Economics for Accounting and finance PDF

Chapters 1-4 Lecture 1 - Supply, Demand and Market Equilibrium 30 September 2024 09:24 Economics studies interactions between households and firms in relation to exchange and the many decisions which are made along the way. Study how society manages its scarce resources Economic...

Chapters 1-4 Lecture 1 - Supply, Demand and Market Equilibrium 30 September 2024 09:24 Economics studies interactions between households and firms in relation to exchange and the many decisions which are made along the way. Study how society manages its scarce resources Economic agents - individual, firm, organisation etc. the person were talking about general term Economy - all production and exchange activities that take place ○ Exists at different scales (local, national, international) Economic Activity - how much buying and selling is going on over a period of time Economic System - way in which resources are organised and allocated to provide for needs of citizens Economic Growth - increase in amount of goods and services over a period of time Capitalist Economic System - relies on private ownership to produce goods and services; production is operated primarily for profit Market Economy - decisions of many households and firms, without government intervention, all interested in their own wellbeing (proven remarkably successful) Planned Economic Systems - system organised by central planners (governments) also called communist or command systems Market Failure - when scarce resources are not allocated to their most efficient use Externality - cost/benefit of agents decision on a third party (bystander) which agent didn’t take into account (e.g. pollution) Market Power - the ability of a single economic agent to have a substantial influence on market Microeconomics - study of how households and firms make decisions and how they interact Macroeconomics - economy-wide phenomena Gross domestic product - market value of all goods and services produced in a country in a given time Standard of living - amounts of goods that can be purchased by population of a country Productivity - the amount of goods and services produced from each hour of a worker’s time. Inflation - increase in overall prices in the economy Market - group of buyers and sellers of a particular good Competitive Market - many buyers or sellers, each has negligible impact on market price ○ All goods for sale are the same Price takers - when the economic agents must accept the price as given Quantity demanded - amount of good that buyers purchase Law of Demand - quantity of goods demanded falls when price rises Demand Schedule - a table that shows the relationship between price and quantity Ceteris Paribus - other factors affecting demand are held constant so that we can analyse the effect of a change in price on demand Market demand - sum of all individual demands for a particular good or service Income effect - Consumers can now afford more with the same income - they're real income has increased Substitute effect - Cheaper than other products so the product will be used to substitute for others Substitutes - two goods for which an increase in price of one will increase demand of the other Complements - two goods for which an increase in price if one leads to a decrease in demand for the other Normal good - good for which, ceteris paribus, an increase in income leads to increase in demand (vice versa) Inferior good - a good for which, ceteris paribus, an increase in income leads to decrease in demand (vice versa) Quantity supplied - amount of good that sellers are willing and able to sell at different prices Law of supply - claim that, ceteris paribus, the quantity supplied of good rises when the price rises Supply schedule - table that shows relationship between price and quantity supplied Supply curve - graph of the relationship between price and quantity supplied Market Supply - sum of all supplies of all sellers Equilibrium/market price (market clearing price) - price where the quantity demanded is the same as quantity supplied Equilibrium quantity - quantity bought and sold at the equilibrium price Surplus - price > equilibrium price, then quantity supplied > quantity demanded. Suppliers will lower the price to increase sales, thereby moving toward equilibrium. Shortage - price < equilibrium price, then quantity demanded > the quantity supplied. Suppliers will raise the price due to too many buyers chasing too few goods, thereby moving toward equilibrium. Comparative statics - comparison of one initial static equilibrium with another Law of supply and demand - claim that price adjusts to bring the quantity supplied and the quantity demanded into balance Elasticity - Measure of how much agents respond to changes in market conditions Price elasticity of demand - Measure how much the quantity demanded of a good responds to a change in price Inelastic demand - demand is not easily changed Price Inelastic Demand - Quantity demanded does not respond strongly to price changes. Price elasticity of demand is less than one. Price Elastic Demand - Quantity demanded responds strongly to changes in price. Price elasticity of demand is greater than one Perfectly Price Inelastic - Quantity demanded does not respond to price changes. Perfectly Price Elastic - Quantity demanded changes infinitely with any change in price. Unit Price Elastic - Quantity demanded changes by the same percentage as the price Total Expenditure - Amount paid by buyers Income Elasticity of Demand - measures how much the quantity demanded of a good responds to a change in consumers’ income Price Elasticity of Supply - Measure how much quantity supplied of a good responds to a change in the price of that good Total Revenue - Total amount generated by supply Questions to Economic Problem: Economics for Accounting and finance Page 1  Questions to Economic Problem: There are 3 questions each economy must face ○ What goods and services should be produced ○ How should these be produced ○ Who should get what is produced To answer them we have resources ○ Land - natural resources ○ Labour - human effort (physical & mental) ○ Capital - equipment and structures used to produce Scarcity and Choice Scarcity - humanity has limited resources ○ Not all goods can be produced How people make decisions Trade-offs --> Trading one for another ○ The loss of the benefits from a decision to forego or sacrifice one option balanced against the benefits incurred from the choice made ○ To get one thing we usually give up another ○ Efficiency vs. Equity ▪ Getting the most out of resources vs. distributing economic prosperity fairly Opportunity Cost ○ Comparing costs and benefits from each alternatives ○ The value of the benefits foregone (sacrificed) ▪ Whatever is given up to obtain something different ○ Thinking at the Margin ○ Marginal changes - small incremental adjustments ▪ Based on idea that economic agents try to maximalise or minimalize everything ○ Rational decisions ▪ Assumption that decision-makers can make consistent choices between alternatives ○ Decision is worth perusing if the marginal cost is lower than marginal benefit ▪ Can be altered by public polities How People Interact - see above Capitalistic Economic System Market Economy - invisible hand Planned Economic Systems Supply and Demand: Forces that make market economies work Determine prices in a market economy and how these allocate scare resources Based on assumptions: ○ Many buyers and sellers ○ No buyer or seller has power to influence price ○ Perfect information for all buyers and sellers. ○ Freedom of entry and exit. ○ Identical goods. ○ Buyers and sellers act in self-interest. ○ Clearly defined property rights (can consider all costs and benefits when making decisions) Demand: As the price increases quantity decreases if Ceteris Paribus is true Demand curve is based on the demand schedule (Graph) (Table with inf) Market demand is the sum of all individual demands for a particular good or service Price of milk per Quantity of milk demanded liters (€) (liters per month) 0.00 20 0.10 18 0.20 16 0.30 14 0.40 12 0.50 10 0.60 8 0.70 6 0.80 4 0.90 2 Movement along the demand curve Caused by change in price If price falls more will be demanded due to ○ Income effect Economics for Accounting and finance Page 2  ○ Income effect ▪ Consumers can now afford more with the same income - they're real income has increased ○ Substitute effect ▪ Cheaper than other products so the product will be used to substitute for others ▪ The demand of the substitutes will then drop Shift in the Demand Curve If something other than price influences demand the curve shifts Causes: ○ Substitutes ○ Complements ○ Normal good ○ Inferior good ○ Tastes (preferences) ○ Size and structure of population ▪ Larger population, ceteris paribus, will mean higher demand ○ Advertising ○ Expectations of customers ▪ Potential future changes in price etc Supply Price of milk per liter (€) Quantity of milk supplied (liters per month) As price increases the supply increases 0.00 0 Supply Curve is based on Supply Schedule 0.10 0 ○ Shows how much producers offer for sale at 0.20 2 given price 0.30 4 Market Supply is the sum of all supplies of all 0.40 6 sellers 0.50 8 0.60 10 0.70 12 0.80 14 0.90 16 1.00 18 Shifts in the supply curve Change to the quantity that sellers produce causes a shift Factors affecting supply other than price ○ Profitability of other goods in production and prices of goods in joint supply ○ Advances in Technology ○ Natural / social factors ○ Input prices: the prices of factors of production ○ Expectations of producers ○ Number of sales Equilibrium Point at which the two lines meet Shows the optimal price There can be a surplus or a shortage ○ This affects the price Changes in equilibrium Increase or decrease in either causes shift in the line ○ This leads to the equilibrium point moving ○ This creates shortage or surplus To calculate shortage or supply take the two points from which they changed and minus one from another Economics for Accounting and finance Page 3 Elasticity Measure of how much agents respond to changes in market conditions Allows to analyse supply and demand with greater precision Inelastic demand - demand is not easily changed Price elasticity of demand The flatter the demand curve that passes through a given point the greater price elasticity of demand The steeper the demand curve that passes through a given point the smaller the price elasticity of demand Measure how much the quantity demanded of a good responds to a change in price Percentage change Determinants ○ Availability of close substitutes ▪ Closer the substitute the more price elastic the good is (easier to swap between the different goods) ○ Necessities versus luxuries ▪ Defined for individuals ○ Proportion of income devoted to the product ▪ Smaller proportion items are more likely to get away with increase in price ○ Definition of market ▪ How many different product are in the market e.g. food is a wide market vanilla ice creams are a narrow category - wide have inelastic price demand ○ Time horizon ▪ For some products it may take a while for the market to react to the change in price Demand tends to be more elastic: ○ the larger the number of close substitutes. ○ if the good is a luxury. ○ the more narrowly defined the market. ○ the longer the time period. Computing the Price Elasticity of Demand Reflects the fact that change in the quantity demanded is proportionately twice as large as the change in the price 0 =< Price Elasticity of Inelastic demand < 1 Percentage change in quantity demanded is less than the percentage change in price PEoD > 1 Elastic Percentage change in quality demanded is greater than the percentage change in price PEoD = 1 Unit or unitary elasticity Calculating Price Elasticity of Demand Midpoint method ○ Preferable since gives the same answer no matter the direction of change ▪ Hence can be used to look both at increasing and decreasing the price ○ Calculating elasticity between two points on a curve ○ Q - Quantity, P - Price ○ Point elasticity of demand method ○ Measures elasticity at a specific point ○ Which can be rearranged to give ○ Variety of demand Curves Perfectly Price Inelastic ○ Quantity demanded does not respond to price changes. Economics for Accounting and finance Page 4 Variety of demand Curves Perfectly Price Inelastic ○ Quantity demanded does not respond to price changes. Price Inelastic Demand ○ Quantity demanded does not respond strongly to price changes. ○ Price elasticity of demand is less than one. Unit Price Elastic ○ Quantity demanded changes by the same percentage as the price Price Elastic Demand ○ Quantity demanded responds strongly to changes in price. ○ Price elasticity of demand is greater than one Perfectly Price Elastic ○ Quantity demanded changes infinitely with any change in price. Other calculations for Elasticity of demand Total expenditure (for customers) or revenue (for companies) ○ Amount paid by buyers ○ ○ Changing the price will change demand -> change in profit ○ When demand is price inelastic (a price elasticity less than 1). price and total expenditure move in the same direction ○ When demand is price elastic (a price elasticity greater than 1), price and total expenditure move in opposite directions. ○ If demand is unit price elastic (a price elasticity exactly equal to 1), total expenditure remains constant when the price changes. Other Demand Elasticities Income Elasticity of Demand ○ measures how much the quantity demanded of a good responds to a change in consumers’ income ○ ○ Demand for goods consumers regard as necessities tends to be income inelastic ○ Demand for goods consumers regard as luxuries tends to be income elastic The Cross-Price Elasticity of Demand ○ Measures how the quantity demanded of one good changes as the price of another good changes ○ Price Elasticity of Supply Measure how much quantity supplied of a good responds to a change in the price of that good Determinants ○ Time Period ▪ Little differences in short periods ▪ Differences easier to create in a long period ○ Productive Capacity ▪ How much can be produced of a given good ○ Size of the Firm/Industry ▪ Supply more price elastic in small industries ▪ True for firms as well at industries as a whole ○ Mobility of Factors of Production ▪ Ability of other firms to swap to producing the good that may be in shortage ○ Ease of Storing Inventory ▪ Supply is more elastic where inventory build-up is easy and cheap Computing the Price Elasticity of Supply Similar to price elasticity of demand Midpoint Method ○ Point Method Economics for Accounting and finance Page 5  Point Method ○ Variety of Supply Curves The flatter the slope the more elastic supply Total Revenue can be calculated Economics for Accounting and finance Page 6  Chapter 5 Lecture 2 - CONSUMER THEORY AND THE DEMAND CURVE 07 October 2024 09:07 Changes on the margin means changes by a single unit Definitions Value - Worth of an individual of owning an item represented by the satisfaction derived from its consumption and their willingness to pay to own it Utility - satisfaction derived from the consumption of a product ○ Amount buyers are willing to pay for a good tells us about value they place ○ Opportunity cost is important Total utility - satisfaction that consumers gain from consuming a product Marginal utility of consumption - increase in utility that agent gets from an additional unit of that good Diminishing marginal utility - tendency for the additional satisfaction from consuming extra units of a good to fall Point of Satiety - point at which marginal utility = 0 and total utility is maximized Budget Constraint - Depicts the limit on the consumption bundles that we can afford Opportunity cost - Comparing costs and benefits from each alternatives Indifference curve - curve that shows consumption bundles that give consumer the same level of satisfaction Axiom - point of relevance Marginal Rate of Substitution - rate at which a consumer is willing to trade one good for another Choice optimalization - combines indifference curve and budget constraint, on the highest indifference curve Inferior good - a good that consumer buys less of when their income increases Income effect - change in consumption that results when a price change moves the consumer to a higher or lower indifference curve Substitution effect - change in consumption that results when a price change moves the consumer along an indifference curve to a point with a different marginal rate of substitution Demand curve - summary of the optimal decisions that arise from their budget constraint and indifference curves Price-consumption Curve - line showing the consumer optimum for two goods as price of only one of the goods changes Giffen good - god for which an increase in price rises the quantity demanded Normal Goods - good for which an increase in income leads to increase in demand Engel Curve - Line showing the relationship between demand and levels of income Bounded rationality - idea that humans make decisions under constraints of limited and sometimes unreliable information Heuristics - short cuts or riles of thumb that people use in decision-making Anchoring – using familiarity to make decisions. Availability – assessing risks of the likelihood of something happening. Representativeness – decisions made based on how representative something is to a stereotype. Persuasion – attributes a consumer attaches to a product or brand. Simulation – visualising or simulating the outcome of a decision Expected Utility theory - idea that preferences can and will be ranked by buyers ▪ Framing theory - differing response to choices depending on the way in which choices are presented (90% live vs 10% die - most will consistently choose first) Standard Economic Model Consumer behaviour theory People face trade-offs in their role as consumers Assumptions: ○ Buyers are rational ○ More is preferred to less ○ Buyers seek to maximize their utility ○ Consumers act in self-interest - not concerned about others Value Worth of an individual of owning an item represented by the satisfaction derived from its consumption and their willingness to pay to own it Water-diamond paradox ○ Difference between value in use and value in exchange ○ Because of this utility is now used Utility - used to find the schedule of demand Desire for things - how much the product you want ○ To mathematize it has to be converted into units - compare preferences Budget Constrains Depicts the limit on the consumption bundles that we can afford We consume less than they desire because their spending is constrained (limited) by their income The budget constraint shows the various combinations of goods the consumer can afford given their income and the prices of the two goods Combination of two different or bundle Ceteris Paribus is important to analyse the graphs efficiently Point under the budget constrain won't make the consumer happy since they don’t spend all their budget ○ Only happy if whole budget spend ○ The slope of the budget constraint line equals the relative price of the two goods, that is, the price of one good compared to the price of the other. It measures the rate at which the consumer can trade one good for the other A change in income ○ causes a shift in the budget constrain line Increase -->, decrease , decrease MR = MC Monopoly profit equals total revenue minus total costs ○ Find the point for poisoning effect? ○ Profit = TR - TC Profit = (TR/Q - TC/Q) Q Profit = (P - ATC) Q Deadweight loss Monopoly charges a price above the marginal cost From standpoint of consumers this high price makes monopoly undesirable However, from standpoint of the owners of the firm the high price makes monopoly very desirable Because a monopoly sets its price above marginal cost, it places a wedge between the consumer’s willingness to pay and the producer’s cost. ○ This wedge causes the quantity sold to fall short of the social optimum. Economics for Accounting and finance Page 25 Inefficient monopoly The monopoly produces less than the socially efficient quantity of output Deadweight loss caused by a monopoly is similar to the deadweight loss caused by tax Difference between the two cases is that the government gets revenue from a tax whereas a private firm gets monopoly profit Social cost ○ Welfare market includes the welfare of both consumers and producers ○ Transfer of surplus from consumers to producers is therefore not a social loss ○ Deadweight loss from monopoly stems monopolies producing less than the socially efficient output ○ If monopoly incurs costs to maintain its monopoly power those costs would also be included in deadweight loss Consumer buys as long as ○ Willingness to pay for another unit exceeds what they must pay for that unit. Producer sells as long as ○ Marginal Revenue exceeds Marginal Cost. Producer takes into account impact of price reduction necessary to sell another unit on revenue. This price reduction is irrelevant for total surplus: Price reduction increases consumer surplus to same extent as it reduces producer surplus. Producing an additional unit of output creates a positive externality to consumers. Price discrimination Price discrimination - selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same Arbitrage - process of buying a good in one market at a low price then selling it in another market at a higher price ○ Limits monopiles ability to price discriminate For it to occur firm must have some market power Perfect price discrimination - situation in which monopolist knows exactly the willingness to pay each customer and can charge each customer a different price ○ Increases monopolist's profit ○ Can reduce deadweight loss Three types ○ 1st type → perfect price discrimination ○ 2nd type → based on quantity - bulk discounts ○ 3rd type → based buyer characteristics - museum ticket Social costs Conclusions Welfare in a market includes the welfare of both consumers Monopolies are common. and producers. Most firms have some control The transfer of surplus from consumers to producers is over their prices because of therefore not a social loss. differentiated products. The deadweight loss from monopoly stems monopolies Firms with substantial producing less than the socially efficient level of output. monopoly power are rare. If the monopoly incurs costs to maintain (or create) its Few goods are truly unique monopoly power, those costs would also be included in deadweight loss. Economics for Accounting and finance Page 26  Chapters 20,21 and 23 Lecture 6 - GDP, Prices and Unemployment 04 November 2024 09:00 Definitions Macroeconomics - study of the economy as a whole, aims to explain the economic changes that affect many households firms and markets at once Gross domestic product - measure of income and expenditures of an economy Consumption (C) - The spending by households on goods and services, with the exception of purchases of new housing. Investment (I) - The spending on capital equipment, inventories, and structures, including new housing. Government Purchases (G) - The spending on goods and services by local and central governments. Does not include transfer payments because they are not made in exchange for currently produced goods or services. Net Exports (NX) - Exports minus imports. GDP per capita - GDP divided by the population of a country to give a measure of national income per head Nominal GDP - values the production of goods and services at current prices. Real GDP - values the production of goods and services at constant prices. GDP deflator - measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. Gross value added - contribution of domestic producers, industries and sectors to an economy Annual chain-linking - method of calculating GDP volume measures based on prices in previous years Cost of living - how much money people need to maintain standards of living in terms of the goods and services they can afford to buy Inflation is used to describe a situation in which the economy's overall price is rising Inflation rate - percentage change in the price level from the previous period Consumer Price Index (CPI) - measures overall cost of the goods and services bought by a typical consumer Indexation - When some money amount is automatically corrected for inflation by law or contract, the amount is said to be indexed for inf lation. Nominal Interest rate - interest rate usually reported and not corrected for inflation Real interest rate - nominal interest rate that is corrected for the effects of inflation Unemployment rate - percentage of labour force that is unemployed Economically inactive - people who aren't employed or unemployed due to reasons such as education, full time careers etc Labour force - the total number of workers, including both employed and unemployed Labour force participation rate (economic activity rate) - percentage of adult population that is in labour force Frictional unemployment - unemployment that results because it takes time for workers to search for the jobs that best suit their tastes and skills Job search - process by which workers find appropriate jobs given their tastes and skills Voluntary unemployment - where people chose to remain unemployed rather than take jobs which are available Involuntary unemployment - where people want work at going market wage rates but cannot find employment Structural unemployment - unemployment that results because the number of jobs available in some labour markets is insufficient to provide a job for everyone who wants one Occupational immobility - where workers are unable to easily move from one occupation to another Geographical immobility - where people are unable to take work because of the difficulties associated with moving to different regions Natural rate of unemployment - normal rate of unemployment around which the unemployment fluctuates Cyclical unemployment - deviation of unemployment from its natural rate Macroeconomics Study of economy as a whole aims to explain the economic changes that affect many households firms and markets at once For An Economy As A Whole, Total Income Must Equal Total Expenditure ○ Every transaction has a buyer and a seller ○ Every £ of spending is £ income for seller ○ Equality of income and expenditure can be illustrated with the circular-flow diagram Households buy goods and services, firms use this money to pay for resources purchased from households When households receive income some is: ○ Saved (S) - providing funds for financial institutions ○ Taxed (T) - can be used by government in making purchases (G) such as education, health Some products and services may be purchased from other countries as imports (M) some are sold abroad as exports (X) Some businesses invest (I) in new capital Leakages (what comes out of the system) are T + S + M Injections (comes into the system) into economy come from G, X and I Gross domestic product Gross domestic product - measure of income and expenditures of an economy It's the total market value of all final goods and services produced within a country in a given period of time Economics for Accounting and finance Page 27  GDP - the market value of all final goods and services produced within a country in a given period of time ○ Output is valued at market prices ○ It records only the value of final goods, not intermediate goods (the value is counted only once) ○ It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, cleaning) ○ It includes goods and services produced in the period we’re considering, not transactions involving goods produced in the past ○ It measures the value of production within the geographic confines of a country. ○ It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months). Includes all items produced in economy and sold legally in markets Excludes: ○ Most items that are produced and consumed at home and that never enter the marketplace ○ Items produced and sold illicitly such as illegal drugs Components ○ GDP (Y) = Consumption (C) + Investments (I) + government purchases (G) + Net Exports (NX) ○ Consumption (C) ▪ The spending by households on goods and services, with the exception of purchases of new housing. ○ Investment (I) ▪ The spending on capital equipment, inventories, and structures, including new housing. ○ Government Purchases (G) ▪ The spending on goods and services by local and central governments. ▪ Does not include transfer payments because they are not made in exchange for currently produced goods or services. ○ Net Exports (NX) ▪ Exports minus imports. ○ Transfer payment - payment for which no good is exchanged GDP per capita - GDP divided by the population of a country to give a measure of national income per head Nominal GDP - values the production of goods and services at current prices. Real GDP - values the production of goods and services at constant prices. Calculations ○ Requires adjusting nominal to real GDP by using the GDP deflator ○ Assume an economy produces only two goods - apples and potatoes GDP deflator - measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. ○ It tells us the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced. ▪ Reflects the prices of all goods and services produced domestically ○ ○ Limitations of GDP GDP is the best single measure of the economic well-being of a society. ○ GDP per person tells us the mean income and expenditure of the people in the economy. ○ Higher GDP per person indicates a higher standard of living. GDP is not a perfect measure of the happiness or quality of life ○ Some things that contribute to well-being are not included in GDP. ○ The value of leisure. ○ The value of a clean environment. ○ The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children and the value of volunteer work. GDP data is used as a way of comparing well-being across different countries. Rich and poor countries have vastly different levels of GDP per person. ○ Countries with low GDP per person tend to have more infants with low birth weight, higher rates of infant mortality, higher rates of maternal mortality, higher rates of child malnutrition and less common access to safe drinking water. Cost of living Cost of living - how much money people need to maintain standards of living in terms of the goods and services they can afford to buy Inflation is used to describe a situation in which the economy's overall price is rising Inflation rate - percentage change in the price level from the previous period Consumer Price Index (CPI) - measures overall cost of the goods and services bought by a typical consumer ○ Reflects the prices of all goods and services bought ○ Reported each month by governments ○ When CPI rises typical family has to spend more money to maintain the same standard of living ○ Calculating Economics for Accounting and finance Page 28 Problems with Measuring the cost of Living CPI is accurate to measure selected goods that make up a bundle - it's not a perfect measure of the cost of living There are three key issues that cause the CPI to overstate the true cost of living ○ Substitution bias ▪ Basket doesn’t change to reflect consumer reaction to changes in relative prices □ Costumers switch to goods that become less expensive □ Index overstates the increase in cost of living by not considering customer substitution ○ Introduction of new goods ▪ The basket does not reflect the change in purchasing power brought on by the introduction of new products. □ New products result in greater variety, which in turn makes each euro more valuable. □ Consumers need less money to maintain any given standard of living. ○ Unmeasured quantity changes ▪ If the quality of a good rises from one year to the next, the value of a euro rises, even if the price of the good stays the same. ▪ If the quality of a good falls from one year to the next, the value of a euro falls, even if the price of the good stays the same. ▪ The ONS tries to adjust the price for constant quality, but such differences are hard to measure The issue over accurate measurement is important because many government programs use the CPI to adjust for changes in the overall level of prices. GDP Deflator vs CPI Both GDP deflator and CPI are monitored to gauge how quickly prices are rising There are two important differences between the indexes that can cause them to diverge GDP ○ prices of all goods and services produced domestically ○ Compares price of currently produced goods to price of the same goods in the base year CPI ○ prices of all goods and services bought by consumers ○ Compares the price of a fixed basket to price of the basket in the base year Indexation When some money amount is automatically corrected for inflation by law or contract, the amount is said to be indexed for inflation. Real and nominal interest rates Interest represents a payment in the future for a transfer of money in the past Nominal Interest rate - interest rate usually reported and not corrected for inflation Real interest rate - nominal interest rate that is corrected for the effects of inflation ○ Economics for Accounting and finance Page 29 Unemployment Someone who does not have a job but is willing and available for work Unemployment rate - percentage of labour force that is unemployed ○ Economically inactive - people who aren't employed due to reasons such as education, full time careers etc Labour force - the total number of workers, including both employed and unemployed Labour force participation rate (economic activity rate) - percentage of adult population that is in labour force ○ Categories ○ Long-run problem ▪ Natural rate of unemployment ○ Short-run problem ▪ Cyclical rate of unemployment ○ Focus in on long-term Measured in two ways ○ Claimant count ○ Monthly survey of households Each adult is placed into one of three categories: ○ Employed ○ Unemployed ○ Not in the labour force Causes of unemployment Frictional unemployment - unemployment that results because it takes time for workers to search for the jobs that best suit their tastes and skills ○ Inevitable because the economy is always changing ○ Job search means there must always be some unemployment ○ Job search - process by which workers find appropriate jobs given their tastes and skills Voluntary unemployment - where people chose to remain unemployed rather than take jobs which are available Involuntary unemployment - where people want work at going market wage rates but cannot find employment Structural unemployment - unemployment that results because the number of jobs available in some labour markets is insufficient to provide a job for everyone who wants one Occupational immobility - where workers are unable to easily move from one occupation to another Geographical immobility - where people are unable to take work because of the difficulties associated with moving to different regions Natural rate of unemployment - normal rate of unemployment around which the unemployment fluctuates Cyclical unemployment - deviation of unemployment from its natural rate Economics for Accounting and finance Page 30 Economics for Accounting and finance Page 31  Chapters 22 and 24 in 4th edition Lecture 7 - Economic Growth 21 and 23 in 5th edition 11 November 2024 09:06 Definitions Capital - level of investment in the country Productivity - amount of goods and services produced for each hour of a worker’s time Factors of production - Inputs used to produce goods and services Physical capital - makes workers more productive Human capital - knowledge/skills (through education, training and experience) Natural resources - inputs provided by nature, such as land, rivers and mineral deposits Technological knowledge – understanding of the best ways to produce goods and services Investment - purchase of new capital, such as equipment or building Saving - spending less than earn and putting it in a bank, stock or funds Financial system - group of institutions in economy that help match one person's saving with another person's investment Market for loanable funds - market in which those who want to supply funds and those who want to borrow to invest demand funds Loanable funds - all income that people have chosen to save and lend out, rather than use for their own consumption Net investment - spending on new capital and not depreciation Steady-state equilibrium - point in a growing economy where investment spending is equal to spending on depreciation and the capital-output ratio remains constant Catch-up effect - countries that start off poor tend to grow more rapidly than countries that start off rich Production Isoquants - Look at lecture 3 final part Production from the view of the economy Production and Growth Country's standard of living depends on production Large changes in the standard of living over time ○ Average income has grown by about 1.3% per year ▪ GDP per person doubles every 50 years Annual growth rates become significant when compounded Productivity - amount of goods and services produced for each hour of a worker’s time ○ A nation’s standard of living is determined by the productivity of its workers. The EU countries had a trend of increasing living standards until the recession hit. Living standards, as measured by real GDP per person, vary significantly among nations. Large changes in living stands over time ○ due to different growth rates ○ Poorest countries average levels of income have not been seen in the UK for decades Solow's Economic Growth Model Growth theory The trend rate of growth is: ○ The average sustainable rate of economic growth over a period of time. The annual growth does not necessarily need to be high but consistent The Solow theory used to explain economic growth Economics for Accounting and finance Page 32  The Solow theory used to explain economic growth ○ Rate of human + physical capital and population growth as being key determinants of growth Other factors that influence economic growth ○ Openness to trade ○ How easy it is to do business Capital - level of investment ○ Extent to which corruption is minimised in the country ○ Extent of violence, war and conflict ○ Regional characteristics ○ Geographical factors Productivity Plays a key role in determining living standards for all nations Productivity - amount of goods and services that a worker can produce from each hour of work Large differences in living standards due to production of goods and services. High standard of living if production of large quantity of goods and services. Determining production: ○ Factors of production - Inputs used to produce goods and services ▪ Physical capital - makes workers more productive ▪ Human capital - knowledge/skills (through education, training and experience) ▪ Natural resources - inputs provided by nature, such as land, rivers and mineral deposits ▪ Technological knowledge – understanding of the best ways to produce goods and services ○ Technical progress means that the quality of physical and human capital is improved Saving and Investment ○ Investment - purchase of new capital, such as equipment or building ○ Saving - spending less than earn and putting it in a bank, stock or funds ○ In a closed economy saving must be equal to investment Financial system ○ Financial system - group of institutions in economy that help match one person's saving with another person's investment Loanable funds ○ Market for loanable funds - market in which those who want to supply funds and those who want to borrow to invest demand funds ○ Loanable funds - all income that people have chosen to save and lend out, rather than use for their own consumption ○ Interest rate - price of the loan Determinates of economic growth Solow's model helps to understand key determinants of growth ○ Output level (GDP) = y ○ Technology = A ○ Capital = K ○ Labour = L In a closed economy Y = Consumption (C) + Savings (S) Long run equilibrium For an economy with a given level of physical capital, the growth path will be dependent on the: Level of technology. Economics for Accounting and finance Page 33  ○ Level of technology. ○ Productivity of labour and capital. ○ Savings rate which determines investment in physical capital. Net investment - spending on new capital and not depreciation. The ratio of capital to labour is one aspect of how productive labour can be. Countries like Korea have a supply of cheap labour and invested in capital ○ Labour productivity is relatively high. ○ There is strong economic growth. African countries' investment in capital stock is extremely low and so: ○ Labour productivity is also very low. ○ There is weak economic growth. Steady-state equilibrium - point in a growing economy where investment spending is equal to spending on depreciation and the capital-output ratio remains constant Solow's model provides understanding of transition of economies ○ Less developed economies will have lower capital-output ratios ○ Investment in capital will increase the capital per worker lead to growth ○ Capital investment needs to be higher than the steady state equilibrium. However, investment is determined by the savings ratio. ○ In less developed countries may be low - incomes are low. ○ Difficult to do business in these countries, so their economies continue to be poor and do not reach steady state equilibrium. Green line is the technology Causes for Growth Endogenous Economic Growth Paul Romer Assumptions of the model Labour is fixed The economy is closed Causes of growth Changes in savings rates ○ Increase in savings rate from I to I1 leads to ▪ Increase in investment above the depreciation rate ▪ Increase in capital-output ration ▪ Economy moves to a new steady-state equilibrium of K** Increase in population ○ Can rise through birth rates being higher than death rates ○ Age of population helps determine the labour force ○ Solow growth model shows that if the labour force is rising then the capital-output ratio remain constant, investment must cover depreciation and provide more capital ▪ If investment doesn't keep pace with the rise in population, people will become Economics for Accounting and finance Page 34  ▪ If investment doesn't keep pace with the rise in population, people will become poorer ▪ This helps explain why many less developed countries experience continues high levels of poverty because their population rises but investment fails to keep pace. Dilution of capital stock ○ Countries with high population growth have large numbers of school-age children. ○ This places larger burden on the education system Promoting technical progress ○ If there are more people then ▪ Greater probability that some of those people will come up with new ideas ▪ Lead to technological progress - everyone benefits Increase in technology ○ Can be seen as a public good ○ Can offset the effects of diminishing marginal product and lead to proportional increases in productive capacity Endogenous growth theory Endogenous growth theory - theory of long-run economic growth which results from the creation of new knowledge and technology which impacts on everyone and makes them more productive as result Economic growth and public policy Government Policies That Raise Productivity and Living Standards. ○ Encourage saving and investment. ○ Encourage investment from abroad. ○ Encourage education and training. ○ Establish secure property rights and maintain political stability. ○ Promote free trade. ○ Promote research and development. Diminishing Returns Diminishing returns - As stock of capital rises the extra output produce from additional unit of capital falls ○ Increase in the saving rate leads to higher growth only for a while. ○ In the long run, the higher saving rate leads to a higher level of productivity and income, but not to higher growth in these areas. Catch-up effect Catch-up effect - countries that start off poor tend to grow more rapidly than countries that start off rich. ○ This helps explain why China had a higher growth rate than Japan even though both countries devoted a similar share of GDP to investment Education For a country’s long-run growth, education is at least as important as investment in physical capital. ○ In the developed economies of Western Europe and North America States, each year of schooling raises a person’s wage, on average, by about 10 percent. ○ Thus, one way the government can enhance the standard of living is to provide schools and encourage the population to take advantage of them. Economics for Accounting and finance Page 35  Chapter 27 + 28 Lecture 8 - Monetary System 18 November 2024 09:04 Definitions Bartering - the exchange of one good for another Double coincidence of wants - situation where two parties each have a good or service that the other wants and can thus enter into exchange Money - set of assets in an economy that people regularly use to buy goods and services from other people Medium of exchange - item that buyers give to sellers when they want to purchase goods and services Unit of account - yardstick people use to post prices and record debts Store of value - item that people can use to transfer purchasing power from the present to the future Liquidity - ease with which an asset can be converted into the economy's medium of exchange Commodity money - money that takes the form of a commodity with intrinsic value Gold standard - system in which the currency is based on the value of gold and where the currency can be converted to gold on demand Fiat money - money without intrinsic value that is used as money because of government decree Money stock - quantity of money circulating in the economy Currency - paper bills and coins in the hands of the public Demand deposits - balances in bank accounts that depositors can access on demand by writing a cheque or using a debit card Central bank - institution designed to oversee the banking system and regulate the quantity of money in the economy Money supply - quantity of money available in the economy Monetary policy - set of actions taken by the central bank in order to affect the money supply Open market operations - purchase and sale of non- monetary assets from and to the banking sector by the central bank. Liquidity - cash needed to ensure transactions in the financial system are honoured. European Central Bank - overall central bank of the 19 countries comprising the European Monetary Union. Euro system - system made up of the ECB plus the national central banks of the 19 countries comprising the European Monetary Union. Spread - difference between the average interest banks earn on assets and the average interest rate paid on liabilities Systemic risk - risk of failure across the whole of the financial sector Credit risk - risk a bank faces in defaults on loans Liquidity risks - risk that a bank may not be able to fund demand for withdrawals Macroprudential policy - policies designed to limit the risk across the financial sector by focusing on improving 'prudential' standards of operation that enhance stability and reduce risk Outright open market operations - outright sale or purchase of non-monetary assets to or from the banking sector by the central bank without a corresponding agreement to reserve the transaction at a later date Refinancing rate - interest rate at which the European central bank lends on a short0-term basis to the euro area banking sector Repurchase agreement - sale of non-monetary asset together with an agreement to repurchase it at a set price at a specified future date Money market - market in which the commercial banks lend money to one another on a short-term basis Repo rate - interest rate at which the bank of England lends on a short-term basis to the UK banking sector Discount rate - interest rate at which eh federal reserve lends on a short-term basis to the us banking sector Inflation - increase in the overall level of prices Hyperinflation - extraordinarily high rate of inflation Price level - snapshot of the weighted average of a basket of goods at a point in time Deflation - negative rate of inflation Quantity theory of money - explains the long-run determinants of the price level and the inflation rate. Nominal variables - variables measured in monetary units Real variables - variables measured in physical units Classical dichotomy - theoretical separation of nominal and real values Relative prices - price expressed in terms of how much of one good has to be given up in purchasing another Real wage - money wage adjusted for inflation, measured by the ratio of fhte wage rate to price Monetary neutrality - proposition that changes in the money supply do not affect real variables Velocity of money - the rate at which money changes hands Quantity equation - relates the quantity, velocity and currency value of the economy's output of goods and services Inflation tax - revenue the government raises by creating money Hyperinflation - period of extreme and accelerating increase in price levels Fisher effect - One-for-one adjustment of the nominal interest rate to the inflation rate Shoeleather costs - resources wasted when inflation encourages people to reduce their money holdings Menu costs - costs of adjusting prices. Economics for Accounting and finance Page 36 Money Bartering Bartering - the exchange of one good for another ○ Requires a double coincidence of wants ○ This was something before money ○ Exchanging for goods ○ You need what the other person wants instantly Money Money - set of assets in an economy that people regularly use to buy goods and services from other people Functions of money ○ Medium of exchange ▪ Medium of exchange - item that buyers give to sellers when they want to purchase goods and services ▪ Anything that is readily acceptable as payment ○ Unit of account ▪ Unit of account - yardstick people use to post prices and record debts ○ Store of value ▪ Store of value - item that people can use to transfer purchasing power from the present to the future ▪ Allows for liquidity □ Liquidity - ease with which an asset can be converted into the economy's medium of exchange Kinds of money ▪ Commodity money ▪ Takes form of a commodity with intrinsic value ▪ Gold, silver, cigarettes ▪ Gold standard ▪ System in which the currency is based on the value of gold and where the currency can be converted to gold on demand ▪ Fiat money ▪ Used as money because of government decree ▪ Doesn’t have intrinsic value ▪ Coins, currency, current account deposits Money in the economy ▪ Money stock - quantity of money circulating in the economy ▪ Measures: □ M1 - currency in circulation plus banks' overnight deposits with the central bank □ M2 - M1 plus short-term deposits □ M3 - M2 plus repos, money market funds, short-term debt securities ▪ Currency - paper bills and coins in the hands of the public ▪ Demand deposits - balances in bank accounts that depositors can access on demand by writing a cheque or using a debit card Banks Central Banks Central bank - institution designed to oversee the banking system and regulate the quantity of money in the economy Whenever an economy relies on fiat money, there must be some agency that regulates the system ○ Known as the central bank Money supply - quantity of money available in the economy Monetary policy - set of actions taken by the central bank in order to affect the money supply Functions of central bank ○ Macroeconomic stability in maintaining stable growth and prices and through the avoidance of excessive and damaging swings in economic activity. ○ The maintenance of stability in the financial system. ○ Open market operations - purchase and sale of non- monetary assets from and to the banking sector by the central bank. ○ To increase the money supply, the central bank buys bonds from the public. ▪ The amount of currency in the hands of the public is increased. To reduce the money supply, the central bank sells bonds to the public. Economics for Accounting and finance Page 37  ○ To reduce the money supply, the central bank sells bonds to the public. ▪ The amount of currency in the hands of the public is reduced. ○ Liquidity - cash needed to ensure transactions in the financial system are honoured. ○ To maintain financial stability central banks supply liquidity to the rest of the banking system. ▪ The central bank can step in as a lender of the last resort. ▪ Central banks assess banks’ ability to meet different levels of financial stress and have the power to impose regulations. European central bank ○ European Central Bank - overall central bank of the 19 countries comprising the European Monetary Union. ○ The ECB was officially created on 1 June 1998 and is located in Frankfurt. ○ It came into being because 11 countries of the European Union had decided that they wished to enter European Monetary Union and use the same currency. ○ The primary objective of the ECB is to promote price stability throughout the euro area. ○ An important feature of the ECB and the Euro system is its independence. ○ Euro system - system made up of the ECB plus the national central banks of the 19 countries comprising the European Monetary Union. Bank of England The Bank of England is the central bank of the United Kingdom. The Bank of England’s primary duty is to deliver price stability. Unlike the ECB the Bank of England does not define for itself what is meant by price stability. This is done by the UK government. In 2013 the target set was inflation of 2 per cent Money supply Banks make profits by accepting deposits and making loans. ○ Hold some deposits as reserves ○ Lend the rest to make profit Spread - difference between the average interest banks earn on assets and the average interest rate paid on liabilities Islamic Sharia principles make profits from the sharing of risk and reward between lenders and borrowers. Banks Balance Sheet ○ Assets ▪ cash, securities it holds, and loans. ○ Liabilities ▪ demand deposits, savings deposits, borrowings ○ A bank must keep reserves to cover possible withdrawals ○ Systemic risk - risk of failure across the whole of the financial sector ○ Credit risk - risk a bank faces in defaults on loans ○ Liquidity risks - risk that a bank may not be able to fund demand for withdrawals ○ Macroprudential policy - policies designed to limit the risk across the financial sector by focusing on improving 'prudential' standards of operation that enhance stability and reduce risk ○ Banks must be able to respond to both defaults (credit risk) and increased withdrawals (liquidity risk). ○ The ratio of this capital in relation to the rest of the bank’s assets is seen as a measure of the financial strength of a bank. It effectively acts as a cushion against financial shocks. ○ A risk occurs if too many of a bank’s liabilities are short term and borrowers demand their money. ▪ Having more long-term debt helps reduce the risk. Creation of money ○ Banks actively find ways of making new loans. ○ In granting a private loan, the bank credits the account of the borrower with the funds. ○ At the point a new loan is agreed, new money is created and the money supply increases. ○ These new loans represent assets to the bank. ▪ Borrower will pay the loan plus interest to the bank. ○ At the same time liabilities increase by the same amount. ○ In this way the bank’s balance sheet also expands. ○ When bank loans are repaid the money supply contracts. ○ Banks also buy and sell a range of assets including bonds. ○ If a bond is purchased from a non-banking sector holder the funds are credited to the seller’s account. ○ This increases the money supply. ○ Equally, if banks sell bonds to the non-banking sector, the buyer’s account is debited with the sum paid and the money supply contracts. Constraints on bank Lending ○ The central bank increases lending rates to the banking system forcing banks to increase the interest rate on lending to maintain spreads. Economics for Accounting and finance Page 38  on lending to maintain spreads. ○ This leads to a reduction in the demand for loans. ○ A reduction in interest rates would be expected to stimulate the demand for loans. Central bank's tools of monetary control Open-market operations ○ When the central bank buys government bonds, the money supply increases ○ The money supply decreases when the central bank sells government bonds ○ Outright open market operations - outright sale or purchase of non-monetary assets to or from the banking sector by the central bank without a corresponding agreement to reserve the transaction at a later date Refinancing rate ○ Refinancing rate - interest rate at which the European central bank lends on a short0-term basis to the euro area banking sector ○ Increasing the refinancing rate decreases the money supply. ○ Decreasing the refinancing rate increases the money supply. ○ In the USA, the refinancing rate is called the discount rate and in the UK it’s called the repo rate. ○ Repurchase agreement - sale of non-monetary asset together with an agreement to repurchase it at a set price at a specified future date ○ Money market - market in which the commercial banks lend money to one another on a short-term basis ○ Repo rate - interest rate at which the bank of England lends on a short-term basis to the UK banking sector ○ Discount rate - interest rate at which eh federal reserve lends on a short-term basis to the us banking sector Quantitative easing ○ Purpose ▪ Put banks in a better position to lend and hence help boost demand. ○ The process of QE involves the central bank buying assets ▪ In selling assets to the central bank, institutions will hold more money in relation to other assets. ▪ They maintain their portfolios by using the money to buy bonds and shares of companies, which is in effect lending to firms. ○ The issue is whether QE is working or how long it would take to see any measurable effects. The classical theory of inflation People use money to buy goods and services form others It's a store of value which is why we are interested in inflation Inflation - increase in the overall level of prices Hyperinflation - extraordinarily high rate of inflation Inflation CPI can be used as a measure of inflation Price level - snapshot of the weighted average of a basket of goods at a point in time ○ Prices in base year are given an index of 100 ○ If index was 103 next year then inflation was 3% If inflation rate changes from 4 to 3 the rate of change is slowing but prices still rose Deflation Economics for Accounting and finance Page 39  Deflation ○ Deflation - negative rate of inflation, price level falls ○ Can be as damaging as inflation because: ▪ There is little incentive to spend today if the expectation is for cheaper prices tomorrow ▪ It might result in consumers not spending at levels that provide incentives for firms to invest in new capacity. ▪ Leading to little or no growth - increased likelihood of unemployment. Classical theory of inflation ○ Prices rise when government prints too much money ○ Inflation is economy wide phenomenon that concerns the value of the economy's medium of exchange ○ When the overall price rises the value of money falls Money supply and demand Value of money is determined by the supply and demand for money Money supply ○ policy variable that is controlled by the central bank. ○ The money supply is fixed until the central bank decides to change it through instruments such as open-market operations, the central bank directly controls the quantity of money supplied. ○ Therefore the supply of money is vertical (perfectly inelastic) until the central bank decides to change it. Money demand ○ Money demand has several determinants, including interest rates and the average level of prices in the economy. ○ People hold money because it is the medium of exchange. ○ The amount of money people choose to hold depends on the prices of goods and services. ○ Therefore the lower the value of money the higher the demand. As price increases the value of money decreases Monetary Injection Quantity theory of money - explains the long-run determinants of the price level and the inflation rate. Quantity of money available determines the value of money. Inflation is caused by growth in quantity of money (see figure 2). Assume that the economy is in equilibrium and the central Bank suddenly increases the supply of money. ○ The supply of money shifts to the right. ○ The equilibrium value of money falls and the price level rises. ○ The quantity theory of money asserts that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate. Economics for Accounting and finance Page 40  inflation rate. Adjustment process An increase in the money supply creates an excess supply of money. People may: ○ Buy goods and services with the funds. ○ Use these excess funds to make loans to others. These loans are then likely used to buy goods and services. Therefore the increase in the money supply leads to an increase in the demand for goods and services. ○ The increase in the demand for goods and services will result in higher prices because the their supply remains unchanged. Classical Dichotomy and Monetary Neutrality Hume and others suggested in the 18C that economic variables could be divided into: ○ Nominal variables measured in monetary units. ○ Real variables measured in physical units. ○ This was termed the classical dichotomy Relative prices ○ Relative prices - price expressed in terms of how much of one good has to be given up in purchasing another ○ Prices in the economy are nominal, but relative prices are real. ○ Relative price is defined in terms of nominal price of one good divided by the nominal price of another ○ The real value of a good is what other goods have been sacrificed in purchasing the good ▪ This is the opportunity cost ○ Relative prices not expressed in terms of money - relative prices are real variables. ○ The relative price is expressed in terms of how much of one good has to be given up in purchasing another Real Wages ○ Real wage - money wage adjusted for inflation, measured by the ratio of the wage rate to price ○ Real wages is a more accurate reflection of how the consumer is affected. ○ The real wage is the money wage adjusted for inflation measured by the ratio of the wage rate to price. Monetary Neutrality ○ Monetary neutrality - proposition that changes in the money supply do not affect real variables ○ Different forces influence real and nominal variables. ○ Real economic variables do not change with changes in the money supply. ○ When studying the long-run changes in the economy, the neutrality of money offers a good description of how the world works. Velocity and quantity equation ○ Velocity of money - the rate at which money changes hands ○ Quantity equation - relates the quantity, velocity and currency value of the economy's output of goods and services Inflation tax ○ Inflation tax - revenue the government raises by creating money ○ Hyperinflation - period of extreme and accelerating increase in price levels ○ When the government raises revenue by printing money, it is said to levy inflation tax An inflation tax is like a tax on everyone who holds money. Economics for Accounting and finance Page 41  ○ An inflation tax is like a tax on everyone who holds money. ○ The inflation ends when the government institutes fiscal reforms such as cuts in government spending Fisher effect ○ Fisher effect - One-for-one adjustment of the nominal interest rate to the inflation rate Costs of inflation Fall in purchasing power ○ Inflation does not in itself reduce people’s real purchasing power. ○ As prices rise, so do incomes. Thus, inflation does not in itself reduce the purchasing power of incomes. ○ However some people’s incomes may not rise exactly with inflation. Shoeleather costs Shoeleather costs - resources wasted when inflation encourages people to reduce their money holdings Inflation reduces the real value of money ○ People minimize their cash holdings The actual cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand Menu costs Menu costs - costs of adjusting prices. During inflationary times, it is necessary to update price lists and other posted prices. This is a resource-consuming process that takes away from other productive activities. Relative price variability Inflation distorts relative prices. Consumer decisions are distorted, and markets are less able to allocate resources to their best use. Tax distortions Inflation exaggerates the size of capital gains and increases the tax burden on this type of income. ○ With progressive taxation, capital gains are taxed more heavily. The nominal interest earned on savings is treated as income for income tax purposes ○ Even though part of the nominal interest rate merely compensates for inflation. The after-tax real interest rate falls when inflation rises, making saving less attractive. Confusion and inconvenience When the central bank increases the money supply and creates inflation, it erodes the real value of the unit of account. Inflation causes money at different times to have different real values. Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time. Arbitrary redistribution of wealth Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need. These redistributions occur because many loans in the economy are specified in terms of the unit of account—money. Economics for Accounting and finance Page 42 Lecture 9 - Aggregate demand and aggregate supply Chapters 33-35 from 4th edition 25 November 2024 09:04 Definitions: Okun's Law - to keep unemployment rate steady, real GDP needs to grow at or close to its potential Lagged indicator - indicator whose changes occur after changes in economic activity have occurred Model of aggregate demand and aggregate supply - model that is used to explain short-run fluctuations in economic activity around its long-run trend Aggregate demand curve - shows the quantity of goods and services that households firms and government want to buy at each price level Aggregate supply curve - quantity of goods firms choose to produce and sell at each price level Natural Rate of Output - output level in an economy when all existing factors of production are fully utilized and where unemployment is at its natural rate. Sticky wage theory Sticky price theory Misperceptions theory Stagflation - period of recession and inflation Fiscal policy - government’s choices regarding the overall level of government purchases or taxes Multiplier effect - additional shift in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending Crowding-out effect - reduction in demand when a fiscal expansion raises the interest rate Phillips curve - curve that shows the short-run trade-off between inflation and unemployment Cost-push inflation - short-run cause of accelerating inflation due to higher input costs of firm which are passed on as higher consumer prices Natural rate of unemployment - normal rate of unemployment around which unemployment rate fluctuates Natural rate hypothesis - claim that unemployment eventually returns to its normal/natural rate regardless of rate of inflation Economic fluctuations & the AD-AS model Key facts about economic fluctuations Irregular and unpredictable ○ Fluctuations --> business cycle ○ Economic fluctuations correspond to changes in business conditions ○ Not regular and are almost impossible to predict Most macroeconomic variables fluctuate together ○ Real GDP is the variable that is used to examine short-run changes in the economy ○ Most variables that measure some type of income or production fluctuate closely together ▪ They fluctuate by different amounts ▪ Investment spending varies over the business cycle As output falls, unemployment rises ○ Okun's Law - to keep unemployment rate steady, real GDP needs to grow at or close to its potential ○ When firms choose to produce smaller amounts they lay off workers ▪ Time-lag between any downturn in economic activity and rise in unemployment and vice versa ▪ Unemployment is a lagged indicator ○ Lagged indicator - indicator whose changes occur after changes in economic activity have occurred Short-run economic fluctuations How the Short Run Differs from the Long Run ○ Most economists believe that classical theory describes the world in the long run but not in short run. ○ Changes in the money supply affect nominal variables but not real variables ▪ in the long run. ○ The assumption of monetary neutrality is not appropriate when studying year-to- year changes in the economy. Basic model of economic fluctuations Economics for Accounting and finance Page 43 Basic model of economic fluctuations Two variables are used to develop a model to analyse the short-run fluctuations In short run we look at ○ GDP deflator = Nominal GDP/Real GDP * 100% Economists use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend. Aggregate-demand curve - shows the quantity of goods and services that households, firms, and the government want to buy at each price level. Aggregate-supply curve - shows the quantity of goods and services that firms choose to produce and sell at each price level. This is only in short run In long run it will look differently Aggregate demand (AD) Four components of GDP contribute to the aggerate demand for goods and services Y = C + I + G + NX Why is the aggregate demand downward sloping Why do they buy less when price is higher Aggregate spending constraint Real balances effect International trade effect Used goods effect Price level and consumption: Wealth effect A decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more. This increase in consumer spending means larger quantities of goods and services demanded. Price level and investment: Interest Rate Effect A lower price level reduces the interest rate, which encourages greater spending on Economics for Accounting and finance Page 44  A lower price level reduces the interest rate, which encourages greater spending on investment goods. This increase in investment spending means a larger quantity of goods and services demanded. Price Level and Net Exports: The Exchange Rate Effect ○ When a fall in the Euroland price level causes Euroland interest rates to fall, the real exchange rate depreciates, which stimulates Euroland net exports. ○ The increase in net export spending means a larger quantity of goods and services demanded. Shift in the Aggregate demand Curve The downward slope of the shows that a fall in the price level raises the overall quantity of goods demanded Other factors affect the quantity of goods and services demanded at any given price level e.g. ○ Consumption. ○ Investment. ○ Government Purchases. ○ Net Exports. When one of these other factors changes, the aggregate demand curve shifts. Short and long term aggregate supply (AS) In long run The curve is vertical Economy's production of goods and services depends on its supplies of labour, capital and natural resources and on the available technology used to turn these factors of production into goods and services Price level does not affect these variables in the long run Shift in long-run AS ○ The long-run aggregate supply curve is vertical at the natural rate of output. Natural Rate of Output - output level in an economy when all existing factors of production are fully utilized and where Economics for Accounting and finance Page 45  ▪ Natural Rate of Output - output level in an economy when all existing factors of production are fully utilized and where unemployment is at its natural rate. ▪ This level of production - potential output / full-employment output ○ Any change in the factors of production in the economy that alters the natural rate of output shifts the long-run aggregate supply curve. ○ Causes of shift ▪ Net immigration ▪ Physical and human capital ▪ Invention of new technologies In short run The curve is upward sloping Short-term fluctuations in output and price level should be viewed as deviations from the continuing long-run trends Why does it slope Upward in short term ○ In the short run, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied ○ A decrease in the level of prices reduces the quantity of goods supplied ○ Theories explaining upward slope: ▪ Sticky wage theory □ Nominal wages are slow to adjust, or are “sticky” in the short run: □ Wages do not adjust immediately to a fall in the price level. □ A lower price level makes employment and production less profitable. □ This induces firms to reduce the quantity of goods and services supplied. ▪ Sticky price theory □ Prices of some goods and services adjust sluggishly in response to changing economic conditions. An unexpected fall in the price level leaves some firms with higher-than-desired prices. This depresses sales, which induces firms to reduce the quantity of goods and services they produce. ▪ Misperceptions Theory □ Changes in the overall price level temporarily mislead suppliers about what is happening in the markets in which they sell their output. □ A lower price level causes misperceptions about relative prices. These misperceptions induce suppliers to decrease the quantity of goods and services supplied. Shifts in the supply curve Economics for Accounting and finance Page 46 Shifts in the supply curve Events that shift the long-run aggregate supply curve will shift short-run as well ○ Labour, capital, natural resources, technology People’s expectations of the price level will affect the position of the short-run ○ Even though it has no effect on the long-run Increase in the expected price level reduces the quantity of goods supplied ○ Shifts the short-run aggregate supply curve to the left. Decrease in the expected price level raises the quantity of goods supplied ○ Shifts the short-run aggregate supply curve to the right Economic Fluctuations Long run equilibrium ○ Long-run equilibrium is found where the aggregate demand curve intersects with the long-run aggregate supply curve. ○ Output is at its natural rate. ○ Also at this point, perceptions, wages, and prices have all adjusted so that the short-run aggregate supply curve intersects at this point as well. Effects of shift in aggregate demand ○ In the short run, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services. ○ In the long run, shifts in aggregate demand affect the overall price level but do not affect output. Contraction in Aggregate Demand A decrease in one of the determinants of aggregate supply shifts the curve to the left: ○ Output falls below the natural rate of employment. ○ Unemployment rises. ○ The price level rises Adverse Shift in Aggregate Supply Effects: ○ Stagflation ▪ A period of recession and inflation ▪ Output falls and prices rise ▪ Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously ○ Policy Responses to Recession ▪ Do nothing and wait for prices and wages to adjust ▪ Take action to increase aggregate demand by using monetary and fiscal policy Economics for Accounting and finance Page 47  ▪ Take action to increase aggregate demand by using monetary and fiscal policy AD-AS, Monetary and Fiscal Policy Many factors influence aggregate demand besides monetary and fiscal policy. ○ Desired spending by households and business firms determines demand for goods ○ When desired spending changes, aggregate demand shifts ▪ causing short-run fluctuations in output and employment Monetary and fiscal policy are used to offset those shifts + stabilize the economy. For closed economy, such as the US ○ the exchange rate effect is not very large For open economy, such as the UK ○ the exchange rate effect is more important and is a major reason for the downward slope of the aggregate demand curve. However, the interest effect is probably more important even for open economies Theory of Liquidity preference Liquidity preference - Keynes' theory that interest rate adjusts to bring money supply and money demand into balance Money Supply ○ The money supply is controlled by the central bank through ▪ Open-market operations ▪ Changing the reserve requirements ▪ Changing the refinancing rate Economics for Accounting and finance Page 48  ▪ Changing the refinancing rate ○ Because it is fixed, the quantity of money supplied does not depend on the interest rate. ○ The fixed money supply is represented by a vertical supply curve. Money Demand ○ Money demand is determined by several factors. ▪ An asset’s liquidity refers to the ease with which it can be converted into a medium of exchange. ▪ The liquidity of money explains why people choose to hold it instead of other assets that could earn them a higher return. ▪ The opportunity cost of holding money is the interest that could be earned on interest-earning assets. ▪ An increase in the interest rate raises the opportunity cost of holding money, so the quantity demanded is reduced. Equilibrium in the Money Market ○ According to the theory of liquidity preference: ▪ The interest rate adjusts to balance the supply and demand for money. ▪ There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded equals the quantity of money supplied. ○ Assume the following about the economy: ▪ The price level is stuck at some level. ▪ For any given price level, the interest rate adjusts to balance the supply and demand for money. ▪ The level of output responds to the aggregate demand for goods and services. Price level ○ Determinant of the quantity of money demanded ○ Higher price level increases the quantity of money demanded for an given interest rate ○ Higher demand leads to higher interest rate ○ The quantity of goods falls Changes in money supply Central bank can cause a shift in the aggregate demand curve when it changes monetary policy ○ Increase in money supply shifts the curve to right ○ Without change to money demand curve interest rate falls ○ Falling interest rates increase the quantity of goods and services ○ Increase in money supply, lowers the interest rate and increases the quantity of goods demanded ▪ shifting aggregate demand to the right Economics for Accounting and finance Page 49 Interest rates Major central banks set the interest rate at which they will lend to the banking sector ○ Called the refinancing rate for the ECB or the repo rate for the Bank of England Changes in the money supply lead to changes in interest rates ○ Monetary policy can be described either in terms of the money supply or interest rate Fiscal Policy Fiscal policy - government’s choices regarding the overall level of government purchases or taxes ○ Fiscal policy influences saving, investment, and growth in the long run ○ In the short run, fiscal policy primarily affects the aggregate demand Government Purchases When policymakers change the money supply or taxes ○ It indirectly affects aggregate demand ▪ through the spending decisions of firms or households When the government alters its own purchases of goods or services ○ It shifts the aggregate demand curve directly Macroeconomic effects from change in government purchases ○ The multiplier effect ▪ Multiplier effect - additional shift in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending ▪ Each pound spent by the government can raise the aggregate demand for goods and services by more than a pound ○ The crowding-out effect ▪ Crowding-out effect - reduction in demand when a fiscal expansion raises the interest rate ▪ Fiscal policy may not affect the economy as strongly as predicted by the multiplier □ Increase in government purchases causes the interest rate to rise □ Higher interest rate reduces investment spending ▪ The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand. Economics for Accounting and finance Page 50  When the government increases its purchases by £10 billion, the aggregate demand for goods could rise by more or less than £10 billion ○ Depending on whether the multiplier effect or the crowding-out effect is larger. When the government cuts personal income taxes, it increases households’ take-home pay. Households ▪ save some of this additional income. ▪ spend some of it on consumer goods. ▪ Increased spending shifts the aggregate demand curve to the right. The size of the shift in aggregate demand resulting from a tax change is affected by the multiplier and crowding-out effects. It is also determined by the households’ perceptions about the permanency of the tax change. Short-run trade-off between inflation and unemployment Inflation and Unemployment Natural rate of unemployment depends on features of the labour market ○ Minimum wage laws, market power of unions, role of efficiency wages, effectiveness of job search Inflation rate depends primarily on growth in equity of money ○ This is controlled by central bank Society faces a trade-off between inflation and unemployment Policymakers ○ At cost of higher inflation ▪ Expand aggregate demand ▪ Lower unemployment ○ At cost of temporarily higher unemployment ▪ Contract aggregate demand ▪ Lower inflation Phillips Curve Phillips curve - curve that shows the short-run trade-off between inflation and unemployment ○ Offers policy makers a menu of possible inflation and unemployment outcomes Cost-push inflation - short-run cause of accelerating inflation due to higher input costs of firm which are passed on as higher consumer prices Short run ○ Philips curve shows short-run combinations of unemployment and inflation that arise as shifts in AD move the economy along the short-run AS ▪ The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level. Economics for Accounting and finance Page 51  economy’s output, and the higher is the overall price level. ▪ A higher level of output results in a lower level of unemployment Long run ○ Friedman and Phelps concluded that inflation and unemployment are unrelated in long run ○ Long run Phillips cure is vertical at natural rate of unemployment ▪ Natural rate of unemployment - normal rate of unemployment around which unemployment rate fluctuates ○ Increases in AD lead only to changes in price level and have no effect on economy's level of output ○ Natural rate hypothesis - claim that unemployment eventually returns to its normal/natural rate regardless of rate of inflation ▪ Supported by historical observations Economics for Accounting and finance Page 52 Lecture 10 - Effects of fiscal policy and monetary policy 25 November 2024 10:49 Only first 2 parts Keynesian Cross First 10 slides notes missing General theory of employment Economics for Accounting and finance Page 53