Economic performance

What is short run economic growth

• Brings idle resources into production

What is long run economic growth

• An increase in the economies productive potential

How is economic growth measured

• Annual percentage change in real GDP

Define economic recovery

• When short run economic growth takes place after a recession

What is recession

• GDP contracts for 2 or more consecutive quarters

What must happen to ensure sustainable economic growth

• LRAS curve must shift to the right

What is the trend growth rate

• The rate at which output can grow on a sustained basis without putting upward or downward pressure on inflation

• Trend growth rate is measured over a period covering more than one economic cycle

What are two types of fluctuations experienced by economic activity

• Seasonal fluctuations- caused by weather

• Cyclical fluctuations- expansions and recessions

What is the economic cycle

• Upswings and downswings in aggregate economic activity taking place over 4-12 years

• Also known as the business and trade cycle

What is the economic cycle primarily caused by?

• Fluctuations in aggregate demand

• However supply side factors have also been recognised as a cause of economic cycles

Sections of the economic cycle

• Boom

• Recession

• Recovery

What does the boom part of the cycle tell you

• Growth above the trend

• High profits

• Low unemployment

• High business/consumer confidence

• Inflation

What does the recession part tell you?

• Declining AD

• High unemployment

• low investment (negative accelerator)

• Fall in prices /low inflation

• Loose policy - low interest rates

What does the recovery section tell you

• Rising consumer/business confidence

• Higher investment

• But policy is still loose

Sometimes the downswings in the economic cycle do not represent recession. Why is that?

• The cycle is showing continuous positive economic growth

• The downswings shown illustrate the rate of positive growth slowing down

• But negative growth does not occur

Causes of change in the phases of the economic cycle

• Fluctuations in AD

• Supply side factors- such as technical advancements and ageing capital

How do external shocks hitting the economy effect the economic cycle

• Can be shocks effecting demand and supply

• An increase in price of imported raw materials increase costs of production

• Cost passed to consumers stifling demand

• Low confidence resulting in low investment

Climatic cycles and the economic cycle

• Changes in weather can effect certain markets like agriculture and travel

• Effecting both supply and demand

Political influences on the economic cycle

• As elections approach the political party in power may engineer a pre-election boom to garner votes

• After election the party in power deflates AD to prevent excessive growth

Changes in inventory and the economic cycle

• Firms invest in stocks of finished goods waiting to be sold

• They do this to cope with swings in demand

• Stocks of goods accumulate when firm over anticipate demand

• Firms may then have to cut production and start destocking which can cause a slowdown

• Destocking - selling finished goods they already have rather than producing more

Marxist explanation of the economic cycle

• Marxist economists explain economic cycles as a restructuring process

• Recessions create conditions in which stronger firms either take over weak competitors by buying assets of rivals at low prices

• The strongest firms survive

• Fortifying the economy

What are output gaps

• They occur when the level of actual real output in the economy is greater or lower than the trend output level

Positive output gap

• When actual output is above trend output

Negative output gap

• When actual output is below trend output

How are economic cycles measured

• In terms of changes in real GDP

• Inflation

• Investment

• Unemployment

What is private sector investment

• Money spent by individuals or businesses (not government) to create or grow economic assets like machinery and factories

Why do employment cycles lag behind output cycle

• Because employers may which to be certain that the economy is improving before hiring workers

• May be reluctant to fire workers as it can be costly

• Must ensure economic changes are permanent or temporary before making descions on staffing

What is frothy job market

• Demand for workers is excessively high and can cause increasing wages

Because GDP and employment cycles are out of sync what can governments do

• Expand the economy to reduce unemployment even when real GDP has began recovery

• Or take demand out of the economy to temper(control) a frothy job market even though GDP has already begun to decline

Negative impact of economic growth

• Finite resources are being utilised quickly and can cause adverse effects on the environment

• Like pollution and desertification

Benefits of economic growth

• Increased living standards and welfare

• Produces a fiscal dividend- tax revenue increases and can be used as investment in public services

• Growth if sustainable can provide environmentally friendly technologies

• Generates a virtuous cycle of greater business confidence, investment, profit and international competitiveness ( more exports can lead to a positive trade balance)

Costs of economic growth

• Inflation

• Utilisation of finite resources

• Environmental degradation

• Urbanisation usurps agricultural land

• Widening inequalities in the distribution of income and wealth- regional disparities, unequal access to opportunities and rising asset process only benefiting those who own assets

Define full employment

• A situation in which the number of people wishing to work at the going market wage rate = the number of workers whom employers wish to hire at this real wage rate

What is frictional unemployment

• Also know as transitional

• Unemployment that is usually short term and occurs when workers switch between jobs

Causes of frictional unemployment

• Geographical immobility of labour

• Occupational immobility of labour

• Better employment opportunities

Geographical immobility of labour

• Caused by factors such as family ties discouraging people from moving to regions with higher vacancies and employment opportunities

• Moving and finding accommodation can be costly

Occupational immobility of labour

• Workers are unable or unwilling to move from one type of job to another if different skills and qualifications are required

How does better employment opportunities effect frictional unemployment

• Workers may leave their current job if they have found another vacancy that may offer a higher wage

What can frictional unemployment be viewed as

• A voluntary search period in which unemployed workers scan the labour market searching for vacancies that meet their aspirations

• Long search periods increase the amount of frictional unemployment

Why do free market economists support a reduction of unemployment benefits

• The availability of a safety net provided by unemployment benefits finance longer search periods

• A reduction in benefits will incentivise people to find a job quickly

What is structural unemployment

• Results from the structural decline of industries which are unable to compete with changing demand and the emergence of more efficient competitors in other countries

• Also caused by changing skill requirements as industries alter their production process

What else can structural unemployment be referred to?

• Technological unemployment which results from the growth of new industries using technology such as automation

What is mechanisation

• Workers operating machines

• increasing demand for labour

Define deindustrialisation

• Decline of manufacturing industries

How can international competition cause structural unemployment

• If a countries industry faces competition from cheaper or more efficient foreign producers

• domestic companies may downsize or shutdown

What is cyclical unemployment

• Also called demand deficient unemployment

• Unemployment caused by a lack of AD in the economy and occurs when the economy goes into a recession or depression ( a severe downturn)

• An involuntary form of unemployment

Explain the cyclical unemployment diagram

• Consumer confidence drops during a downswing in the economy

• AD shifts left

• Price level and output drops reflecting the deficient AD

• Leftward movement of output showing cyclical unemployment as there’s less need for workers when demand is low

What do free market economists argue about cyclical unemployment

• Its temporary and self correcting provided that markets are competitive and wages are flexible (responsive to changes in the economy)

Explain cyclical unemployment being self correcting diagram

• In a down turn businesses make workers redundant

• Wages fall as there is now a surplus of labour

• Reducing costs

• Making it cheaper to hire labour again

• Prices can afford to be lower inducing demand

What is seasonal unemployment

• Workers are laid off on a short term basis at certain times of the year

• Occurring in sectors like agriculture, tourism and catering

• Unemployment resulting from fluctuations in weather conditions or demand

What is real wage

• The purchasing power of the nominal wage.

When do real wages fall and rise

• When inflation is higher than the rise in the nominal wage rate

• Nominal wage rate increases more rapidly than inflation

Real wage rate unemployment

• Happens when wages are set above the market equilibrium causing supply of labour to be greater than the demand for labour

• Leading to unemployment as more people want to work at high wage but firms cant afford to hire

Explain the real wage unemployment diagram

• Equilibrium employment is when demand for labour meets supply of labour → which determines the equilibrium wage rate

• If wages are fixed above equilibrium, more workers will wish to supply their labour

• Q_d is the labour demanded at the minimum wage rate and Q_s is the labour supply available at the minimum wage rate

• Causing excess supply of workers - creating real wage unemployment

Why do free market economists believe rea wage rate unemployment is temoporary?

• Employers will hire less workers at minimum wage rate

• Overtime workers will accept a lower wage

• Causing minimum wage to fall to equilibrium wage

• Clearing the labour market

What happens in times of labour market rigidity

• Its causes by vigorous trade unionism

• Minimum wage rate will not fall to equilibrium

• Causing persistent unemployment

What is equilibrium unemployment

• Refers to unemployment that still exists even when the labour market is in equilibrium ( demand for labour = supply of labour)

• Showing unemployment that persists even when economy is working at full capacity

• E.g. frictional and structural

Explain the structural/frictional unemployment diagram

• Difference between ASL and ASLN shows the amount of frictional/structural unemployment

• Workers that are willing to work at the wage rate but can due to structural and frictional reasons

• Difference between E1 and Efe is the natural level of unemployment that persists depite full employment

Consequences of unemployment in terms of human capital

• Waste of human capital. Not all of the economies productive resources are being used to produce output. Economy is thus operating under the PPF

How does unemployment increase poverty and inequality

• Low or no income means basic necessities cannot be afforded

• Pushing families into absolute poverty

• Impacting living standards

• Whereas those who are well off have a stream of income due to job stability causing the gap between the rich and poor to widen

Unemployment and government spending

• Unemployed develop a reliance on welfare benefits and apply for job seekers allowance

• To fun these benefits government may increase tax and cut spending in other significant areas like healthcare and infrastructure

How does unemployment cause the erosion of a skilled workforce

• A worker who has been unemployed for a long period can effectively become “unemployable” due to minimal execution of their skill

• Employers who could retrain workers who have been economically inactive may assume workers with more recent job experience present fewer risks and are more likely to get hired over those who have been unemployed for a prolonged period of time

How does unemployment reduce international competitiveness

• High unemployment signals a weak economy, which can discourage business investment

• Lack of capital investment can lower productivity and increase costs

• Allowing countries with an efficient productive process to overtake export sales

• Trade deficit incurs

Why do free market economists believe a certain degree of unemployment is required to enhance the operation of the economy?

• Downward pressure on wages decreasing costs

• Reduces inflation- less consumption, lower AD, lower prices

Unemployment and emotional welfare

• Those without work can feel marginalised from normal economic and human activity

• Reducing self esteem and amplifying alienation

• More likely to face health risks, stress and a poor diet

• Causing strains on relationships

What is the shadow economy

• Economic activity not recorded, regulated or taxed by government

Policies to reduce unemployment

• Improving geographical mobility of labour

• Can reduce search periods between jobs as people can easily move to regions with job vacancies through government subsidising travel and accommodation costs

Retraining workers

• Improves and implements skills that may be in high demand

• Making it easier for workers to transition between jobs in different markets

• Increasing productivity

Subsidising firms to help with unemployment

• By subsidisng industries, especially those in decline

• costs of production will be lowered

• and firms are able to retain and hire workers

Monetary policy and reducing unemployment

• Cutting interest rates may boost AD

• Firms are more likely to hire workers to keep up with demand

• But this is ineffective if interest rates are already low only resulting in a lack of business confidence

Fiscal policy to reduce unemployment

• Higher government spending can boost economic activity and create new jobs

• By investing into infrastructure projects like construction of houses and roads there will be a surge in jobs in the relevant areas

• Can trigger the multiplier effect- gov spending increases income and thus consumption

• Boosted demand may encourage firms to hire workers

Define inflation

• A continuing rise in average price level

Deflation

• Fall in average price level

2 causes of inflation

• Excess demand - demand pull inflation

• Rise in production costs - cost push inflation

Demand pull inflation

• A rising price level caused by excess/ increasing AD

• If economy is initially producing output on the SRAS curve but below normal capacity level of ouput

• prices must rise to persuade firms to produce more to meet demand - to retain profitability

Explain the demand pull inflation diagram

• Equilibrium national income is at point x

• Real output is at Y1 and price level is P1

• A rightward shift in demand causes price to rise to p2

• Real national income increases to normal capacity level of output at Y2

• Equilibrium income is now at point Z - economy is operating at its full capacity

• Any further shift in demand will only cause prices to rise not output

Cost push inflation

• A rising price level caused by an increase in the costs of production

What supply side condition can cause cost push inflation

• Trade unionism/wage bargaining

• Rising prices of commodities

Explain cost push inflation diagram

• Equilibrium national income is at point x with real output of y1 and price level at p1

• A rise in the cost of production causes a leftward shift of SRAS

• Price rises to P2 and output falls to y2

• Equilibrium national income is now at point Z

2 large commodity price spikes

• 2008 and 2011 caused by surging global demand in fast growing economies like China and India

What is an emerging market country

• A country that is progressing towards becoming more economically advanced due to rapid growth and industrialisation

How do emerging market countries influence inflation

• Decreasing global inflation → countries like China and India often produce goods cheaply due to low labour costs(as they have a larger supply of labour). These goods are exported cheaply keeping prices down

• Increasing global inflation→ Supply is slow to adjust to rising demand so in the short run a rise in prices is the only way to regulate a surplus in demand

How does a booming world economy cause higher prices

• Demand for commodities increase

• Prices increase

• UK imports inflation from booming economies

• Vice versa in a recession

Effects of depreciation and appreciation on trade

• Deprecation= Imports expensive Exports cheaper

• Appreciation= Imports are cheaper Exports expensive

How does the BOE generally deal with inflation

• View excess demand as the main cause of inflation

• Therefore they manipulate interest rates

How can increasing interest rates appreciate a currency

• High IR attracts more foreign investment as they get a higher return

• Effectively investors buy more of that countries currency ( to be able to invest)

• Increased demand for the currency leads to currency appreciation

How does a stronger currency reduce inflation

• Reduces export demand

What is the monetarist theory of inflation

• Pro free market economists can be known as monetarists

• They agree with the demand pull theory of inflation

• But they argue excess demand is caused by a prior increase in the money supply

• “inflation is a monetary phenomenon”

What is the quantity theory of money

• Oldest theory on inflation

• Stating that an expansion of the money supply greater than the increase in real national output causes individuals to hold onto excess money which when spent pull up the price level

• As an real output does not increase in line with spending power

Equation of exchange

• M x V = P x Q

• M= money supply

• V= velocity of circulation

• P= Price level

• Q= Quantity of output

What is the velocity of circulation

• The speed at which money circulates around the economy when people use money to buy goods

• Monetarists argue V is constant

Monetarist explanation for the equation of exchange

• V is constant

• When M increases it is spent on goods and services

• If Q is unable to increase the price level is pulled up by excess demand

Keynesian explanation for the exchange equation

• When M increases it may be partially absorbed by a slowdown in V

• Meaning that extra money is not spent

• As people may hold onto money in economic downturns despite increase in money supply- this is called a liquidity trap

• But some extra money might be spent on investment in new capital, stimulating Q rather than P

Effects of expectations on changes in the price level

• Peoples expectations of future inflation can effect current inflation

What is inflationary behaviour

• If people expect inflation to rise in the future they will behave in a way that speeds up inflation

• Delivering the feared inflation quicker

Examples of inflationary behaviour

• Trade unions may bargain for higher wages in anticipation for tomorrows higher inflation rate

• Causing employers to then rise prices

• Workers and firms try to retaliate first to avoid being injured when the inflation rate they are expecting materialises

Positive inflationary behaviour

• When people expect inflation rate to fall they behave in a way than enables low inflation to be achieved

• People aren’t in a rush to spend now if they believe prices will remain consistent in the future

How do government utilise inflationary behaviour

• They try to talk down down the rate of inflation by convincing people government polices are effective and credible

BOE is operationally independent what does that mean?

• Through its MPC the bank can make decisions on monetary policy without government interference

• Independence ensures that monetary policy is focused on long term stability rather than short term political agendas

How does inflation reduce real value of accumulated debts

• Inflation erodes purchasing power of the money used to repay debts

• Essentially people or governments are paying back debts with money that’s worth less than the money they initially took out