Macroeconomics Test 3

Protectionism; March 2018 US imposes 25% tariffs on steel and 10% tariffs on aluminium

+ Should move their current account towards surplus, deterring imports + May positively impact the environment through less transporting of goods + Domestic firms may become more competitive and employ more workers - Can lead to inflation if goods become more expensive for domestic consumers - May reduce real output if domestic firms struggle to acquire raw materials for production

In November 2017 Uk inflation was at 3.1%. The BoE raised IR from 0.25% to 0.5%. Contractionary monetary.

+ inflation should fall + equality improves; bonuses and dividends fall - growth may slow - investment may fall - current account (hot money) may move in direction of deficit - unemployment may rise

How can commercial banks undermine the MPC

- Commercial banks can refuse to respond to cuts in the Bank's base rate/ not passing cuts in full. Don't follow BoE base interest rate and make their own commercial rates. - Not providing credit needed to stimulate economic growth (view the population as untrustworthy/ won't pay back) e.g. don't give mortgages to consumers and instead invest it into assets

Causes of inflation

- Demand-pull (AD shifts out) e.g. lower interest rates, rise in house prices, rise in consumer confidence, decrease in income tax - Cost-push (AS shifts in) e.g. rise in oil price, increase in NMW, increase in VAT (indirect tax increases costs for producers), higher tariffs on raw materials

Causes of busts

- Housing market crash e.g. 2008 financial crisis - Stock market crash e.g. 1929 Wall Street crash - Commodity price rises e.g. 1973 oil prices ( supply shifts inwards) - High interest Rates (C+I and AD fall) and AS in long run - Fall in real wages (C and AD fall) - Loss of consumer confidence (C and AD fall) - Trade wars

CPI (rate of inflation)

- Index value of base period x rate of inflation in the general price level

Causes of economic growth

- Innovation and R+D into new products/ new production processes e.g. Google, Microsoft, Apple - Increasing house prices - wealth effect and C increase - Higher brith rate/ immigration - Government spending on education/ subsidies/ healthcare/ infrastructure - Rising incomes globally may lead to higher demand for exports (AD increases) - Low interest rates (C+I increase --> AD+AS (long-run) increases

Budget deficit

A deficit which arises because government spending is greater than its receipts. Government therefore has to borrow money from the public sector to finance the difference (Public Sector Net Borrowing - PSNB)

Policies to improve a trade deficit: Relative inflation

Contractionary fiscal policy Decrease government spending and/ or increase taxes e.g. government increases income tax; consumption and so AD falls, inflation falls (danger that it will fall below target level of 2%, may lead to extra danger of delayed purchases and potentially a deflationary spiral), (employment and real incomes fall) makes good more competitive so exports rise ( less deposable income from lower taxes will lead to a fall in the propensity to import, overall reducing the UK's trade deficit) AD shifts in

What is the difference between a structural deficit and a cyclical deficit?

Cyclical deficits links to the trade cycle. During a recession, moves towards a deficit (automatic stabilisers/ expansionary policy). During a boom, moves towards a surplus. Structural deficit: consistent deficit every year. Debt builds up quickly.

Policies to improve a trade deficit: Consumers' income

Demand management: Reduction in government spending, higher taxes, higher interest rates could all have an effect on dampening consumer demand reducing the demand for imports. This leads to an increase in spare productive capacity which can then be allocated towards exporting. AD shifts in

Causes of economic growth Demand-side (AD shifts out)

Demand-side growth is often associated with the economic cycle. It is affected by factors like: - interest rates - household income - expansionary fiscal policy - confidence - exchange rate

Bust

During a bust, growth and wages tend to fall while unemployment rises. Generally, they are caused by demand shocks and so inflation will fall. PPF, point of production moves inside the curve

Policies to improve a trade deficit: Hot money

Policy: lower interest rates The MPC could lower interest rates. This would cause foreign investors to invest elsewhere. As a result the pound will depreciate, leading to a trade surplus. AD shifts out/// Many exports require imported components, so the gain in price competitiveness for domestic producers from depreciation can be eroded by a higher rate of inflation, And there is also a risk that a weaker pound will cause a rise in cost—push inflation.

Aggregate supply

Represents the total level of goods and services produced in an economy at a given price level.

Keynesian AS curve

Represents the total level of production in the economy given its current resources. 1) Minimum wage, benefits and trade unions prevent wages (and therefore prices) falling below this level 2) Here workers are becoming more scarce so wages and prices start to rise 3) At full unemployment, output is maximised, regardless of any increase in the price level The gap between the economy's current output (Y) and YFe is the level of unemployment/ spare capacity.

What government objective relates to the balance of payments

Balanced current account

Expansionary monetary policy

BoE wants to increase the rate of economic growth by lowering interest rates

Causes of economic growth Supply-side (AS shifts out)

Supply-side policy comes from an increase/ improvement in the factors of production i.e. land, labour, capital: - infrastructure investment - education and training - R&D - immigration - fall in energy prices

Recession

Two consecutive quarters of negative economic growth

Financial Crisis: Lowering interest rates

- MPC lowered base interest rate from 5% to 0.5% ---- Crisis caused demand in the economy to shrink substantially, leading to a significant negative output gap and high levels of spare capacity in the economy ----- Lowering the base rate reduces the cost of borrowing for consumers, in turn encouraging the to borrow money and make purchase and increase the level of consumption ------ Consumption is a component of aggregate demand, so this should in turn lead to an increase in AD from AD1 to AD2 as shown on the diagram. This will lead to an increase in real output from Y1 to Y2, reducing the negative output gap. ------ There may be additional positive impacts on the level of real output as a result fo the multiplier effect causing additional increases in AD. Evaluation: - Interest rates do not guarantee higher consumption as consumption is also affected by the level of confidence in an economy. - When the MPC lowered the base rate, confidence was very low so consumption failed to rise. - In continuing to reduce the rate, the MPC approached the zero lower bound and the economy entered a liquidity trap where interest rates were at their lowest level but failing to stimulate AD. ----- As a result, Ad failed to shift outwards from AD1 and the economy continued to experience a negative output gap and high unemployment.

Financial Crisis: Quantitative easing

- MPC used QE; a demand-side policy, in which the central bank electronically prints money and uses it to buy government bonds from commercial banks and other financial institutions. ----- In the UK, the MPC authorised the purchase of £375bn of government bonds over the years following 2008. - In doing this, the central bank increase the liquidity of the commercial banks, raising the availability of credit and resulting in a decrease in commercial interest rates. ----- This will result in a decrease in the cost of borrowing and therefore and increase in the level of borrowing in the economy ----- Higher borrowing will drive consumption and investment (both components of aggregate demand), and cause AD to shift out from AD1 to AD2. This should result in a rise in real output from Y1 to Y2 and a decrease in the negative output gap. ---- In addition, there will be a decrease in the level of unemployment, supporting another key macroeconomic goal. HOWEVER - QE amounts directly to increasing the supply of money so there is a danger of inflationary pressure in the economy. ----- As shown on the diagram, the price level rises from P1 to P2. indicating an increase in the rate of inflation in the economy ----- Another key macroeconomic goal for the MPC is to maintain inflation at 2% and so this policy includes the risk of compromising this target ----- This goal was particularly at risk of being compromised at the start of the QE program given the rate of inflation was 4.5% in 2011.

Impact of lower interest rates C+I+X increases, M decreases - Increase in aggregate demand

- More business start-ups - More household borrowing - More business investment - More house buying - Higher wealth effect - Lower level of inequality (less saving - upper class, more borrowing - lower class) - Less unemployment - Less savings - Lower income of retirees - Lower wealth effect (savings worth less, people who don't own houses are not affected) - Lower exchange rate (less imports and more exports) - Leads to higher inflation (no buffer if there is a recession_

Supply-side policies - interventionist (more government)

- R&D into new technology - improves productivity - competition policy - breaking up monopolies/ encouraging competition (lowers prices for consumers and the variety of goods and services) - infrastructure - improves productivity through faster transport/ communication - labour mobility increases - reducing the power of trade unions - improves labour mobility, more likely to be fired, reduces costs - encouraging immigration - increases the size of the workforce - minimum wages - higher to incentivise workers or lower to reduce costs - improving quality education and training -(effectiveness demands on quality of education) to improve productivity - improved health care should reduce sickness and absence and increase output per worker - government increases bank lending to further investment and productivity - Funding for Lending

Financial Crisis: Austerity

- The government employed a policy of austerity in response to the financial crisis, beginning in 2010 under David Cameron - This involved reducing the level of government spending and increasing taxes such as the rise in VAT from 17.5% to 20% - The aim of this policy was to reduce the level of debt in the economy - In raising taxes and cutting spending the government was aiming to reduce the fiscal deficit and reduce the amount of borrowing required each year to fund government expenditure - In reducing he level of borrowing, the government is aiming to reduce the accumulation of debt and eventually achieve a fiscal surplus that will facilitate the use of tax revenue to pay off the debt - Lower levels of debt will have positive effects including increasing the availability of government funds to use on public services rather than debt interests However, austerity is a contractionary policy due to the decrease in government spending and effect on higher taxes in reducing disposable income and in turn reducing consumption. - As components of AD, lower consumption and government spending will cause AD to fall as shown on the diagram from AD1 to AD2. - The effect of this would be to increase the size of the negative output gap, reducing real output and raising unemployment.

Reducing debt will help to alleviate the following problems:

- low confidence in the economy - if debt spirals and interest payments rise, tis has an opportunity cost to the government - high debt can lead to higher commercial interest rates, determining investment/ HDI

Supply-side policies - market-based (less government)

- lower income tax - increases incentive to work, increased competitiveness in labour market - reducing welfare benefits - increases incentive to work - reducing cooperation tax - lowers production costs and more retained profit may encourage investment - privatisation - improves productivity because private firms are driven by the profit motive - deregulation - lowers costs, encourages competition leading to greater efficiency

Impacts of unemployment:

- unemployment benefits; strain on the government- higher costs of welfare spending, less tax revenue collected (budget deficit) - lower incomes may lead to lower consumption - negative multiplier effect - supply of labour is high; leads to lower wages (lower costs for firms) and high availability of workers - long-term unemployment can lead to loss of skills -> AS/ PPF can shift in (loss of productivity) - lower incomes may lead to a fall in imports (less domestic demand), however exports may also fall if production decreases. Trade may not change in its balance, but the environment from lower transportation/ production. - potential rise in inequality due to unemployment, particularly affecting low skilled workers/ higher skilled worker may have their hours cut (underemployment) - negative impact on happiness as lower income households and lack of work - may lead to lower standard of living/ lack of luxury purchases X however, individuals are somewhat protected by welfare benefits and may enjoy extra leisure time

What is the UK's current account balance as a percentage of GDP

-4.3%

Supply-side policies are designed to increase the productive potential of the economy. They focus on increasing the quality/ quantity of factors of production and increasing productivity.

1) Add AD 2) Add AD and SRAS (shifts outwards). SRAS lowers costs for firms, LRAS increases FoP Shown by movement of AS to right Supply-side policies are universally expansionary. This is because they do not face a trade-off between growth and inflation. The one exception here may be policies designed to protect the environment though limiting output.

Policies to address cyclical unemployment (AD shifts in)

1) Expansionary fiscal policy; government spending increases, taxation decreases, aggregate demand rises 2) Expansionary monetary policy; lower interest rates, aggregate demand rises (forward guidance) quantitative easing if necessary

Impact of supply-side policies

1) Growth, increases (may be time lags for policies e.g. education) 2) Inflation, decreases (however the policy may have a demand-side effect e.g. lower income tax pushes AD and inflation up) 3) Employment, increases (however policies like R&D and investment in capital could displace labour) 4) Trade, fall in PL and increase in quality - surplus as exports more competitive (however policies like lower income tax could lead to a rise in imports) 5) Environment, worsens due to more production (however new/ more efficient capital/ energy use may help the environment) 6) Inequality, depends (interventionist improves inequality, market-based makes it worse) 7) Budget, it depends (policies could go either way) Budget deficit (lower income/ corporation tax , infrastructure, R&D, education, lower minimum wage). Budget surplus (less benefits, higher minimum wage, privatisation) Size of national debt, creditworthiness of UK government, prioritisation of objectives such as fiscal deficit reduction limiting scope, conflict between other policies (e.g. growth and inflation): macroeconomic objectives

Discuss the impacts of a market based and an interventionist supply-side policy of your choice on the economy (25) (consider growth, employment, inflation, trade, environment, inequality, budget balance)

1) Market based; reducing welfare benefits - draws more people into the Labour force, increasing employment - LRAS shifts outwards, productive potential of economy increases; growth increases, inflation decreases (shown by SRAS and LRAS shifting outwards) Evaluation: economy is already near full employment, will have limited impact on GDP growth, but a large impact on deflation 2) Interventionist: infrastructure e.g. HS2; growth increases and less inequality (improved labour mobility), but cost to environment PPF shifts outwards

Impacts of inflation on different groups:

1) On savers: inflation erodes the real value of their savings 2) On workers: the purchasing power of their wages falls 3) On borrowers: the real value of debt falls with inflation so borrowers benefit 4) On consumers: goods are more expensive so real income has fallen, also high inflation results in uncertainty over prices and consumers incur shoe leather costs (resources wasted when inflation encourages people to reduce their money holdings) 5) On exporters: lose competitiveness 6) On firms: uncertainty may deter investment, firms incur menu costs as they have to change their prices more regularly, may face higher wage demands from workers 7) On government: may reduce the value of government debt, but may raise the cost of spending projects 8) Broad economy: inflation leads to uncertainty and, if prolonged, could lead to economic decline and even political unrest.

Timeline of he financial crisis

2006: growth is high, unemployment is low, banks are lending to lots of people (in a boom) 2008: households are failing to pay back their mortgages, banks are starting to fail and there is a massive loss of confidence in the economy (recession: high unemployment, deflation, slow economic growth) 2008: The BoE decides that it needs to take action by lowering interest rates. 2009: The BoE's policy isn't working, so it decides to carry out a policy of quantitative easing (BoE creates money to buy government bonds from the central bank, commercial banks are now highly liquid and this could lead to lower commercial interest rates and greater availability of credit, higher borrowing by firms and households, increases C, I, AD, RO. Once economy grows, BoE sells bonds and sterilises the cash). 2009: Quantitative easing should help to lift the economy out of a recession 2010: The government implements a policy of austerity (large cuts in government spending and an increase in taxation in order to reduce government debt).

Two likely effects on the recent fall in the value of sterling

A depreciation in the exchange rate, means the currency is worth less compared to other countries'. As a result, exports (more competitive) will be cheaper and imports will be more expensive. Thus there will be a likely increase in exports and a decrease in the quantity of imports. Domestic firms will benefit from increased sales, which may lead to job creation and lower unemployment, especially in export industries. The increase (X-M) will help increase aggregate demand and thus lead to higher economic growth. On the other hand, due to depreciation making exports more competitive, in the long-term this may reduce incentives for firms to cut costs, and could lead to declining productivity and rising prices. Depreciation tends to cause inflation, because imports become more expensive, leading to higher domestic demand so firms have less incentive to cut costs. Thus, consumers who buy imports, firms who buy imported raw materials and those on fixed incomes and wages lose out due to inflation cause by the fall in the exchange rate. This can lead to a decrease in real wage growth, as inflation could cause household's nominal salaries to rise, but since the purchasing power of money falls, their real wage and standard of living falls. A depreciation will tend to improve the current account balance of payments. This is because exports increase relative to imports, thus injecting more money into an economy the withdrawing it. Depreciation will only improve the current account deficit if the XED is greater than 1. In the short-term, demand for exports tends to be inelastic, leading to an improvement in the current account. Therefore, there is a bigger increase in demand for exports. With less demand for imported goods due to higher prices, firms may decide to cut costs and decrease the umber of people they employ and their wages, leading to a rise in unemployment. However, the impact of a fall in the exchange rate depends on the state of the economy. If the economy is in a recession, a depreciation may help boost growth with little effect on inflation. But if inflation is already high, a fall in the exchange rate will make inflation worse. The impact also depends on other components of AD. Whilst as exchange rate falls, export demand increases, if there is also a fall in consumer confidence, this may offset the rise in AD so there may be no overall increase.

Fiscal policy

A government policy regarding taxation and public spending. Can be loose (more G and less T to boost economic activity with acceptance of a wider fiscal deficit) or tight (less G and more T for a slower-growing economy)

Direct tax

A tax levied directly on an individual or organisation e.g. income tax, National Insurance contributions (paid by individuals, levied on earnings), corporation tax (tax paid by companies levied on company profits)

Indirect tax

A tax on a good/ service e.g. VAT (20% tax on most goods and services), exercise duties on goods such as petrol, drink, tobacco (levied on the volume of goods bought), council tax (paid by homeowners on the notional value of property), business rates (paid by firms, tax on the notional rent of a property)

Impact of a rise in AD:

AD shifts out, causing a rise in real output and price level. Without output above equilibrium, costs rise and SRAS shifts in. Price level rises and real output returns to equilibrium. E1 to E2 to E3

Inflation indicates growth in the economy and therefore should be encouraged. Discuss.

Agree: - outward shift in AD leads to high growth and employment - reduces the real value of government debt, any household or firm too - may lead to nominal wage increases, happiness rises - higher borrowing, improves equality Disagree: - If caused by AS; lower production potential, lower growth - May hinder future growth, uncertainty/ instability may reduce investment - Savings eroded, lower investment/ negative wealth effect - Lower real incomes; lower purchasing power, lower standard of living - If AD is on vertical part of AS, no effect on growth

Assess the likely effectiveness of demand-side policies in increasing the level of economic growth, given the UK's current level of unemployment.

An increase in AD may increase inflation greatly, but have little effect on real output as we are near full employment. Diagram on the right, YFe is vertical from top of AS

Effects of inflation; wage-price spiral

An initial shock triggering higher inflation could lead to a further upwards spiral of prices (wage-price spiral): - prices rise due to some external shock - workers see their real incomes fall - workers demand higher wages - production costs rise, forcing firms to push up prices Therefore, inflation can cause further inflation

As the level of output rises, workers tend to demand higher wages so the price level also rises.

As a result the curve slopes upwards. In the short run, we expect that workers can do overtime or reduce their hours temporarily.

NAIRU = non accelerating inflation rate of unemployment/ the minimum level of unemployment that can be achieved without causing high levels of inflation.

As shown by the AS curve, inflation and unemployment conflict with eachother as government objectives. The NAIRU is the point at which this conflict occurs. NAIRU IS THE SHOWN ON THE X AXIS BETWEEN YFE AND Y1 (when it is just about still horizontal) E.g. interest rates push level of employment beyond the NAIRU level = high inflation

Impacts of economic growth

Economic growth is a measure of the increase in real GDP (AS/ AD shifting outwards) Real economic growth increases LRAS and lower inflation Positive: - lower unemployment - supply-side growth could lend to lower price level - income and standard of living rise (can afford more foods and services), poverty rates fall - appreciated currency, good for reducing cost of imports - accelerator effect - high growth leads to a rise in investment - budget surplus due to automatic stabilisers - increased tax revenues for the government which may be used to improve public services or redistribute incomes - higher profit for companies which may he used to improve the quality of products or produce new products —— increased retained profit and higher business confidence - increase investment e.g. into sustainable technology which can have environmental benefits - if there is export led growth, then the current account of the balance of payments would improve Negative: - growth tends to benefit the rich the most, leading to higher inequality e.g. companies may not invest but distribute profits to shareholders - demand-side growth tends to lead to high inflation (demand-pull inflation) - appreciated currency likely to lead to trade deficit - negative environmental impacts; growth may involve a depletion if natural resources - long run ; technological unemployment - growth could lead to a deterioration in the Balance or Payments since Britain has a high MPM - growth from supply side improvements may reduce inflationary pressure

Real wage unemployment

Exists when real wages are stuck at a level above equilibrium in the labour market e.g. unskilled workers struggling to find a minimum wage W1 is NMW

Effectiveness of demand-side policies in stimulating growth: National debt and conflicting policies

Expansionary fiscal policy can be problematic if it leads to the accumulation of debt. Some economists would argue that the benefits of using fiscal policy to stimulate the economy during a recession are outweighed by the cost of more debt. They would argue that fiscal policy should only be used when trying to encourage a contraction as this will help the government to run a budget surplus and avoid the problems caused by significant national debt. Keynesians would argue that in the short tun the national debt is less of a problem - the government can pay it off once it has pushed the economy back into a boom.

Causes of economic growth Expert-led growth (AD shifts out)

Expert led growth is important for countries like Germany and China, as well as many developing countries that cannot rely on high domestic consumption.

Cut in the exchange rate = value of pound falls.

Exports increase (more competitive), whilst imports fall. Aggregate demand rises (increase in PL and RO) -- expansionary

Contractionary fiscal policy

Fiscal policy which leads to a fall in aggregate demand. Fiscal policy is said to tighten as a result.

Expansionary fiscal policy

Fiscal policy which leads to an increase in aggregate demand. Fiscal policy is said to loosen as a result.

What happens to inflation when we try to boost economic growth while we have a negative output gap e.g. caused by a recession?

Gap between Yfe and line vertical to top of As = spare capacity (unemployment) Recession: inflation falls, unemployment rises, growth falls Spare capacity allows us to produce more goods and services without a rise in the price level Interest rates remained low for the past ten years If there is a recession, there is no scope for the government to lower interest to encourage a boom

Effectiveness of demand-side policies in stimulating growth: Time lags

Government investment projects e.g. road-building, house-building, nuclear power plant etc. tend to have a significant time lag between the announcement of the project and its effect on the economy. This is due to the time it takes to carry out the investment and build the projects. This is not an effective way of dealing with urgent problems in the economy - the situation may have changed by the time the project is complete. In contrast, monetary policy has a much smaller time law and tends to be more effective at providing quick stimulus/ dampening to the economy.

Hot money

Hot money is money that flows around the global economy looking for the highest rate of interest. When interest rates change, this can affect hot money and lead to subsequent changes in trade. Rates decrease, hot money flows out of UK, demand for pound falls, depreciation, exports rise imports fall = rise in aggregate demand This reinforces the existing rise in C+ I (when interest rates rise) Affects 4/5 components of AD

The key determinant for the size of the multiplier is the level of withdrawals from the economy. The level of withdrawals is measured by the Marginal Propensity to Withdraw (MPW)

Multiplier = 1/ MPW = 1/ (MPM+MPT+MPS) = 1/ 1-MPC Th AD curve continues to shift out beyond its initial change.

However, government policy also had an automatic stabilising effect:

If the economy enters a recession: - profits and employment fall - so tax also falls - less withdrawals - as unemployment rises, government spending on welfare rises - more injections Vise versa fro booms

Policies to improve a trade deficit: Protectionism

Impose tariffs The government could impose tariffs on foreign goods in order to lower imports. This would mean foreign firms have to pay the UK government to import. Less imports -> trade surplus. AD shifts out

Evaluation for monetary policy: Liquidity trap

In some situations, monetary policy may be unsuccessful, particularly in the case of lowering interest rates to stimulate growth. After the recession, interest rates were lowered to near 0. Confidence was so low that the economy failed to start growing. In this situation, the central bank can no longer lower interest rates as they are at the zero lower bound. This leaves them a liquidity trap with no space to lower rates, but also an economy with stagnant growth.

What is implied about employment by a negative output gap? What might a positive output gap imply about our workers? How reliable are calculations of the output gap?

Increased unemployment Higher rate of economic growth = higher labour demand = more employment. Higher productivity and employment, strong growth in GDP per capita, rise in real wages of workers, higher standard of living The output gap cannot be directly observed, only estimated with the help of various surveys and judgements by forecasters

Effectiveness of demand-side policies in stimulating growth: Zero lower bound:

Interest rates can be lowered if the central bank wishes stimulate the economy. However, both central banks and commercial banks are generally disinclined to reduce their interest rates too much - especially when they reach zero and below. Negative interest rates create unusual incentives, charging savers and paying borrowers. As a result, there is only a limited distance that central banks can lower rates before hitting the zero lower bound. If rates as low as 0.5% still fail to stimulate aggregate demand, the economy is said to be sugaring from a liquidity trap.

Evaluate policies that were used during the Great Depression (25 markers)

KAA1: Expansionary monetary policy; interest rates fell from 6% to 4% Ev: Negative effects of low rates e.g. high inflation, depreciation (imported raw materials more expensive) KAA2: Supply-side policy; New deal - increase in growth and employment, would have been a policy recommended by Keynes AS shifts out Ev: Neoclassical evaluation Government debt increases - opportunity cost

Assess the parallels between policies used in the Great Depression and the 2008 Financial Crisis

KAA1: Monetary policy; similar as both lower rates - aim to stimulate the economy by increasing AD Ev: Financial Crisis; hit 0 lower bound (5% to 0.5%), whereas in GD (6% to 4%) Quantitative easing in financial crisis vs. Gold Standard in GD (expanding monetary supply vs. fixed money supply) KAA2: Expansionary fiscal policy; Bails outs and New Deal (similarity) Ev: Austerity in FC- David Cameron (2010) Tariffs in GD

Monetary policy

Monetary policy is conducted by the central bank and involves changing interest rates/ supply of money and doing quantitative easing (introduction of new money into the money supply by a central bank). The aim of the BoE is to keep inflation at 2%. - If inflation is too high, the BOE will raise interest rates - If inflation is too low, the BOE will lower interest rates

Stagflation e.g. 1970s

Negative AS shocks can lead to both a fall in real output and a rise in the price level. This is problematic for policy makers as expansionary demand-side policies are at risk of generating high inflation. Low output + high inflation = stagflation. E.g. crude oil is a commodity that is considered vulnerable to negative supply side shocks due to its volatile middle east location. Higher oil prices could increase the costs of production and cause the SR AS curve to shift inwards, to the left (leads to a fall in RO and rise in PL) - the government could decrease the money supply (contractionary fiscal/ monetary policy) and reduce AD but this would only make the recession deeper as real wages fall and so does C and I as consumer/ business confidence fall///// or they could increase RO by lowering IR stimulating AD but this would cause higher inflation

Effectiveness of demand-side policies in stimulating growth: Crowding out:

Neo-classical economists argue that when the government increases spending it uses factors of production and investable funds that the private sector could have used. As the public sector grows, the private sector tends to shrink as fewer resources are available to it. This would suggest that the multiplier effect is actually very small so government spending will not necessarily stimulate private sector investment or lead to much growth. Keynesian economists argue that there is a large multiplier and that government spending can have a multiplied effect on aggregate demand. - When crowding out occurs, there is supply a reallocation of resources so the economy moves from A to B. There is no economic growth so it does not move out to C. - PPF, public sector on one axis, private sector on the other axis.

Effectiveness of demand-side policies in stimulating growth: Neo-classical vs. Keynesian

Neo-classical economists argue that, in the long-run, stimulating demand will simply lead to inflation, without an effect on economic growth. Expansionary demand-side policies can create temporary positive output gaps, however these will eventually lead to higher wage demands, returning the equilibrium real output in the economy to its original level. In contrast, Keynesian economists argue that the economy is rarely at full employment and that stimulating aggregate demand can have a more persistent effect on the level of real output. They argue that demand-side policies can be effective at reducing negative output gaps.

Effectiveness of demand-side policies in stimulating growth: Speed of adjustment

Neo-classical economists believe that demand-side policies will correct themselves in the long-run. Long-term unemployment is a supply-side problem so demand-side policies will be ineffective. - SRAS shifts to the left, LRAS shifts to the left - The long run level of output has fallen from Ye to Ye2. the only way to reverse this permanently is to shift LRAS2 back out to LRAS. In contrast, Keynesian economists do not think that the economy will necessarily return to equilibrium, as a result they would support demand-side policies to take long-term unemployment.

Stabilisers

Normal fiscal policy tends to involve active government spending and/ or tax decisions by the government. If the economy starts to slow down, we might expect a lowering of the income tax rate and/ or a rise in government spending projects. This would aim to stabilise the economy.

Cyclical unemployment (also called demand-deficient)

Occurs when the economy is not in a boom e.g. holiday companies.

In a recession, the Bank of England can lower interest rates

Only if the recession is caused by a demand shock (like in the diagram)

Impacts of economic growth

POSITIVE - Fall in unemployment - Accelerator effect - rise in investment - Higher wages - higher standard of living/ quality of life - Higher tax revenue - Stronger currency - imports rise, cheaper goods for consumers and more consumer choice - Rise in immigration - increases As and Ad NEGATIVE - Environmental damage from higher production - Inequality tends to worsen (rich get richer at a faster rate) - High inflation may reduce real wages - Stronger currency may make exports less competitive - firms struggle to sell, may lay off workers - Increase in the level of debt due to high levels of confidence (inflation lowers the value of debt and encourages borrowing)

Impact of a rise in LRAS e.g. caused by greater incentives to work (lower income tax), education/ training, R+D into capital, population growth: Neoclassical economists say this is the only sustainable growth because it actually increases the production potential of an economy.

PPF shifts outwards SRAS also shifts to the right A--> B

Monetary Policy Committee

Responsible for setting the short-term base interest rate The level of inflation that the Bank of England targets is 2% +-1%

Frictional unemployment

Short-term unemployment of workers moving between jobs. This will always exist to some degree in the economy e.g. teaches moving from one school to another

The trade cycle

Shows the trend level of GDP for an economy and how the actual level varies in relation to the trend.

Effectiveness of demand-side policies in stimulating growth: Quantitative easing

Some argue that quantitative easing is effective at stimulating the economy as households and firms borrow more for purchases of goods and services, driving consumption. Others argue that the extra liquidity tends to be directed into assets like houses and shares. The price of these assets rises but it fails to significantly affect real output - there are no new goods and services being produced or consumed, simply existing assets where supply is relatively inelastic.

Hysteresis

Some demand-side shocks can cause particularly severe recessions. In these cases, there may be long-term unemployment and a loss of skills, causing the productive potential of the economy to shrink. This problem is called hysteresis. AD and AS fall (AS curves start at same origin)

Policies to address structural unemployment (AS shifts in) As industries decline and workers no longer have relevant skills, the productive potential of the economy shrinks

Supply-side policies: - education and training - infrastructure spending - subsidise certain industries - lower minimum wages - lower corporation tax

Policies to improve a trade deficit: Relative production costs

Supply-side policy Policies to raise productivity (make UK exports more competitive and reduce dependency on imported goods): measures to bring about more innovation and incentives to increase investment in industries with export potential are supply-side measures designed to boost exports performance and compete more effectively with imports. E.g. R&D (however could displace labour), tax incentives to encourage investment in human capital and business innovation. Policies to encourage business start-ups - successful small businesses, with export potential. Investment in education and health-care to boost human capital and increase competitiveness in fast-growing and high value industries such as bio-technology, engineering, finance and medicine. e.g. more/ better education and training (more efficient, reduces labour costs, increase quality of goods - more competitive) Lower minimum wage, reduction in welfare benefits Investment into critical infrastructure to support business and industries involved in international markets: Ev - the time-lags for supply-side policies are long Supply-side policies in theory offer the best prospect of achieving a durable improvement in the current account. Foreign investment for example helps to increase LRAS and export capacity. But in practice there might be trade-offs with other objectives such as a possible widening of inequality and risks of structural unemployment as government policies prioritize expansion in emerging industries. The decline of oil, gas and coal replaced by a range of capital-intensive renewable industries is an example of this.

Output gap

The amount by which the economy can growth without generating harmful inflation. The difference between the real level of output and the previous trend growth rate.

Multiplier Effect

The circular flow of income demonstrates how income flows around the economy. Injections like investment become flows of consumption/ wages. As a result, an injection can have a much larger fine impact on GDP than its size would suggest e.g. a £10bn G project might increase GDP by £30bn in the long-run. This gives us the multiplier effect: An injection into the economy will lead to a more than proportional rise in GDP.

Trade balance

The difference in the VALUE of a country's imports and exports

Effectiveness of demand-side policies in stimulating growth: Fine-tuning:

The economy is difficult to fine-tune given the broad spectrum of variables that affect it. Shocks can occur both internally and externally with substantial effects on the key measures of performance (growth, unemployment, inflation, balance of trade). Trying to use demand-side policies to make small nudges to keep the economy on trend is both futile and an inefficient use of resources. Generally it is better to ignore small changes in the level of GDP in order to avoid constant fine-tuning.

Budget surplus

The government receives more revenue than it spends so there is a negative PSNB. The government can use the difference to repay party of the National debt.

Equilibrium National Income

The level of national income at which AD=AS or at which planned injections into the circular flow of income equal planned leakages.

Trend growth

The long-run average growth rate for a country over a period of time

National debt

The total accumulated borrowing of government which remains to be paid to lenders. Its official name is public sector net debt.

Evaluation for quantitative easing. However:

There is a danger that increasing the money supply will lead t high levels of inflation. Commercial banks may not use the money for loans. Instead they could simply invest in financial assets, benefitting existing asset holders (the wealthy)

However, in the long run, Adam Smith (who this model is based off) thought that all markets inc. labour market should clear. This means that the economy should always return to the same equilibrium level of unemployment and therefore output.

This can be shown on a PPF: E - workers could briefly work overtime but this is not sustainable. D - workers could be fired/ unemployed but will end up finding more work if they are willing to work for a lower wage.

Evaluation of supply-side policies

Time it takes for supply side policies to take effect e.g education Effectiveness of supply side policies e.g. infrastructure/ investments/ education/ health care at delivering sustainable growth Privatisation may lead to private monopolies and less efficiency and lower economic growth. Business confidence may effect investment Cut in income tax designed as an incentive to work and invest may be ineffective if workers use it as an opportunity to work less for the same income Cut in corporation tax ineffective if companies use the cut in corporation tax to boost short term profits rather than investment Interest rate may effect investment Effectiveness of policy to deliver desired outcome Actions of other countries to attract investment Increase in UK taxation elsewhere may have an effect on incentives Concern about the ability of the government to repay its debt if it gets too large Magnitude of policy change

Quantitative easing

When normal interest rate policy fails to stimulate the economy, central banks may revert to quantitative easing. This occurred in the UK, US and Eurozone after the 2008 financial crisis. The Process: 1) The central bank creates money electronically 2) It uses this money to buy government bonds from commercial banks 3) The commercial banks now have a lot of cash i.e. they are highly liquid 4) The high supply of gas should lead to lower commercial interest rates and greater availability of credit 5) Borrowing by households and firms rises, C+I+AD rise = economic growth This is an expansionary policy, designed for when low interest rates are failing to stimulate the economy. Once the economy has begun to grow, the central bank aims to sell the bonds and sterilise the cash.

Inflation expectations

When the BoE changes rates, it can take some time to feedback into the economy. As a result, it is not only interested in what inflation is now, but also what it will be. For this reason, inflation expectations are very important. - Even more so as they can be self-fulfilling. If people expect prices to rise they will bring forward purchases and ask for higher wages.

Negative output gap

When the economy is producing less than its trend level of output. Employment and growth are low. Inflation is likely below target and workers may be underemployed.

Positive output gap

When the economy is producing more than its trend level of output. Employment and growth are high. Inflation is likely above target and workers are working over time.

Structural unemployment

When the pattern of demand and production changes, leaving workers unemployed in labour markets where demand has shrunk. This can be regional or sectorial e.g. miner

Seasonal unemployment

When workers move in and out of work at different times of the year e.g. beach lifeguard, skiing instructor