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Flashcards · 4EC1 · Topic 2.1

Government and the economy flashcards

28 cards on Topic 2.1, subtopics 2.1.1 to 2.1.3. Pick a subtopic or study them all.

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2.1.1 Macroeconomic objectives

Economic growth, and nominal vs real GDP
Economic growth: a rise in the output of goods and services in an economy over time. Nominal GDP is at current prices; real GDP is adjusted for price changes and is the measure of growth.
Nominal GDP rises from 600 to 645 and the price index from 100 to 104. Find real growth
Real GDP = 645 ÷ 104 × 100 = 620.19. Real growth = (620.19 − 600) ÷ 600 × 100 ≈ 3.37% (nominal growth was 7.5%).
The economic cycle: describe the four stages
Boom: high growth, rising inflation, low unemployment. Downturn: growth slowing but positive. Recession: negative growth, low inflation, high and rising unemployment. Recovery: growth picks up; unemployment falls slowly (it lags output).
Unemployment and the unemployment rate
Unemployment: people able and willing to work, and looking for work, who cannot find a job. Rate = number unemployed ÷ labour force × 100, where the labour force is employed + unemployed.
Five types of unemployment
Cyclical: a fall in total demand. Structural: industry decline or a skills mismatch. Seasonal: time-of-year changes in demand. Frictional: time between jobs. Voluntary: refusing available work at the pay offered.
Consequences of unemployment
Lost output (inside the PPF); wasted labour and fading skills; poverty; higher benefit spending and lower tax revenue; weaker consumer and business confidence; social problems.
Inflation, deflation and the CPI
Inflation: a sustained rise in the general level of prices. Deflation: a sustained fall in the general level of prices. CPI: a weighted index of the average change in prices of a basket of goods and services bought by households.
Demand-pull vs cost-push inflation
Demand-pull: total demand grows faster than the economy can produce (AD shifts right). Cost-push: rising costs of production (wages, raw materials, energy, indirect taxes) are passed on in higher prices (AS shifts left).
Menu costs vs shoe leather costs of inflation
Menu costs: the costs to firms of changing their prices (relabelling, reprinting). Shoe leather costs: the time and effort spent protecting the value of money, such as searching for cheaper prices.
Current account: what it records, and visibles vs invisibles
The part of the balance of payments recording trade in goods and services. Visibles: traded goods. Invisibles: traded services such as tourism, banking and insurance. Current account balance = visible balance + invisible balance.
Four impacts of a current account deficit
A leakage from the circular flow (less spending at home); inflation if import prices rise; low demand for exports, so lost output and jobs; problems finding foreign reserves to pay for it.
Absolute vs relative poverty, and progressive taxation
Absolute poverty: unable to afford basic needs (food, water, shelter, clothing). Relative poverty: income far lower than what is normal in that country. Progressive tax: the percentage of income paid rises as income rises; it helps redistribute income.

2.1.2 Government policies

Fiscal policy, and expansionary vs contractionary fiscal policy
Fiscal policy: the government's use of taxation and government spending to influence the economy and meet its macroeconomic objectives. Expansionary: higher spending and/or lower taxes, to raise demand. Contractionary: lower spending and/or higher taxes, to reduce demand.
Direct vs indirect tax
Direct: a tax on income or profit, paid straight to the government by whoever is taxed (income tax, corporation tax). Indirect: a tax on spending, collected by sellers and included in the price (VAT, excise duties).
Fiscal deficit vs national debt
Fiscal deficit: government spending greater than revenue in a year (a flow). National debt: the total stock of past borrowing. Revenue 640, spending 700 → deficit of 60; with GDP 3,000 that is 2.0% of GDP.
Monetary policy and the transmission mechanism of a rate rise
Monetary policy: changes to interest rates (and related tools) by the central bank to influence the economy. Rate rise → borrowing dearer, saving pays more → consumers spend less, firms invest less; currency tends to rise → AD falls → inflation and growth slow, unemployment may rise.
Asset purchasing (quantitative easing)
The central bank creates money and buys assets, mainly government bonds, usually when the policy rate is already very low. Bond prices rise and yields fall, so borrowing costs fall and spending rises. Risks: inflation, higher asset prices that benefit existing owners.
Limits of monetary policy
Time lags; weak confidence (people may not borrow even at low rates); dearer borrowing does not cure cost-push inflation; fixed-rate borrowers respond slowly; aims conflict (fighting inflation can raise unemployment).
Supply-side policy
Government action to raise productive capacity by making resources more productive or more plentiful.
Name seven supply-side policies
Privatisation; deregulation; education and training; regional policy; infrastructure; lower business (corporation) taxes; lower income tax.
How might cutting income tax act as a supply-side policy, and what is the limit?
Take-home pay rises (gross 2,000: net 1,600 at 20% tax, 1,700 at 15%, up 6.25%), so more people work or work longer, raising output. Limit: behaviour may not change, and tax revenue falls.
Regulation, legislation, fines and permits: one disadvantage each
Regulation: compliance costs, heavier for small firms. Legislation: slow to pass, costly to police. Fines: work only if firms are caught. Pollution permits: the cap may be set too high, and monitoring is needed.

2.1.3 Relationships between objectives and policies

Trade-off between objectives
Improving one macroeconomic objective makes another worse.
Explain the trade-off between lower unemployment and inflation
Higher government spending raises demand → firms hire → unemployment falls → spare workers run out, so firms offer higher wages → costs rise and are passed on → inflation rises. Sharper near full employment.
Explain the trade-off between economic growth and environmental protection
Higher output needs more energy and materials, so emissions and waste rise. Limiting pollution raises firms' costs, which can slow growth. It depends on whether cleaner technology is available.
Explain the trade-off between inflation and the current account
If prices at home rise faster than abroad, foreign buyers switch away from exports and domestic buyers switch to imports, so the current account moves towards deficit.
How can supply-side policy ease the unemployment–inflation trade-off?
Training raises output per worker, so firms can fill vacancies without bidding wages up. Output grows without extra price pressure, so unemployment and inflation can both stay low. The gain takes years.
Unemployment falls from 8% to 5%. State the change in percentage points and as a percentage
A fall of 3 percentage points. As a percentage of the original rate: 3 ÷ 8 × 100 = 37.5%.

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