Flashcards · 9214 · Topic 2

How economies work flashcards

60 cards on Topic 2, subtopics 3.2.1 to 3.2.5. Pick a subtopic or study them all.

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3.2.1 Introduction to the national economy

Interest rate: What borrowing costs and what saving earns, as an annual percentage.
What happens to consumers' saving, borrowing and spending when the interest rate rises?: Saving becomes more attractive (higher reward). Borrowing becomes dearer, so fewer loans and mortgages, and variable-rate borrowers pay more. Spending tends to fall. A rate cut pushes each the other way.
What happens to firms' investment when the interest rate rises, and why?: Loans cost more and retained profit earns more in a deposit, so fewer projects earn more than the interest charged. Investment falls.
A firm can spend 30,000 on equipment that adds 2,100 a year to profit. Should it borrow at 5%? At 8%?: Return = 2,100 ÷ 30,000 = 7%. At 5% interest costs 1,500, leaving a gain of 600: invest. At 8% interest costs 2,400, more than the 2,100 gained: do not invest.
Why does Islamic (sharia-compliant) finance avoid ordinary interest, and how does a murabaha work?: It does not allow riba, a fixed charge for lending money. In a murabaha the bank buys the item and sells it on at cost plus a disclosed mark-up, paid in instalments: equipment of 20,000 at a 5% mark-up costs 21,000.
Mudarabah, musharakah, ijara and sukuk: Mudarabah: one party gives funds, the other manages; profit split in an agreed ratio. Musharakah: both put in funds; profit shared by agreement, losses by contribution. Ijara: bank owns the asset and charges rent. Sukuk: certificates giving a share in an asset and its income.
Direct tax and indirect tax, with examples: Direct: charged on what a person or firm earns, paid by that taxpayer (income tax, corporation tax). Indirect: a tax on spending, paid by the buyer and collected by the seller (sales tax or VAT, excise duties, import duties).
Progressive, regressive and proportional taxes: Progressive: the share of income paid climbs as income climbs. Regressive: the share of income paid shrinks as income climbs. Proportional: the same percentage at every income. Judge by percentages of income, not amounts of money.
Tax is 0% on the first 5,000 and 25% above. Find the tax and average rate on an income of 15,000.: Only the slice above 5,000 is taxed: (15,000 − 5,000) × 0.25 = 2,500. Average rate = 2,500 ÷ 15,000 × 100 = 16.7%. (On 45,000 it is 10,000, or 22.2%, so the tax is progressive.)
Main areas of government spending: Health, education, social protection (pensions and benefits), defence, transport and infrastructure, law and order, and interest on debt. Every spending choice has an opportunity cost.
Exam trap: is government borrowing a source of revenue?: No. Revenue is mainly taxes (plus fees, state-enterprise profits and asset sales). Borrowing is how a budget deficit (spending − revenue) is financed.
Interest rates: "it depends on…" evaluation points: The size of the change, whether loans are fixed or variable, confidence, inflation and how much debt households and firms hold. Savers, such as retirees living on interest, gain from higher rates while borrowers lose.

3.2.2 Government objectives

Main macroeconomic objectives of a government: Economic growth, low unemployment (high employment), price stability (low and stable inflation), a sustainable balance of payments position, and a fairer distribution of income and wealth.
Economic growth versus economic development: Growth is a rise in output, measured by GDP, real GDP or GDP per capita. Development is a broader rise in living standards: health, education, infrastructure. GDP can rise while development stalls.
Cyclical unemployment: Rises and falls with the wider economic cycle: it rises in a recession.
Structural unemployment: Caused by the long-term decline of a specific industry.
Frictional unemployment: Short-term, between one job ending and the next starting.
Seasonal unemployment: Follows a predictable yearly pattern, for example in tourism or agriculture.
Cost-push versus demand-pull inflation: Cost-push starts on the supply side: rising production costs (e.g. imported raw materials) are passed on as higher prices. Demand-pull starts on the demand side: spending outstrips what producers can supply, pulling prices up.
Growth vs inflation (conflict): Faster growth raises demand economy-wide, which can outstrip supply and pull prices up (demand-pull inflation).
Equality vs growth (conflict): Redistributing income through higher taxation can reduce the incentive to work or invest, potentially slowing growth.
Balance of trade versus balance of payments: The balance of trade covers goods and services only. The balance of payments is broader, also including income, investment and financial flows. The current account is the narrower trade-and-income measure.
Real GDP and GDP per capita: Real GDP: nominal GDP adjusted for inflation, so growth comparisons show the actual change in output, not rising prices. GDP per capita: total GDP ÷ population, used to compare living standards between countries of different sizes.
A price index rises from 120.0 to 123.0. What is the inflation rate?: Inflation = (new index − old index) ÷ old index × 100 = 3.0 ÷ 120 × 100 = 2.5%.

3.2.3 How governments manage their economies

Fiscal policy: Government decisions on what to spend and what to tax, aimed at steering the economy.
Budget deficit, budget surplus and national debt: Deficit: spending greater than revenue in a year, paid for by borrowing. Surplus: revenue greater than spending. National debt: the total the government owes from past borrowing. Deficit is one year's gap; debt is the running total.
Expansionary fiscal policy: what changes, and the chain for an income tax cut: Government spending up and/or taxes down. Tax cut → higher disposable income → more consumption → more demand → firms raise output and hire → incomes rise. Limit: households may save much of the cut, and demand may pull up prices.
Government spending rises by 2.5 and 60% of each extra unit of income is spent again in the country. What is the total effect on income?: Total = injection ÷ (1 − 0.6) = 2.5 ÷ 0.4 = 6.25. The knock-on factor is 1 ÷ 0.4 = 2.5. (The 9214 specification does not use the word multiplier.)
Monetary policy, and the chain for an interest rate rise: Monetary policy is changing interest rates to steer the economy. A rise makes borrowing dearer and rewards saving, so consumption and investment fall, total demand falls and inflation slows. A cut does the reverse.
How can a cut in interest rates help the balance of payments?: Lower rates usually weaken the currency, so exports become cheaper abroad and imports dearer at home, tending to narrow a current account deficit. The size of the effect depends on how strongly buyers respond to price.
Supply-side policy: Action to raise the economy's capacity to produce and cut costs, shifting long-run supply to the right.
Four supply-side policies and the main drawback of each: Education and training: costly and slow. Lower direct (income) taxes: lost revenue, helps high earners most. Lower taxes on business profits: profits may not be invested. Privatisation and deregulation: risk of monopoly power, job losses or weaker standards.
Privatisation and deregulation: Privatisation: sale of a government-run firm to private owners. Deregulation: removal or loosening of rules that limit entry or behaviour.
Why are demand-side policies poorly suited to cost-push inflation?: Cutting demand (higher taxes or rates) works on demand-pull inflation. When rising costs are the cause, cutting demand mainly reduces output and jobs rather than tackling the cost rise.
Demand: Qd = 90 − 3P. Supply: Qs = 3P − 30. A tax of 6 per unit is placed on sellers. Find the old and new equilibrium.: Before: 90 − 3P = 3P − 30, so P = 20, Q = 30. With the tax, Qs = 3(P − 6) − 30 = 3P − 48, so P = 23, Q = 21. Buyers pay 3 more, sellers keep 17. Tax revenue = 6 × 21 = 126.
Evaluating fiscal, monetary or supply-side policy: what does the outcome depend on?: Time lags, spare capacity, leakages into saving and imports, confidence, who gains and loses (borrowers, savers, taxpayers), conflicts with other objectives, and short run versus long run.

3.2.4 International trade and the global economy

Exchange rate, appreciation and depreciation: Exchange rate: the amount of one currency needed to buy a unit of another. Appreciation: a rise in a currency's value against another. Depreciation: a fall in its value.
Benefits of international trade: Specialisation raises total output, imports bring lower prices and more choice, a bigger market gives economies of scale, countries gain resources they cannot produce, and foreign competition pushes local firms to be efficient.
Free trade versus a free-trade agreement (FTA): Free trade is trade with no tariffs, quotas or other barriers. An FTA is a deal that removes barriers only between its member countries.
Arguments against free trade (for protection): Infant industries need time to grow, job losses in uncompetitive industries, dumping below cost, strategic industries such as food and energy, overdependence on imports or a few exports, and weaker standards abroad undercutting local firms.
Where does demand for a currency come from, and where does its supply come from?: Demand: foreign buyers of the country's exports, tourists visiting, investment into the country, savers attracted by high interest rates, speculators expecting a rise. Supply: residents buying imports, travelling abroad or investing abroad, and speculators expecting a fall.
Exchange rate diagram, in words: what happens when demand for the currency increases?: Vertical axis: exchange rate (foreign currency per unit). Horizontal axis: quantity of the currency. Demand slopes down, supply up. A rightward shift in demand raises the rate: an appreciation. A rightward shift in supply lowers it: a depreciation.
What does a depreciation do to import and export prices?: Imports become dearer at home (firms using imported parts face higher costs). Exports become cheaper for foreign buyers, so exporters are more price competitive. An appreciation reverses both. Effects depend on elasticity and may take time.
1 arlo = 2.5 bexo, then the arlo falls to 2.0 bexo. What happens to the arlo price of a 500-bexo import?: At 2.5: 500 ÷ 2.5 = 200 arlo. At 2.0: 500 ÷ 2.0 = 250 arlo, 50 arlo more. Depreciation makes imports dearer.
Globalisation: The closer linking of economies, which rely more on each other, through trade, investment, people, ideas and technology.
Two main causes of globalisation in the specification: New technology: cheaper communication and transport, so distance matters less and firms source, make and sell abroad. Multinational companies: they invest abroad, build supply chains, seek lower costs and bigger markets, and spread global brands.
Multinational company (MNC) and foreign direct investment (FDI): An MNC is a firm that operates in more than one country. FDI is an MNC building or buying productive assets in another country.
Globalisation: moral, ethical and sustainability issues, and responses: Issues: child labour, unsafe or very low-paid work, unfair prices for small producers, pollution, emissions and resource depletion (often external costs). Responses: fair-trade schemes, labour and environmental standards, consumer pressure, MNC codes of conduct; but higher standards raise costs.

3.2.5 The role of money and financial markets

Money: Anything people will accept in exchange for goods, services and repayment of debts.
The four functions of money: Medium of exchange: used to complete a purchase. Unit of account: the measure in which prices and debts are stated. Store of value: spending power kept for later. Means of deferred payment: paying later for what you get now.
Barter and its main problem: Barter is swapping goods directly, without money. It needs each side to want what the other has, and many exchange rates: 8 goods need 8 × 7 ÷ 2 = 28 rates, but with money only 8 prices.
Liquidity, and the usual order of liquidity: How easily and quickly an asset can be spent without losing value. Order: cash, then current accounts, then savings deposits, then property.
The two roles of the central bank: Influencing interest rates: it sets the policy rate, which guides the rates banks charge and pay. Ensuring stability: it supervises banks, sets rules on funds they must hold, and can lend to a bank short of cash.
Commercial bank, and how it makes a profit: A private firm that takes deposits and makes loans. It earns the gap between the rate charged on loans and the rate paid on deposits. Example: pays 1.5% on 800 of deposits (12), earns 5.5% on 600 of loans (33): margin 21 before costs.
Roles of insurance companies, pension funds and the stock market: Insurance: pools premiums from many to pay the few who suffer a loss. Pension fund: collects savings in working life and invests them for retirement income. Stock market: lets firms raise funds by selling shares and investors trade them.
Bank run: Many depositors withdrawing at once because they fear the bank will fail.
Savings earn 4% while inflation is 3%. Roughly what is the real return?: About 1%: (1.04 ÷ 1.03 − 1) × 100 = 0.97%. A rise in money value is not a rise in spending power if prices rise as much (nominal versus real).
Policy rate, and the chain when it is cut: The interest rate set by the central bank to guide other rates. A cut makes borrowing cheaper, so spending and investment rise and aggregate demand rises. Limit: slow effects or low confidence.
Why do money and the financial sector matter to consumers, producers and government?: Consumers: buy and save without barter, borrow for big purchases, insure against loss. Producers: price goods, pay wages, borrow to invest, raise funds through shares. Government: collects taxes, borrows by selling bonds, uses interest rates to manage the economy.
Exam trap: is money only notes and coins?: No. Bank account balances are accepted as payment, so they count as money, and broader measures include savings deposits. Notes and coins are a small share: 9 bn of a broad total of 120 bn is 7.5%.