also not only have the effect of households increasing saving but also saving a higher proportion of their income. I –Interest Rate– An increase in the Interest rate increases the reward on saving and so generally savings increases. On the other hand though some people are target savers aiming to achieve a particular sum in savings and so in their case higher interest rates reduce the amount they need to save and so in turn may increase spending. E– Consumer Confidence and Expectations – Households and firms tend to save more when they are uncertain or concerned about the future. S – Saving Schemes – Some saving is contractual. People agree to save a certain amount on a regular basis in insurance and pension schemes. NOTE – Increases in saving  Decreased Consumption  Fall in AD, ceteris paribus and vice versa Ceteris Paribus –With other conditions remaining the same Saving – Real disposable income minus Spending Target Savers – People who save with a target figure in mind. Dissave – Spending more than disposable income Savings Ratio – Savings as a proportion of disposable income Net Savers – People who save more than they borrow 3 Created by K.Longe CuTE SPIRIT Pc (Investment Determinants): Cu – Capacity Utilisation – Firms are more likely to invest if they are operating at close to full capacity. On the other hand though if there is large spare capacity then it may be possible to increase output without investment. T – Advances In Technology – A firm may buy new capital equipment if it thinks that it will produce better quality products or produce products more cheaply. In either case the firm would expect to earn higher profit. In the first case it would be because the firm would anticipate higher demand, and in the second case the firm would anticipate that its unit cost would fall. If other firms are investing in more new technology then a firm may be forced to do so as well in order to stay competitive and maintain profit levels. E – Expectations About The Future – Firms are more likely to invest if they feel optimistic about future economic prospects. The extent and speed of changes in expectations are the main reasons for the volatility of investment. S – Subsidies – An increase in subsidies effectively reduces the cost of production which in turn increases profits and so increases the amount of money available for Investment and so Investment may increase. P – Profits –High Profit Levels can encourage investment in two ways. They provide finance to invest but they also are likely to make firms more optimistic about the future. I – Real Disposable Income – If real disposable income is increasing , demand for consumer goods and services is also likely to be rising. This will mean it is likely the firm will need to expand their capacity. In order for this to happen though the firm must be confident that the rise in demand will last and also that their existing capital is 100% insufficient to produce the required output. R – Relative Factor Prices – If the prices of other factors of production such as labour decrease then this will most likely decrease investment as firms may look to increase output via increasing labour rather than capital. – I AM UNSURE ABOUT THIS ONE! I – Interest Rates – There are 4 reasons as to why an increase in IR would decrease investment: 1. It will increase the opportunity cost of investment: o A firm can use its profit for investment, placing it in financial institutions to earn interest or for distributing it to shareholders in the form of dividends. By choosing to use the profit on investment the firm sacrifices money that could have certainly been gained by placing it in a saving account in a bank. 2. Borrowing money for use on Investment would be more expensive: o Although most investment is from retained profit some is financed by borrowing. Higher interest rates would make borrowing more expensive and so in turn make investment more expensive. 3. A higher interest rate will affect the expected return on investment: o Firms will anticipate consumer spending falling because borrowing is more expensive and saving would give a better return. 4 Created by K.Longe  4. Higher interest rates reduce the demand for shares, which decreases the funds for available for investment: o This is because some people who may have bought shares may place their money in an interest-bearing account instead. The lower demand for shares will reduce the firm’s price level and so decrease the funds that firms can raise for investment T – Corporation Tax – A decrease in corporation tax increases the amount of profit firms can keep and so in turn can increase investment. Pc – Price of Capital Equipment – A reduction in the price of capital equipment may increase investment. Such a fall may make it viable for more firms to use the equipment or firms already using the equipment to expand their capacity. Capital Utilisation – The extent to which firms are using their capital goods Corporation Tax – A tax on firms’ profits Retained Profits – Profit kept by firms to finance investment Unit Cost - Average cost per unit of output Accelerator Effect – When an increase in national income / An increase in demand for consumer goods results in a proportionally larger rise in investment. Accelerator Effect / Theory:  If demand is growing at a strong pace, firms will respond to growing demand by expanding production and making fuller use of their existing productive capacity. They may also choose to meet higher demand by running down their stocks of finished products.  At some point, if they feel the higher level of demand will be sustained, they may choose to increase spending on capital goods in order to increase their spare capacity. If this investment goes beyond what is needed to simply replace worn out, fully depreciated machinery, then the capital stock of the firms will become larger. NOTE – The accelerator effect is not an absolute effect as it is also very possible that the higher demand will simply lead to demand-pull inflation. 5 Created by K.Longe FEET (Government Expenditure Determinants): F – The Govt’s View On The Extent Of Market Failure And Its Ability To Correct It – In countries where there is a high level of state intervention, government spending usually forms a higher proportion of AD than countries where free market forces play a greater role. E – The Level Of Economic Activity In the Economy – If there is a high level of unemployment, a government may raise spending in a bid to increase AD and the output of the economy. If there is a high inflation rate, a government may reduce its spending. E – A Desire To Please The Electorate – Voters can put pressure on the government to increase spending. A government may also increase spending before a general election in order to gain votes. T – War, Terrorist Attacks And Rising Crime, Or Their Threat – All of these may cause the government to increase spending. HAPPIER (Net Exports (X-M) Determinants): H – Real Disposable Income At Home –If income at home rises then export sales may fall. This is because firms may divert some products from the export market to the home market in order to meet domestic demand. A – Real Disposable Income Abroad – A rise in income abroad is likely to increase the amount of exports being sold. P – The Domestic Price Level – The value of exports may fall and the value of imports rise if the domestic price level rises relative to the price levels in the country’s trading partners. If domestically produced products become more expensive, firms and households at home and abroad will switch from them to products made in other countries. P – Productivity– A rise in productivity is likely to lead to a lower cost of production meaning that firms can lower the prices of their exports, making them more price competitive thus leading to an increase in exports. I – Innovation– A rise in innovation is likely to increase the quality of exports which should lead to an increase in the competitiveness of exports thus leading to an increase in exports. E – The Exchange Rate – The price of exports and imports are also affected by exchange rates. A fall in a country’s exchange rate will reduce the price of exports and raise the price of imports. This will likely lead to an increase in export revenue and a fall in import expenditure. R – Government Restrictions On Free Trade – A country’s net exports may rise if other countries’ governments remove trade restrictions because if something such as a tariff was removed it would lower the price of that good/service and so make it more price competitive. Exchange Rate – The price of one currency in terms of another currency Tariff - A tax on imports Quota – A physical limit on the number of imports into a country 6 Created by K.Longe Aggregate Demand NOTE – The AD curve can be drawn as a straight line / No need to bend it. There are 3 reasons as to why the AD curve is downwards sloping: There are 3 reasons as to why the AD curve is downwards sloping (WIT): 1. The Wealth Effect: o A fall in the price level increases the amount of goods and services that wealth, kept in the form of money in bank accounts and other financial assets, can buy. 2. The Interest Rate Effect: o A rise in the price level means that some people will sell financial assets such as government bonds, to obtain more money to pay the higher prices. The resulting increase in the supply of government bonds reduces their price and a fall in the price of bonds raises Interest Rates due to their inverse relationship. The inverse relationship is because the amount paid in interest on a bond stays the same when its price alters. The higher interest rate is then likely to reduce consumption and investment leading to a contraction in AD. 3. The International Trade Effect: o A rise in the price level, assuming no change in foreign prices and the exchange rate, will make the country’s products less internationally competitive. This would cause households and firms to buy from more foreign producers and less from domestic producers. Net exports would fall and AD would contract. Aggregate Demand – The total demand for a country’s goods and services at a given price level and in a given time period Government Bond - A financial asset issued by the central or local government as a means of borrowing money Macroeconomic Equilibrium – A situation where aggregate demand equals aggregate supply and real GDP is not changing NOTE - AD shifting is caused when there are any changes in any of the determinants of any of the components of AD. + A change in one component of AD can be cancelled out or overturned by another e.g. Consumption increases but Govt. Spending Decreases may result in no net change. This means if you talk about one component of AD you are likely assuming ceteris paribus. 7 Created by K.Longe  P – Price Level O – Output E - Employment Real GDP can be calculated via Real National Output, Real National Income and Real National Expenditure so: Real National Income = Real National Output = Real National Expenditure If the economy is initially operating with considerable spare capacity, and increase in AD is likely to: Price Level – Unchanged Output – Increases Employment - Increases A rise in AD, if either the economy moves from a position of significant space capacity to one where there are shortages of resources, or it moves from one where shortages are already occurring to one where shortages are even greater, then: Price Level – Rises Output – Increases Employment - Increases 8 Created by K.Longe Lastly if the economy is already operating at full employment level with no spare capacity, an increase in AD will be purely inflationary and so: Price Level – Rises Output – No Change Employment – No Change Comment on the three key influences on the effect of a change in AD on POE:  The size of the initial change  The size of the multiplier (Next Page )  The original level of economic activity Average Propensity To Consume (APC) – The proportion of disposable income spent. It is consumption divided by income Average Propensity To Save – The proportion of disposable income saved. It is saving divided by income. Marginal Propensity To Consume – The proportion of an aggregate raise in pay that a consumer spends on the consumption of goods and services, as opposed to saving it. Marginal Propensity To Save – The proportion of an aggregate raise in pay that a consumer uses on saving rather than on the consumption of goods and services. 9 Created by K.Longe  APC and MPC are different. Don’t confuse the two. MPC means how much extra you would spend on top of what you already have spent if given for example another £100. The same is pretty much likewise for Multiplier Effect APS and MPS. Multiplier Effect – The process by which any change in a component of aggregate demand results in a greater final change in real GDP. MPS Multiplier (m) You can use either formula. Multiplier Effect Diagram: This graph is an example of how the multiplier effect can be shown on a graph. AD1 is the initial level of AD which then increases to AD2 (the size of the initial injection) at which the price level and output both increase. AD2 will not be the final increase though as the multiplier effect will cause AD to increase further from AD2 to AD3 at which the price level and output have both increased further. AD3 is the final rise of AD after the initial injection. Typically though AD2 is not drawn and so you would just draw AD increasing from AD1 straight to AD3. 10 Created by K.Longe Aggregate Supply Aggregate Supply – The total amount that producers in an economy are willing and able to supply at a given price level in a given time period Productivity – Output, or production, of a good or service per worker per unit of a factor of production in a given time period Privatisation – Transfer of assets from the public to the private sector Extra Detail: Red Line – AS is perfectly elastic between the start and end of the red line. Green Line – AS is at first elastic but become increasingly more inelastic. In addition to the reasons given in the diagram another reason for its shape is due to scarce resources forcing firms to employ less efficient workers and machinery pushing up unit costs of production and the price level. Blue Line – AS is perfectly inelastic. Production is unable to increase irrespective of how high the price level is. 11 Created by K.Longe This is the flat part of the LRAS curve and, as said before, it shows that when AD increases there is a change in both output and employment (in the same direction) and absolutely no change in the price level. 1 2 This is the intermediate (middle) part of the LRAS curve. As said before, Fig1. shows that if AD changes then the price level, output and employment will all be affected. Fig2. On the other hand shows that the price level, output and employment will all be affected by the increase in SRAS and that in fact and increase in SRAS would increase both output and employment but also decrease inflationary pressure unlike Fig1. that would increase inflationary pressure. The Difference Between SRAS and LRAS:  SRAS assumes that the level of capital is fixed (in the short run you can’t build a factory). In the short run an increase in the price of goods, encourages firms to take on more workers, pay slightly higher wages and produce more as it is now more profitable. So the SRAS curve (by itself) suggests that an increase in prices leads to a temporary increase in output as firms employ more workers. This means that SRAS supply shifts when there are any sort of changes in the costs of production such as a fall in wage rates.  LRAS on the other hand is determined by all the factors of production – size of workforce, size of capital stock, levels of education (quality of labour) and labour productivity. This means that any change in the quantity or quality of resources would shift the LRAS right. NOTE – An increase in productivity would shift both SRAS and LRAS because higher productivity reduces cost of production but it also means the quality of labour has increased as well. Knowing which curve to use: If showing a change in wage rates, oil prices etc... I would use SRAS If showing an increase in capital stock, investment, size of workforce etc… I would use LRAS 12 Created by K.Longe This graph shows the vertical part of the LRAS, also known as the classical AS AD model. Yfe is full employment and so this graph shows that when employment is at its highest level any change in AD will be purely inflationary or deflationary and there will be no change in output or employment. PL This diagram shows how an increase in AS can affect the economy. An increase in AS causing the AS curve to shift is great for increasing economic growth without inflation as: Price Level – Falls Output – Increases Employment - Increases Comment on the two key influences on the effect of a change in AS on POE:  The size of the initial change  The original level of economic activity The original level of economic activity matters because if AD is so low that it is causing the economy to have large amounts of spare capacity then the increase in AS will not be utilised. 13 Created by K.Longe Short-Run AS Shifter: 1. Changes in the costs of production: o The economy’s cost of production may fall as result of a fall in raw material costs, fall in wages, increased productivity etc… causing AS to increase (shift to the right). Long-Run AS Shifter: 1. Changes in the quantity of resources o The quantity of labour may increase as a result of net immigration of people of working age, a higher proportion of women entering the labour force or a rise in the retirement age. o A decrease in corporation tax could lead to the purchase of extra capital goods, referred to as net investment, increasing the quantity of capital goods causing AS to increase (shift to the right). o The quantity of land may increase via land reclamation, discovery of natural resources or through greater use of high-yield farming methods. o The quantity of enterprise may be increased by a reduction in rules and regulations placed on firms, more privatisations and government incentives to start up new businesses. 2. Changes in the quality of resources o Improvements in education and training will improve the quality of labour and raise productivity causing AS to increase (shift to the right) o The quality of capital goods is raised by advances in technology. Even if old capital is being replaced rather than the new capital being added on AS may still increase (shift right) as new capital often has more advanced technology. o The quality of enterprise may be raised by management training and improved education. 14 Created by K.Longe  What is meant by the circular flow of income(Jan 2009):  The movement of spending and income throughout the economy or The Circular Flow Of Income  Flow of products and income between producers/ firms and households/consumers. The circular flow of income is a model that seeks to explain how the economy works and how changes in AD occur. In this diagram there are 2 sectors, households and firms. Between these two sectors are the flows: incomes, goods / products and factor services (where factors is in the diagram). Households provide factor services and in return receive incomes. They use these incomes to buy goods / products produced by firms. Circular Flow Of Income – The movement of spending and income throughout the economy Factor Services - The services provided by the factors of production Factor Incomes – The returns earned by the factors of production (Profit, Interest, Rent, Wages) Output Expenditure Income In practice, not all the income that is earned is spent. There are additional Leakages: forms of spending that do not arise from the circular flow. 1. Imports Income that is not spent on domestic output is said to leak out of the 2. Savings circular flow. Leakages reduce AD. 3. Taxes In contrast injections increase AD, injecting extra spending into the Injections: economy. 1. Investments When the value of injections equals the value of leakages, output will 2. Exports not be changing and there will be macroeconomic equilibrium. 3. Government Expenditure Leakages – Withdrawals of possible spending from the circular flow of income Injections – Additions of extra spending into the circular flow of income 15 Created by K.Longe Some changes can affect both AD and AS:  If firms spend more on capital goods, AD will increase because investment is a component of AD and AS will increase because the productive capacity of the economy would have increased.  Immigration of people of working age can affect both due to larger population with money to spend Increased consumption and also an increase productive capacity.  Government Expenditure on training that improves worker productivity also affects both as government expenditure is a component of AD and the increased productivity increases the productive capacity of the economy. Overheating - The growth in aggregate demand outstripping the growth in aggregate supply, resulting in inflation Output Gap – The difference between an economy’s actual and potential real GDP Trend Growth – The average sustainable rate of economic growth over a period of time. Below Trend Growth = Negative Output Gap – If the economy experiences a sustained slowdown or recession then output will fall short of potential GDP leading to a negative output gap. The result is a downward pressure on prices and rising unemployment because of a lack of AD. Above Trend Growth = Positive Output Gap – If the economy grows too quickly then AD will eventually exceed LRAS and lead to a positive output gap emerging (excess demand in the economy). This can lead to demand-pull and cost-push inflation. In the short run an economy can have a positive output gap. This can be made possible by workers working overtime, people who are not usually in the labour force entering it or the use of machinery flat out. This will not be possible to sustain in the long run of course unless AS increases. Most countries with a positive output gap tend to experience inflation because of this. 16 Created by K.Longe Government Economic Policy Objectives And Indicators Of National Economic Performance Economic Growth – In the short run, an increase in real GDP, and in the long run, an increase in productive capacity, that is, in the maximum output that the economy can produce Unemployment – A situation where people are out of work but are willing and able to work Labour Force – The people who are employed and unemployed, that is, those who are economically active Economically Inactive - People of working age who are neither employed nor unemployed Deflation - A sustained fall in the general price level Balance Of Payments - A record of money flows coming in and going out of a country Elastic – Responsive to a change in market conditions Inflation Rate - The percentage increase in the price level over a period of time Government Economic Policy Objectives: Economic Stability:  Sustainable Economic Growth  Absence of fluctuations in the economy  High Employment / Low Unemployment  Absence of booms and bust / absence of  Low and Stable Inflation economic or trade cycle.  Satisfactory Balance of Payments  Avoidance of volatility in – economic growth rates, inflation, employment, Extra: exchange rates - Redistribution of Income: o One of the ways in which this can be done is by government taxing the rich and providing state benefits for the poor - Economic Fluctuations: o Governments more recently are now trying to achieve and promote economic stability. This is done by preventing significant fluctuations in output, employment and inflation. This is because such fluctuations make it difficult for households, firms and the govt. to plan ahead. These fluctuations can discourage workers from improving their skills, firms from investing and the govt. from undertaking major reforms. So reducing economic fluctuations should increase an economy’s long term growth potential. Reasons as to why the UK has had a relatively low inflation rate:  A reduction in inflationary expectations resulting from the success of the govt.’s monetary policy  A high value of the pound  Increased global competition putting pressure on firms to keep their costs and prices low 17 Created by K.Longe Sustainable Economic Growth – Economic growth that can continue over time and does not endanger future generations’ ability to expand productive capacity Trend Growth – The expected increase in potential output over time. It is a measure of how fast the economy can grow without generating inflation Hyper Inflation – An inflation rate above 50% Short-Run Growth - Caused by Increase in AD. Long-Run Growth –Increase in the quantity and / or quality of the factors of production causing productive capacity to increase. NOTE – Net investment increases AD and AS Demand-pull inflation - Increases in the price level caused by increases in AD Cost-push inflation - Increases in the price level caused by increases in the costs of production How to achieve positive and stable economic growth:  Increasing material living standards  Trend growth  Avoiding depleting non-renewable resources and damaging the environment, also to reduce pollution and searching for cleaner sources of energy. Full employment - A situation where those wanting and able to work can find employment at the going wage rate Another policy is a low and stable inflation rate. It does not mean a 0 inflation rate with the price level remaining unchanged. Price stability means a low and consistent rate of inflation. The reasons for this are because measures of inflation tend to overstate price rises and because a low inflation rate has advantages. One use is that it allows firms to reduce their costs by not raising wages in line with inflation rather than by making workers redundant. Current Account:  Trade in Goods  Trade in Services  Current Transfers  Income From Investment Another policy is a satisfactory balance of payments particularly with respect to trade in goods and services. A government may not be too concerned if import expenditure temporarily exceeds export revenue due to imported raw materials that will get used to make finished goods some of which can be exported. The govt. may also not mind if the current account deficit is offset by net inflow of direct and portfolio investment. In the long term though the government will still want to see an increase in international competitiveness of its producers, in order to keep AD and output high in the economy. 18 Created by K.Longe Nominal GDP – Output measured in current prices and so not adjusted for inflation Real GDP – Output measured in current prices adjusted for inflation GDP Figure x Base Year Price Index Real GDP = Current Price Year Index GDP Measuring: - Real GDP can be calculated by totalling up the output, income or expenditure of the country and economic growth can be measured by changes in any of these. - When using the output method double counting must be avoided. This would include things such as counting the output of raw materials and then including them again in the value of the finished product - When using the income method, only incomes that have been earned in return for providing goods and services are included so transfer payments are not. - When using the expenditure method it is important to remember to only include exports and to exclude imports. NOTE – Production and productivity can move in opposite directions. When an economy is expanding production will rise but if less skilled workers have to be recruited to make the extra output, productivity may fall. This may indicate that an economy’s ability to sustain rises in output may be unlikely. Real GDP Per Capita - A measure of the total output of a country that takes the gross domestic product (GDP) and divides it by the number of people in the country. NOTE – Real GDP Per Capita is especially useful when comparing one country to another because it shows the relative performance of the countries. Informal Economy – Economic activity that is not recorded or registered with the authorities in order to avoid paying tax or complying with regulations, or because the activity is illegal. Negatives of the Informal Economy: 1. Distorts the range of economic data o The rate of inflation in the informal economy is usually much lower in comparison to the rest of the economy. This means that official measures of inflation are overstated. The work undertaken in the informal economy also means that official data, as well understating real GDP, also understates unemployment 2. Tax revenue is lower than would be possible if all economic activity were taxed: o This can have consequences for tax rates and government spending 3. An informal economy can result in lower productivity o Firms in the informal economy tend to stay small to avoid attention from the authorities. This limits their ability to use advanced tech and take advantage of EoS. Economies of Scale (EoS) – The advantage of producing on large scale, in the form of lower long-run average cost. 19 Created by K.Longe On the surface Real GDP suggests that living standards are improving as more goods and services are being produced but there are several reasons as to why this may not be the case:  It is important to consider the composition of real GDP. If more is produced but the extra output consists of capital goods, people will not immediately feel better off, although they will be in the long run.  Output may also rise because of an increase in what economists call ‘regrettables’. If, for example, the rise in real GDP has been accounted for by increasing the police force to match rising crime, people may actually feel worse off.  Other reasons include the fact that many of the population may not benefit if income is very unevenly distributed or if they are working longer hours, or under worse conditions. In addition the official figures do not include positive and negative externalities. If pollution rises real GDP does not fall even though people will experience a lower quality of life. Unemployment Rate - The percentage of the labour force who are out of work Labour Force Survey (LFS) – A measure of unemployment based on a survey using the ILO definition of unemployment International Labour Organisation – A member organisation of the United Nations that collects statistics on labour market conditions and seeks to improve working conditions Claimant Count – A measure of unemployment that includes those receiving unemployment – related benefits Advantages of LFS / Disadvantages of Claimant Count:  The LFS measure is thought to capture more of those who are unemployed. This is because some people are actively seeking work but are not entitled to claim benefits. This is includes people whose partner is working or claiming benefits and young people who are under 18 looking for work – These people would not appear in the claimant count  The LFS measure is widely used by most countries so it allows for better international comparisons unlike the claimant count which is not suitable for such comparisons as the categories of people entitled to benefits differs from country to country.  The claimant count can be skewed as there may be fraudsters claiming benefits on false pretences Advantages of Claimant Count / Disadvantages of LFS:  On the down side, the LFS measure is a lot more expensive to collect and there is also a risk that it may be subject to sampling errors. The claimant count is also much quicker to compile than LFS. 20 Created by K.Longe Inflation - A sustained rise in general price level Consumers Price Index (CPI) - A measure of changes in the price of a representative basket of consumer goods and services. How CPI is calculated – Jan 2013(5 Marks): 1. Selecting a base year o This should be a relatively standard year in which nothing unusual happened. The variable being measured is given a value of 100 in the base year and other years are compared to it. 2. The ONS carries out the Family Expenditure Survey (In The UK) o This involves sampling more than 6,000 households, which are asked to keep a record of their expenditure 3. Use the Family Expenditure Survey to create a ‘Basket of Goods and Services’ 4. These products are put into different categories and weights are attached to them 5. Weights are based on items’ importance in people’s expenditure 6. Weights / Items are changed each year 7. Prices are checked in a range of outlets 8. Price changes are compared over time 9. Weights are multiplied by price changes 10. The weighted price changes are then totalled to calculate the inflation rate Retail Price Index (RPI) - A measure of inflation that is used for adjusting pensions and other benefits to take account of changes in inflation and frequently used in wage negotiations. How CPI and RPI differ in coverage and methodology:  The CPI - includes university accommodation fees and stockbroker’s charges which are not included in the RPI. The RPI - includes all housing costs including mortgage interest payments and council tax. It also includes the road fund licence and television licence which are not included in the CPI. Difficulties of measuring inflation: 1. Goods and services change, often improving in quality o The CPI / RPI may not give an accurate representative picture of what is actually happening in the economy 2. CPI / RPI often overstate inflation, as they measure the price of a fixed basket of products o Measures do not take into account people’s ability to alter what they buy during the year 21 Created by K.Longe  Key: Balance Of Payments Green means necessary Balance of Payments Red means not entirely necessary (but should know of existence) Current Account: Capital Account: Financial Account: Net Errors and Omissions Trade in Goods Other Capital Transfers Total Net Direct Investment Trade In Services Migrant Transfers Total Net Portfolio Investment Income from Investment Other transaction in financial assets Current Transfers Transactions in reserve assets Trade in Goods and Services – Fairly self-explanatory apart from the fact that money spent by foreigners in the UK count as exports and money spent abroad by people from the UK count as imports. NOTE – Additionally the UK has a surplus in trade in services Income From Investment – The UK usually has a surplus on this as its residents earn more in terms of profit, interest and dividends on their investments abroad than foreigners do on their investments in the UK Current Transfers - Government payments to and from the EU and money sent out UK by foreigners working in the UK to relatives to abroad. Net Errors and Emissions – This is added to ensure that the balance of payments is based on information relating to a vast number of transactions, it is not surprising that some mistakes are made and some items are initially left out 22 Created by K.Longe Current Account Current Account Deficit – A measurement of a country’s trade in which the value of goods, services, investment income and transfers it imports exceeds the value of goods, services, investment income and transfers it exports NOTE – The current account also includes income from investment, such as interest and dividends, as well as current transfers such as foreign aid, though these components tend to make up a smaller percentage of the current account than exports and imports The Causes of a Current Account Deficit: - The country’s inhabitants have spent more on goods and services from abroad than overseas residents have spent on the country’s products - There has been a net outflow of investment income o This will occur if the investments foreign residents have made in the country earn more than the investments the country’s inhabitants have made in other countries o Whether this occurs depends on factors including the relative volume of investments made, the level of profit, interest and dividends earned on the investments NOTE – A current account surplus could be caused by the opposite any of the above reasons. The Causes of a Deficit on the Trade in Goods and Services: 1. Changes in income at home and abroad o If incomes are falling abroad, demand for the country’s exports is likely to fall. A rise in incomes at home would also contribute to a deficit. 2. Rise in the exchange rate o A higher pound will raise export prices |Decreased price competitiveness Decreased UK Demand for exports Decreased Exports| o and lower import prices |Increased price competitiveness Increased UK Demand for Imports Increased Imports | 3. Structural problems o More concerning than the other two as income and exchange rate are likely to change in the future. If deficit is caused by firms charging too much for products, producing bad quality products or not picking up on changes in demand, the deficit may persist. 23 Created by K.Longe The Causes of a Surplus on the Trade in Goods and Services: 1. Strengthening economy o The country is likely to have a surplus if its products are of high quality, are produced at a low cost and reflect what households and firms at home and abroad want to buy 2. Fall in the exchange rate as a lower pound will: o Lower export prices |Increased price competitiveness Increased Demand for UK exports Increased Exports | o And raise import prices |Decreased price competitiveness Decreased UK Demand for imports Decreased Imports| 3. Economy is in a recession o In such a situation, a country’s inhabitants may not be buying many products, including imports, and its firms, finding it difficult to sell at home, may be competing more vigorously in export markets Comment on the extent to which the exchange rate affects the trade in goods and services / X-M:  How long the £ has risen / fallen for  Size of the rise / fall The Consequences Of A Deficit On The Current Account Of The Balance Of Payments:  Consuming more than producing meaning that income is going abroad  If the deficit rises, AD will decrease in the economy leading to lower output, lower employment, downward pressure on the price level, lower exchange rate and raise external debt. The Consequences Of A Surplus On The Current Account Of The Balance Of Payments:  Producing more than consuming means that a net inflow of money and income. The higher money supply means that banks have more money and so can raise bank lending.  If surplus rises, net exports are rising, so AD rises and likely to push up the exchange rate. Comment On The Significance Of A Current Account Deficit: - The significance of the effects of a current account deficit depend on o It’s size o Duration o Cause – A deficit caused by structural problems is much more concerning o What is happening to the financial an capital account – If the financial and capital account are greater than the deficit then the effects may not be so strong. ILO Unemployment Definition:  Those who are without a job, want a job, have actively sought work in the last four weeks and are available to start work in the next 2 weeks, or  Out of work, have found a job and are waiting to start it in the next two weeks. Unemployment – People available, willing and able to work at the going wage rate but cannot find a job despite an active search for work. 24 Created by K.Longe BOTS CH (The Consequences Of Unemployment): B – Govt. Spending on Unemployment Benefits – If unemployment rises, the govt. will have to spend more on unemployment related benefits. This may mean that it has to reduce spending on other areas, such as education, or it will have to raise its borrowing or tax rates.This means that the money spent on unemployment benefits has opportunity cost. O – Lost Output – Having people who are willing and able to work without jobs is a waste of resources. If these people were in work, the country would produce more goods and services, and so material living standards would be higher. T – Lost Tax Revenue – If more people were in work, incomes, spending and possibly profits would be higher. This would mean that the govt. would collect more tax revenue from all form of taxes (Direct Tax and Indirect Tax) and this revenue could be spent on education, health transport etc… which could improve the quality of people’s lives and increase the country’s productive capacity. S – Pressure on Other Forms of Govt. Spending – Unemployment can put upward pressure on other forms of govt. spending. When people are unemployed they are more likely to suffer health problems, including mental health problems, marital difficulties and some even turn to crime. 1. More health problems means higher waiting lists for health care if the govt. don’t increase spending on the sector raise the sector’s productivity 2. Marital break-ups increase the need for housing benefit and the provision of social housing 3. Increased crime means the govt. have to spend more on police and the judicial system C – Costs To The Unemployed – There are a lot of costs of unemployment to unemployed people:  Poor Health  Family Break-ups  Unemployment benefit is likely to be lower than what they got when they had a job  Some people feel a loss of self-purpose, worth or status when becoming unemployed  The children tend to have worse health  The children tend to do worse at school due to having less educational tools at home, a lower chance of having their own room to study in and their parents tend to have lower expectations of them causing demotivation. H – Hysteresis – The longer people are out of work, the more difficult it is for them to get employed. Employers are less reluctant to hire someone who has been out of work for a long time because: 1. Being out of a job that long may suggest they are not good workers 2. The longer someone is unemployed, the more there skills deteriorate and the more the more out of touch they become with advances in working methods and technology. On the supply side, the long term unemployed tend to seek work less actively over time because: 1. They may lose the work habit and get used to being at home 2. They may become discouraged by continuous rejections Hysteresis – Unemployment causing unemployment Long-term unemployment – Unemployment lasting for more than a year 25 Created by K.Longe Cyclical Unemployment - Unemployment arising from a lack of AD Structural Unemployment – Unemployment caused by the decline of certain industries and occupations due to changes in demand and supply Frictional Unemployment – Short term unemployment occurring when workers are in-between jobs Seasonal Unemployment – When people are unemployed at certain times because they work in industries where they are not needed all year round. Classical Unemployment – When real wages are kept above the market clearing wage, leading to a surplus of labour supplied The Costs of Unemployment To Other Economies:  Unemployment in a country’s trading partners is likely to reduce demand for exports. This, in turn, will reduce the country’s AD and may cause some unemployment.  A country may also experience immigration from countries with high and rising unemployment. This can be beneficial if the country has an ageing population and a shortage of labour, but it may place a burden on the country’s housing stock. The Benefits of Unemployment:  It may give some people time to search for a more rewarding job  The existence of unemployment makes it easier for firms, wishing to expand, recruit workers  It can reduce demand-pull and cost-push inflation  It can help decrease the pressure on the price level (at the correct amounts).  The existence of relatively high unemployment may discourage workers from seeking wage rises and may dissuade them from take industrial action Comment On The Significance of Unemployment: - The significance of the effects of unemployment depend on o How much unemployment there is o How long on average people are unemployed o The type of unemployment o The distribution of unemployment The Significance of Unemployment (Extra):  The higher the rate of unemployment, the more serious the costs are likely to be: o Low rates of unemployment are fine and are to be expected as there will always be frictional unemployment but higher rates of about 10% will lead to a greater loss of output, higher govt. spending on benefits and a greater loss of tax revenue.  Generous unemployment benefits reduce the costs of unemployment but they have an opportunity costs for the economy. o If the unemployment is cyclical it is the worst as it is more likely to be widespread, frictional unemployment has the lowest costs and structural unemployment is worse than frictional but better than cyclical.  The costs of unemployment are not usually borne evenly: o This is because particular groups, such as young men, tend to be more susceptible to unemployment. This uneven distribution of unemployment can be socially divisive. 26 Created by K.Longe  Key: Anything in an orange box is a Inflation definition! FUN IS FAM RC (Consequences Of Inflation): F – Fall In The Value Of Money – With the price level rising, each pound will buy less. Whether or not a household experiences a loss in purchasing power depends on how much their income changes relative to inflation. U – Uncertainty – Inflation creates uncertainty. If firms are uncertain about what their costs will be and what prices they will receive from selling their products, they may be reluctant to invest. Inflation also complicates household financial planning, making it difficult for people to decide how much to save and where to place their savings. N – Inflationary Noise – It means the market prices do not signal the relative scarcity of products efficiently. For example without inflation, if the price of a television rises, it can be concluded that it has become relatively more expensive. With inflation on the other hand consumers will not know whether or not the good has become relatively more expensive or if it has just in line with inflation. Inflationary Noise – The distortion of price signals caused by inflation. I – Inflation causing Inflation – Demand-pull inflation may be caused by inflation as households will expect prices to rise in the future so they may buy more products now. Cost-push inflation may be caused by inflation as workers will expect prices to rise and so they may ask for pay rises in order to protect their current real earnings. Firms expecting inflation may also raise their prices in order to protect their real profit levels. S – Shoe Leather Costs –During periods of inflation, households and firms cannot afford to have money lying idle, not earning interest, as it will be losing value. They have to place it in financial institutions and have to search out the most rewarding rate of interest. For households the cost is of their own time and effort and for firms it is the cost of their staff time (both of which have opportunity cost) and effort spent finding good savings accounts, opening them and moving the money out of them. Shoe Leather Costs – Costs in terms of the extra time and effort involved in reducing money holdings. F – Fiscal Drag –If tax brackets are not adjusted in line with inflation, people’s income will be pushed into higher tax bands. Taxpayers will pay a higher proportion of their income in tax causing their disposable income to fall also causing the govt. to receive more tax revenue. Fiscal Drag – People’s income being dragged into higher tax brackets as a result of tax brackets not be adjusted in line with inflation. A – Administrative Costs– Inflation can impose administrative costs on firms. Staff time may have to devoted to adjusting accounts, assessing raw material costs, negotiation with unions about wage rises and estimating appropriate prices. M – Menu Costs – They get their name from the need for restaurants to print new menus on a frequent basis. Menu Costs – The costs of changing prices due to inflation. 27 Created by K.Longe R – Random Redistribution Of Income – Inflation increases the cost of living, as people have to pay more to buy the same basket of goods and services. This means the purchasing power of money falls but this does not necessarily mean that people’s ability to buy products will fall. What determines that will be the specific consumer’s change in income relative to the price level. Additional points are that some workers with weak bargaining power may not receive wage rises keeping up with inflation. Borrowers will gain and lenders will lose if inflation reduces the real interest rate. Real Interest Rate – The nominal interest rate minus the inflation rate e.g. If, for example, the rate of interest is 6% and there is 2% inflation, A lender lending £100 would expect the £106 they would receive at the end of the loan period (£100 borrowed with 6% interest = £106 paid to lender) would only buy them approximately £4 more goods and services rather than £6 if there was no inflation. C – Loss Of International Competitiveness – If a country’s inflation rate is above that of its main competitors, its goods and services will become less price competitive. This is likely to result in a decrease in exports and an increase in imports. The Benefits of Inflation: - A low and stable rate of inflation that is demand-pull inflation o The higher AD and steady rise in the price level may encourage firms to increase output - Workers like rise in their pay o Even if these are matched by higher prices, with their real pay remaining the same, psychologically we like to feel that we are being appreciated and that our employers think that we are doing well even if the pay rise is only in money terms - It allows firms to alter worker’s real pay easily o This can help labour markets operate more efficiently and reduce unemployment. Workers tend to resist cuts in their money (nominal) wages. Inflation allows firms to reduce their real wages by either keeping money wages the same or by raising them by less than inflation. Without inflation it is difficult to cut real wages, and so firms may have to make some of their workers redundant in order to reduce their costs. Deflation: Deflation tends to occur less frequently than inflation but it happens more often than people think. Measures of inflation tend to overstate prices rises and so sometimes mask a fall in the price level. Benefits of Deflation:  It is beneficial if it has happened because of changes in the supply side. If AS has increased then output should increase and the country should also be more competitive. Consequences of Deflation:  If deflation has occurred because of a fall in AD it may result in a harmful deflationary spiral. Lower AD will cause firms to cut back production, leading to higher unemployment. Households will then most likely reduce their spending in fear of redundancy and because they expect lower prices in the future, reducing AD further. 28 Created by K.Longe Comment On The Significance Of Inflation: - The significance of the effects of inflation depend on o The rate of inflation o It’s cause - Cost–push tends to be more harmful o Whether it is fluctuating o Whether it was correctly anticipated o Rate relative to that of other countries o Significance of inflation varies between people The Rate of Inflation:  A low rate of inflation is unlikely to cause significant problems and indeed it can actually provide some benefits. The Cause of Inflation:  Cost-push tends to be more harmful because cost-push inflation is often accompanied by a fall in real GDP and a rise in unemployment. Whether Inflation is Fluctuating:  Fluctuating inflation leads to inflationary noise that makes it difficult for the govt., firms and households to plan ahead. Whether or not the Inflation was correctly anticipated:  Unanticipated inflation causes uncertainty and can result in random redistribution of income e.g. If workers expected 5% inflation they may ask for a wage rise of 8% in order to get increase in their real pay but if inflation increases by 10% the workers would actually be worse off. If inflation is anticipated then measures can be taken to prevent such problems. Rate relative to that of other countries:  If it is relatively high then exports will most likely decrease and imports increase, worsening the trade balance. The significance of inflation varies between people  For example young people may experience lower inflation than suggested if things such as electronic goods rise in price at a lower rate than the price level. The Cost of Economic Growth:  If an economy is using all its resources (Any point lying on the PPF curve) it can only increase output by switching resources from making consumer goods to capital goods. Even if in the short-run you may have to sacrifice more consumer goods to create less capital goods, in the long run the extra capital goods will allow more consumer goods to be made.  If it is not sustainable growth then it may harm the environment and also result in a depletion of non-renewable resources.  It may also reduce the quality of some people’s lives. A growing economy is one that requires some people to adopt new skills and some to change jobs which may cause the pace of work to increase too. Some people may find these changes stressful and so their quality of life may be reduced. 29 Created by K.Longe The Benefits of Economic Growth: - There is likely to be a rise in people’s material standard of living. o If real GDP per head / real GDP per capita increases then the population can enjoy more goods and services. Whether all of the population will be able to or not depends on the distribution of income because real GDP per head is an average including GDP from both the rich and the poor. - Poverty and/or its costs can be reduced without have to redistribute existing income. o Higher output raises tax revenue without having to increase tax rates, and some of this can be used to finance schemes to help the poor, improve public services (such education and health care) and improve the environment. - Employment is likely to increase o Whether or not this happens though depends on whether or not AD rises in line with production or not. If for example the productivity of workers increase by 5% but AD only increases by 2% then firms may be able to produce the extra output necessary with fewer workers which would actually lead to higher unemployment. - The country is likely to gain more status and power in international organisations o Economic growth raises the level of a country’s real output which can lead to gaining more power and status in organisations such as the IMF and WTO thus increasing their power in international negotiations as well. International Monetary Fund (IMF) – An international organisation that helps co-ordinate the international monetary system World Trade Organisation – An international organisation that promotes free international trade and rules on international trade disputes Exchange Rate – The price of one currency in terms of another currency Monetary Policy Committee (MPC) - A committee of the Bank of England with responsibility for setting the interest rate in order to meet the govt.’s inflation target Trade Weighted Index:  This in an index used by the Bank of England’s MPC. It measures the £ exchange rate against a basket of currencies, giving each country a weight in proportion to the amount of trade, both in goods and services, that the country has with the UK. These weights are regularly updated to reflect changes in the pattern of trade. NOTE – Most countries’ exchange rate are determined by the market forces of demand and supply Example of how exchange rates can change:  If the exchange rate of the £ changes from £1 = $1 to £1 = $2. In this case the pound has risen in value as each pound now buys more dollars and more dollars need to be sold to buy £1. 30 Created by K.Longe CASHI FDI (Exchange Rate Determinants): C – International Competitiveness –If UK products are internationally competitive then the demand for pounds is likely to be high and supply is likely to be low. This is because foreigners would be wanting to buy pounds to buy UK products, while UK citizens would not be selling many pounds to buy imports. A – Income Abroad – If incomes abroad are rising then foreigners are likely to buy more UK exports. This would increase demand for pounds and so cause a rise in value of the pound. S – Speculation – Speculators buy and sell currency, hoping to make a profit from movements in interest rates and exchange rates. If speculators respond to a falling exchange rate by selling of some of their holdings of the currency, this can cause the exchange rate to fall even further. If, however, they think this falling rate will soon start to rise they will purchase more of the currency now, thereby preventing a large fall. H – Income at Home – If incomes at home rise then then the supply of pounds will increase as UK citizens will sell more pounds to get foreign currency to purchase more imports. I – Relative Interest Rates – If UK interest rates rise, relative to other countries interest rates, the demand for pounds should increase. This is because foreigners will want to buy pounds in order to open accounts in UK financial institutions to benefit from the higher interest rates. FDI – FDI – Pounds are also bought and sold by those wishing to undertake FDI. For example a Japanese firm will buy pounds if it wants to buy a UK car company or to build a new car factory in the UK. FDI in the UK will be attracted by a strong UK economic performance, a skilful labour force and favourable govt. policies such as regional development grants being made available for incoming foreign firms. Foreign Direct Investment (FDI) – A controlling ownership in a business enterprise in one country by an entity based in another country 31 Created by K.Longe  Key: The Relationship Between The Exchange Rate And The Interest Rate:  = Leads to Increased Exchange Rate  Higher Export Prices Decreased Price Competitiveness of UK exports Demand For UK Exports Decreases  (X-M) Component of AD decreases because of Lower Exports  Fall in AD  Fall in Inflationary Pressure  Monetary Policy Committee (MPC) may Reduce Interest Rates in order to meet Inflation Target  Hot money flowing out of the country because of lower return on money held in financial institutions due to lower interest rates. Which means more of the currency is being sold as people are trying to get rid of it in order to buy another currency/s in a country with a better return  Increase in Supply of £  NOTE – This means that the Supply Shifts Right  exchange rate is determined by the demand for and supply of a Lower Exchange Rate currency. Evaluation On The Relationship Between The Interest rate And Exchange Rate:  Whilst a change in in interest rates usually causes the exchange rate to move in the same direction, this isn’t always the case. This is because a cut in UK interest rates might make foreigners more confident about the prospects of economic growth in the UK. In this case they would buy more pounds which means demand for the pound would increase causing the value of the pound to rise. Comment on the extent to which the level of interest rates affects the economy as a whole:  How long the interest rate has risen / fallen for  Size of the rise / fall Depreciation – A fall in the exchange rate caused by the market forces of demand and supply 32 Created by K.Longe The effect of a change in the exchange rate on export prices:  A fall in the exchange rate will reduce the price of exports in terms of foreign currencies. For example if the exchange rate was £1 = 2$ then a £100 export would sell for $200 in the USA. If the value of the pound fell to £1 = $1.50 then the export would sell for only $150. This is because exporters would be likely to let their export prices fall in line with the exchange rate as selling at a lower price would in most cases increase their total revenue. Whether or not their total revenue would increase or not though would depend on the PED for the export. If the PED was inelastic for the export then the exporter may decide to continue to sell their product at $200 even if the exchange rate has fallen to £1 = $1.50 because that would increase their total revenue. Vice Versa for imports. The effect of a fall in the exchange rate on the economy (Advantages): - A fall in the exchange rate is likely to improve the current account’s position in the Balance of Payments o This is because the lower exchange rate should cause a fall in the price of exports which would increase export revenue (if PED is elastic) and decrease import expenditure (if PED is elastic). This means the (X-M) component of AD will increase causing AD to increase. This means that if the economy was previously operating below full capacity then the increase in AD should increase employment and raise real output. The effect of a fall in the exchange rate on the economy (Disadvantages): - The fall in the exchange rate may put an upward pressure on inflation for 2 reasons 1. The price of imported raw materials will rise thereby increasing the cost of production further causing an increase in the price of imported finished goods that count in the calculation of the country’s inflation rate 2. Domestic firms will find that imported rival products will be more expensive and so the domestic firms will be under less pressure to keep their costs and prices low, which may very well lead to a rise in the price level as firms may look to make more of a profit by increasing prices just lower than the imported rival goods or push any potential increases in costs of production onto the consumer. The effect of a rise in the exchange rate on the economy (Advantages):  It is likely to put a downward pressure on inflation  A higher exchange rate would mean that domestic firms that import products to sell or import raw materials would now find it cheaper causing their costs of production to decrease, enabling them to lower their price, making it easier to sell abroad  People travelling abroad will find that their currency will buy them more The effect of a rise in the exchange rate on the economy (Disadvantages):  Likely to worsen a current account deficit, due to worsened trade balance  Likely to lead to a decrease in AD leading to lower real output and lower employment 33 Created by K.Longe  E – Elastic Marshall-Lerner Condition and J Curve O – Only I – Irritates Effect*(Slightly Beyond The Syllabus) S - Skin Marshall-Lerner Condition:  The Marshall-Lerner condition states that a currency depreciation will only correct a current account deficit if: It is not necessary to know either the Marshal-Lerner Condition or the J Curve effect but if you are able to understand either of PEDX + PEDM >1 them then they would be great evaluation points for an 18 marker and due to their complexity would likely impress the PED and Total Revenue Link: examiner and so help you get past evaluation with saying less. The EO means that if PED is elastic then a change in price will cause the opposite to happen to total revenue: Elastic – Increase in Price  Decrease in Total Revenue Elastic – Decrease in Price  Increase in Total Revenue The IS means that if PED is inelastic then a change in price will cause the same change to happen to total revenue: Inelastic – Increase in Price  Increase in Total Revenue Inelastic – Decrease in Price  Decrease in Total Revenue PEDX Inelastic – Depreciation  Decrease in Price of Exports  Decrease in Total Revenue. This means that Export Revenue would decrease. PEDM Inelastic – Depreciation  Increase in Price of Imports  Increase in Total Expenditure (Because the revenue is going to another country). Means that Import Expenditure would increase. This means that Export Revenue would be decreasing and Import Expenditure would be increasing which would worsen the trade balance thus worsen a current account deficit. This effect can be generalised into one elasticity PED(X-M). PEDX + PEDM = PED(X-M) PED(X-M) Inelastic – Depreciation  Overall Price on (X-M) is falling  Total Revenue Falls Current Account Deficit Worsens J Curve Graph In the short run you will find that PED(X-M) is often inelastic as firms are tied down to pre-existing trade contracts that have to be honoured and even once those contracts finish and export prices decrease and import price increase, there is an extra time lag due to it taking time for consumers to realise the changes in price of both imports and exports. Because of this it means that even if PED(X-M) is elastic in the long run, the current account’s trade balance is likely to get worse before it gets better, hence the J curve. 34 Created by K.Longe The Application Of Macroeconomic Policy Instruments And The International Economy Fiscal Policy – The taxation and spending decisions of a government Fiscal Policy: Fiscal policy is using changes in govt. spending and/or taxation to influence the level of AD. So ultimately it is basically all about affecting the C + I + G components of AD.  Increasing the G component of AD is fairly self-explanatory and would just involve increasing govt. spending.  One way of increasing the C component of AD is by decreasing income taxes as this would raise people’s disposable income, causing consumption to increase, further causing AD to rise.  One way of increasing the I component of AD is by cutting corporation tax as this would increase firm’s profits causing them to be more willing and able to invest. NOTE – All of the increases in AD listed above would lead to multiplier effects on the economy meaning that AD would rise even further than the initial injection of spending Reflationary / Expansionary Policy – Policy measures designed to raise AD Deflationary / Contractionary Policy – Policy measures designed to reduce AD Discretionary Fiscal Policy – Deliberate changes in government spending and taxation designed to influence AD Automatic Stabilisers Example:  When economic activity rises, government spending on unemployment related benefits decreases. This is not because the government has changed the benefit rate but because there will be fewer who will claim it.  Additionally the government will receive more tax revenue when real GDP rises without having to change tax rates. This is because there will be more people who are employed, who are receiving income, and some people may be earning higher wages.  The fall in govt. spending and rise in tax revenue will reduce the growth in AD and so may help prevent inflation. Economic Cycle – The tendency for economic activity to fluctuate outside its trend growth rate, moving from a high level of economic activity (boom) to negative economic growth (recession) Typically there are 4 stages in the cycle. 1. Recession / Trough 2. Recovery / Expansion 3. Boom / Peak 4. Slowdown / Contraction 35 Created by K.Longe Progressive Tax – A tax that takes a higher percentage from the income of the rich e.g. Income tax Regressive Tax – A tax that takes a higher percentage from the income of the poor e.g. VAT Government Spending can be divided into several categories:  Capital spending (on schools, hospitals roads)  Current Spending (Teacher’s pay, Purchase of medicine to be used in NHS etc…)  Transfer payments (Money transferred from taxpayers to benefits recipients)  Debt Interest Payments (Payments made to the holders of govt. debt) Most important areas of Government Spending (as of late):  Social Protection e.g. Benefits  Health  Education  Defence  Debt Interest NOTE: Balanced Budget – Govt. Spending = Tax Revenue Budget Surplus – Govt. Spending < Tax Revenue This is the government budget. It has nothing to do with the current Budget Deficit – Govt. Spending > Tax Revenue account. Recession – When real GDP falls for two consecutive quarters Monetary Policy – Using changes in money supply / interest rates / exchange rate to influence the level of AD NOTE – Monetary Policy involving changing the interest rate in order to affect C I and (X-M) is also known as the Monetary Policy Transmission Mechanism. Monetary Policy:  Monetary policy is set by the Bank of England’s Monetary Policy Committee (MPC) Deflationary / Contractionary Monetary Policy:  Reduce AD via raising interest rates to push up the value of the £ as this will decrease (X-M) Reflationary / Expansionary Monetary Policy:  Increase AD via lowering interest rates to lower value of the £ as this will increase (X-M) NOTE – A decrease in the money supply causes interest rates to go up and vice versa. 36 Created by K.Longe Quantitative Easing*(Not in the syllabus but could be used as alternative for interest rates (evaluation)) Quantitative Easing (QE) – The introduction of new money into the money supply by a central bank  Central banks recently have been switching to QE due to nominal interest rates already having been cut too close to zero and because it was felt that low interest rates were having too small an effect on AD, the bank has decided to try something to boost AD further. QE Process (What it is intended to do): The central bank create electronic money They use this money to buy things such as bonds and other assets Leading to an increase in demand for bonds Price of bonds rises leading to fall in long term interest rate (they have an inverse relationship) Additionally the purchase of bank assets means that banks also have better balance sheets This should incentivise banks to lend more and so further incentivise C and I Increase in AD that should help central bank meet inflation target Problems with QE: 1. Cash Hoarding: o Asset purchases increase the liquidity (cash) of commercial banks but rather than increase lending banks have been happy to “sit on the cash”. 2. De-leveraging (Typically done via paying off existing debt on balance sheet): o Commercial banks are still desperate to reduce their existing debt before increasing lending. Because of this they are cautious about increasing their lending. 3. Credit availability remains low o Due to the 2 points above it means that many firms who need funds to expand still feel that they are frozen out of the loans market or have to pay premium interest rates as banks are reluctant to increase their lending. 4. Opportunity Cost: o The BoE have currently spent about £375bn on QE. This is an incredibly large amount of money and it could be put to better use. 5. Future Inflation: o Such huge expansions of the money supply through QE risk causing much higher inflation in the years ahead. This will likely have adverse effects on the economy and so is a reason as to why QE is thought, by some, to be a poor solution in the long run. Conclusion on QE: QE could be a great method of the central bank but due to its reliance on the actions of privately owned banks, whose aims are to make profits, it is unlikely to ever actually work as it should. On top of that even if it is to work it has great opportunity cost and is also likely to have awful inflationary effects in the future. 37 Created by K.Longe Supply-side Policies – Polices designed to increase AS by improving the efficiency of labour and product markets Supply-Side Policies: - Govt. Spending on Education and Training o Govt. Spending on education and training should raise the occupational mobility of labour and labour productivity  Increase in Potential Output of Economy - Govt. Assistance to New Firms o New, small firms provide employment, develop entrepreneurial skills and introduce new ideas. A govt. can help them by providing them with grants and charging them a low rate of corporation tax  Increase in Potential Output of Economy - Reduction in Direct Taxes o Whilst it would increase AD the lower direct taxation could also increase AS. This is because lower direct taxes increases incentives to firms, workers and potential workers. A cut in corporation tax will increase the funds that a firm has available to invest and so increase their willingness and ability to do so. This would cause both AD and AS to increase. o The lower direct tax rates are also likely to incentivise workers to become more productive, and the unemployed to enter / re-enter the labour force. This is because the potential amount of disposable income they can obtain has increased and the unemployed will be more willing to accept employment at the going wage rate which will likely cause AS to increase. o A potential downside to this though is that lower income tax may encourage workers to take more leisure time as they can earn the same disposable income by working fewer hours. Additionally for the unemployed it may not be the going wage rate keeping them from accepting employment but the rather that there just aren’t enough jobs. - National Minimum Wage (NMW) o There is debate about whether the introduction of a NMW or the removal of one is a supply-side policy. The key determinant is whether an NMW encourages people to enter the labour force or whether it reduces the efficiency in the labour market. - Reduction in Unemployment Benefit o A reduction in unemployment benefits will widen the gap between income from employment and benefits which may incentivise the unemployed to accept employment at lower wage rates. This in itself does not increase productive capacity but it does reduce the negative output gap and move output closer to full capacity. o A potential risk of this though is that unemployment may be increased by this. If the unemployment is of a cyclical nature (lack of AD leading to unemployment) then cutting benefits will reduce consumption which in turn will lower AD causing some firms to cut back on output further leading them to lay off some workers. Cutting benefits is also likely to widen income inequality. - Reduction in Trade Union Power o A reduction in trade union power may increase the efficiency of labour markets. This will be the case if trade unions reduce employment by pushing wage above the equilibrium level and encouraging workers to engage in restrictive practices. In such a situation, reducing trade union power will increase labour productivity and reduce the cost of employing labour further causing firms to be more encouraged to employ more workers and raise output. Restrictive Practices – An arrangement by a group of workers to limit output or restrict the entry of new workers in order to protect their own interests. 38 Created by K.Longe  o It could be argued though that trade unions make labour markets work more efficiently as they may act as a counter-balance to the market imperfection of very powerful employers. They may also reduce firm’s costs as they act as a channel for communication between employers and workers on issues and so as it is cheaper to negotiate with one body than individual workers, reducing trade union power may actually raise firm’s costs and unemployment. - Privatisation o It can be argued that more firms should be transferred from the public sector to the private. This is because economic systems leading more towards the free market tend to be more efficient because if firms don’t provide the products consumers want at competitive prices, they will go out of business. o It can also be argued though that government ownership of firms is useful in a number of cases where there is a high risk of market failure. - Deregulation o This should give firms greater freedom to make their own decisions and increase competition by making it easier for new firms to enter an industry which should increase the productive capacity of an economy. Policies to Reduce Unemployment Demand-side policies to reduce unemployment: - If the economy is below full employment then AD could be raised by either: 1. Using fiscal policy via increasing govt. spending and lowering taxation. 2. Monetary policy via decreasing interest rates or increasing the money supply.  Arguably increasing govt. spending is likely to have a greater impact on AD. This is because an extra £10 billion of govt. spending would initially raise AD by the full £10 billion whereas a cut in taxes of £10 billion may lead to an initial rise in AD of £6 billion as it is very possible £3 billion may be put into savings accounts and £1 billion could be spent on imports.  On the down side demand-side policies may have undesirable effects as an increase in AD may increase inflation as the economy moves closer to full employment. Additionally any existing deficit on the current account of the balance of payments may worsen as UK residents tend to buy more imported goods Supply-side policies to reduce unemployment:  Increase economic incentives and quality of labour by the (long-term) unemployed  Improve quantity / quality of information available to the unemployed about job vacancies and to employers about those seeking jobs  Improve education + training and provision of work experience may raise the skills of the unemployed  Help lone parents with more provision of low cost child-care so the lone parents can work  Widening the gap between income received from working and income received benefits should incentivise the unemployed to work  Subsidise the special equipment and adapt buildings to help employ more disabled workers  Cut rules and regulations firms face in hiring, employing and firing workers NOTE – At any one time, unemployment may be the result of both a lack of AD and supply-side problems Choice of Measures to Reduce Unemployment is Influenced By:  Cause of Unemployment  Rate and Duration of Unemployment  State of Other Macroeconomic Objectives 39 Created by K.Longe Policies to Control Inflation The measures implemented will be influenced by what is causing the inflation Controlling cost-push inflation in the short-run:  If it’s due to excessive wage rises, the govt. may try restrict wage rises by restricting increases in the govt. spending allocated to public sector pay  The govt. can try to lower firm’s costs by reducing corporation tax. An additional plus is that this may stimulate investment.  Govt. may provide subsidies so that firms can cover costs without having to raise prices. Subsidy may reduce costs in the long-run if some of it is spent on investment. The