Economics Second Term Revision

ECONOMICS IFY Semester 2

Teaching Notes

Dr Stephen Byrd PhD, MBA, FITOL, FICM.

2015-6

ECONOMICS IFY Semester 2

THE NATIONAL ECONOMY Produced By Dr Stephen Byrd PhD, MBA FITOL FICM

THE MEASUREMENT OF MACROECONOMIC PERFORMANCE

Macroeconomic Performance – The Basics Aggregate Demand

Aggregate Supply

Total Demand in the economy made up of: - Consumption (C) - Investment (I) - Government Expenditure (G) - Net Exports (Exports = X, Imports = M) The identity for aggregate demand is: C + I + G + (X – M) Total value of goods and services supplied in the economy

The interaction of these two forces produces a macroeconomic equilibrium.

Measuring Macroeconomic Success FOUR FACTORS CONSIDERED WHEN MEASURING MACROECONOMIC SUCCESS Economic Growth Ideally our capacity to produce goods will grow over time Full Employment Ideally we will have an efficient economy in which all resources are used Price Stability Ideally we will have control over prices and low inflation Balance of Trade Ideally exports will be greater than or equal to imports

Macroeconomic Performance Indicators – The Basics Economic Indicators

Economic statistics that provide information about: - The expansions and contractions of business cycles - The current state of the economy - The economy’s likely future direction

Economic Growth Economic Growth The capacity of the economy to produce more goods and services over time GDP Total value of goods and services produced in the economy (in one year) Gross Domestic Product - Nominal GDP has not been adjusted for inflation - Real GDP has been adjusted for inflation GNP Total value of goods and services provided by the economy (in one year) Gross National Product GNP = GDP + Net Income from Foreign Investments Net income from foreign investments may be generated from: - Money earned by UK residents working abroad - UK residents owning shares in a foreign firm

Measuring Economic Growth: 1. Calculate the percentage change in GDP from Year 1 to Year 2 (nominal GDP) 2. Deduct inflation to calculate real GDP growth When comparing GDPs between countries the GDP should be divided by the population to get GDP per capita.

Economic Growth Cycle Negative Output Gap: - Economy producing less than trend output - GDP below productive potential) - Usually low output and high unemployment - Often described as a recession - When very serious described as a slump - Government try increasing aggregate demand -

A recession is when an economy is growing at less than its long-term rate of growth

Positive Output Gap: - GDP exceeds trend GDP (GDP above productive potential) - Usually described as recovery - When very significant described as a boom -

Increased employment and incomes increase aggregate demand When aggregate demand exceeds aggregate supply prices rise So, positive economic growth leads to increased inflationary pressure Increased inflation decreases the competitiveness of the economy’s goods This could lead to an increased balance of trade deficit

THIS CAN LEAD TO A TRADE-OFF WHICH IS WHEN ONE MACRO-ECONOMIC OBJECTIVE HAS TO BE CURTAILED IN FAVOUR OF ANOTHER OBJECTIVE.

Employment and Unemployment Employment

Unemployment

Where labour is actively engaged in a productive activity, usually in exchange for payments such as wages.

High employment rates imply that an economy is successful at producing jobs for its labour force.

Where there are people without jobs seeking work at current wage rates.

This leads to wasted output which can never be recovered.

COSTS OF UNEMPLOYMENT Confidence fall  alcoholism/depression/family-breakdown  high social services expenditure Lower income  purchases taken for granted now unaffordable  reduced standard of living High unemployment  shops closing (negative multiplier effect)  crime  high police costs Income from tax falling + benefit expenditure increasing  tax rises on employed/budget deficit

Individual Family Area Government

Growth and Employment -

Rapid growth  low unemployment BUT technological unemployment may occur

-

Growth brings immigrant workers which reduces supply constraints This is because immigrant workers provide additional labour for firms

Inflation Inflation A persistent rise in general price over time

The rate of inflation is a good indicator of: - Whether the UK is price competitive internationally - Whether government policies to control price rises are successful

This has several costs to the economy: - Rising prices  reduced business confidence  less employment - Less employment  negative multiplier effect - Income redistribution problems (prices rise  those on minimum wage suffer) - Prices higher than competitors  import more + export less  trade deficit - The risk of hyperinflation

There is inflationary pressure in positive output gaps because: 1. Actual growth is above trend growth 2. This leads to a shortage of labour 3. Workers can demand higher pay 4. Firms pass this cost onto their consumers through higher prices

Government Targets and Manipulation -

The government has a target of 2% inflation The Bank of England has the responsibility to ensure that this target is met The Bank does this by manipulating aggregate demand

1. Positive output gap  aggregate demand high  inflation high 2. Bank attempts to reduce aggregate demand through raised interest rates

Measurement of Inflation Index Numbers Weighting

A weighted average of a group of items compared to a given base value of 100 Where a commodity is given a weighting proportional to its importance in the general pattern of consumer spending

Calculating Index Numbers: 1. Select a base year and give the index number 100 to all goods EG: Apples = 50p = Index 100 2. Calculate annual percentage price increase for the good and apply this to index EG: Apples = 75p = Increase of 50% = Index 150 3. Weight and average all figures to get an overall index figure EG: Apples = 150 (Weight: 2), Plums = 120 (Weight 1)  Inflation = 420/3 = 140 4. Take 100 from this figure to get an overall figure for inflation 140 – 100 = 40  Inflation = 40% from Year 1 to Year 2

Economic Indicators of Inflation -

RPI Retail Price Index

CPI Consumer Price Index -

Main domestic measure of inflation in UK Measures average change in ‘basket of goods’ (650 products consumed by most households) Weighted price index (measures rate of inflation over a year) Gives breakdown for particular products and services (eg: food, leisure) Calculated by Office of National Statistics

CPI is like RPI but does not include changes in house prices and related areas Assesses price stability in euro area Compares inflation directly with that of EU countries Rising house prices are problematic for UK population Inflationary increases more serious than CPI shows

International Competitiveness Exporting Importing

The sale of goods or services to a foreign country This generates income for the home country The purchase of goods or services from abroad This leads to expenditure for the home company

Factors Affecting Our International Competitiveness - High inflation  exports too expensive in overseas market  less competitive - Inefficient factories  low productivity  higher costs + prices  less competitive

Problems Resulting From Low International Competitiveness 1.

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4.

Unable to sell abroad Less demand for labour within UK  increasing unemployment Negative multiplier effect Increased negative output gap

Benefits of High International Competitiveness 1.

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Increased demand for products from abroad Increased demand for labour for production in UK Increased employment + output Increased positive output gap

THE CIRCULAR FLOW OF INCOME

Economic Models Flow Balance of Payments

Models used to show the essential characteristics of complicated economic conditions in order to analyse them and predict the result of changes of variables Something measured over a specific period of time Exports minus imports A deficit means more is imported than exported Recession

Boom

When an economy is growing at less than its long-term rate of growth.

Can lead to: - High levels of unemployment - Reduced economic ability Stage in economic cycle characterised by an increase in output and economic growth.

Can lead to: - Firms struggling to recruit labour - Rapid inflation - Growing balance of payments deficit

The Four Sector Economy Injections = Withdrawals Injections > Withdrawals Injections < Withdrawals

National Income in Equilibrium National Income Rising National Income Falling

Planned Saving = Planned Investment Injections > Withdrawals Injections < Withdrawals

AD = Income AD = C + I + G Withdrawals Investment Savings Multiplier Effect Net Government Spending

National Income in Equilibrium National Income Rises National Income Falls

Economy in Equilibrium

- Money not passed on in circular flow - Reduces national income/output/expenditure Spending by firms on buildings, machinery and improving labour.

- Withdrawal from circular flow - Income induced (rise as income rises, fall as income falls) Increase in spending leads to larger than proportionate change in national income.

Government spending â&#x20AC;&#x201C; Taxation

Importance of Consumption Consumption Disposable Income

Makes up 60% of aggregate demand Income available to households after statutory deductions - Higher percentage of income consumed by low-income families

Factors That Cause Changes in Level of Consumption Wealth Effect

Inflation

Rate of Interest

Expectations

1. Value of house increases 2. Consumers borrow against value of house 3. Consumption increases 1.

2.

1.

2.

3.

Value of house falls Consumers feel worse off and reduce consumption Inflation expected to rise Consumers expect products to be dearer in future Consumption increases (anticipatory buying)

If inflation continues to rise it has a negative wealth effect.

1. Low interest rate 2. Cheap to borrow 3. Borrowing increases 4. Consumption increases 1.

2.

3.

4.

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2.

High interest rate Expensive to borrow Borrowing decreases Consumption decreases Positive expectations (consumer expects future to be good) Increased consumption

1. Negative expectations 2. Increased saving and decreased consumption

AGGREGATE DEMAND AND AGGREGATE SUPPLY

Aggregate Demand Why the AD Curve Slopes Downwards -

Lower prices  wealth effect Consumers buy more at lower prices

-

Fall in price of UK goods  fall in price of UK exports Fall in price of UK goods  rise in price of UK imports

-

Consumers expect prices to rise  increased consumption

Shifts of the AD Curve AD curve shifts if there is change to any of five factors of Aggregate Demand.

INVESTMENT

Left Shift

Right Shift

Rate of interest

Increase in rate of interest (Firms save rather than spend) Negative Expectations (Firms expect future profits to fall) Lower than that of other countries (Import more) Decrease in income (Firms do save rather than invest)

Decrease in rate of interest (Firms spend rather than save) Positive Expectations (Firms expect future profits to rise) Higher than that of other countries (Export more, consumption rises) Increase in income (Firms invest)

Business expectations Rate of technological progress Rate in change of income (especially at full capacity) Accelerator Effect

Relation between change in new investment and rate of change of national income - National income rises, investment rises

GOVERNMENT EXPENDITURE

Effect

Privatisation (Sale of government assets to private sector) Increase in government spending (EG: investment into education)

LEFT SHIFT - Government expenditure falls RIGHT SHIFT - Government expenditure rises - AND consumption rises as incomes rise

NET EXPORTS

Left Shift

Right Shift

Demand for exports

UK trading partners in recession (Demand for exports falls) Strong exchange rate (Exports = expensive, imports = cheap) High growth  increasing incomes (Increased imports)

UK trading partners growing (Demand for exports rises) Weak exchange rate (Exports = cheap, imports = expensive) Negative growth (Decreased imports)

Exchange rate UK economy growth

Aggregate Supply Keynesian Aggregate Supply Diagram -

As prices increase, firms increase output

-

Prices increase by small amount when lots of labour available Prices increase sharply as labour market tightens (wages rise) Economy reaches full employment and output cannot change

Short-Run Aggregate Supply SRAS assumes that the firm’s costs remain the same.

SRAS curve shifted by any factor that affects firms’ costs: FACTOR Money Wage Rate Price of Raw Materials Corporation Tax Rate of Interest

Left Shift Increase (costs rise) Increase (costs rise) Increase (costs rise) Increase (Borrowing more expensive)

Right Shift Decrease (costs fall) Decrease (costs fall) Decrease (costs fall) Decrease (Borrowing cheap)

Long-Run Aggregate Supply Long-Run Aggregate Supply Natural Rate of Unemployment

Economy’s productive capacity Rate of employment consistent with stable rate of inflation

The LRAS potential output occurs at the natural rate of unemployment which is below full employment as there are some workers who prefer to stay on benefits rather than work for low wages meaning that maximum output is below the economy’s productive capacity.

FACTOR Increase in capital Improved technology Entrepreneurialism encouraged Policies encouraging employment Increased productivity

Shift Right (increased ability to produce) Right (increased ability to produce) Right (increased ideas  increased levels of productivity) Right (increased labour force  increased production) Right (increased output)

Macroeconomic Equilibrium

Aggregate Demand Increase in AD

Decrease in AD

AD1  AD2 = rise in output and prices AD2  AD3 = small rise in output and great rise in prices Beyond AD3 = no change in output and rise in prices (INFLATION)

1.

2.

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1. Aggregate demand rises faster than aggregate supply 2. Inflation occurs 3. Increase in imports 4. Balance of payments deficit

Reduction in aggregate demand Unemployment  fall in national income Business expectations fall Investment falls Government tax income falls Benefit expenditure rises

Short-Run Aggregate Supply Supply-Side Shock

Left Shift Right Shift

Something which affects costs of all firms in economy EG: Increase in price of oil

Increased prices, reduced output Decreased prices, increased output

Long-Run Aggregate Supply Left Shift Right Shift

Rise in prices, reduced employment, inflation, less competitive economy Fall in prices, increased employment, more competitive economy

MACROECONOMIC POLICY INDICATORS

Policy Objectives

Targets or goals that government wants to achieve.

Measured in terms of: - Full employment - Economic growth and higher living standards - Control of inflation - Satisfactory balance of payments Policy Instruments Techniques used by government to achieve policy objectives.

Policy Objective Full Employment

Economic Growth

Stable Prices

Balance of Payments

Policy Instruments Monetary Policy Fiscal Policy Supply-Side Policy Monetary Policy Fiscal Policy Supply-Side Policy Monetary Policy Fiscal Policy Supply-Side Policy Monetary Policy Fiscal Policy Supply-Side Policy

Policy Indicators Claimant Count Figures ILO Statistics

GDP

RPI CPI % of GDP ONS Figures

Full Employment Benefits of Full Employment - Increased standard of living - Reduced human suffering - Increased tax payments - Reduced benefit expenditure

Costs of Unemployment - Economic, social and health problems for unemployed -

Reduced tax payments Increased benefit expenditure

Governments could achieve full employment by increasing aggregate demand: 1. AD1 ď&#x192; AD2 = increased employment 2. AD2 ď&#x192; AD3 = full employment However, this is INFLATIONARY.

Governments could achieve full employment by shifting the LRAS to the right using supply-side policies which will make labour more employable.

1. Output increases from LRAS1 to LRAS2 2. This creates employment as prices fall 3. Reduced inflation and more competitive UK

Productivity Labour Productivity Total Factor Productivity

Output per worker per period of time Overall productivity of inputs used by a firm in producing a particular level of output

Increasing productivity causes the LRAS to shift right: - Allows same amount of workers to produce more in same period of time - Releases workers to increase production elsewhere

Economic Growth Benefits of Economic Growth Rise in material living standards - GDP rises faster than population - Everyone has more to spend on average - They are materially better off - Citizens take holidays and eat out more Rise in welfare of the population - Capacity of economy to produce more grows - Government devotes more resources to services such as health and education - Improves general welfare of country - Particularly important in developing countries where progress can include increase in life expectancy and greater literacy rate Rise in employment and fall in unemployment - Rise in output means more workers required for production - Unemployment rate drops Reduction in poverty - Output and incomes rise - Government takes more in taxes from rich - This revenue can be used to raise living standards of those with lower incomes

Cost of Economic Growth Inflation - Rate of growth too fast for economy to respond without rise in general price level Lower quality of life - Can change people’s lifestyles badly - Some may move to city and face stress Inequalities of income and wealth - Benefits of growth unevenly spread - Gap between rich and poor widens Congestion - Economic growth often concentrated in certain urban areas - These areas often become overcrowded - Pressure on local services (eg: hospitals) Environmental costs - Greater output  more pollution - More road transport = more pollution - Greater output worldwide  global warming Loss of non-renewable resources - Economic growth used resources that can’t be replaced (eg: oil, metals and minerals) - More trees cut to increase timber output - Many animals and plants  endangered

Trend Rate of Economic Growth • •

Trend rate of economic increased through right shift of LRAS Right shift is likely to come from supply-side factors o Government can put supply-side policies in place

Inflation Inflation

Persistent rise in average prices in economy

Deflation

Demand-pull inflation: Demand above rate of production  rise in prices Cost-push inflation: Rise in costs of production  rise in prices Persistent fall in prices in economy - Consumers hold off buying and wait for prices to fall further Firms increase wages to attract desired labour

Tight Labour Market

Costs of Inflation -

Extremely hard on some social groups: o Those on fixed incomes (eg: pensioners) o Those with weak bargaining power

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Redistributes income from lenders to borrowers: 1. Lenders lose out so raise cost of borrowing 2. Investment slows down as funds are more expensive 3. Reduced economic growth rates

-

Distorts behaviour by economic agents: 1. Anticipatory buying increases aggregate demand 2. Increased aggregate demand increases inflation 3. Increased inflation brings fears of unemployment 4. Increased saving and reduced spending 5. Rapid fall in aggregate demand  recession 1. Workers anticipate inflation and demand wage rises 2. Increased cost of production 3. Increase in cost-push inflation  wage-price spiral

-

Increased balance of payments deficit: 1. Imports cheaper than UK goods 2. Imports increased, demand for exports decreased

Reason for 2% Target Inflation -

Takes into account improvement of goods and services (encourages innovation) Prevents risk of deflation

Balance of Payments Balance of Balance of Payments Expenditure = Income Balance of payments deficit Expenditure > Income Balance of payments surplus Income > Expenditure

OUTFLOW OF MONEY INFLOW OF MONEY

Reasons for Balance of Payments Deficit INDUSTRY CHANGES - UK economy provides services ď&#x192; reduction in manufacturing output - Massive increase in manufactured goods imported APPETITE FOR IMPORTED GOODS - UK consumers demand goods produced abroad (eg: luxury goods) INTEREST 1. Interest much higher than that of trading partners 2. Bank deposits in UK more attractive 3. Deposits abroad moved to UK (sell original currency, buy new one) 4. Increase in demand for new currency 5. Price of new currency rises 6. Increased value of pound (stronger exchange rate) 7. Imports = cheap, exports = expensive

Credit Crunch Credit Crunch 1.

2.

3.

4.

5.

Borrowing becomes more expensive or unavailable

Deficit suddenly starts to grow Overseas investors no longer wish to hold money in UK Foreign banks and other lenders refuse to lend money UK government cut domestic spending to reduce demand for imports Reduced economic growth and rising unemployment

ECONOMIC GROWTH AND THE ECONOMIC CYCLE

The Need for Demand for Economic Growth -

For economy to grow there needs to be adequate demand This demand absorbs extra goods and services produced Increased aggregate demand creates right climate for investment

Short-Term Economic Growth or Economic Recovery -

Economy is at point A inside the production possibility boundary Economy not reaching its productive potential Factors of production not fully employed AB BC

AD1  AD2 AD2  AD3

Economic recovery Economic growth

Economic growth (non-inflationary) Positive output gap (inflation) - Increase interest rate to reduce aggregate demand

Long-Term Economic Growth Right shift of LRAS leads to: Lower prices Increased output More competitive country LRAS affected by: Increase in quantity of factors of production Increase in productivity Advances in technology and their take-up by firms

The Population and Economic Growth Participation Rates

Proportion of country’s population that makes up labour force - Increased by immigration - Decrease in ageing population - Increased due to changing female expectations

Productivity and Economic Growth Productivity can be increased by: - Improving education - Increasing labour flexibility - Technical advances (also leads to new products that generate extra expenditure) - Investment into growing industries

Economic Growth and the Production Possibility Frontier A B

C D

Below economic capacity Increased capital goods  economic growth Leads to outward movement of boundary BUT opportunity cost of consumer goods Increased consumer goods More of BOTH consumer and capital goods available

Economic Growth and AD/AS Model 1. Increase in investment (AD) 2. Right shift of AD curve 3. Investment lowers firms’ costs 4. Right shift SRAS 5. Investment leads to increased economic capacity 6. Right shift LRAS

EMPLOYMENT AND UNEMPLOYMENT

Full Employment and the Measurement of Unemployment Full Employment

All willing and able to work have a job at current wage rates.

NOT 100% employment as some will be unemployed due to: - Labour turnover - Movement between jobs - Incapacity to work At AD3 there may not be full employment as the skills of the labour force may not be those required by expanding firms.

The level of unemployment will fall over time as people acquire the necessary skills.

Unemployment and Inflation 1. Fall in unemployment 2. Workers in stronger position - Workers demand higher wages - Firms offer higher wages to attract best workers 3. Cost-push inflation 4. Less competitive goods and services (international market) 5. Increased balanced of payments deficit Short Term 1. Reduce inflation by reducing demand 2. Unemployment rises

Long Term 1. Reduce inflation by reducing demand in UK 2. Increased international competitiveness 3. Increased demand from abroad 4. Increased demand for labour in UK for production 5. Increased employment in UK

Causes of Unemployment Demand-Side Causes of Unemployment Demand-Deficient Unemployment Cyclical Unemployment

Expenditure-Based Unemployment

Deindustrialisation

Investment-Based Unemployment

Insufficient AD in economy to employ available labour Occurs due to economic cycle (multiplier effect): 1. Negative output gap 2. Level of AD below full employment level 3. Insufficient demand to employ available labour (MPC will reduce rate of interest to increase demand) Effect of government expenditure on employment: 1. Government reduces expenditure 2. Decrease in employment in public sector Reduction of industrial activity in economy: 1. Production cheaper abroad 2. Industries in UK decline 3. Loss of jobs to overseas industries 4. Unemployment in UK Effect of investment on employment: 1. Investment leads to the provision of jobs 2. Reduction in investment ď&#x192; reduction in employment

Supply-Side Causes of Unemployment Frictional Unemployment Voluntary Unemployment Structural Unemployment

People moving between job - Also known as search unemployment Workers not prepared to take job at current wage levels Changes in structure of economy: - Technological unemployment (machines replace workers) - Regional unemployment (workers occupationally/geographically immobile) Overcoming requires occupational training for workforce

Unemployment and Output Gaps Positive Output Gap 1. Increasing aggregate demand 2. Increasing employment 3. Tight labour market BUT some will be structurally unemployed

Negative Output Gap 1. Decreasing aggregate demand 2. Negative multiplier effect 3. Cyclical unemployment 4. Discouraged workers

1. High government expenditure 2. High benefits 3. Increased length of time unemployed

Discouraged workers: Workers who leave labour market as they are unable to find job after several attempts.

THE BALANCE OF PAYMENTS ON CURRENT ACCOUNT

Balance of Payments Current Account Trade in Goods Trade in Services Investment Income Transfers

Trade in Goods + Trade in Services + Investment Income + Transfers Exports of goods – Imports of goods (tangible/visible) Exports of services – Imports of Services (intangible/invisible) Investment income – Investment outgoings (from past investments) Official and private transfers of money (out – in)

Balance of Trade of Goods NB: BALANCE OF TRADE ONLY REFERS TO TANGIBLE GOODS Balance of Trade Surplus Balance of Trade Deficit Trade Gap

Exports > Imports Imports > Exports Difference between imports and exports

Why We Have a Balance of Trade Deficit Deindustrialisation

Globalisation

Fall in proportion of national output accounted for by manufacturing sector of economy due to: - Cheaper production costs elsewhere - Countries with no minimum wage - UK losing competitive edge - Increased innovation elsewhere Ability to produce and sell goods anywhere in the world

How to Decrease a Balance of Trade Deficit • •

Increase investment to increase productivity and lower average costs Encourage innovation and enterprise

Importance of Balance of Trade • •

Exports are injection into circular flow and boost national income Multiplier effect amplifies effect of exports

• •

Dependence of manufacturing industries and employment on exports Manufacturing regions rely on exports (otherwise widened regional income gap)

Trade in Services Exported Services - Financial - Tourism

Imported Services - Sea transport - Civil aviation

Growth of service income due to: Education Skills and expertise

Economy relying on trade in services not sustainable as relies on other countries for manufactured goods.

Investment Income Investment Income

Earnings made from investments overseas MINUS Income flowing abroad from foreign investment in UK

Generating Future Investment • • •

Banks giving loans to foreign nationals Buying of shares in foreign companies Setting up new businesses abroad

Flow of capital into UK for any of above reasons  Outward capital flows in future

Transfers Private Transfers

Government Transfers

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Money sent to UK from Britons working overseas Money sent home from immigrants working in UK

Grants to overseas countries UK contributions to EU budget Contributions to international organisations Maintenance of troops abroad Maintenance of embassies and consulates

Reasons for Changes in Current Account Exchange Rate Income Inflation Productivity Innovation

Strong exchange rate  Expensive exports, cheap imports  DEFICIT Rise in national income  increased AD  increased imports  DEFICIT Inflation above trading partners  expensive exports, cheap imports  DEFICIT Increase in labour productivity  lower prices  more competitive  SURPLUS Innovation  new products  increased competitiveness  SURPLUS

Current Account and AD/AS Model Current Account Surplus

Current Account Deficit

1. Increase in exports, decrease in imports 2. Increase in AD to AD2 3. Increase in price and real output

1. Decrease in exports, increase in imports 2. Decrease in AD to AD2 3. Decrease in price and real output

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5.

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Further increase in exports, decrease in imports 4. Reduction in inflationary pressure Increase in AD to AD3 Positive output gap Inflation but no increase in real output

Current Account Equilibrium Current Account Equilibrium

Current account exercises no effect on domestic economy - Leads to greater level of stability in economy

Arguments that deficit is of little importance Some major imports were capital goods: - UK will have increased productivity in future - Output will increase and deficit will reduce Deficit due to consumer demand = self-correcting: - Economic cycle will lead to reduced demand in future - Imports will reduce UK has attracted inward investment: - Can finance current account deficit

Issues with Deficits Withdrawals from circular flow on income: - Reduced output - Reduced employment Indicates loss of competitiveness due to: - Insufficient investment - Low productivity - Loss of comparative advantage Unemployment due to loss of industry: - Occupationally immobile unemployed

MONETARY POLICY

Monetary Policy

Central Bank

Controlling the economy via changes in monetary variables such as: - Money supply - Interest rates In UK it is managed by the Monetary Policy Committee (MPC) Financial institution in country/group of countries responsible for: - Issuing notes and coins - Setting short-term interest rates

Interest Rates Interest Rate

Real Interest Rate

-

Cost of borrowing, reward for saving Great variety of interest rates (borrowing higher than saving) Interest rates tend to move together

Interest rates and AD have an inverse relationship: - Increase in interest rate  fall in AD - Fall in interest rate  rise in AD Money rate of interest – rate of inflation

Monetary Policy and Price Level in AD/AS Model Increase in Interest Rate

Reduction in Interest Rate

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Inflation Increase in interest rate Reduction in AD to AD2 Fall in price Inflationary pressure eased

Low real output Decrease in interest rate Increase in AD to AD2 Rise in real output BUT small rise in price

Monetary Policy and Aggregate Demand Transmission Mechanism Influence of changes in base interest rate on components of Monetary Policy of aggregate demand

EFFECT OF RISE IN INTEREST RATES ON...

Consumption 1. Interest rates rise 2. Saving more profitable 3. Increased saving, reduced spending 4. Reduced Consumption 1.

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Interest rates rise Borrowing more expensive Reduced demand Reduced consumption

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Interest rates rise Increased variable-rate mortgage payments Reduced disposable income Reduced consumption

1. Interest rates rise 2. Reduced mortgage equity withdrawal 3. Reduced household income 4. Reduced consumption Government Spending NO MAJOR EFFECT Investment 1. Interest rates rise 2. Businesses save for future investing (more profitable)

Exports Imports

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Interest rates rise Consumption falls Reduction in firmsâ&#x20AC;&#x2122; confidence Reduction in investment The interest rate in UK increases Bank deposits in UK become more attractive People with deposits abroad move money to UK Original currency sold, new currency bought Increase in demand for new currency The price of the new currency rises UK exports more expensive abroad (fall in exports) UK imports cheaper (increase in imports) Increased current account deficit.

Monetary Policy and Inflation RPIX CPI Repo Rate

Measure of price level - Excludes payments to service mortgage interest from RPI Measure of price level used as target measure for inflation - Excludes housing-related costs and is thus inaccurate Interest rate set by Monetary Policy committee to influence inflation - Used by banks as ‘base rate’

The current UK target for inflation is 2%: - Inflation above this  rise in interest rates - Inflation below this  fall in interest rates -

Effectiveness of these changes hindered by time lags MPC forecasts future inflation and work interest rate around this

Money Supply Money Supply Narrow Money Broad Money

Total amount of money in an economy Notes, coins and balances available for normal transactions Money held in banks and building societies not immediately accessible

Increase in Money Supply

Decrease in Money Supply

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Increase in money supply Increase in spending power Increase in aggregate demand to AD2 Pressure on supply Increase in inflation

Decrease in money supply Decrease in spending power Decrease in aggregate demand to AD2 Reduction in price level Fall in inflation

Exchange Rates Exchange Rate Price at which one currency exchanges for another Hot Money Money liable to rapid transfer from one country to another - Attracted into UK by high interest rates - Increase in demand for pounds  stronger exchange rate

ADVANTAGES OF STRONG POUND

COSTS OF STRONG POUND

Cheaper Imports 1. Lower import prices 2. Rise in real living standard of consumers Lower Production Costs 1. Cheaper to import raw materials 2. Lowers production costs for firms

Reduced Business Confidence/Investment 1. Reduction in demand for exports 2. Reduction of confidence and investment Increase in Trade Deficit 1. Exports expensive  reduced exports 2. Imports cheap  increased imports

1.

2.

3.

4.

Increased Unemployment 1. Exports expensive abroad 2. Deindustrialisation 3. Loss of industry to abroad 4. Structural unemployment

Cheaper to import new technology Encourages investment for firms Increased investment  increased productivity Increased LRAS

Lower Inflation 1. Domestic supplies face competition from cheap imports 2. Domestic suppliers reduce costs and prices 1. Cheap imports of foods and drinks reduce inflation

Slower Economic Growth 1. Fall in exports 2. Fall in aggregate demand 3. Reduction in rate of economic growth Fall in employment, output, living standards

FISCAL POLICY

Fiscal Policy Automatic Stabilisers

Policy of government regarding taxation and expenditure - Influences aggregate demand and aggregate supply Changes in government income and expenditure dependant on economic activity.

EG: Increase in activity ď&#x192; increase in employment ď&#x192; increase in tax income + decrease in benefits expenditure

Government Spending and Fiscal Policy Current Spending Capital Spending

Transfer Payments

Government spending on running of public sector eg: - Raw materials - Wages of public-sector workers Government spending to improve productive capacity of nation eg: - Infrastructure - Schools - Hospitals Government payments to individuals for which they receive no service eg: - State benefits

Budget States and Fiscal Policy Balanced Budget Budget Deficit Budget Surplus

Government receipts = government spending Government spending > government receipts Government receipts > government spending

Economic Upturn Economic Downturn - Increased tax revenue - Decreased tax revenue - Decreased welfare spending - Increased welfare spending GOVERNMENT ABLE TO BALANCE BUDGET OVER ECONOMIC CYCLE.

Demand-Side Fiscal Policy Demand-Side Fiscal Policy Discretionary Fiscal Policy Expansionary Fiscal Policy Contractionary Fiscal Policy

- Changes in level/structure of government spending and taxation - Aimed at influencing components of aggregate demand - Deliberate manipulation of government spending and taxation - Aims to influence economy USED DURING PERIOD OF DOWNTURN - Increase government spending relative to taxation - Stimulates aggregate demand USED DURING PERIOD OF UPTURN - Increase taxation relative to government spending - Reduces aggregate demand

Use of Demand-Side Fiscal Policy Type Main Goal Aims How? Multiplier

Tax

Expansionary Fiscal Policy Reflating the economy - Economic Growth - More employment Budget deficit - Government increases spending (EG: hospitals) - This provides more jobs - Multiplier effect - Government reduces tax - Increases disposable income - People spend more - Consumer expenditure rises - Multiplier effect BUT must take care not to stimulate AD too much as this could lead to inflation

Contractionary Fiscal Policy Deflating the economy - Reducing inflation - Reduce of balance of payments deficit Budget surplus - Government decreases spending (EG: benefits) - This reduces income for others - This leads to the multiplier effect - Government increases tax - Decreases disposable income - People spend less - Consumer expenditure falls - Multiplier effect

Supply-Side Fiscal Policy SupplySide Fiscal Policy -

Changes in level/structure of government spending and taxation Improves supply side of economy Aims to shift LRAS right which: o Increases productive capacity of economy o Lowers prices reducing inflationary pressure

TARGET Labour Market Incentives

STRATEGY - Cut welfare benefits - Reduces benefit trap (individuals receive more through benefits than working) - Encourages voluntarily unemployed people to seek work - New people enter labour market - Increases capacity of country to produce -

Capital Spending

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Cut income tax Encourages people to seek work Workers earn more ď&#x192; work harder ď&#x192; increased productivity BUT may encourage workers to work fewer hours for same pay Government improves infrastructure (eg: schools, hospitals) Contributes to investment across whole economy

Entrepreneurship

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Research Development Innovation Human Capital Improvements

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Reduce rate of corporation tax Stimulates higher level of business investment May attract inward investment Government spending funds expansion in rate of new business start-ups EG: through provision of loans Government spending, tax credits and tax allowances for businesses Encourages increase in private sector research and development Increases overall productivity Increased government spending on education and training Increased human capital of workforce

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Increased government spending on healthcare and transport Positive supply-side effects in long run

SUPPLY-SIDE POLICIES

Supply-Side Policies

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Measures designed to increase aggregate supply Increases potential output of economy Increases economic growth without inflation

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Many improvements come from private sector (Firms boost productivity to stay competitive)

POLICY Labour Market Measures

EXAMPLES - Improving education and training - Reducing power of trade unions - Profit-related/performance-related pay - Encouraging more flexible pension arrangements Tax Reforms - Reducing burden of income tax - Replacing direct taxes with indirect taxes Reform of Welfare State - Reducing state welfare benefits - Incentive to choose employment over benefits - Reducing poverty trap Industrial and Competition - Privatisation Policy Measures - Deregulations - Contracting out Financial and Capital Market - Deregulating financial markets Measures - Promoting greater competition among banks - Encouraging saving with special tax privileges - Encouraging wider share ownership - Promoting entrepreneurship/popular capitalism - Encouraging an â&#x20AC;&#x2DC;enterprise cultureâ&#x20AC;&#x2122;

Labour Market and Supply-Side Policies Labour Market

Factor market where labour is bought and sold

AIMS OF LABOUR MARKET SUPPLY-SIDE POLICIES 1. Improve quality and quantity of labour supply 2. Improve flexibility of labour market ď&#x192; reduced risk of structural unemployment 3. Increase productive potential of economy Reduce Disincentives Lower rate of income taxation (short term demand boost): to Work - Improve incentives to work longer hours - Encourage people to take a new job

Education Training

Trade Union Reforms

Decrease social security benefits: - Those on benefits have reduced income - Encourages unemployed to take up employment - Reduces unemployment trap Government provision of training opportunities: - Increases productivity, mobility and flexibility of work force - Improves countryâ&#x20AC;&#x2122;s international competitiveness - Well-educated workforce attracts foreign investment Trade unions restrict supply of labour to increase wages of their members BUT this leads to a fall in employment which: - Reduces efficiency - Reduces international competitiveness SO government aims to reduce power of trade unions

Product Market and Supply-Side Policies Product Markets

Markets in which all kinds of goods and services are traded

AIMS OF PRODUCT MARKET SUPPLY-SIDE POLICIES 1. Increase competition and efficiency 2. Increase productivity of industries 3. Shift LRAS curve to right Privatisation

Sale of government-owned assets to private sector: - Privately-owned enterprises more efficient and competitive - Exposure to discipline of market  right shift of AS curve Deregulation Removal of government control/barriers to entry from markets: - More competitive markets replace public sector monopolies - Competition  incentive to be efficient Toughening of Increase competition: Competition Policy - Firms forced to be more efficient in use of scarce resources - Reduced costs  lower prices - Reduces risk of market failure due to monopoly power Commitment to Free Expand free trade within EU and world: International Trade - Increased competition  incentive to be efficient - Lower prices for consumers Entrepreneurship Encourage entrepreneurship and investment: and Capital Spending - Increase rate of new business starts-ups through loans - Provision of regional policy assistance - Advice for new firms

Saving, Investment and Supply-Side Policies Supply-Side Increase of Economic Growth 1. Lower tax rates on investment income 2. Increased return from savings 3. Savings and investment rise 4. Decreased consumption 5. Economic growth without inflation

Fiscal Increase of Economic Growth 1. Higher tax on investment income 2. Reduced return from savings 3. Saving and investment fall 4. Increased consumption 5. AS can’t keep up with AD – inflation

Supply-Side Policies and AD/AS Model Desired effect of supply-side policies: 1. Shift (LR)AS curve to right 2. Increase in trend rate of growth WITHOUT INFLATION 3. Increase in potential GDP There must be a substantial increase in AD for this to be effective: - LRAS shift without AD shift leads to increase in output of INC1 - LRAS shift with AD shift leads to increase in output on INC2

Supply-Side Policies and the PPB Curve Desired effect of supply-side policies: 1. Rise in labour/productivity/capital 2. Increased productive efficiency 3. Increased capacity to produce 4. Outward shift of production possibility boundary