2.3.1 INTRO Key terms

Schools of Economic thought

Different groups of perspectives on how an economy should function, how to address economic problems…

Economic growth

Increase in total amount of goods and services produced by an economy - must be sustainable (able to last for many years)

National income

Total market value of goods and services produced by citizens of an economy over a period of time(money flowing in and out)

Short run economic growth

Annual % change

Long run economic growth

Increase in overall economic productiveness (over many years)

(Rate of) Inflation

Increase in overall average price level in an economy, compares how much higher or lower prices are compared to the same month a year ago - governments aim for 2%

Deflation

Decrease in overall price level of an economy

Disinflation

Falling level of inflation - still rising, but not as quickly as before

Hyperinflation 

Inflation increases rapidly, value of money becomes worthless

Unemployment

Number of people looking for a job but can’t find one at that point in time

Underemployment 

Workers can’t find suitable jobs for their experience and qualifications OR can’t find enough hours to work - country not using scarce economic resources effectively 

Balance of payments 

Value of exports (earning) - Value of imports (spending)

Healthy balance of payments / equilibrium 

Value of exports and imports are equal (large margin for error since dealing with a lot of money)

Deficit

Imports greater than exports (losing money) - money needs to be borrowed to pay off

Surplus

Exports greater than imports (earning money)

Hidden economy

Economic activity where trade and exchange (though cash) go unreported to tax authorities  aren’t recorded in income statistics

Green GDP

Measure of GDP that takes into account of the environmental costs of production eg. pollution and use of non-renewable resources

GDP

Measure of the market value of goods and services produced over a period of time

Transfer payments

Income for which there is no corresponding good or service eg. pension

Net national income

Measure of national income including net income from investments abroad and an allowance for deprecation of the nation’s capital stock

GNI

GDP + money flowing from other countries(by citizens) - money flowing to other countries (by foreigners)

% Change(in GDP) Calculation

= Change/GDP in first year 100

Real GDP(At year 1 prices) Calculation

= Nominal GDP / (Year 2 price index /Year 1 price index)

GDP per capita Calculation

= GDP/Population

Benefits of economic growth

• Increased investments

• Rise in exports

• Increase life expectancy

• Increase standards of living

• Increase employment

Drawbacks of economic growth

• Unsustainable - pollution, global warming, *short term

• National/global inequality

• Increase inflation

Hysteresis - Trade cycle

• Effects that remain after the removing what caused the effects

• *When recession is too low, the effects remain

• This causes the country’s trend growth line to shift downwards/fal

• This happens because of permanent loss of human capital(workers retiring early..) or physical capital (Firms cutting back on investment, machinery going out of date)

Phases of the trade cycle

• Boom

• Recession

• Depression

• Recovery

Trade cycle - Boom

• High national income

• Full employment

• High consumption and investment

• High tax revenue

• Increase in imports

• Increasing wages and profit -> risk of inflation

Trade cycle - recession

• Falling national income

• Rising unemployment

• Falling consumption and investment

• Falling tax revenue

• Falling imports

• Wage and profit demand decreases -> decreased risk of inflation

Trade cycle - Depression

• Lowest national income

• Peak unemployment levels

• Low consumption and investment

• Low tax revenue

• Low imports

• Low wages and profits -> Possibility of deflation

Trade cycle - Recovery

• Increasing national income

• Decreasing unemployment

• Increasing consumption and investment

• Increasing tax revenue

• Increasing imports

• Increasing wages and profit -> inflationary pressure

Recession

When real GDP falls for two consecutive quarters

Purchasing Power Parities

measures how many units of one country’s currency are needed to buy the same basket of good & services as can be bought with a given amount of another

currency of USD, adjust GDP according to PPP - High PPP increases GDP (low cost of living, can purchase more with same amount

Real GDP

GDP adjusted for inflation (compared to a base year)

Nominal GDP

GDP measured at the prices of that year

GVA - gross value added

GDP that includes spending on exports, takes away spending on imports

Globalization

Process in which national economies are becoming increasingly integrated and inter-dependent

Deindustrialization

Moving away from the manufacturing/primary sector, into secondary/service sector

Securitization

Pooling debts/loans and selling them, investors gain stream of income from debts being repaid + interest

Credit crunch

Reduction in availability of loans from banks, leading to reduced consumer spending

Austerity

Cuts to government spending, so tax revenue decreases and people can keep more of their money

Securities

Tradeable financial assets

Easterlin paradox

• Happiness and income positively correlate at low levels of income

• However, once basic needs are met (higher levels of income), higher income does not necessarily lead to higher happiness

Economic growth != increased standard of living

• Unsustainable - could reduce productive potential in future generations (pollution = asthma..)

• Inequality - associated with national inequality, only the top 1% enjoying benefits. Globally, globalization increases global inequality - e.g. when Finland imports from Congo for cheap minerals, FInland grows economically, however at the expense of those mining in Congo

Measures of National happiness

• GNH - Gross National Happiness

• OECD BLI  - OECD Better Life Index : Includes more measurements/categories, however results are similar to HDI

• HDI - Human development Index

Benefits of GDP

• Easy to compare over time

• Easy to compare either different countries

• Correlates with other measures eg. HDI

Flaws of GDP

• Statistical errors

• Hidden economy

• Home production (not traded)

• Doesn’t show inequality

• Doesn’t account for quality of goods, environmental impact/depletion of natural resources

Wellbeing

Considers personal life satisfaction of citizens, taking into account:

Real GDP per capita

Unemployment rate

Education

Health and life expectancy

Subjective happiness

Self reported levels of happiness, usually through surveys

Stagflation

• Occurs when there is recession(low employment) and high inflation rates

• Usually caused by the increase in prices of necessary goods (like food/fuel)

Reflation

• Steady inflation/rise in prices after recessions/economic downturns

Deflationary policies

• Implemented when prices are rising too quickly, meant to slow down and return to target rate of inflation

• Eg. Higher taxes, raise interest rates

Consumer Price Index (CPI)

• Most common measure of inflation, can compare index between years to know rate of inflation

METHOD:

• Send out survey to many households to find out their consumption habits

• Basket is made of goods and services purchased by an average household

• Price levels of each item is determined (averaged through different stores) and includes indirect taxation (as it measures price for consumers)

• Prices are averaged out to find average price of goods and services in the basket

• Different categories are weighted according to how important they are - Food, fuel and clothing. Changes in food prices will lead to more significant impact on CPI than other categories

Problems with CPI

• Doesn’t include housing costs/ mortgage and rent

• Doesn’t measure different spending habits across different types of household (pensioner households may spend more on food)

• Doesn’t indicate changes in quality of goods and services

• Struggles to capture innovation

• Doesn’t include spending of firms/governments - only consumers (only 60% of the economy)

Producer Price Index (PPI)

• Similar to CPI, has a basket of goods and services weighted to reflect their importance (collected monthly)

• Focuses on producers - spending of producers (includes money spent exporting goods from other countries to the firm)

• Includes price of raw materials (input prices) which are impacted by change in exchange rate - eg. oil depends on USD

• Also includes prices retailers pay for finished goods (factory gate/ output prices)

• PPI helps predict CPI trends - if production price increases, producers must raise product of price to increase profit (therefore CPI also increases) - there may be a time lag between increase in PPI and CPI

Retail Price Index (RPI)

• Collected similar to CPI, but includes council tax, mortgage  and other housing costs

• This makes RPI more volatile than CPI, showing higher rates of inflation 

• Excludes top 4% of earners and pensioners, as they are not typical households

• Inaccurate, used less

Alternatives to CPI

• CPIH - Includes housing costs - mortgage payments and rent

• CPIY - Excludes indirect taxes, used to help understand price changes before government intervention

• Core inflation - Excludes goods and services subject to volatility, like food and fuel - helps understand long-term trends of inflation

2 Main causes of inflation:

Demand-Pull inflation

• Increasing aggregate demand (AD), supply stays the same

Cost-push inflation

• Decreasing aggregate supply (AS), demand stays the same

Demand-pull inflation:

AD increases and no change in AS - excess demand leads to rise in price levels

Caused by:

• Excessive consumer spending (low interest rates for savings, less people save money, easy access to credit cards, rise in housing prices = rise in consumer confidence of homeowners)

• Rise in firm investment (companies buying/putting money into economy that doesn’t increase productivity - eg. buying more computers)

• Rise in government spending/massive tax cuts (unemployment benefits, more money to spend)

• Rise in world demand for exports (More money earnt and put into economy)

• Rise in money supply (printing of more money, easier to lend money)

Cost-pull inflation:

AS decreases and no change in AD, rise in price levels

Caused by:

• Increase in wages (Firms have to spend more to pay employees, production price increases, meaning price levels also need to increase)

• Increase in import prices (Vulnerable to rise in prices of raw materials if they can’t produce themselves - more money spent to import, production price increases - also impacted by change in strength of currency)

• Firms rising prices to increase profit margins (Inelastic goods like fuel and wheat increase prices to earn more money, those using products have to spend more money to buy - production price increases)

• Government increases indirect taxes/decreases subsidies + tariffs (Firms purchase goods for production and have to pay taxes, push taxes to consumers)

• Rise in running costs of firms (Rising rental cost, increases cost of production)

**Inflation is usually a mix of both, but will only ever have to refer to one at a time

Consequences of high inflation:

• Growth and unemployment (Harder for firms to plan - investments… - consumers may increase or reduce spending. Disruptions could lower national output and lead to unemployment

• Competitiveness (Eg. two countries sell same good, if one countries rate of inflation is higher, the good is more expensive and less people buy their good)

• Redistributional cost (Pensioners on fixed incomes spending power is reduced, as well as people with wages set before inflation. If inflation runs higher than interest rates, savers are affected. If government spending does not increase - unemployment benefits - real value decreases)

• Psychological and political cost (People feel worse off,causes social upheaval and more likely for political unrest)

• Shoe-leather costs (metaphor for time wasted by consumers looking around for lowest price - concerned prices are changing)

• Menu costs (Costs on firms having to waste time to recalculate new prices according to inflation - change labels, vending machines…)

Economic actors -

Firms, consumers and governments) can reduce costs of inflation if anticipated, giving a chance to prepare.

Indexation-

Way to anticipate inflation - wages automatically rise in response to annual changes in RPI, CPI (or pensions)

Consequences of deflation:

• Can cause AD to shift inwards (Falling prices lead to lower consumer confidence, reluctant to purchase goods as they may continue to decrease and be cheaper in the future)

• Decrease animal spirits (Owners of firms) and reduce investment

• Households encouraged to save - low and falling interest rates have higher real rate of return + real value of debts increase

Benefits of low inflation:

• Avoids problems of deflation and high inflation (2%, still increase price levels)

• Firms have incentive to innovate and invest (prices are still increasing)

• Central banks and governments have room to adjust economy (introduce policies that may shift AD)

• Inflation reduces real value of borrowed money - easier to repay debt, boost AD

Labour force

• ‘Active population’, people within a certain age range that are willing and able to work

• Doesn’t include inactive/those unable to work. Disability, sickness, retired or studying

• Made up of Employees, self-employed, underemployed and unemployed

• Data is collected through surveys or number of people claiming unemployment benefits

• Churn  - movement in the labour force

Employed

- in paid work

• Employees - employed by another individual, firm or government; Full or part time

• Self-employed - Working for themselves

Underemployed

• Would prefer to work longer hours OR

• Have jobs not suitable for their skill-levels

Unemployed

• Members of the labour force who are not in work but are seeking work

• Short-term: Out of work for less than 12 months

• Long-term: Out of work for more than 12 months

• Hidden unemployed: Lose a job and don’t actively seek for a new one (don’t believe they can find a suitable one, remain in full time education). No longer part of labour force, ‘hidden’ as skills aren’t being utilized

Employment rate

= No. employed / Population of working age  (Number of those in work/population of working age)

Unemployment rate

= No. unemployed/Labour force (Number of those not in work/active population)

Activity rate

= Number of those in work + Number of unemployed / Population of working age (Number of people working/looking for a job(labour force)/ population of working age

Inactivity rate

= Number of those not in work + not unemployed / Population of working age (Number of people not working + not looking for jobs/population of working age)

Causes of unemployment:

• Frictional unemployment

• Seasonal unemployment

• Structural unemployment (Regional, sectoral, technologic)

• Cyclical unemployment

• Real wage unemployment

Frictional unemployment

• Short-term unemployment, occurs in free market economies as they are not 100% efficient

• Eg. when teachers find new jobs, they are unemployed until the start of the next academic year

• Longer redundancy pay (payment after quitting in proportion to time at company) = longer time person can be unemployed and look for a job

Seasonal unemployment

• Jobs that depend on the season due to varying demand for labour

• Eg. tourism, agriculture

Structural unemployment

• Regional: When certain geographical regions suffer long-term unemployment due to difficulty of shifting factors of production (eg. when imports of raw materials increased from Asia as they were cheaper,  an area called the Rust belt in USA that was focused on extracting raw materials suffered)

 

• Sectoral: When certain sectors decline in importance, leaving previously valued and skilled workers unemployed (imports of raw materials from Asia increased, coal-miners lost their jobs)

• Technological: New technology puts groups of workers in an industry out of work (eg. self-driving cars)

Cyclical unemployment

• Caused by movements in the trade cycle - unemployed while an economy is in recession

Real wage unemployment

• Real wages (value of wage compared to minimum wage/ unemployment benefits) Caused by minimum wages or unemployment benefits being too high ; better to accept unemployment benefits rather than work/ work below minimum wage is illegal & jobs can’t be offered.

Methods to reduce unemployment:

• Increasing quality and quantity of labour force

• Increasing participation of certain groups 

  • Women, 60+, 16 to 24s

Increasing quality and quantity of labor force:

*MIGRATION

• Immigrants are younger, more motivated; more likely to be employed and don’t take unemployment benefits (Though may be underemployed)

• Spending increases AD, meaning firms expand and hire more workers

HOWEVER:

• Migration may decrease wages, as labour supply increases

• Local workers struggle to compete with more motivated and skilled migrants, who may work for lower wages

**Gov solves this by up-skilling labour force

• Makes labor force more competitive globally, reducing structural unemployment

• Done through training schemes or investing in education

Increasing participation in certain groups

Women:

• Lower participation rates due to family care. Bringing more women into labour force will increase GDP and tax revenues + reduce need to pay pension

Over 60s:

• Retire before reaching state retirement age, Government tries to keep them in work to increase GDP and tax revenues + reduce chance of having to pay benefits before state pension starts

• **Hard to solve, because in order to reduce unemployment, age requirement for retirement should be increased. Most of voters for government are in this age group, therefore popularity would be lost

16 to 24s:

• Often ‘underemployed’, even though they bring innovation

• Gov. offers subsidies and incentives for firms who hire people within this age range

Costs of unemployment:

Unemployed:

• Loss of income and savings

• Skills deteriorate, less attractive to employers

• Stress, social stigma, psychological problems

Dependents on unemployed:

• Negatively impacted, similar to unemployed

Local communities:

• Higher rates of crime, vandalism and violence

• Reduced tax revenue → less investment in local infrastructure

Government:

• Pay more for unemployment benefits

• Lose tax revenue → budget deficit

• Lose popularity

Economy:

• Suffer reduced real output (GDP)

• Social costs

Consumers:

• Spend less, firms lose money and close down → less choices/options

Firms:

• Loss of demand (due to reduced consumer confidence and reduced spending)

• Reduced pool of skilled workers to hire

Benefits of unemployment:

Decrease inflation:

• More unemployed = less spending, firms lower prices

Equilibrium on balance of payments:

• Less spending = decreased imports

Environment:

• Less spending → decreased production, less resources used up = decrease in pollution

UBI (Universal Basic Income)

• Economic idea that all citizens should be paid a regular sum of money by the government no matter what

Four reasons global economy has become more interconnected

• Increased proportion of nation’s output is traded internationally

• Increased proportion of assets(shares..) owned by overseas economic agents

• Increased migration between countries

• Increased sharing of technology  between countries

Impact of increased exports on PPF:

USUALLY Causes PPF to shift outwards, as increased exports = more need to be produced

However, sometimes it shifts inwards, as more raw materials and exported and less products can be produced

Countries have huge disparities(differences) in volume of exports of goods and services depending on location, access to resources and needs of that country

Components of BOP account:

Current account:

• Goods and services (visibles and invisibles)

• Primary and secondary income

Capital and financial account

• Payments associated with savings/investments

Current Account:

• Payments for the purchase and sale of goods and services - trade balance (X - M)

• Shows credits (payments received from other countries for exports), and debits (payments made to other countries from imports)

• Can be positive (Surplus) or negative (deficit)

Made up of:

• Goods(visibles) - raw materials, semi-manufactured goods or finished goods

• Services(invisibles) - Include financial services(bank loans/investments), transport, tourism and entertainment (healthcare and education can also be exported)

• Primary income - income generated from the actual production of goods and services and ownership of assets, wages, cross-boarder investments

• Secondary income - Payment of an economic value by one country that does not directly provide an item of economic value in return

Capital and financial account:

• Payments associated with saving, investment.. (shares)

BOP and current account imbalances:

In general, governments aim for export-lead growth HOWEVER

There are instances where economic growth leads to current account deficits - increase in consumption increases demand = need for more imports

When a country goes into recession, demand for imports fall (because unemployment rises), leading to a decrease in current account deficit

What is a Balance of Payment account

The BOP account is the record of all transactions between economic agents of one country with economic agents of all other countries

• Imports are negative, exports are positive

• Usually measured in USD

Economic growth

• Increase in total market value of goods and services produced by an economy in a period of time

• Measured in % change of real GDP per capita

• Real: adjusted for changes in prices - compares over time

• Per capita: Adjusted for population size - compares countries

• Causes an increase in national income

National income

• Total market value of goods and services produced by citizens of an economy over a period of time - home or overseas (net income)

PPP

• Exchange rate that takes into account the differences in cost of living of different countries (Higher PPP increases GDP, as more can be purchased with same amount of one currency)

Standard of living

• How well off individuals, households or economies are

• Measured by variables like income, health, environment, education and political freedom

HDI

• Statistic that includes life expectancy, education and income

TRADE CYCLE

• The difference between the trend growth line and actual growth line is called an output gap

• Negative output gap: Spare capacity, resources are not fully being utilized

• Positive output gap: Economy beyond capacity, workers are on overtime, resources overused, risk of inflation

  • If an economy operates beyond capacity for too long, there is risk of overheating: economic growth exceeds productive capacity = high inflation and resource strain/depletion

• Boom: Increase tax revenue - invest on infrastructure, decrease inflationary pressure as people keep less of their money

• Recession: Decrease tax revenue, people pay less taxes and keep more of their money + unemployment benefits

Benefits of economic growth:

• Increase in aggregate demand

• Greater range of high quality goods and services

• Increase life expectancy and standards of living

• Lower unemployment and increase tax revenue = develop on infrastructure and improved public services

• Increased firm investment