2.3 Macroeconomic Objectives: Inflation

Explain possible consequences of poverty, including low living standards, and lack of access to health care and education.

- low living standards - lack of acces to sufficient health care - low levels of education

Explain possible causes of poverty, including low incomes, unemployment and lack of human capital.

- one is born into a household of low income - one has received poor or no education - they may have suffered in terms of poor health care and malnutrition - they may have found it necessary to find work before completing education

Discuss the possible consequences of a high inflation rate

- redistributive effects. Creditors will lose out since the real value of the debt owed to them will fall, whilst debtors will gain since the real value of the debt they owe reduces. If IR on debt repayments does not vary flexibily with inflation then this will also favour debtors. - reduction of purchasing power: real incomes will fall if wages don't increase in line with inflation and people will be able to buy fewer goods and services. However, for those workers who have infation linked incomes this will be less significant, but if salaries are negotiated to increase by 2% (expected inflation rate) and the actual inflation rate is 3% then the living standards of these workers will be worse off. - less saving: it is possible that the real interest rate (nominal interest rate minus the rate of inflation) is negative. In this case it is better to spend money than put it in a savings account. In addition, consumers will feel prices are "cheap now" and so buy some white goods/big ticket items now rather than delaying. - damage to export (international) competitiveness: inflation which is higher than a country's trading partners will cause exports to be less price competitive. The value of the price elasticity of demand for exports will determine how significant this lack of price competitiveness is. Export values could significantly fall. Furthermore, imports will be more price competitive and import expenditure will rise, and the magnitiude will be determined by the price elasticity of demand for imports. - greater uncertainty: can lead to business investment plans being affected. Less investment may take place as businesses will be unsure of prices and costs. - labour unrest: disputes may arise if workers feel that their salaries are not keeping pace with inflation and their living standards are falling. Unions may get into difficult disputes with employers which could impact people significantly if national strikes take place.

Explain how the Gini coefficient is derived

A measure of statistical dispersion intended to represent the income or wealth distribution of a nation's residents, and is the most commonly used measure of inequality. The greater the coefficient, the greater the inequality. A / (A + B)

Explain the difference between equity in the distribution of income and equality in the distribution of income.

Equity means "fairness". Governments intervene to make the distribution of income fairer. Equality means that everyone would receive an identical income. This is not desirable since people would lose the incentive to work harder.

Distinguish between inflation, disinflation and deflation

Inflation: A sustained rise in the average price level. Disinflation: A fall in the rate of inflation. Prices are rising, but at a slower rate. Deflation: A sustained fall in the average price level. The inflation rate is a negative value. Governments aim for low and stable inflation, as high inflation and deflation are both very damaging. Some inflation is useful, as this allows firms to pass on increased costs in the form of higher prices.

Distinguish between progressive, regressive and proportional taxation, providing examples of each.

progressive - many countries use a progressive tax as the main way to redistribute income from higher income earners to low income earners, as progressive tax means that, as incomes rise, people pay a higher proportion of this income in taxes. Thus, a progressive tax takes larger percentages at higher incomes. regressive - if the proportion of income paid in tax (the average rate of tax) falls as income rises. Indirect taxes are regressive taxes. The tax is regressive because a higher proportion of income is paid to lower levels of income. proportional - if the proportion of income paid in tax is constant for all income levels. The same percentage of tax is paid at all levels of income. *complexity of most tax systems *gov may earn less revenue than expected as people find ways to avoid paying taxes *possible disincentive effects of taxes on working * high rates of taxes discourage people to work harder, as they will be reluctant to lose their own gains to igher taxes If taxes were to be constant, then this could be viewed as a supply-side policy to encourage greater incentives to work and therefore raise labour supply

Draw a Lorenz curve and explain its significance.

A Lorenz curve uses data gathered from surveys on household income and presents the information graphically. The vertical axis of the Lorenz Curve grap is "cumulative percentage of total population". The data can be graphed in deciles (equal groups of ten) or quintiles (equal groups of five). (A) = area between line of equality and Lorenz curve (A) + (B) = total area under line of equality The closer the the Lorenz curve is to the line of equality, the more equal the distribution of income.

Distinguish between absolute poverty and relative poverty.

Absolute poverty was defined by the United Nations as: a condition characterised by severe deprivation of basic human needs, including food, safe drinking water, sanitation facilities, health, shelter, education and information. It depends not only on income but also on access to services. Typically it is measured as people living on less than $1.25 a day. - - - - - - - - - - - - - - - - - Relative poverty: refers to a standard which is defined in terms of the society in which an individual lives and which therefore differs between countries and over time. An income-related example would be living on less than X% of average UK income. Typically it is measured as less than 60% or 50%.

Evaluate government policies to promote equity (taxation, government expenditure and transfer payments) in terms of their potential positive or negative effects on efficiency in the allocation of resources.

Advantages: - The very poor will be able to afford access to crucial resources, such as education and medical care, so the amount and quality of productive resources available to a country increases. etter education and health improves labour as productivity will be higher - The propensity of the poor to consume is higher than that of the rich so redistribution will increase AD, especially for basic goods and services - Social tensions will be lower. If people feel that they enjoy the fruits of economic growth then they will be willing to work harder and sacrifice more now in order for them or their children to enjoy more at a later date. They will be willing and able to save more, allowing higher rates of investment and so growth. Fewer social tensions decrease uncertainty and risks of domestic and foreign investors - Trust increases among the population so the cost of economic transactions decreases. More economic activity will take place so growth will accelerate. Disadvantages: Economists who support a new classical point of view tend to argue against the active role of government in redistributing income for the simple reason that it interferes with market forces and results in inefficiencies. As we know, this view argues that the optimal allocation of resources occurs in free markets and so government taxation must be kept to a minimum. - if firms have to pay insurance and social security costs for workers, then this will encourage firms to hire fewer workers, thus contributing to unemployment - high taxes in a country might discourage entrpreneurial activity and encourage entrepreneurs to leave a country in search of more favourable tax climates - high taxes have negative effects on overall growth in the economy due ot the disincentive effects mentioned earlier; lower taxes will encourage economic activityleading to an overall increase in output that will be to the beneift of all people - an excessively equal income distribution could lower economic efficiency. This is not to say that there is no role for government in an economy, and no reason for taxes to be collected. However, economists promoting a free market view might argue that tayes should be used to finance the obligations of the government to ensure property righrs, reduce the effects of market failure, provide an effective security and judicial system and promote competition, but taxations should not be used to redistribute income.

Define economic development

An improvement in quality of life and living standards, e.g. measures of literacy, life-expectancy and health care.

Describe, using an LRAS diagram, economic growth as an increase in potential output caused by factors including increases in the quantity and quality of resources, leading to a rightward shift of the LRAS curve

An increase in GDP as a result of the shift of the LRAS curve. LRAS shifts rightwards from LRAS1 to LRAS2 along the AD curve. With this shift, there is a decrease in the price level from P1 to P2 and an increase in output from Yf1 to Yf2

Define economic growth

An increase in real GDP

Describe, using a production possibilities curve (PPC) diagram, economic growth

An outward shift of the PPC can only be achieved if if there is an improvement in the quantity/quality of factors of production. A shift in the curve indicates an increase in the potential output. In order to however achieve an increase in the actual output, the current point of actual output would need to move towards the new PPC.

How are inflation and deflation typically measured?

By calculating a consumer price index (CPI), which measures the cost of living for the "average household". To measure the inflation, the CPI examines the consumer basket. This basket consists of all the goods an average househould purchases. To calculate the rate of inflation, the CPI measures changes in price of the basket. - Household surveys indicate the products that households spend their money on and the proportion of income spent on the products. - A "basket of goods" is chosen in which a number of products are entered. The products are adapted over time so that some products leave the basket and others join. - Price surveys are carried out to establish prices of the basket of goods across various locations within a country. - Theprice data is put into index form - The price data in the index is weighted according to the proportion of income which people spend on the products - Changes in the consumer price index are used to calculate the rate of inflation

Explain that different income earners may experience a different rate of inflation when their pattern of consumption is not accurately reflected by the CPI

Different income earners may experience a different rate of inflation when their pattern of consumption is not accurately reflected by the CPI. This is because the basket used to measure the CPI represents the purchasing habits of a "typical" household, while this is not applicable to all people (large family with children vs. eldery couple). If the national average is used as the basis for wage negotiations or pension changes then these may not accurately reflect the price changes for a particular group. Harmful if the group has a higher cost of living than suggested by the national average (reduction in standards of living) and beneficial for those whose spending costs are less than the average.

Distinguish between direct and indirect taxes, providing examples of each, and explain that direct taxes may be used as a mechanism to redistribute income.

Direct taxes are taxes on people's income or wealth (such as income tax and inheritance tax) and on company profits (corporation tax). Theoretically, these taxes are unavoidable since households and firms are required to declare their full income and profits. Direct taxes can be used to redistribute income by collecting tax revenue and allocating it to different segments of society - - - - - - - - - - - - - Indirect taxes are taxes on expenditure. When consumers buy a product they pay the tax to the seller and the seller then pays the tax to the government. These taxes are therefore said to be avoidable since consumers can choose whether or not to buy a product. Typically countries vary the rate of indirect tax on products, for example, necessity goods typically are charged a lower rate of indirect tax. Indirect and direct taxes can be placed into three different categories: Progressive taxes - as incomes rise, people pay a higher proportion of income in taxes. Regressive taxes - as incomes rise, people pay a smaller proportion of income in taxes. Proportional taxes - the proportion of income paid in tax is constant for all income levels.

Discuss the possible consequences of deflation

Economists generally view deflation as being more harmful than moderate/high inflation. - high levels of cyclical unemployment: if AD is low then business are likely to lay off workers, possibly leading to a deflationary spiral and collapse in consumer and business confidence. If prices are falling, consumers will put off the purchase of expensive durable goods as they will want to wait until the prices drop even further (deferred consumption), further reducing AD. If households become pessimistic about the economic future then consumer confidence will fall. Low consumer confidence is likely to fruther depress AD. - effect on investment and bankruptcies: when there is deflation, businesses make less profit, or make losses. This may lead them to lay off workers. Furthermore, business confidence is likely to be low and thus is likely to result in reduced investment. This has negative implications for future economic growth. In addition, if profits are low, this may make it difficult for businesses to pay back their loans and there may be many bankruptcies, further worsening business confidence. - debtors lose, creditors gain: Anyone who has taken a loan (including all homeowners who have taken a mortgage to buy their home) suffers as a result of deflation because the value of their debt rises as a result of deflation. Negative equity (when debt on house purchased is greater than value of house due to price falls) can have particularly detrimental effects on confidence since household wealth is undermined.

- LOW AND STABLE RATES OF INFLATION -

Goal of macro-economic policy. Developed countries tend to target around 2% inflation if target set by central bank, developing countries higher due to lower supply side constraints

Explain the term transfer payments, and provide examples, including old age pensions, unemployment benefits and child allowances.

Governments can use tax revenues to redistribute income and provide different types of assistance to groups in the economy to improve their living standards. While transfer payments are not included as income in national income accounting, because they do not represent payment for the production of a good or a service, they are payments made to increase the income of particular groups within the economy. (i.e. child support assistance, pensions, unemployment benefits, payments to disabled people and subsidies to producers).

Explain that governments undertake expenditures to provide directly, or to subsidize, a variety of socially desirable goods and services (including health care services, education, and infrastructure that includes sanitation and clean water supplies), thereby making them available to those on low incomes.

Governments use large amount of their taxation revenue to provide directly, or to subsidize, a number of goods and services that are socially desirable. These tend to be goods and services that have positive externalities of consumption. The provision is carried out to ensure that the porrermembers of the economy have access to essential goods and services and so leads to economic development.

Explain that due to unequal ownership of factors of production, the market system may not result in an equitable distribution of income.

Households hold factors of production to different degrees. For example, some people inherit properties worth millions while others do not inherit any property. Consequently, some people can gain from rental income for renting out their properties while others do not receive any rental income, thereby not resulting in an equitable distribution of income.

Explain an inflationary spiral

If we assume the economy is near full employment then the increase in AD results in an increase in demand-pull inflation as the price level rises from P1 to P2.The higher price means that costs of production rise. Additionally, this increase in price level causes workers to negotiate for higher wages and this further increses the costs of production. There will also be a shift in SRAS from SRAS1 to SRAS2 as a result of cost-push pressures. This is the movement (2). The cycle will not necessarily stop here. Higher wages may give househoulds the illusion that they have more spending power, encouraging further increases in consumption shown as another increase in AD to AD3 and the movement (3).

Explain the importance of investment for economic growth, referring to investment in physical capital, human capital and natural capital

In the long run, economic growth is achieved when the economy experiences improved productivity as improved productvity means greater output per unit worker. For such productivity gains to be achieved, investments in natural capital, physical capital and human capital are prerequisites. natural capital: i.e. timber - replacing physical capital: better technology and machinery human capital: training and education

What are the redistributive effects of a high inflation rate?

Inflation is good for borrowers and bad for lenders because it reduces the value of the money paid back to the lenders. The inflation rate is built in to the nominal interest rate, which is the sum of the real interest rate and expected inflation. When the inflation rate rises or falls unexpectedly, wealth is redistributed between creditors and debtors. In general, this means that those with savings in the form of currency or bonds lose money from inflation. Those with negative savings (debt) or savings in the form of stocks, however, are better off with higher inflation.

List the five macroeconomic objectives

Low unemployment, low and stable rate of inflation, sustainable economic growth, balance of payments balance over time, and equity in the distribution of income

CAUSE FOR INFLATION: Explain, using a diagram, that cost-push inflation is caused by an increase in the costs of factors of production, resulting in a decrease in SRAS

Occurs as a result of an increase in the costs of production - a fall in SRAS, resulting in an increase in the average price level and a fall in the level of real output. Examples: - The oil price rises - Wage rises - Domestic or imported raw materials rise in price - Domestic or imported capital goods rise in price

Discuss the possible consequences of economic growth, including the possible impacts on living standards, unemployment, inflation, the distribution of income, the current account of the balance of payments and sustainability

Positive consequences Over time, with increased population size and increased incomes aggregate demand will grow. This can generate inflation, which would be a negative point, but if accompanied by an increase in LRAS economies can experience non-inflationary growth. Supply-side policies can result in lower unemployment and downward pressure on inflation. If economic growth causes GDP per capita to increase, then the income of the average person will increase and it can be assumed living standards will rise. Growth can arise from advances in technology, but can also lead to advances in technology. These can lead to higher living standards, eg, healthcare, transport, communication. Increased incomes over time are likely to lead to increased tax revenues for governments. This enables more funds to be allocated to merit and public goods which will improve living standards. Tax systems can redistribute income and reduce inequality. Growth that arises from increased productivity can lead to increased competitiveness of a country's exports. This will further increase aggregate demand. However, people will likely demand more imports and so the final impact on net exports is unknown. It is argued that growth leads to higher levels of education and therefore human capital, and that this leads to demands for more freedom and democracy. Negative Consequences Increased income does not equal increased happiness. Therefore the belief that increased incomes leads to increased living standards must be questioned. For example, leisure time may be sacrificed and people may live with more pollution such as in China. The very fact that people have increased incomes enabling them to purchase more may actually result in them never being satisfied with the quantity of goods and services that they are able to buy. Not every citizen benefits to the same extent from a country's growth and some people can be worse off - for example, structural unemployment can result from an economy moving its output towards the tertiary sector and away from the secondary sector. Environmental impacts of growth - negative externalities of production and the depletion of non-renewable resources. Growth may therefore arise but sustainable development will not be achieved.

Explain that economists measure a core/underlying rate of inflation to eliminate the effect of sudden swings in the prices of food and oil, for example

Prices may change for a variety of reasons that are not sustained. - i.e. seasonal variations in the prices of food and volatile oil prices may lead to unusual movements in the inflation rate and can be misleading even if accurate in the SR. Thus, statisticians attempt to reduce such distoring effects by identifying a "core" rate of inflation that uses the information of the consumer price index but excludes food and energy prices.

Explain that a producer price index measuring changes in the prices of factors of production may be useful in predicting future inflation

Producer Price Index (PPI) is a weighted index of prices measured at the wholesale, or producer level (tracks the prices of goods as they leave the factories and before distributors, wholesalers or retailers add their profit margins). When using this index to measure changes in the prices of factors of production, future inflation can be predicted. The PPI looks at three areas of production: industry-based, commodity-based and commodity-based final demand-intermediate demand. Upward movements in commodity prices are signals of cost-push pressures and may be a leading indicators (indicators which predict that a change will occur in the future) of inflation.

Explain that inflation figures may not accurately reflect changes in consumption patterns and the quality of the products purchased

Statisticians try to take into account changes in consumption habits by making changes to the basket. If the items in the basket are changed, then this limits the ability of analysts to make comparisons from one time period to another. This is complication by the fact that the quality of goods changes over time. - i.e. when a computer company upgrades a computer (change in product), then the quality of the product improves. The price of the computer may rise to reflect the improvement, however it will feed into a higher rate of inflation.

Evaluate government policies to deal with the different types of inflation

The policies used depend on the type of inflation. Given that demand-pull inflation is due to excess AD, then an appropriate policy would be to reduce AD through the deflationary fiscal policy (increase taxes and lower government spending) an/or deflationary monetary policy (raise interest rates and reduce the money supply). Such contractionary policies come with various problems. From a political view, they are highly unpopular. Fiscal policy, a voting population is unlikely to be happy to accept higher taxes as it reduces disposable income and the level of consumption. A reduction in gov. spending will inevitably impact upon a variety of groups in the economy and this may result in less support for the government. It is time consuming for a gov. to bring about a change in its fiscal policy. Budgets are developed over a long period and changes need to go through lengthy legislative procedures where there may be great opposition to any budget cuts. Therefore, there would be a long time lag involved. Regarding the monetary policy, higher interest rates will also harm some people in the economy, most obviously anybody who has taken a loan/mortage. Higher interest rates mean higher loan and mortage repayments and will therefore be unpopular. A government that intends to be reelected will be reluctant to these methods to fight inflation. However, the monetary policy is carried out by central banks (mostly an independent body whose main goal is the maintenenace of low and stable rates of inflation). Targeting inflation (a central banking policy that revolves around meeting preset, publicly displayed targets for the annual rate of inflation), whether explicitly or implicitly, is beneficial as it results in a reduction in inflationary expectations. The target acts as an anchor, holding down inflationary pressure (however, people must have faith in central bank's ability to contain inflation). If they do not expect higher inflation, then they will not make demands for increases in wages any higher than the expected rate of inflation and this will keep the costs of labour from rising excessively. This suppresses cost-push inflationary pressure. The more independent the central bank, the more likely that price stability will be maintained. If inflation is rising or inflationary pressures are building up, then a way to bring these down would be to raise interest rates. While a government would be reluctant to keep very close watch on signs of inflation, the central bank can make the politically unpopular decision because it does not have to worry about being re-elected. Nowadays, monetary policy is considered to be the most effective way of managing AD in the economy and changes in interest rates are considered the best weapon in the fight against inflation. Fiscal policy is not seen to be as effective as monetary policy in battling inflation. It would be very difficult for governments to reduce their spending because of their commitments to the public. Moreover, even if governments could reduce their spending, it would take a long time for the cuts to have any effect on the price level . If inflation is of a cost-push nature, then deflationary demand-side policies may bring down the price level, but they will result in lower national output and are likely to cause unemployment to rise. Thus, demand-side policies are ineffective and supply-side policies are the appropriate policies to deal with cost-push inflation. However, as you might predict, when inflation does occur, it is difficult to distinguish the demand-pull from the cost-push factors and so policy-makers are likely to use a mix of solutions. For monetarists who believe that inflation is caused by excessive growth of the money supply, then the solution is plain. The money supply should only increase by the same amount as the real increase in national output. If national output is growing by 3%, then the money supply should also grow by 3%. If more money is supplied, the economy willface a situation where there is too much money chasing too few goods and so prices will rise to ration the output. It is difficult for governments and/or central banks to control the actual money supply in the economy. A significant problem facing governments is the possible trade-off between their different policy objectives. They may want to fight inflation by bringing about a decrease in AD, but this might result in a higher level of unemployment. If they try to fight unemployment and increase economic output (achieve economic growth) by increasing AD, it might create inflationary pressure. Generally, elected governments may not have the long term interests of the economy at heart and might make fiscally irresponsible decisions to maintain popularity. Therefore, responsibility for managing AD might be best left with the automatic stabilizers of fiscal policy and the careful changes in monetary policy carried out by an independent central bank.

CAUSE FOR INFLATION: Explain, using a diagram, that demand-pull inflation is caused by changes in the determinants of AD, resulting in an increase in AD

When AD rises as a result of one or more of the components of AD rising. Average price level is "pulled up" from P1 - P2 Examples: - a positive wealth effect as a result of rising house prices could cause consumption to rise - a rise in business confidence could cause investment in capital goods to rise - a rise in government spending on roads would cause government spending to rise - a rise in exports would cause net exports to rise

Describe, using a PPC diagram, economic growth as an increase in production possibilities caused by factors including increases in the quantity and quality of the factors of production, leading to outward PPC shifts

long term - the increase in economic growth arises from an increase in the quantity or quality of factors of production and may result from fovernment supply side policies (interventionist or market based)