Revision Sheets. AS Economics National Economy in a Global Context. Revision Sheets

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1 AS Economics National Economy in a Global Context

2 Macroeconomic Objectives Low unemployment Improve external performance Objectives of government economic policy Actual Growth Price Stability Income Distribution There are two types of economist, Keynesian and Monetarist. Keynesians would rank the objectives in the order: 1. Low Unemployment 2. Actual Growth 3. Income Distribution 4. Price Stability 5. Improve External Performance Monetarists would start with Price Stability and work around it

3 Macroeconomic Objectives These objectives are measured with four macroeconomic indicators: Unemployment Inflation Balance of Payments Growth As with all government intervention, there are conflicting objectives. In the Short Run, some of these objectives are mutually exclusive. The Phillips Curve, for instance, outlines the trade-off between unemployment and inflation. There are different ways to measure the size or success of an economy, with GDP being the most common. GDP stands for Gross Domestic Product, it is the value of output of a country (i.e. the final goods and services produced by the factors of production over a specific period). It is measured within the geographical output of a country. GDP per capita = GDP/ Population Real GDP = GDP Inflation This works in theory, but in practice there are several challenges to using GDP. Time: Prices can go up and down with inflation/deflation There can be time lags in collecting data Problems of comparison Exchange rate movements can occur Financial Infrastructure for data collection Some countries may lack the stability and infrastructure for accurate data

4 Macroeconomic Objectives Black Economy (unrecovered) Work carried out under the radar, where transactions are not declared. Sustenance/ DIY/ Bartering Goods and services exchanged without money. Income Distribution No reflection of how income is shared around the country. PPP Purchasing Power Parity Circular Flow of Income The circular flow of income is a model of the economy in which the major exchanges are represented as flows of money, goods and services, etc. between economic agents. Injections Government Spending, Investment, Exports Household Leakages Taxation, Savings, Imports Goods & Services Wages, Rent & Dividends Consumption Expenditure Firm Factors of Production

5 Inflation Inflation is a persistent rise in the general level of prices over time. It is a macroeconomic indicator Inflation is measured using the Retail Price Index, or the Consumer Price Index. Both are surveys that analyse how much prices have risen across a standard set of goods and services. Retail Price Index (RPI) Basket of 670 goods and services A market research company conducts a survey each month Analyses prices over 12 months to reach an inflationary rate The goods and services included change over time with consumer tastes and preferences Different goods and services are weighted to give a more realistic impression of average household costs. Consumer Price Index (CPI) Includes a wider section of the population than the RPI Does not include council tax and other housing payments Inflation will always appear lower in the CPI than the RPI Generally preferred by governments Demand Pull Inflation Occurs when total demand for goods and services exceeds total supply Happens when there has been excessive growth in AD Or when current growth exceeds trend growth

6 Inflation Cost Push Inflation Occurs when firms increase prices to maintain or protect profit margins after experiencing a rise in costs Growth in labour costs Rising input costs Increases in indirect taxes Higher import prices Policies to Control Inflation: G T R I + C Costs and Effects of Inflation: 1. Inefficient allocation of resources 2. Effect on UK Competitiveness 3. Wage Price Spiral 4. Reduction in the real value of savings 5. Disruption of business planning 6. Higher interest rates needed

7 Fiscal Policy Fiscal Policy involves the use of taxation and government spending to achieve economic objectives. GDP The aim is to reduce the output gap Time An expansionary fiscal policy is where the government runs a budget deficit G > T AD An contractionary fiscal policy is where the government runs a budget surplus T > G AD An loosening of fiscal policy involves cutting Tax or raising Government Spending G T An tightening of fiscal policy involves cutting Government Spending or raising Tax G T

8 Exchange Rates The Exchange Rate is the price of one currency in terms of another. If the currency depreciates then the pound reduces value relative to other currencies. Imports become more expensive Exports become cheaper If the currency appreciates then the pound reduces value relative to other currencies Imports become cheaper Exports become more expensive

9 Monetary Policy Monetary policy is the macroeconomic policy laid down by the central bank. It involves management of money supply and interest rate and is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption and growth. Tools include: Interest Rates The Money Supply The Exchange Rate If a government pursues an Expansionary Monetary Policy (Loose): Low interest rates Money supply allowed to grow Weak exchange rate If a government pursues an Contractionary Monetary Policy (Tight): High interest rates Restricted money supply Strong exchange rate

10 Unemployment Unemployment is the measure of people of working age and ability, but not currently in employment. It is measured in a couple of ways: The Claimant Count is a survey identifying the number of people claiming unemployment related benefits. It is a monthly count of the unemployed. The Labour Force Survey (LFS) is a measurement of people who have actively sought work in the past four weeks, and are able to start in the next two. It is an internationally recognised measurement of unemployment, and has a higher figure than the claimant count. There are four key types of unemployment: Cyclical Seasonal Structural Frictional Unemployment has a variety of consequences, such as: Lack of demand for goods and services Government spending on welfare benefits Loss of skills from the workforce Reduction in revenue from income tax Lead to larger budget deficit

11 Aggregate Demand Aggregate Demand is defined as the total spending on goods and services in an economy over a given time. It is calculated with the following formula: AD = C + I + G + (X M) where: C illustrates Consumer Spending I illustrates Investment G illustrates Government Spending X M illustrates Exports minus Imports General Price Level AD1 AD 0 National Output

12 Aggregate Demand The Aggregate Demand (AD) curve measures the relationship between national output and general price level. The curve slopes downwards, so a rise in price will lead to a fall in total demand for goods and services. Factors causing the AD curve to shift: Event AD Shift Explanation Rise in injections (C, G, I or X) Right Injection Income tax cut Right Increase disposable income Interest rate rise Left More people save An increase in budget deficit Right G increases Stronger pound Left M is more expensive, (X-M) falls Increase in general price level No shift Price causes a movement not a shift Rise in imports Left Withdrawal A closed economy means there is no international trade. Monetary Accommodation means to increase money supply in line with output in the economy.

13 Aggregate Supply Aggregate Supply (AS) is the total supply of goods and services that firms in a national economy sell during a specific time period. Price LRAS SRAS LRAS = Long Run Aggregate Supply SRAS = Short Run Aggregate Supply National Output LRAS LRAS Price A shift in the LRAS to the right could be caused by: An increase in the capital stock An increase in productivity A decrease in production costs A reduction in the price of oil National Output Price LRAS LRAS A shift in the LRAS to the left could be caused by: A decrease in the capital stock An decrease in productivity Major natural disaster An increase in the price of oil Increased production costs National Output

14 Multiplier Effect The multiplier is defined as the ratio of the change in national income to the change in expenditure that brought it about. External Effects Money In Desired Effect Adds to GDP Example: Investment in a firm on new machinery 100 Million This raises company income by 100 Million This income will be used in future spending and investing Adding to the GDP effects Aggregate Demand = Total Market Demand AD = Consumer Spending + Investment

15 Government Spending The Public Sector Net Cash Requirement (PSNCR) is the amount the government has to borrow to balance budget and receipts. The National Debt is the accumulation of the PSNCR each year. The Laffer Curve Maximum Revenue Equilibrium Revenue No Revenue 0% Tax Rates 100% The Laffer curve demonstrates how maximum revenue is not reached by maximum tax rates. The incentive to produce economically is higher with tax rates, so more money is made. The optimum level of revenue is gained when the incentive to be economically active and a reasonable tax rate are met.

16 Government Spending Government spending is exogenously determined, i.e. it is based on political decisions outside of the AD model. The Chancellor of the Exchequer outlines his/her spending plans several years in advance. AD = C + I + G + (X - M) G does not include transfer payments, e.g. contributions to the EU budget, overseas aid, welfare benefits or student grants because there is no corresponding output in the economy. Government Spending is determined by a variety of factors: National Income (Real GDP) Fall in real GDP = More G Stimulate economic activity Tax Revenue GDP Growth = Higher growth = Moves to higher tax brackets = More tax revenue Demographic Change Older People More money needed on healthcare Demand for merit and demerit goods Technology As technology progresses New spending is needed

17 Investment & Current Account Investment is the production of items that are not for immediate consumption or purchase by the firm of equipment or materials that will add to its stock of capital. Autonomous Investment is investment that is unrelated to the level of national income. Motivations for Investment: Higher profits Increased productive capacity Improved productive efficiency Economics of Scale (LRAC) Creating a barrier to entry Enhanced technology to remain competitive The opportunity cost of capital investment is effectively the interest rate. It is the interest you would have gained if you left your money in the bank. The Current Account records the flow of money between countries, not the movement of goods and services. The two main elements of the current account are: Trade in goods section (Visible Balance) Trade in services section (Invisible Balance) It also includes Transfers and International Flows of Wages, Interest, Profit and Dividends.

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