CB2 : Chapters 13-18

Define balance of payments account. List 3 constituents and state a 4th item that might be needed for it to balance

record of all economic transactions between residents of a country and the rest of the world for a specific time period. made up of

1. current account

2. capital account

3. financial account

4. (net errors and omissions item)

Define current account of balance of payments and outline the 4 components

records country’s imports and exports, incomes and transfers of money to and from abroad

1. trade in goods account = exports(+)-imports of physical goods(-)

2. trade in services account = income from(+) - expenditure on services (-)e.g. insurance

3. net income flows = rent, dividends, interest, wages earned abroad by country’s residents (+) and earned within country by foreign residents (-)

4. net current transfers of money = international transfers by indivs, firms, gov (+) and receipts from international (-)

What is recorded in the capital account of the balance of payments?

transfers of capital to (-) and from (+) abroad. divided into

1. capital transfers e.g. transfer of ownership of long term assets, money brought into country by migrants

2. acquisition/disposal of non-produced, non-financial assets e.g. patents, copyrights

What is the financial account of balance of payments and outline 4 components

records flow of money into (+) and out of (-) country for investment or deposits in banks/other fin institutions. made up of:

1. direct investment into physical assets e.g. factories

2. portfolio investment in securities e.g. shares and bonds

3. other financial flows e.g. short term bank deposits/loans

4. flows to and from country reserves of gold and foreign currency

Define exchange rate and exchange rate index

rate at which one country trades for another on FX market = nominal exchange rate. In a free market, determined by supply and demand for currency

index = weighted average of exchange rate of currency against all other currencies expressed as index, where weights based on proportion of transactions between each currency

What is arbitrage and floating exchange rate?

arbitrage = buying asset in market where it has lower price and selling it again in another market where it has a higher price - making a profit

floating exchange rate = gov and central bank do not intervene in FX markets so exchange rate determined solely by supply and demand of currency markets

What are 6 possible causes of currency depreciation?

1. fall in domestic interest rates relative to abroad - so hot money goes abroad

2. higher inflation domestically than abroad - domestic goods less competitive

3. rise in domestic incomes - demand for imports increase

4. relative investment prospects improving abroad - investments move abroad

5. speculation that exchange rate will fall - traders start to sell currency

6. longer term changes in international trading platforms e.g. due to changes in consumer tastes, production costs

Explain how even with a rise in UK interest rates, balance of payments will automatically balance without intervention in FX markets

IR rise leads to short term financial inflows (people abroad deposit money in UK to enjoy higher returns) - this leads to higher demand for £

financial outflows will also decrease as UK residents want to keep money - this leads to fall in supply of £

So financial account will go into surplus and £ will appreciate

this causes imports to become cheaper and exports more expensive so current account moves to deficit

there will be movement up along new demand/supply curves until new eqm reached

Outline evolution of financial systems in Western economies

Changes include

1. financial integration

2. globalisation

3. deregulation

4. financial innovation

these have altered operation and impact of financial system on rest of economy

greater productivity, higher liquidity, capital mobility and economic growth but also increased financial interdependence and systemic risk from financial integration and globalisation

Outline evolution of financial systems in China

Moving towards market-oriented economy (driven by demand/supply and not gov control).

has undertaken reforms where main commercial banks listed on stock exchanges and play a key role in economic growth

resulted in China’s banking sector becoming one of the world’s largest

What are the main services provided by financial system and financial intermediaries?

1. expert advice to customers

2. expertise in channeling funds for minimal cost = connect savers to borrowers

3. maturity transformation = funds from short term savers to long term borrowers

4. risk transformation = to those wanting to hold them and spreading risk/diversify

5. transmission of payments e.g. debit cards, cheques

6. monitoring investments and corporate gov

7. transfer consumption across time e.g. pension saving

Describe chain of financial intermediation

process where household savings transformed into physical capital:

1. households don’t consume i.e. save

2. save via financial products sold by financial institutions

3. financial institutions lend to corporations

4. corporations use funds to invest in capital

5. capital provides return to corporations

6. this is passed back down the chain

How are banks, insurance companies and others exposed to credit risk, liquidity risk and systemic risk?

Banks: credit risk from loans, liquidity risk from lots of depositors wanting to withdraw, systemic risk from failure of one bank causing further failures

Insurance: credit risk from bond issuers and reinsurers, liquidity risk from large claim payouts, systemic risk e.g. risk of recession where one insurer writes large volumes of credit insurance

Other: credit risk from holding corporate bonds, liquidity risk low from this as bonds can be sold on secondary markets

How does systemic risk in financial system be reduced?

1. regulators could impose add. capital requirements and increased supervision on large banks

2. central banks might use lender of last resort facilities for banks close to insolvency

3. gov might recapitalise banks

4. bankruptcy law developed to isolate failing banks

Give 2 examples of innovation in financial system. Why is innovation difficult?

1. use of internet e.g. peer to peer lending

2. securitisation (pooling debt and selling as tradable bonds) - allows diversification of credit risk

innovation difficult because rare for new firms to enter - structural (high start up costs, capital requirements) and strategic barriers (switching costs, aggressive pricing used by existing banks)

Give 2 examples of how smaller banks and insurance companies have challenged large firms in innovation

1. Direct Line let customers deal with it directly rather than broker to reduce costs

   1. In banking, new entrants established online only banks specialising in fintech - data analysis to get tailored new products

What are the principles of Islamic banking? How can a mortgage product be designed to comply?

1. no making money from money i.e interest on money

2. should not cause harm i.e. invest in alcohol, tobacco or gambling

3. encourages sharing of risk through equity rather than debt

an islamic compliant mortgage will involve bank buying property (owning 100%) and selling to occupier in instalments. Occupant will also pay rent on portion they don’t own until bank owns 0%

What is the role of retail/wholesale banks and building societies?

Retail = provide banking services for indivs/bus at published rates of interest and charges

Wholesale = large scale deposits and loans - mainly companies and other banks/financial institutions. Interest rates and charges might be negotiable

Building societies = specialise in providing mortgages, as well as other retail banking services for members

What are the 5 main liabilities for retail banks?

1. sight deposits = withdrawn on demand without penalty e.g. current account

2. time deposits = require notice of withdrawal/penalty e.g savings account

3. certificates of deposit = tradable certificates issued by bank for fixed term interest-bearing deposits (usually other firms/banks)

4. sale and repurchase agreements (repos) = agreement between two financial institutions where one will sell to other and agree to buy it back at a fixed price on a fixed date

5. capital and other funds = amount contributed by shareholders

What are 5 main assets of retail banks?

1. cash

2. deposits at central bank = in form of reserve balances (for clearing) and cash ratio deposits (required in UK, earns no interest and cannot be withdrawn on demand)

3. short term loans - e.g. bills of exchange, market loans

4. longer term loans - e.g. overdrafts, mortgages

5. investments - often gilts

Define liquidity, liquidity ratio and maturity gap

liquidity = ease of asset to be converted into cash without loss

ratio = proportion of bank’s assets held in liquid form

maturity gap = difference in average maturity of loans and deposits

How does maturity gap relate to profitability and liquidity?

maturity gap increases then liquidity decreases

maturity gap increases then profitability increases

What is the conflict between liquidity and profitability for banks?

they want to lend out as much as possible on a long term basis because they are typically more profitable but they need to maintain sufficient liquidity to meet short term demands for cash. So they have to balance desire for profitability (low liquidity ratio) with need to avoid financial panic (high liquidity ratio)

Define secondary marketing, securitisation, special purpose vehicle, collateralised debt obligations

SM = sale of assets before maturity e.g. securitisation

S = pooling assets e.g. loans/mortgages and selling marketable securities backed by assets

SPV = legal entity created by FI to conduct specific financial function e.g. securitisation

CDO = fixed income bonds backed by range of assets, issued as part of securitisation

Explain how secondary marketing can reconcile conflicting objectives of liquidity and profitability

Secondary marketing can maintain/reduce maturity gaps for banks for liquidity and increase/maintain for profitability

e.g. if bank raises funds issuing CDs, it has illiquid liability as it won’t have to pay bearers until end of period. So it can use this money to make long term loans without increasing maturity gap. But because CDs are liquid to holder (sold at any time), bank can pay low interest rate and increase profitability

Define sub-prime debt and capital adequacy/capital adequacy ratio

SPD = debt with high risk of default e.g. mortgages granted to low-income earners

CA = measure of bank’s capital relative to assets where assets weighted according to degree of risk

Define open market operations and quantitative easing

OMO = sale/purchase by authorities of gov securities in open market to reduce/increase money supply and therefore interest rates - routine operations

QE = deliberate attempt by central bank to increase money supply by buying large quantities of securities (private debt or gov bonds) through OMOs

Why can securitisation lead to moral hazard?

By pooling loans/mortgages, securitisation reduces cash flow risk facing investors and lets originator pass risk of default onto the CDO buyers so it could encourage banks to lower credit criteria (so they can sell more CDOs)

What are the potential adverse effects of securitisation on banking system?

1. lower liquidity ratio throughout banking system - leads to banks making more and more loans, so it is easier for people to lend money (cheaper), this money is then used elsewhere e.g. stocks, houses so then the prices of these assets soar - esp as people get scared to buy in the future so they have to borrow now to buy now and not buy when prices get even higher - BUBBLE

2. moral hazard

3. increased systemic risk of banking collapse because fortunes of banks more intertwined and lower liquidity ratio through system

Explain the role of securitisation in 2008 financial crisis

it enabled massive increase in bank lending in 2000s as they can immediately sell off to investors as CDOs, including to sub-prime household borrowers

In 2006, higher interest rates led to many of the borrowers defaulting

This led to losses for holders of CDOs incl. financial institutions in many countries

This led to deterioration of bank balance sheets globally because of the collapse in demand for securitised assets (no-one would lend because no-one knew who was safe) and this dried up liquidity as banks couldn’t securitise products anymore

What are 6 functions of the central bank?

1. issuer of notes

2. banker to gov, banks and overseas central banks

3. operator of gov monetary policy

4. provider of liquidity when necessary - liquidity backstop2

5. oversees activity of banks and other FIs - prudential control (adequate liquidity) on banks and macro-prudential regulation (overall stability of financial system)

6. operator of country’s exchange rate policy via exchange equalisation account (gold and foreign currency reserves)

What’s the difference between capital and money markets?

Capital = longer-term debt e.g. gilts bought and sold

money = short term loans between banks, gov and industry. divided into discount (trading treasury bills and corporate bills) and repo markets (sale/repurchase agreements) and parallel money markets (CDs, FX, inter bank lending)

Explain the role of BoE as lender of last resort

If banks are short of cash, they can:

1. sell gilts to BoE (in exchange for cash) with an agreement to buy them back at a fixed price at a fixed date (repo)

2. BoE can buy back Treasury bills (gov borrowing from bank short term) from them before maturity (and at a price below face value) i.e. rediscounting

What is meant by asset bubble, give an example

Period where asset prices increase rapidly over short period of time, normally due to speculation - they typically burst which leads to dramatic fall in asset prices e.g. tulipmania 17th century Holland, dot com bubble 2000

What is meant by a banking crisis and how can these occur?

occurs when large number of banks fail/come close to failure

caused by asset bubble where banks lend to those investing in an asset in the bubble

when the price of the asset reaches an unrealistic level, bubble bursts and falling prices lead to losses for investors. This leads to losses for banks, which could have multiple of these loans

Depositors and lenders lose confidence in banks

What were the causes of the 2007-08 banking crisis?

asset bubble in US house pricing as cheap credit available after dot com crash and 9/11 led to low interest rates

existence of securities based on US mortgages e.g. CDOs that were also affected by bubble bursting

false expectation that large pools of CDOs would be low risk causing CDOs to be very popular and widely held (even by banks)

requirement for banks books to be marked to market (assets booked at the current price not the price they bought at) so banks suffered large losses in 2008 when bubble burst and CDO values fell

What were the govs reponses to 2007-08 banking crisis?

changes were made to Basel regulations e.g.

1. requirement to hold more equity to absorb losses

2. requirement to hold sufficient liquidity to cope with outflows during periods of stress

In EU, all banks must have recovery and resolution plans in place so they can recover without creating systemic risk (one bank failing causes failure of system)

What are the failings of classic economic theory?

econ = study of human behaviour and assumes people make rational decisions not based on emotions

since 2008, psycho-analysts have taken more note of behaviours of participants in stock market and discovered human emotions involved

classic theory focuses on explaining way economic agents behave but doesn’t concern itself whether the result is good, bad, moral or ethical

crisis has foccussed attention on ethical issues e.g. rescue of major banks by govs caused debate on moral hazard

What are the 4 main functions of money?

1. medium of exchange

2. means of storing wealth

3. means of evaluation

4. means of establishing value of future claims and payments e.g. pension liabilities

What is cryptocurrency and discuss pros and cons in relation to traditional currency/other assets

encrypted digital asset stored on computerised database

+provide security and anonymity

+not prone to inflation

-prices volatile due to speculation and inflexibility

they lie outside regulatory system which could be seen as + or -

Define in terms of money supply:

monetary base (narrow money)

broad money

bank deposits multiplier

money multiplier

public sector net cash requirement

MB = notes in circulation outside central bank

BM = cash in circulation + retail and wholesale bank and building society deposits. M4 in UK

BDM = number of times greater the expansion of bank deposits is vs additional liquidity in banks that cause it = 1/liquidity ratio i.e. Deposits created per £1 of new reserves

MM = number of times greater expansion of broad money supply is vs expansion of monetary base that caused it i.e. Total money created per £1 of new base money

PSNCR = annual deficit of public sector = amount public sector has to borrow i.e. how much gov spends - how much tax it earns

What is the credit creation in theory?

Process through which bank deposits expand.

If bank’s liquid assets increase, they can be used as a base for increasing loans. Individuals/firms take out loans to spend money and that might be eventually deposited into recipient’s bank accounts. Those deposits can be used as a base for even more lending etc.

What is the money multiplier formula? Give 2 reasons why it is typically smaller than bank multiplier

(1 + fraction of rise in public deposits)/(fraction of increase in bank deposits held as reserves + fraction of rise in public deposits)

1. firms/households might choose to not borrow as much as banks willing to lend

2. some extra cash created by lending might be retained by firms/households and held outside banking system

What are 3 complications affecting credit creation process which means it will be hard to predict the effect of increased monetary base on broad money supply?

1. bank liquidity ratios vary e.g. seasonally

2. firms/households’ willingness to borrow might vary

3. proportion of extra cash retained by firms/households unpredictable

What are 5 main causes of changes in money supply?

1. change in monetary policy by central bank

2. change in banks’ liquidity ratios

3. change in firm/households’ cash holdings

4. inflow/outflow of funds to/from abroad

   1. public sector deficit

What is the flow of funds equation for M4 in UK. How do its components influence money supply?

Change in M4 = PSNCR - sales of public sector debt to non-bank private sector + bank/building society net lending to private sector + external effect

Gov borrowing from central bank to finance PSNCR leads to direct increase to money supply as BoE creates more money to buy the loans. If it is borrowing from banks/public, it won’t increase as much

If there is net bank lending to UK private sector, this will lead to multiplied increase in money supply (as banks create money from nothing) - effect reduced if they choose to hold more capital

net inflow of funds from abroad (external effect) increases money supply

Endogenous vs exogenous money supply?

Exo = does not depend on interest rates

Endo = does depend on interest rates

What are the 3 motives for holding money?

1. transactions

2. precautionary

3. speculative i.e. storing wealth

What are the 5 factors affecting transactions and precautionary demands for money?

1. money national income i.e. GDP not incl. inflation - if higher, need more money in hand

2. frequency people get paid

3. seasonality/other factors which affect consumption

4. interest rate

5. financial innovations e.g. increasing credit card use

What are 3 factors affecting speculative demand for money?

1. Interest rate/return on alternative assets

2. Expectations of changes in prices of securities and other assets

3. Expectations of changes in value of currency

What are 2 additional effects of expectations on total demand for money?

1. expectations about prices

2. expectations of interest levels over longer term

What are 3 reasons why increase in money supply causes reduction in domestic exchange rate?

1. part of excess money spent on foreign assets - increases supply of domestic currency on foreign exchange market so the demand for it will decrease

2. rate of return on domestic assets falls relative to foreign ones so investors sell UK assets and buy from a different country

3. speculators expect domestic currency to depreciate so sell and buy foreign currencies

What are 3 possible approaches to role of central bank in monetary policy and give examples

1. gov sets both policy target and measures needed to achieve it e.g. interest rate. Used in UK until 1997

2. gov sets policy targets but central bank given independence on interest rate. Current approach in UK

3. central bank given both responsibilities. Used in Eurozone

What are the 2 key influences on monetary growth over medium and long term? Explain how they could be controlled to reduce monetary growth

1. bank liquidity ratios - central bank can impose minimum reserve ratio to prevent banks from reducing liquidity ratio and expanding credit

2. gov borrowing - central banks can control public sector deficits

What is long-run neutrality of money theory? What does it mean for money control?

in long run, change in money supply ultimately changes general level of prices but it will not lead to permanent changes in real variable e.g. output, employment as they depend on real factors e.g. tech

so in order to keep inflation under control, need to control money supply and short term monetary expansion can’t be allowed if we want to achieve long term monetary control

What are 3 categories of monetary measure used to tighten monetary policy in short term?

1. reducing money supply - which increases interest rates

2. increasing interest rates (and then reducing money supply)

3. rationing credit offered by FI so money supply falls without increasing interest rates

What are 2 broad approaches to controlling money supply?

1. altering level of liquidity in banking system - affects how much it can loan out

2. altering size of BDM by altering ratio of reserves to deposits

What are 4 techniques that central bank can use to reduce bank liquidity (reducing amount of cash) and hence money supply?

1. OMO - central bank sells gilts in open market (commercial banks who pay with their cash reserves)

2. reducing amount it is willing to lend banks to reduce their cash/liquid assets

3. funding - get government to shift from issuing Treasury bills to issuing gilts

4. raising minimum reserve ratio (cash reserves:deposits) - reduces bank lending

Why might it be difficult for central bank to control monetary base?

banks could choose to deliberately hold excess cash so they can respond to central banks raising the minimum reserve ratio by reducing this cash instead of reducing lending

if minimum reserve ratio doesn’t apply to hedge funds, overseas banks etc. some lending will shift there which means monetary base still grows

if banks who have to follow minimum ratio are short of cash, they could attract cash away from uncontrolled institutions or offer higher interest rates to depositors to expand cash reserves

central bank always prepared to provide cash to banks via repos and/or rediscounting as lender of last resort

Why might it be difficult for central bank to control broad money supply and what are the problems/

1. value of money multiplier varies unpredictability (broad money = monetary base * money multiplier)

2. potential purchases of bonds under OMO might hold off buying if they think interest rates will rise in future so a large immediate rise in bond interest rates might be required

3. during recession where central bank wants to increase broad money supply, people might not want to spend/borrow and banks might not want to lend

4. changing money supply can lead to large fluctuation in interest rate - uncertainty and reduced investment/growth

How does central bank control interest rates assuming it decides to raise them and how will this affect interest rates more generally?

announce increase and create shortage of banking liquidity e.g. by OMO

as lender of last resort, it will raise interest rate at which it lends to banks (through repo and treasury bill rediscount rate)

this leads to higher interest rates generally

What are 2 reasons why interest rates might be ineffective at controlling credit (how much lending is happening)?

1. demand for money insensitive to interest rates - so maybe only increasing the interest rate by a lot will decrease demand for money - adverse effects to other parts of economy

2. demand for money might vary greatly and unpredictably due to speculation about interest rates, exchange rate, inflation and economic growth

What are 5 problems of a high interest rate?

1. reduce long term investment so long term economic growth

2. add to production costs and so inflation in short run

3. politically unpopular

4. require issue of high interest rate bonds which gov have to service in future

5. attract inflows of foreign money which increases exchange rate - makes it harder to export

Discuss the effectiveness of monetary policy in influencing AD

Particularly weak when it works oppositely to firms/households expectations of inflation and when it is implemented too late

tight monetary policy will eventually reduce lending and AD

expansionary policy less reliable as firms/households cannot be forced to borrow, no matter how low interest rates are

particular difficulty with cutting interest rates as they can’t be negative - problem when the economy can’t be stimulated even with really low interest rates

interest rates can be changed quickly so can be used to signal commitment to reduce inflation and so influence expectations

What are the 2 main policy responses of BoE and ECB to 2008 financial crisis?

1. cut lending rates to banks to record levels

2. quantitative easing to increase money supply

What are the aims of quantitative easing?

1. drive up bond prices so reducing borrowing costs (as interest rates fall) and increasing C and I

2. increasing money supply by increasing bank liquidity and their lending to firms/households

What is surplus value and labour power?

SV = value output workers have produced in excess of own labour cost - enjoyed by owners of capital

LP = commodity (i.e. mental and physical capabilities) that workers provide to owners of capital in exchange for wage . Value of labour power (long run wage rate) = amount sufficient to sustain workers

What is Marx’s labour theory of value?

value of product determined by number of hours of labour used to product it

he argues it can explain value of all commodities including labour power/long run wage rate (number of hours work sufficient to sustain workers i.e. for them to afford to live)

but the owners of capital make the workers work in excess of what is necessary to sustain them - surplus value is kept by owners of capital

Explain why Marx predicted collapse of capitalism

predicted competition amongst capitalists would drive most out of market and into the labour market and create monopolies

eventually, workers would gain enough power to dismantle whole system - socialist system inevitable

message adopted by political movements and socialist regimes formed e.g. Soviet Union 1922

What are the views of heterodox economists?

1. reject assumptions of neoclassical economics, particularly assumption of rational optimising behaviour

2. believe people unable to form rational expectations and it is difficult to make prediction so decisions hampered by uncertainty

3. highlight importance of understanding various influences on institutional and human behaviour

Explain why Austrian school believes central planning would be impossible

1. believe info about consumer preferences and costs of different ways of producing goods/services is subjective and dispersed (throughout society)

2. different people have different preferences that can’t be known by gov - making central planning impossible

3. preferences might be complex and not necessarily rational

Give an example of irrational behaviour. Explain how market can cope according to Austrian school

customer might have preference to buy product from mutually owned insurance company even though it is more expensive and identical in other respects

Austrian school believes market process reveals consumer preferences so competition and entrepreneurship within market is necessary to promote welfare of society. It can’t be known in advance whether different ways of producing goods/services will be cheaper/satisfy consumers better but the process of competition will make sure efficient firms that innovate and produce goods which are valued by customers will prosper

Explain why Austrian school places little weight on modelling eqm outcome and focuses on risk and uncertainty

preferences/costs of different production methods continually changing - modelling a fixed end point (eqm) is meaningless

they believe businesses will pursue many ideas and ventures because of the uncertain environment - it’s only in retrospect that success/failure can be identified so building a model predicting future is meaningless

as a result, they focus on uncertainty (can’t be quantified) and risk (can be quantified)

What is the Austrian school’s view of government intervention in the form of provising a legal framework?

believe gov should provide framework of law to enforce contracts and prevent fraud

Explain, with reference to finance sector, Austrian schools’s view of gov intervention in form of regulation

1. does not support government regulation that directs economic activity in particular ways (shouldn’t tell business how to operate)

2. in particular, doesn’t approve of regulation of products/risk management in financial institutions (telling banks what they can sell, how risk is managed because market itself with correct bad risk management)

3. argue that successful regulations cannot be known in advance

4. use e.g. 2008 financial crisis to demonstrate many forms of government regulation could have opposite to intended effect - actually created condition for crisis (e.g. low interest rates set by central bank, moral hazard of banks to take on more risks as they thought govs would bail them out, Basel rules incentivising banks to hold more MBSs as they were told they were safe)

5. also believe regulatory systems evolve within market itself so emphasise role of market

What is the Austrian school’s view of monetary policy?

1. central banks’ pursuit of a monetary policy that is too loose (low interest rates, quantitative easing, making credit too easily available) would lead to distortion of economy and inflation

2. argue that e.g. low interest rates cause unsustainable investment boom which will correct itself

Explain why, according to classical theory, savings equals investment

brought about by flexible interest rates in market for loanable funds i.e. market for loans and deposits into banking system

investment demand from firms to finance new PPE represents demand for loanable funds whilst savings represents supply of loanable funds

Real interest rates will adjust until demand = supply for loanable funds

Define “gold standard”

System whereby:

1. countries’ exchange rates fixed in terms of certain amount of gold

2. balance of payments deficits were paid in gold - physically give gold to foreign country who UK owe

Explain why, according to classical theory, imports equals exports

Let’s say trade deficit M>X. Under gold standard, deficit had to be paid for in gold from country’s reserves. They were then supposed to respond to outflow of gold by reducing amount of money in economy and hence reducing total expenditure

This would create surplus in goods and labour market leading to price and wage falls

Resulting fall in price of domestic goods would increase exports and reduce imports until deficit eliminated

Explain why, according to classical theory, governments should balance their budget to achieve eqm

Flexible interest rates and prices, as well as gold standard, would ensure S=I and M=X

So if gov balanced it’s budget to make T=G, total withdrawals = total injections and eqm achieved

What is Say’s law and use it to explain why, according to classical theory, at the eqm level of output, there will be no deficiency of demand (therefore no unemployment)

Say’s law = supply creates its own demand i.e. production of goods creates sufficient demand to ensure they are sold

No deficiency of demand and full employment as when firms produce goods, they pay out money to other firms and income to households. This income is partly paid back to firms as consumption expenditure - inner circular flow of income

but any withdrawals are also fully paid back as injections as long as gov balances budget (as in classical theory, X=M, S=I). So all incomes generated by firm’s supply will be transformed into demand - no leaking out of money from circular flow of income

What is the equation of exchange/quantity equation. Describe the assumption and main prediction of the quantity theory of money

MV=PY where M=money supply, V=velocity of circulation (average number of times per year money is spent on goods and services that make up GDP), P=price level(expressed as index) and Y=real national income(real GDP). MV =total spending in economy and PY = total value of output

Quantity theory of money assumes V and Y stable and any increase in money supply leads to proportionate increase in prices (inflation) - increasing money supply does not increase output (as there are already at full employment)

Define neutrality of money. Explain why, according to classical theory, an increase in money supply causes inflation

Principle that changes in money supply only affect nominal variables e.g. prices and have no affect on real variables e.g. real GDP, employment, living standards, capital

Classical economists argued as V and Y determined independently to money supply, they could be assumed to be constant in equation of exchange so increases in money supply only led to inflation and would not affect output

What were the 3 main causes of Great Depression in UK in 1930s?

1. return to gold standard at pre-war rate of £1=$4.86 coupled with loss of exports during war and rise in imports to rebuild economy caused severe trade deficit

2. deflationary prices introduced to drive down wages and increase competitiveness of exports led to severe recession

3. wall street crash 1929 led to US slump - resultant world slump reduced international trade incl. UK exports leading to deeper depression

What is the classical view of the following policies to combat Great Depression?

1. encouraging wage cuts

2. encouraging saving

3. public works projects

1. would reduce prices and restore export demand so correcting balance of payments

2. would lead to lower interest rates and more investment hence output and demand for labour

3. would not reduce unemployment and could have costly side effects e.g. crowding out private sector expenditure (private firms spend less) and high inflation

What is crowding out in general, resource crowing out and financial crowding out?

General = increased public expenditure diverts money/resources away from private sector

Resource = gov uses resources e.g. labour that would otherwise be used by private sector - less of a problem when there are unemployed resources

Financial = extra gov spending diverts funds from private sector so they don’t have finance needed for investment - demand for extra borrowing by gov likely to drive up interest rates generally

Use labour market model to explain why classical economists believe labour market always at eqm and only natural unemployment will occur

labour market initially in equilibrium with certain real wage rate - only natural unemployment present. If prices fall, e.g. recession, real wage rate will increase and cause surplus in amount of labour. This surplus then drives down nominal wage rate and then real wage rate to get back to real wage rate and unemployment returns to natural level

Explain why classical economists believed LRAS curve is vertical using AD-AS model

If AD increases, output and prices increase. But eventually, this will cause SRAS to fall as nominal wages increase. So ultimately, output falls back to natural level of real output

Explain how Keynes criticised classical policy of cutting wages

1. wages sticky downwards as workers resist wage cuts

2. so wages would not fall far or fast enough to clear labour market (get it to eqm) and get rid of demand deficient unemployment (not enough jobs for people)

3. reducing wages would reduce consumption so AD (fall in firm profits, further wage cuts, recession etc.)

How did Keynes criticise classical loanable funds theory?

1. even though encouraging saving might decrease interest rates so encourage investment, it would also reduce consumption and AD

2. This would reduce business confidence and hence investment

3. also, savings and investment might be very insensitive to changes in interest rates

How did Keynes criticise classical quantity theory of money?

1. if there is slack in economy (has spare capacity - idle factories and people unemployed), then increasing money supply might lead to increased spending and substantial increases in real income (Y) with little effect of prices (P) i.e. more stuff might be produced

2. on the other hand, major effect of cutting money supply to reduce prices might reduce output and employment instead

How did Keynes criticise Say’s law and outline his main conclusion and policy recommendation

1. argued demand creates supply so if AD increased, firms would produce more and employ more

2. main conclusion = unregulated market economy could not ensure sufficient demand

3. recommendation = gov should abandon laissez-faire (no intervention) and intervene to control AD

Why do Keynesian economists believe labour market is not always at eqm and that demand-deficient unemployment can occur?

1. wages inflexible as often set annually

2. this is concerning when AD falling as it can lead to significant fall in output and employment

3. firms respond to falls in consumption by laying off workers/cutting hours rather than cutting wages

   1. so wages often insensitive to fall in demand so will fail to fall to bring labour market to eqm - resulting in disequilibrium unemployment (demand-deficient)

Why do Keynesian economists believe SRAS curve might be horizontal and LRAS curve no vertical?

1. sticky wages mean short run output might change instead of prices

2. argue prices and wages exhibit inflexibility over long period of time so LRAS might not be vertical - economy could then be stuck at output below potential level

Define multiplier effect, demand management policies and stop go policies.

ME = initial increase in AD leads to greater absolute increase in Y (national income)

DMP = demand side policies (fiscal, monetary) designed to smooth out fluctuations in business cycle

SGP = alternate contractionary and expansionary policies to tackle currently most pressing out of the four problems (growth, inflation, unemployment, balance of payments) that fluctuate with business cycle

Define principle of cumulative causation and propagation mechanisms

Principle = initial event can cause ultimate effect that is much larger

PM = means by which economic shocks are transmitted through economy

Give an example of a fiscal and monetary policy that could be used when AD too low

Fiscal = Lower taxes (which increases consumption hence investment) or increased gov spending (which increases AD)

monetary = print more money (quantitative easing), lower interest rates

What are 5 criticisms of Keynesian policies that emerged in 1960s?

1. Keynesian demand policies were supposed to smooth out business cycle but economic fluctuations still existed

2. neglect of underlying structural problems e.g. unemployment might not be caused by AD

3. balance of payments problems with fixed exchange rate meant deflationary policies (cut demand) were pursued to boost net exports

4. breakdown of simple Phillips curve as both inflation and unemployment increased

5. focus on AD meant supply side largely ignored

Define marginal propensity to consume, disposable income, consumption smoothing and buffer-stock saving

MPC = proportion of a rise in national income that goes on consumption = change in C/change in Y

DI = household income after tax and benefits

CS = act by households of smoothing levels of consumption over time despite facing volatile incomes

BSS = people engage in saving partly to self-insure against unexpected events e.g. being sacked

Distinguish between factors causing

1. movement along consumption function

2. change in slope of consumption function

3. shift in consumption function

1. change in national income

2. change in mpc - affected by changes in marginal propensity to save and be taxed

3. change in autonomous/exogenous consumption