Chapter 4: Aggreagte demand and aggregate supply and their interaction

First chapter of part 2 of the book: A study of the whole economy. The nature of that aggregate demandand aggregate supply and how they interact to affect output, unemplyment and inflation.

Aggregate demand(AD): total demand for a contry's goods and services at a given price level and in a given time period.

Calculate AD: C + I + G + (X – M)

The components of aggregate demand

C = Consumer expenditure:

• Real disposable income

• Wealth

• Confidence and expectations

• The rate of interest

• Age

• Distribution of income(give from the rich too the poor, bcause poor spend a higher%)

• Inflation

(Saving:(stop buying things)

• Real distposable income(higher income=higher savings)

• The rate of intrest

• Confidence and expectations about the feature

• Savings schemes(contractual)

• Range of financial institutions(put their money somewhere to save them)

• Government policies(tax free schemes?)

• Age)

I = Investment: (from companyes when:)

• Changes in real distposable income(increasing → demand for goods/services increases)

• Expectations, feel optimistic

• Capacity utilisation: the extent to which firms are using their capital goods

• Current profit levels: provide the finance to invest or contribute to firms optimism about feature.

• Corporation tax: tax on a firms profit

• The rate of interest

• Advances in technology: unit cost would fall.

• Price of capital equipment, reduction in the price of.... → more money to expand their capacity

G = Government spending:

• War, terrorists etc, can increase government spending

• Voters pressure on the government to spend money on health, education transport

• Level of economic activity in the economy, high unemplyment → G rise its spending

• Governments view on the extent of market failure and its ability to correct it

(X – M)= Net Exports

• Real disposable income abroad

• Real disposable income at home

• The domestic price level. Value of export might be higher than imports and vise verca.

• The exchange rate: price of one currency in terms of another currency

• Government restictions on free trade. Tariff: A tax on imports.

The realationship between aggregate demand and the price level

AD is inversely related to the price level. A rse in the price level causes a fall, contraction, in aggregate demand and a fall in the price level results in a rise or extension, in aggregate demand.

AD is downward sloping:

1. The wealth effect

2. The rate of intrest effect

3. The international trade effect

Aggregate supply: AS: The total amount that producers in an economy are willing and able to supply at a given price level in a given time period.

Shifts in the AS curve

• Main cause- short run: Change in the costs of production

• Main cause- long run: Productive capacity: Changes in the quantitu and quality of resources.

Def:

Productivity: Output/production, of a good or service per worker per unit of a factor of production in a given time peroid.

Privatisation: Transfer of assets from the public to the privvate sector.

Macroeconomic equilibrium: A situaton where AD equals AS and real GDP is not changing.

(Real GDP:the contry's output measured in constant prices and so adjusted for inflation.

Demand pull: AD shift to the right

Cost push: AS shift to the left

The circular flow of income: Movement of spending and income throughout the economy.

Income earned by households is spendt on buying goods/services from firms. Or going to:

Leakages: (withdrawals of possible spending from the circular flow of income) Savings, imports and taxes.

Firms use on production and:

Injections: additions of extra spending into the circular flow of income: Investment, government spending and exports.

The multiplier effect: The process by which any change in a component of aggregate demand results in a greater final change in real GDP.

Changes in AD:

Effected by the output of an economy, unemplyment and inflation:

• the size of the intial change

• the size of the multiplier

• the orginal level of economic activity.

Changes in AS:

Depend on the size of the change and the initial level of economic activity. An increase in AS occourring when the economy is at, or close to full capacity will raise the output of the economy and lower the price level. Rises mainly due to advances in technology and improved education.

Changes in AD and AS

AD grows more rapidly than the growth in productive capacity → inflation.

Overheating: The growth in AD outstripping the growth in AS, resulting in inflation.

Output gap

def: The difference between an economy's actual and potential real GDP. (when an economy is not producing at full capacity.)

Trend growth: The expected increase in potential output over time.

Chapter 5. Government economic policy objectives and indicators of national economic performance

Key performance indicators:

Economic growth: in the short run, an increase in real GDP, and in the long run, an increase in productive capacity, that is, in maximum output that the economy can produce

Unemployment: A situation where people are out of work but are willing and able to work

Labour force: The people who are employed and unemployed, that is, those who are economically inactive

Economically inactive: People of working ago who are neither employed nor unemployed

Inflation: A sustained rise in the price level; the percentage increase in the price level over a period of time.

Hyperinflation: an inflation rate above 50 per cent.

Deflation: A sustained fall in the general price.

Balance of payment: a record of money flows coming in and going out of a country.

Distributed income: Government will redistribute, and taxing the rich and providing state benefits for the poor → Stability

Promote economic stability: fluctuations in output, employment, and inflation → Long term growth potential in the economy.

Current trends:

UK: Economic growth by combining low unemployment and stable inflation → UK's AS curve is more elastic. Can improve by:

• Better transport infrastructure

• Higher economic activity rate

• Better education

• Higher productivity

• More spending on research

• Development and more innovation

Inflation rates fallen and stays low:

• governments monetary policy

• Strong pound

• Competitions → push firms to keep cost and price low

• Technology

• Immigration of workers

Elastic: Responsive to a change in market conditions.

Inflation rate: The percentage increase in the price level over a period of time.

Objectives of government economic policy:

1. Economic growth:

   Sustainable economic growth: Economic growth that can continue over time and does not endanger future generations' ability to expand productive capacity.

   Trend growth: The expected increase in potential output over time. It is a measure of how fast the economy can grow without generating inflation.

2. Employment and unemployment

   Full employment: A situation where those wanting and able to work can find employment at the going wage rate

3. Inflation: a low and consistent rate of inflation

4. Balance of payment:

   Current account deficit: When more money is leaving the country than entering it, as a result of sales of its exports, income and current transfers from abroad being less imports and income and current transfers going abroad.

5. Economic stability: Unstable → Under perform in terms of economic growth.

6. Income redistribution: Taxing rich people and give benefits for the poor people.

GDP and real GDP

GDP: (Gross domestic product) The total output of goods and services produced in a country.
Real GDP: The contras output measured in constant prices and so adjusted for inflation.

Nominal GDP: output measured in current prices and so not adjusted for inflation

Calculate: Difference in output from last year to this year/Last year output x 100%

Measuring economic growth:

Percentage change in real GDP(change in a countrys output)

Production and productivity:

Labour productivity: Output per worker

Difficulties in interpreting changes in Real GDP:

• Rise In population → rise in output.

Informal economy: Economic activity that is not recorded or registered with the authorities in order to avoid paying tax or complying with regulations, or because the activity is illegal.

Economy of scale: The advantage of producing on large scale, in the form of lower long-run average cost.

Measuring unemployment

Unemployment rate: The percentage of the labour force who are out of work:

Calculation: Th eUnemployed x 100% / labour force

Labour force survey: a measure of unemployment based on a survey using the ILO definition of unemployment.

International labour organisation(ILO) A member organisations of the United Nations that collects statistics on labour market conditions and seeks to improve working conditions.

Claimant count: A measure of unemployment that includes those received unemployment-related benefits.

Measuring inflation:

Consumer prices index: A measure of changes in the price of a representative basket of consumer goods and services. Differs from the retail prices index (RPI) in methodology and coverage.

Calc figures into index numbers: Actual figure(of product) x 100 / Base year figure

The CPI and other measured of inflation

Retail prices index(RPI): Measure of inflation that is used for adjusting pensions and other benefits to take account of changes in inflation and frequently used in wage negotiations. Differs from the consumer prices index(CPI) in methodology and coverage.

The structure of the current account of the balance of payments

• The current account: Trade of goods&services, (investment-)income and transfers of money.

• The capital and financial accounts: movement of direct investment.

• Net errors and omissions: info to ensure that the balance of payments does balance.

Causes of economic growth:

• Increase in AD

• A cut in income tax

• A rise in consumer confidence

• Increase in government spending or net investment

The causes of unemployment

• Cyclical unemployment: Unemployment arising from a lack of aggregate demand.

• Structural unemployment: unemployment caused by the dicline of certain industries and occupations due to changes in demand and supply.

• Frictional unemployment: Short term unemployment occourinwhen workers are in-between jobs.

The causes of inflation:

Demand-pull inflation: increases in the price level caused by increases in AD

Cost-push inflation: Increases in the price level caused by increases in the cost of production.

The consequences of unemployment

• Lost output

• Lost tax revenue

• Government spending on unemployment benefits

• Pressure on other forms of government spending

• Cost to the unemployed

• Hysteresis(unemployed causing unemployment)

Long-term unemployment: Unemployment lasting for more than a year.

The benefits of unemployment

• Give people time to a more rewarding job

• Easier for firms that wants to expand

• Reduce demand-pull and cost-push inflation

The consequences of inflation

• Fall in the value of money

• Menu costs: Cost of changing prices due to inflation

• Shoeleather costs: Costs in term of the extra time and effort involved in reducing money holdings

• Administrative costs

• Inflationary noise: The distortion of price signals caused by inflation.

• Random redistribution of income: Real intrest rate: nominal intrest rate – inflation rate.

• Fiscal drag: Peoples income being dragged into higher tax bands as a result of tax brackets not being adjusted in line with inflation

• Uncertainty

• Inflation causing inflation

• Loss of international competitiveness

The benefits of inflation:

• Encourage firms to increase output

• Psychologically, we feel better when out income increase even if this is mating with the prices.

• Market operate more efficiently and reduce unemployment

Deflation:

• Country's competitiveness will increase

• Can lead to higher unemployment

The benefits of economic growth:

Def:

International Monetary Fund(IMF) An international organisation that helps co-ordinate the international monetary system.

Word Trade Organisation (WTO): An international organisation that promotes free international trade and rules on international trade disputes.

Determination of exchange rates:

Def:
Exchange rate: The price of one currency in terms of another currency or currencies.

Monetary Policy Committee (MPC) A committee of the Bank of England with responsibility for setting the interest rate in order to meet the governments inflation target.

Chapter 6: The application of macroeconomic policy instruments and the international economy

The government use three main economic policies:

• Fiscal policy: the taxation and spending decisions of a governments

• Monetary policy: central bank, and/or government decisions on the rate of interest, the money supply and the exchange rate.

• Supply-side policies: policies designed to increase AS by improving the efficiency of labour and product markets.

To influence economic activity and to achieve their macroeconomic policy objectives.

Fiscal policy(supply side policies)

The government affecting AD.

Eg:Rise AD by increasing its own spending/reducing taxes= Reflationary: :of policy measures designed to increase aggregate demand. Deflationary(det motsatte) of policy measures designed to reduce aggregate demand) & Multiply effect.

The nature of fiscal policy

government try to stabilise and make AD match AS, this is called “acting counter-cyclically. The G is seeking this, by offsetting changes in private sector spending by:

• Discretionary fiscal policy: deliberate changes in government spending and taxation designed to influence AD

• Automatic stabilisers: forms of government spending and taxation that change automatically to offset fluctuations in economic activity

Economic cycle: the tendency for economic activity to fluctuate outside its trend growth rate, moving from a high level of economic activity(boom) to negative economic growth(recession)

Types of taxes

• Progressive tax: a tax that takes a higher percentage from the income of the rich

• Regressive tax: a tax that takes a greater percentage from the income of the poor.

Government spending: (divided into:)

• capital expenditure(roads, hospitals, schools etc.)

• current spending(public services)

• transfer payments(money transferred from taxpayers to recipients of benefits)

• debt interest payments (to the holders of government debt)

The budget

Shows the relationship between government spending and tax revenue.

Def: Recession: A fall in real GDP over a period of six months or more.

+

Monetary policy: (supply side policies)

The rate of interest, the money supply and the exchange rate.

Eg: A rise in interest rate → decrease AD, by reducing consumption investment and export – imports.

Changes in the money supply and interest rates are inversely related. A rise in money supply, reduces the interest rate.

The monetary policy committee(MPC) of the bank of England sets rates in the UK.

=

Trying to increase AS

Supply-side policies

Policies seek to increase or decrease AD depending on the level of economic activity.

Examples:

• Education and training

• Government assistance to new firms

• Reduction in direct taxes

• National minimum wage(NMW)

• Reduction in unemployment benefit

• Reduction in other benefits

• Reduction in trade union power

• Privatisation

• Deregulation

Policies to reduce unemployment

Demand-side policies

Supply-side policies

Policies to promote economy growth

Short run:

• Lower rate of interest is likely to stimulate consumption and investment

• Higher investment will increase AS

• Increase government spending

Long run:

• Quality and or quantity of resources

• Human capital: Education, training and experience that a worker, or a group of workers, possesses.

Stable growth

Actual growth to match trend growth and for that trend growth to rise over time.

Policies to improve the balance of payments

Short run:(concentrated on the demand side)

Government try to raise export revenue/reduce import expenditure to correct a current account deficit: Causing a fall in the exchange rate, reducing demand for all products whatever their source and specifically reducing demand for imports.

• Exchange rate adjustments: Exchange rate to be on a current level with other country's.

• Deflationary demand management: Reduce government spending, higher taxes, etc.

• Import restrictions: Reduce expenditure on imports by composing import restrictions including:
  Tariffs: A tax on imports

  Quota: A limit on imports

Long run(concentrated on the supply side):

Lack of quantity competitiveness, low labour productivity or high inflation, then reducing the value of the currency deflationary demand-side policy instruments and import restrictions

Current account surplus: when more money is leaving the country than entering it, as a result of its exports, income and current transfers from abroad being less than imports,income and current transfers going abroad.

Effectiveness of ficial policy: Drawbacks:

• government spending and tax rates take time to have an effect on the economy, it can also take time to recognise the need for a change in policy and to gether the information on which to base the change.

• Time lag between introducing a fiscal policy instrument and that instrument having an impact on the economy. Eg: Income tax in changes , households take some time to adjust their spending.

• Forms of government spending are inflexible. Difficult to cut spending on health care and pensions.

The effectiveness of monetary policy:

• The effects of monetary policy tend to be more concentrated on certain groups than do changes in income tax for example.

• Limit with using interest rate changes is that when the interest rate falls to very low levels, a further cut is likely to be ineffective in stimulating activity.

• ?: Extend AD → change in response to interest rate changes.

The effectiveness of supply-side policies

• Increasing the productive potential of an economy on its own, will not be sufficient in raising economic performance if there is a lack of AD.

• Eg: Spending on education → long time to have an effect

Possible conflicts between policy objectives:

Economic growth and low unemployment may benefit from expansionary demand-side policy measures, but this will make it more difficult for a government to achieve low inflation and satisfactory balance of payments position.

• Interest rate

Advantages that may be gained from international trade

• Enables the country to specialise as the products it does not produce it can import

• Lower prices and higher quality that results from the higher level of competition that arises from countries trading internationally

• Enjoy a greater variety of products, including a few not made in the country.

Methods of protection:
Def: Protectionism: The protection of domestic industries from foreign competition.

• Tariffs: a tax on import

• Quotas: a limit on imports

• Voluntary export restraint(REV) A limit placed on imports from a country with the agreement of that country's government.

• Foreign exchange restrictions: Seek to reduce imports by limiting the amount of foreign exchange made available to those wishing to buy imported foods and services or invest , travel abroad

• Embargoes: Ban on the export or import of a product and/or a ban on trade with a particular country.

• Redtape: Time-delaying customs procedures may be used to discourage imports

• Etc.....