Lecture 5 Steering Markets PDF

Lecture 5 Friday, 25 October 2024 08:45 05_Steering _Markets Steering Markets Aggregates: Individual goods and services are determined by supply and demand In the whole economy there are many goods and services The macro-economy...

Lecture 5 Friday, 25 October 2024 08:45 05_Steering _Markets Steering Markets Aggregates: Individual goods and services are determined by supply and demand In the whole economy there are many goods and services The macro-economy is the most complex system ever invented Aggregates: ○ The total quantity of goods and services ○ The average price of goods and services Helps to make sense of whole economy Output: The total of all goods demanded is known as aggregate output (Y) This is the equivalent to the quantity in the supply and demand diagrams Measure by GDP Aggregate demand = total of all things demanded GDP: Output is most often measured by GDP GDP tells us how much a country is selling - should match how much money w Measure GDP in a few different ways: - Total value of all goods produced and sold by a country we make and how much people spend on our goods GDP: Output is most often measured by GDP GDP tells us how much a country is selling - should match how much money w Measure GDP in a few different ways: - Total value of all goods produced and sold by a country - Total income earned in a country - Total value of all spending on a country's goods and services They should all measure the same - but never do! Growth: This is the change in output Recession - fall in output (for 2 consecutive quarters) Growth is how much richer (or poorer) we're getting Growth is needed to maintain a constant living standard We need exponential growth Average price: The average price of all goods and services is known as the price level This is the equivalent to the price in the supply and demand diagrams Economists use a basket of commonly purchased goods (to measure average p Inflation: Inflation is the rise in prices Deflation is a fall in prices Disinflation is a fall in inflation Inflation measures how much more expensive things are getting Real vs nominal: Real = when they account for price changes Nominal = what you see in the data E.g. nominal wage is what you get paid and your real wage is what you can buy If inflation is low = real and nominal are pretty much the same (no big price cha Inflation is high = reduce the real value substantially - nominal wage stays the s Important when comparing to the past Why is inflation bad? - Erodes savings: as prices rise, the amount you can buy with your life-savings fa - Wealth transfers from savers to borrowers: encourages taking on debt - Investors might take on more risk to avoid low rates of return = excess risk takin - Wealth transfers from employees to employers - Messes with the market mechanisms - Inflation erodes wages: particularly affects those on minimum wage ○ People with strong bargaining power can negotiate but some can't particu we make and how much people spend on our goods price) y with those wages anges to distort things) same but your real wage falls as prices have increased alls (currency becomes practically worthless) ng and bubbles ularly those on minimum wage  - Investors might take on more risk to avoid low rates of return = excess risk takin - Wealth transfers from employees to employers - Messes with the market mechanisms - Inflation erodes wages: particularly affects those on minimum wage ○ People with strong bargaining power can negotiate but some can't particu Inflation is a spiral: Inflation can create more inflation When prices rise, they may expect prices to keep rising in the future so workers in businesses so prices go up All this contributes to inflation Once inflation or deflation starts, it can be very difficult to remove - change peop Fighting inflation is costly: Main weapon against inflation is raising interest rates - to slow economy down a ○ This raises borrowing costs - loans, mortgages, rent - makes like more dif Central banks = deal with criticism when they fight inflation - affects borrowers m ○ Main reason the central bank is often independent - take difficult steps go Inflation makes you poorer: Rising prices = things more expensive (cost of living crisis) But inflation is insidious - happen slowly We end up being poorer without realizing why Fertile ground for con-artists and get-rich-quick-schemes and politicians can cla Aggregate demand and supply: Aggregate supply is the total value of everything produced Aggregate demand is total value of everything consumed Equilibrium is where aggregate supply meets aggregate demand Equilibrium output is what we measure as GDP Equilibrium price level is what we measure using our basket of goods ng and bubbles ularly those on minimum wage s will demand higher wages for next year = costs go up ples beliefs and reduce demand fficult for people most (poorest members of society) overnment may be unwilling or unable to do aim to solve these problems Equilibrium is where aggregate supply meets aggregate demand Equilibrium output is what we measure as GDP Equilibrium price level is what we measure using our basket of goods GDP Measure GDP - amount of spending or selling So we can either use aggregate supply or demand to measure it What causes inflation and growth? - Changes to supply and demand ○ These will shift both prices and output Movements in the economy: Decrease in aggregate supply: Less supply - willingness for suppliers to sell is going down Less willing to sell at that price - e.g. cost of something goes up = more expens goes down Output goes down and prices go up (recession) sive to make = amount willing to sell at a certain price  Less supply - willingness for suppliers to sell is going down Less willing to sell at that price - e.g. cost of something goes up = more expens goes down Output goes down and prices go up (recession) Causes of supply falling: Weather/disease e.g. covid Political regime change Market power e.g. OPEC reduces oil supply to boost prices Trade e.g. Brexit Costs Investment - banks reluctant to lend after a financial crisis Increase in aggregate demand: If people demand more goods on aggregate People are willing to spend more money Prices go up = inflation GDP goes up = boom Causes of demand rising: Richer population Reduction in savings Increases in borrowing e.g. due to lower interest rates Increase in population Increased government spending or reduced taxes sive to make = amount willing to sell at a certain price  - Inflation is caused by a decrease in supply or an increase in demand - An increase in supply is the best outcome (reduced inflation and increased outp policies Increase in aggregate supply: Firms supply more goods on aggregate Prices go down = lower inflation Output goes up = boom Supply side policies: Policies designed to increase supply Tax cuts - to incentivize work and investment Deregulation to remove bureaucratic barriers to doing business Labour market reforms to increase flexibility - easier to hire and fire people Funding education and training - skilled workforce Infrastructure investment - allow businesses to work Funding research and development Trade liberalization - free trade easier - easier access to global markets - reduc Promoting immigration Problems with supply side policies: put) - this is why governments pursue supply-side ce tariffs and quotas  Infrastructure investment - allow businesses to work Funding research and development Trade liberalization - free trade easier - easier access to global markets - reduc Promoting immigration Problems with supply side policies: Have distributional consequences Difficult and take time When we have inflation we want to try reduce demand as this reduces inflation. Howe Contractionary policies: Reduce aggregate demand = reduces prices However = recession Expansionary policies: The opposite If we have a recession we want to try and boost the economy These aim to stimulate aggregate demand and boost growth ○ Increased government spending and tax cuts ○ Reduced interest rates But may lead to inflation Policies to fight inflation: Reduced government spending or increased taxes ○ This reduces aggregate demand since less money is spent ○ This is contractionary fiscal policy Increased interest rates ○ Leads to more saving and less borrowing ○ Less borrowing = businesses make less investment ○ This reduces aggregate demand since people spend less ○ This is contractionary monetary policy Monetary policy: Central banks adjust the interest rate through Open Market Operations (OMO) Government bonds are the main safe way to store value ○ No-one will lend at a rate lower than this Government bond rate is the 'floor' - so if this goes up this pushes everything up Raising the bond rate will increase borrowing costs ○ Households save more and consume less ○ Forms borrow less, reducing investment ○ Inflation falls with aggregate demand The central bank can influence the bond interest rate by choosing how much it lends Operations (OMOs). Expansionary OMO: ce tariffs and quotas ever there can be side effects of recession. p to the government. These are called Open Market  ○ Inflation falls with aggregate demand The central bank can influence the bond interest rate by choosing how much it lends Operations (OMOs). Expansionary OMO: - Central bank lends more to the government by buying bonds - Increasing the supply of credit to the government - Reducing bond rates to try boost output Contractionary OMO: - Central banks lends less to the government by selling bonds - Increases the bond rate to try fight inflation Taylor rule: Inflation is above target = raise the interest rate Output is below target = reduce the interest rate Taylor rules take the form: to the government. These are called Open Market Taylor rule: Inflation is above target = raise the interest rate Output is below target = reduce the interest rate Taylor rules take the form: it is the interest rate that the Central Bank sets πt is inflation πT is the target rate of inflation (typically 2%) Yt is GDP or output YT is the target output θπ describes the relative importance of inflation θY describes the relative importance of output Central bank credibility: Fighting inflation is very costly as it involves reducing output to reduce prices ○ It will increase unemployment hence it will be politically very unpopular. A central banks reputation for fighting inflation is important - if a bank has strong cost as people wont ask for higher wages and inflation won't increase Hawkish central bank = tough on inflation even if it means causing a recession Doveish central bank = soft on inflation e.g. allowing high inflation because it en g credibility and is powerful they can do it without any ncourages growth in output