Economics Unit 2

National income

The total sum of all incomes earned by residents of an economy over a year. (This income is received in return for the factors of production)

Injections

An addition of money into the circular flow of income that originates from outside the household sector. They include investment, government spending and exports.

Inflation

An increase in the average level of prices over a period of time.

1) Measuring Economic Growth

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2) Measuring Inflation

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3) Measuring unemployment and measuring the balance of payments

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5) Circular Flow of Income

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6) The Components of Aggregate Demand

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Disadvantages of economic growth (4)

1) Inflation risk: If an economy grows too quickly there is a danger that it might try and consume more than it is producing. This over-consumption leads to demand-pull inflation. 2) Environmental concerns. - Growth can create external costs (costs not taken into account by those directly involved in a transaction) for example consumption of cars causes CO2 emissions which damages the environment. 3) Income inequality: GDP per capita is a misleading figure as it simply takes the mean average - dividing the total GDP by the population. In some countries the wealth may be distributed amongst relatively few leaving the majority of the population still in poverty. 4) Structural unemployment & capital-labour-substitution: Some economic growth involves new technology where capital directly replaces labour in the production process, for example, robots replacing workers in motor vehicle factories. Specific labour skills developed over many years suddenly become redundant. Structural unemployment is created.

Problems associated with calculating GDP (4)

1. Black economy: Output of some goods & services are deliberately not declared. E.G. a. To avoid tax (cash in hand jobs) b. To avoid detection of illegal activity (e.g. drugs) 2. Non-Marked goods or services: Some goods and services produced are not traded for money therefore have no price attached to them. (e.g. home-grown products or voluntary work) 3. Quality of Products not considered: Over time there have been dramatic improvements in the quality of various goods and services, for example, the quality of motor car. This is not shown by real GDP figures which just look at the volume of output of motor vehicles. Consequently, real GDP may underestimate improvements to living standards over time. 4. Purchasing power of income: In making comparisons between countries it is clear that the statistics need to be given in a single currency. However assumes that 1$ will buy the same amount of goods and services in different countries. In some countries (often LEDCs) 1$ will buy many more goods and services than in the US. For this reason GDP statistics may understate the total value of goods and services produced in LEDCs.

Problems with inflation measurements (3)

1. Changes in expenditure: Spending patterns can change more quickly as new products become available. The basket of goods used needs to be constantly updated. 2. Changes in quality: Measures of price change do not consider changes in quality. A computer is less expensive in comparison to 15 years ago but it is much better quality. 3. Special Offers: the RPI/CPI doesn't make account for out of season discounts or special offers which reduce inflation.

Problems associated with Unemployment

1. Costs to the unemployed: a. Loss of income that could have been earned had the person been in employment. b. Social Stigma: psychologically associated with failure c. Hysteresis effects: Being unemployed can diminish ones employability. - It reduces their human capital because; i. Lose work skills as they are not being trained in the latest developments ii. Employers use length of time out of work as a means of sifting through applicants - it sends a signal of lack of skills. 2. Costs to the local community: a. Social deprivation: - require greater welfare expenditure and organisations - e.g. increase in soup kitchens b. Unemployment linked to negative externalities e.g. crime rates. c. Unemployment is linked to other aspects of social dislocation, (worsening health, divorce rates, life expectancy d. Danger that it will lead to long term problem because of discouraged workers. 3. Costs to the Economy a. Persistent unemployment is an example of market failure (i.e. a misallocation of resources.) - It is a waste of scarce resources. b. Redundancies are a waste of resources invested in training and educating the workforce. c. Negative effect on the growth potential as workers become deskilled. d. Unemployment benefit rise and become a drain on government spending.

Why is there a deficit in the trade of goods?

1. Cyclical causes: As our incomes rise we are eager to buy more foreign produced luxury goods. Therefore when incomes we end up spending more on imports. This is especially true where there is high income elasticity of demand for imports. 2. Structural causes: Long-term decline in the capacity of manufacturing industry because of de-industrialisation. Companies have shifted manufacturing goods to lower cost emerging markets. 3. External shocks: UK imports commodity such as foodstuffs and beverages. It also has seen a sharp rise in imports of oil and gas as North Sea oil becomes depleted. When the price of imported goods rises this could cause a current account deficit (assuming the goods are PED inelastic) as we end up having to spend more money on them. 4. Exchange Rate Fluctuations: Traditionally the value of sterling has been high relative to other currencies this makes UK exports more expensive to foreigners.

Problems with unemployment measurements?

1. If the claimant count is used every time the government changes the eligibility for claims, the unemployment figures will change. 2. The LFS uses a sample of the population and may not be representative 3. It is difficult to assess whether the unemployed are genuine or unwilling to accept a lower wage rate. 4. If the unemployment is the result of a rescission, which is thought to be short term people may not bother registering for the Job Seekers Allowance

Benefits of inflation

1. Impact on Borrowers: Inflation reduces the real value of debt. Home owners with large mortgages might benefit from inflation which would mean that there debt is eroded. 2. Impact on Tax Revenue: The government gains from 'fiscal drag'. Higher prices can mean more revenue from VAT and also if incomes increase people are dragged into higher tax brackets. 3. Psychological effects for Businesses: Business may like the fact that they can raise prices and feel like make extra profits especially if their inputs are acquired from abroad where inflation is lower.

Problems of inflation (4)

1. Impacts on savers: When inflation is high the real value of savings is reduced. 2. Impacts on wages: Inflation tends to hurt people in jobs where it is difficult to re-negotiate wages. If there are no trade unions protecting them they may see the real value of their wage eroded? Even if they do manage to adjust their incomes they may find themselves in a higher tax bracket and liable to pay a higher rate of income tax. (This is known as fiscal drag) 3. Impacts on business: Loss of business confidence: It is difficult to work out rate of return on buying new capital when the prices keep changing. Therefore they may reduce planned investment. Menu Costs: This includes all costs associated with re-pricing goods. 4. Impact on consumers Shoe Leather costs: People have to search for the assets with the highest rate of return in order to try and retain the value of their money. Therefore, people spend lots of time going to and from the back to withdraw cash Money illusion: People make systematic mistakes in calculating the real values of their income and make bad spending decisions. Fiscal drag: Consumers end up paying a higher amount of VAT as prices have risen (this is also known as fiscal drag)

Advantages of economic growth (4)

1. Reduction in Poverty: Economic growth leads higher average incomes. This can facilitate increased production and consumption of material goods & services. The higher incomes may initially be concentrated among the wealthy in society but will tend to trickle down to middle & lower income groups as the wealthy may employ more servants, gardeners, cooks, security personnel, chauffeurs etc. 2. Reduces unemployment: As an economy grows it needs to produce more and therefore more of its population can find jobs. 3. Fiscal dividend: The government can collect more revenue from taxation which can be used to provide more or better public services. 4. New products & improved quality: As demand for goods rises, firms feel confident enough to take risks. These risks could lead them to innovate and produce newer better quality goods.

Why deficits on the current account can be seen as a problem.

1. The current account deficit may be a symptom of a wider structural problem - loss of competitiveness. The country is not producing much so needs to buy in from abroad. 2. The large trade-gap often represents an unbalanced economy with too much consumer demand. 3. Loss of output and employment: More money is leaving the economy than entering so national income falls. A decline in exports can also lead to firms shedding workers and increasing unemployment. Problems in financing the current account deficit: in order to obtain foreign currency to buy a good made abroad, foreigners need to be willing to trade their currency for a sterling asset. Foreigners need to be willing to either save their money in the UK (by buying UK bonds) or invest directly in the UK (Foreign direct Investment). The money that comes into the UK is known as capital inflows. Essentially people in the UK are borrowing money from foreigners who are saving in the UK. This means that to keep attracting their savings they may be required to offer higher rates of interest. Eventually this can become unstable as foreigners will lose faith in the people UK meeting their debt requirements. At this point they may withdraw their funds.

Index figure definition

A chosen base number which is adjusted up or down to reflect a percentage rise or fall in a specific variable.

Human Development Index

A measure of the quality of life in different countries which uses a range of criteria including per capita income, life expectancy and literacy rates?

Stock

A measurement of quantity at one specific point in time

Flow

A measurement of quantity over a specific period of time.

Circular Flow of Income

A model of the economy that shows the flows of income and expenditure between households and firms.

Labour force survey

A quarterly telephone survey of 60,000 households which estimates the number of people unemployed, defined by the ILO (International Labour Office) as persons of working age who are without work, are available to start work and are actively seeking work.

The BOP current account

A record of a country's trade in goods and services, income and current transfers over a period of time (a year). This includes a. Trade in goods (often known as visible - because the object moves from one country to another) b. Trade in services (often known as invisible (e.g. tourism/financial services) - no Physical good is taken from one country to another.) Income -Profits, dividends and interest payments that are received from abroad minus those paid from the UK to abroad. (E.g. the money earned by BP abroad and sent back to the UK will be a + but the money sent back to Japan from the a Toyota dealer in the UK will be a d. Current transfers -Includes government transfers (aid, or the UK's contribution to the EU)

Balance of Payments:

A record of all financial transactions that take place between economic agents of one country and all other countries that take place over a period of time. (a year)

AD equation

AD = C + I + G + (X-M).

The expenditure approach

Adding together the total amount of money that is spent on goods and services that are produced in a country. This is known as total expenditure. Economists often refer to this as Aggregate Demand.

Consumer Goods

Any good which is purchased by consumers.

The output method (calculating GDP)

Calculating the total value of all goods produced and services supplied in an economy.

Voluntary unemployment

Classical economists believe that all markets tend towards equilibrium including the labour market. In a free market there will be a going wage rate. At that wage everyone that wants a job will get one. Those without jobs (above N*) are unwilling to take the equilibrium wage and prefer leisure. This type of unemployment is considered voluntary as it represents a choice for leisure.

Determinants of consumption

Disposable income The wealth effect Interest rates Availability of credit Expectations of inflation Expectations concerning economic growth and unemployment.

Fiscal Drag

Due to inflation, workers may try to adjust their incomes so their real wage remains constant. However, they may find themselves in a higher tax bracket and liable to pay a higher rate of income tax.

Total Expenditure (E) or Aggregate Demand (AD) Equation.

E (or AD) = C + I + G + (X - M)

Features of Consumer Price Index (4)

Excludes housing costs The CPI is representative of all UK households. Only expenditure within the UK is covered but includes spending by foreigners within the UK. The CPI uses a geometric mean. (Thought to be more accurate)

Consumption

Expenditure by households on goods and services produced in the domestic economy.

Firms

Firms produce then finished goods and services which then give back to households.

Money flows

Flows of Money around the economy.

Real flows

Flows of goods and services around the economy.

GDP

GDP is the total value of goods and services produced in an economy over a given period of time (usually a year).

Capital Goods

Goods and services used to produce other goods and services.

HDI equation

HDI= (GDP per capita + Educational attainment + life expectancy)/3

What happens in a real flow?

Households demand and consume goods and services that firms produce. Firms require resources like Labour in order to make the goods and services. They employ individuals from households in order to make the goods.

Households

Households own the wealth of the nation. They own the stock of land labour, capital & entrepreneurship that can be used to create goods.

What happens in a money flow?

Households pay for the goods they acquire with money. Firms require money in order to pay for wages. Households receive the money from firms as remuneration for the resources they provide. i.e. wages in return for labour.

Injections > Leakages

If injections are greater than leakages (withdrawals) (i.e. more money is coming into the economy) the economy is growing.

Leakages > injections

If leakages are greater than injections (i.e. more money is leaving the economy) the economy is shrinking.

The impact of migration on unemployment

Immigrants might displace local employees. Many immigrants join the labour market with inappropriate skills. Many immigrants come for the purposes of study. It is unclear whether they will remain in the UK or.

Relationship between the three aproaches to calculating GDP & Equation

In equilibrium there should be absolutely no difference between the three approaches. Therefore: GDP = O = Y = E

PPF trade off

In this model of the economy there is a trade off (opportunity cost) between allocating resources towards the production of goods that provide direct utility to people (i.e. consumer goods) or towards goods that are used in the production of other goods (capital goods).

Limits of Total GDP

It is misleading if it is used as a measure of living standards or how well an economy is really performing. Often in measuring the economic performance of a country it is more useful to consider how rich on average an individual from the country is, rather how rich the country as a whole is.

Features of Retail Price Index (4)

Includes housing costs Excludes the highest earners and pensioners dependent on state benefits. It includes expenditure both within the UK and abroad by UK households The RPI takes an arithmetic mean:

Disposable Income

Income that is left over to households after taxation, national insurance liabilities have been paid.

Disadvantages of HDI (3)

It does not offer a direct measure of poverty. Difficulty in collecting the data especially in some low income developing countries which make the results less reliable. It ignores ecological / environmental issues such as the diversity of wildlife and the amount of rain forest or pollution levels from a country.

Capital inflow

Movement of funds into the domestic economy from abroad representing the purchase of either financial or physical assets by foreigners or the borrowing of foreign funds by domestic residents.

National Income equation

National Income (Y) = Income + Profits + Rent + Interest

Transfer Payments

Payments received by individuals that do not require any productive effort (i.e. they are not in return for any good/ service).

Real GDP calculation

Real GDP = (Nominal GDP x Price index in base year)/Price index in current year.

Seasonal Unemployment

Some workers (e.g. tourism) work on a seasonal basis. Unemployment tends to fall in the summer when such industries are in greater demand.

Economic Growth

The percentage change in the total value of goods and services produced in an economy over a year adjusted for inflation.

Example of transfer payment

The Job Seekers Allowance is simply a transfer of income from those paying taxes to those receiving the unemployment benefit.

Which one out of the claimant count and the LFS is usually higher?

The LFS is usually higher than the claimant count as some are out of work but do not or cannot claim benefits

Lorenz Curve (disadvantage of economic growth).

The Lorenz curve shows the line of perfect equality where the income share is distributed equally. The larger section A, the more inequitable the distribution. The Gini Coefficient is the measure of inequality: Area A/(A+B).

Measurements of the unemployment rate

The claimant count The labour force survey

Claimant count

The number of people eligible for and claiming Job Seekers Allowance. Claimants have to be 'actively seeking work' and over 18.

Three ways of calculating GDP

The output method The income method The expenditure approach

Withdrawals

The part of national income that is not spent on goods and services produced in the domestic economy and is withdrawn from the circular flow of income. They include: savings, taxation and imports.

National Income (calculating GDP)

The sum of all or incomes earned by residents of a country in return for the factors of production over a given period (Usually a year).

The income method (calculating GDP)

The total amount of income that is received (by all residents of a country) in return for goods and services.

Aggregate demand or Total expenditure:

The total demand or expenditure on all goods and services by households, firms, governments, and foreigners within an economy over a year.

Aggregate demand

The total expenditure on all goods and services by households, firms, governments, and foreigners within an economy over a year. It is given by the formula:

Real GDP

The total output in an economy adjusted for inflation.

GDP per capita

The total output in an economy per head. It tells us the mean average income in the country.

The wealth of a country

The wealth of a country is therefore the stock of assets which produce the flow of income over time. Countries with high levels of wealth, which includes human or non-human wealth, tend to produce higher levels of income than countries with lower levels of wealth. However: wealth can be mismanaged and used poorly so the correlation doesn't always match.

Frictional unemployment

There will always be some people unemployed. This is because on any given day many people will lose their jobs or decide to quit and others will be hired. Unemployed is caused simply by people moving between jobs who are engaged in job searching. However how long a person spends in unemployed depends upon how long it takes them to find a new job or how long it takes firms to find people to fill their vacancy. Frictional unemployment refers to people moving between jobs and therefore tends to be quite short term. The higher the welfare benefits the longer people are willing to spend searching for a job. Job centres and improvements in the flow of information are likely to reduce frictional unemployment as they make job searching easier.

Gross National Income

This differs slightly to GDP since it also includes income that is earned from abroad even though the goods and services were not created in the country. It also does not include those incomes which go to foreigners even though the goods/services may have been made in the country.

Human Poverty Index

This is based on four basic dimensions of human life: Longevity, knowledge, economic provisioning and social inclusion.

Cyclical unemployment

This is sometimes known as Demand-deficient unemployment occurs because the economy is not in a boom. Businesses shed jobs to try and cut costs because they are worried about the lack of demand for their products. Classical economists tend to believe that this is unlikely to happen in the long run. As demand falls, less labour is demanded by firms but this pushes down wage rates until firms decide to start hiring again. Keynes argued claiming that that sometimes the demand for labour could be too low for a long time. Wages would not fall as they are "sticky downwards". This means that people often work better when they are paid a higher wage so firms are reluctant to cut the wage rate. Instead they prefer making people unemployed or, more often, stop hiring leaving people unemployed.

Equilibrium

This is where there is no tendency for anything to change as everything is in balance with each other. The value of all the goods/services produced should equal the amount of money people are spending on those goods and services, which should equal total income.

Structural Unemployment

This occurs when people are made jobless because of 'capital-labour-substitution' Firms find that they can reduce costs be introducing new technology (e.g. robots in car manufactories that displace human labour). Equally firms may decide to outsource their works which are labour intensive to where labour costs are cheaper (e.g. call centres in India)

Gross Value Added (GVA).

To overcome the problem of double counting in the output method, economists use the concept of Gross Value Added (GVA). Rather than adding up the total value of every good and service they add up only the difference between the sales revenue received and the cost of materials used for each good.

GDP per capita equation

Total GDP/Population

Causes of unemployment

Voluntary unemployment Frictional unemployment Seasonal Unemployment Structural Unemployment Cyclical unemployment

Purchasing Power Parity

When an amount of one currency can be exchanged for an amount of foreign currency and the two amounts will buy identical baskets of goods.

Problem with the output method + example (calculating GDP)

When using the output approach it is important to avoid the problem of double counting. If you add the value of output from a paper mill and the value of output from a book publisher, the total would be too high since the value of the paper in the books is being counted twice.

Structural Unemployment.

Where labour require new skills and retraining in order to obtain work.

Why deficits on the current account may not be seen as a problem.

a. Deficit allows a country to consume cheaper imports thereby increasing their standard of living. b. Some of the deficit can be due to increased imports of new cheaper capital and technology which improve the productivity in the long run. c. Providing a country has a stable economy it is possible for it to finance the deficit with capital inflows. As long as foreigners are content that the value of sterling is reasonably stable they will continue to save their money in pounds by buying UK assets even if the interest rates remain low. In such conditions there is little fear that the foreigners will withdraw their funds.

Income

o A person's income is the money received for their labour (wages/profit) or as rent for land and capital over a period of time. (per year). It can also include interest payments from savings.

A person's wealth

o A person's wealth is everything that he or she owns that has value. This may include: financial assets (savings, shares, bonds & cash) and physical assets (house, car etc.)

An economy's wealth

o The wealth of the economy is its stock of assets at any given point in time. It includes the factors of production, namely: land, labour, capital & enterprise.

Advantages of HDI (3)

• It is a broader measure of economic progress than just real GDP per capita. This makes it more effective in measuring the standard of living. • It is useful for highlighting different levels of development between countries with similar levels of GDP per capita. • It is a useful way of gauging the success of government policies in achieving economic development.

The impact of migration on employment

• Many immigrants come having already attained a definite job. • Many immigrants can fill vacancies that cannot be filled by indigenous workers that may not have the right skills set. • Increased supply of labour should reduce the average wage. This should increase the demand for labour by firms. • The increased population size leads to increased spending; this in turn can create employment as firms need to expand to meet demand.

Problems with the Labour force survey

• This is based on the International Labour Organisation (ILO) definition that includes all people of working age who are without work during a period of time and available to start work in the next two weeks having sought work in the past four weeks.

Problems with the claimant count

• This is number of people claiming the Job Seekers Allowance (JSA). i. It may overstate the number of people unemployed because some people claim benefits but are not actually seeking work. ii. It may understate the number because there are those who are excluded from claiming benefits (under 18s or over 60's) who are actively seeking work.

Current account deficit

➢ A current account deficit means that more goods and services are entering the UK and more money is leaving.

Current account surplus

➢ A current account surplus means more goods & services are leaving the UK and more money is entering

How can an economy increase its productive potential?

➢ Government might subsidise research and development so that new technologies can facilities better quality machinery. ➢ Migration into the economy may improve the quantity and quality of the amount of labour available. ➢ Government spending on education can improve the quality of the labour force and the quantity of entrepreneurs.

How can injections and withdrawals be influenced by the government.

➢ Governments can decide to change their level spending and or alter taxation to manipulate the economy. This is known as fiscal policy. ➢ The government (through the bank of England) can also influence the rate of savings and investment through the altering the level of interest. This is known as monetary policy. ➢ Imports and exports can also be controlled by changing the exchange rates. This is known as exchange rate policy.

Examples of injections

➢ Investment, government spending and exports represent money entering the domestic economy. They are known as injections into the circular flow.

Examples of leakages/withdrawals

➢ Savings, taxes and imports represent money leaving the domestic economy - they are known as leakages/withdrawals from the circular flow