Flashcards · 7136 · Topic 2

The national and international economy flashcards

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3.2.1 The measurement of macroeconomic performance

The four main macroeconomic objectives: Economic growth, price stability (low and stable inflation), minimising unemployment, and a stable balance of payments on current account. Others: balancing the budget and a more equitable income distribution; their importance changes over time.
Match each indicator to its objective: Real GDP and real GDP per capita: growth and living standards. CPI and RPI: price stability. Unemployment measures: unemployment. Current account balance: external balance. Productivity: efficiency of resource use.
A price index rises from 100 to 108. What does that mean?: Prices have risen by 8% relative to the base year (8 ÷ 100 × 100). An index number is relative, not an absolute value.
Features of a price index such as CPI: A base year set to 100, a basket of goods and services representing typical household spending, and weights reflecting each item's share of spending.
An index goes from 104.0 to 106.6. Inflation rate?: (106.6 − 104.0) ÷ 104.0 × 100 = 2.5%. Divide by the old index, not 100, unless the old value is 100.
Real GDP vs nominal GDP, and real GDP per capita: Real GDP is adjusted for inflation (measured at constant prices); nominal is at current prices. Real GDP per capita = real GDP ÷ population, a broad living-standards indicator.
Limits of national income data as a measure of living standards: It ignores the distribution of income, the informal (hidden) economy, externalities such as pollution, and non-marketed activity such as unpaid work.
Why use purchasing power parity (PPP) for international comparisons?: PPP exchange rates adjust for differences in the cost of living, so they show what income can actually buy. Market exchange rates do not.

3.2.2 How the macroeconomy works: the circular flow of income, aggregate demand/aggregate supply analysis and related concepts

Injections and withdrawals in the circular flow: Injections: investment, government spending, exports. Withdrawals: saving, taxation, imports.
Equilibrium national income (circular flow): Planned injections equal planned withdrawals, so the flow is steady and income is not changing.
Full employment income: Income when every available resource is in use. Equilibrium can settle below it (spare capacity). Spending that pushes demand beyond it cannot raise real output further, so it puts pressure on prices.
Aggregate demand and its components: Spending plans for the whole economy's output at each possible price level. AD = C + I + G + (X − M).
Determinants of consumption and investment: Consumption: income, interest rates, wealth, confidence, availability of credit. Investment: expected demand (the accelerator), interest rates, business confidence, technology, availability of finance.
The multiplier and the MPC: Multiplier = final change in income ÷ initial change in spending. MPC = change in consumption ÷ change in income. Simple multiplier = 1 ÷ (1 − MPC) = 1 ÷ MPW in a closed economy without tax.
MPC is 0.75 (no tax or trade). Investment rises by 20bn. Final change in income?: Multiplier = 1 ÷ (1 − 0.75) = 4. Income rises by 4 × 20 = 80bn, if there is spare capacity.
SRAS vs LRAS (AQA definitions): SRAS: the output firms will supply at each price level while costs are given; shifted by changes in costs. LRAS: output at normal capacity, set by the quantity and quality of resources.
Keynesian AS curve: Flat when there is a lot of spare capacity, rising as bottlenecks appear, vertical at full capacity. So the effect of a rise in AD on real output depends on where the economy is.
Diagram: a demand-side shock that lowers AD: Price level on the vertical axis, real output on the horizontal. AD shifts left along an upward-sloping SRAS: the price level and real output both fall.
Diagram: a supply-side shock such as a rise in oil prices: SRAS shifts left (up). The price level rises and real output falls along the existing AD curve: cost-push inflation with lower output.

3.2.3 Economic performance

Short-run vs long-run economic growth: Short run: rising actual output, usually from higher AD using spare capacity. Long run: rising productive capacity (LRAS or the PPC shifting outward); the trend rate.
Output gap: actual 612, potential 600, and actual 585, potential 600: (612 − 600) ÷ 600 = +2.0%, a positive gap. (585 − 600) ÷ 600 = −2.5%, a negative gap. Always divide by potential output.
Nominal GDP grows 6.0% and prices rise 2.5%. Real growth?: 1.060 ÷ 1.025 − 1 = 3.4%.
The economic cycle: Fluctuations of actual output around the trend: boom, downturn, recession, recovery. Caused by demand-side and supply-side shocks, which may be domestic or global.
ILO (LFS) measure vs claimant count: LFS: a survey using the ILO test: no job, available to start within two weeks, looked for work in the last four weeks. Claimant count: people claiming an unemployment-related benefit, which misses unemployed people not entitled to or not claiming benefit.
Frictional, structural and cyclical unemployment: Frictional: between jobs, searching and matching. Structural: skills or location do not match vacancies after demand changes. Cyclical: too little aggregate demand overall (demand-deficient).
Natural rate of unemployment: Unemployment when the economy is at potential output: frictional and structural, with no cyclical element. The gap between actual and natural is cyclical unemployment.
Deflation vs disinflation: Deflation: the price level is falling. Disinflation: the rate of inflation is falling but prices are still rising (3.0% then 2.1% then 1.2%).
Quantity theory of money: MV = PQ. M = 250, V = 4, Q = 500. What is P, and what if M rises 10%?: MV = 1,000, so P = 1,000 ÷ 500 = 2.0. With M = 275, MV = 1,100 and P = 2.2, also +10%. The monetarist result assumes V is stable and Q fixed in the long run.
Who gains and loses from unexpected inflation?: Lose: savers when interest is below inflation, people on fixed incomes, workers whose pay lags. Gain: borrowers with fixed debts. Firms face menu costs, uncertainty and lost competitiveness.
Short-run vs long-run Phillips curve: SRPC: downward-sloping trade-off between inflation (vertical) and unemployment (horizontal), for given expectations. LRPC: vertical at the natural rate of unemployment: in the long run there is no trade-off.
Benign vs malign deflation: Benign: falling prices caused by rising supply capacity (productivity, technology). Malign: falling prices caused by collapsing aggregate demand, with falling output and jobs.

3.2.4 Financial markets and monetary policy

The functions of money: Medium of exchange, store of value, unit of account and standard of deferred payment.
Narrow vs broad money: Narrow: notes and coins (and, in many definitions, banks' balances at the central bank); the most liquid. Broad: narrow money plus other bank and building society deposits.
Bond yield: formula and example: Yield = annual coupon ÷ market price × 100. Coupon 7 per 100 nominal at a price of 112: 6.25%. At a price of 70: 10%.
Why do bond prices fall when market interest rates rise?: The coupon is fixed. New bonds offer more, so demand for existing bonds falls and their price drops until their yield matches the market rate.
Money market, capital market and foreign exchange market: Money market: short-term borrowing and lending. Capital market: long-term finance through shares and bonds (primary for new issues, secondary for trading existing ones). Forex market: buying and selling currencies.
Commercial bank vs investment bank: Commercial: takes deposits and lends, mainly to households and firms; runs payments. Investment: serves large clients with advice on takeovers, raising finance through shares and bonds, and trading.
Credit creation, and liquidity vs capital: When banks lend they create new deposits. Liquidity: the ability to meet payments when due. Capital: the owners' stake that absorbs losses.
Systemic risk vs moral hazard in banking: Systemic risk: trouble at one institution spreads and threatens the whole system. Moral hazard: riskier behaviour when another party (such as the state) carries part of the downside.
Monetary Policy Committee and the inflation target: The Bank of England's MPC votes on Bank Rate to meet the government-set target of 2% CPI inflation. The government sets the target; the MPC pursues it.
Monetary transmission mechanism after a rise in Bank Rate: Market rates rise; borrowing is dearer and saving more rewarding, so C and I fall; asset prices and confidence fall; the pound tends to appreciate, cutting net exports. AD falls, easing inflation after a lag.
Quantitative easing: The central bank creates electronic reserves to buy assets, mainly gilts. This raises bond prices, lowers long-term interest rates and aims to raise spending. It is not printing banknotes.
Nominal rate 6% and inflation 2%: real interest rate?: Exactly 1.06 ÷ 1.02 − 1 = 3.92% (about 4%). If the nominal rate is below inflation, the real rate is negative and savers lose.

3.2.5 Fiscal policy and supply-side policies

Fiscal policy: macro and micro functions: Manipulating government spending, taxation and the budget balance. Macro: influence AD, growth, jobs, inflation and the external balance. Micro: change outcomes in particular markets or for particular groups.
Current vs capital government spending, and transfer payments: Current: day-to-day running costs of services. Capital: spending on lasting assets. Transfers: income moved without buying output (pensions, benefits); they affect AD only when spent.
Direct vs indirect tax: Direct: on income, profit or wealth; borne by the person taxed. Indirect: on spending; collected by sellers and partly passed on to buyers.
Budget deficit vs national debt: Deficit: spending greater than revenue in a period (a flow), which is borrowed. National debt: everything the government owes on one date (a stock). A deficit adds to the debt.
Cyclical vs structural deficit: Cyclical: caused by the economic cycle; reverses as output returns to potential. Structural: remains when output is at potential; needs a policy change to remove.
Automatic stabilisers vs discretionary fiscal policy: Automatic stabilisers: tax receipts and benefit spending change with the cycle with no decision, cushioning AD. Discretionary: a deliberate change in tax rates or spending.
Crowding out: Government borrowing raises interest rates and reduces private investment, or public activity uses resources the private sector would have used.
Supply-side improvement vs supply-side policy: Improvement: any rise in productive capacity or efficiency, from any source (often private firms). Policy: deliberate government action to bring one about.
Free-market vs interventionist supply-side policies: Free-market: remove obstacles and strengthen incentives and competition: tax cuts, deregulation, privatisation, labour market reform. Interventionist: government acts directly: education, training, infrastructure, R&D support.
Why do supply-side policies matter for the Phillips curve?: They lower the natural rate of unemployment and raise the trend rate of growth, shifting LRAS right, so growth and low unemployment can be had without rising inflation. Most effects take years.
Office for Budget Responsibility (OBR): An independent body that produces economic and fiscal forecasts and assesses the public finances.

3.2.6 The international economy

Globalisation and its causes: The growing integration of national economies as goods, services, capital, labour, technology and ideas cross borders. Causes: trade liberalisation, lower transport and communication costs, growth of MNCs, freer capital flows.
Multinational corporation and FDI: MNC: a firm with operations it owns or controls in two or more countries. FDI: money put into owning or building productive assets abroad, giving lasting control; portfolio investment buys shares or bonds without control.
Absolute vs comparative advantage: Absolute: needs fewer inputs for a good; one country can have it in every good. Comparative: gives up less of the other good (lower opportunity cost); decides who should specialise.
Tariff vs quota: Tariff: a tax on imports, raising the price by a set amount; earns government revenue. Quota: fixes the quantity of imports and lets the price adjust; foreign suppliers may gain the quota rent.
Free trade area vs customs union vs single market: Free trade area: no tariffs between members. Customs union: free trade plus a common external tariff. Single market: also free movement of goods, services, capital and labour, with common standards.
The current account of the balance of payments: Trade in goods, trade in services, primary income (profits, interest, dividends, cross-border wages) and secondary income (one-way transfers: remittances, aid). The accounts sum to zero, so a "deficit" means the current account.
Expenditure-reducing vs expenditure-switching policies: Reducing: cut total demand and so imports (higher taxes, higher interest rates). Switching: move spending from imports to domestic output (depreciation, protectionism).
Freely floating vs fixed vs managed exchange rates: Floating: set by market demand and supply. Fixed (pegged): the government commits to a central rate and defends it with reserves and interest rates. Managed float: floating, with occasional central bank intervention.
Marshall-Lerner condition and the J-curve: A depreciation improves the current account only if the sum of the price elasticities of demand for exports and imports exceeds 1. In the short run demand is inelastic, so the balance first worsens, then improves (J-curve).
Currency union: costs and benefits: Benefits: no transaction costs or exchange rate uncertainty within the union, price transparency. Costs: one interest rate for all members, no exchange rate to absorb shocks, loss of independent monetary policy.
Economic growth vs economic development: Growth: a rise in real output (real GDP or real GDP per capita). Development: a wider improvement in living standards: health, education, income, freedom, lower poverty. The HDI combines health, education and income.
Barriers to growth and development: Corruption and weak institutions, poor infrastructure, low human capital, primary product dependency, debt, capital flight, and a large informal sector.