Untitled Flashcards Set

Aggregate output (GDP) is the output of all producers in a country, not just those of some region, firm, or sector.

Measure standards of living:

Gross Domestic Product – market value of all final goods and services that were produced in the territory of one country for one year.

Gross National Product – market value of all final goods and services produced by members of one nation for one year

GDP imperfections: it does not include domestic work nor the activities within the gray economy.

Nominal GDP: expressed in current market prices and is not adjusted for price change (inflation)

Real GDP: expressed in constant market prices

Expenditure (Spending): The total spent by households, firms, the government, and residents of other countries on the home economy’s products.

Output (Production): The total produced by the industries that operate in the home economy.

Income: The sum of all the income received, comprising wages, profits, the incomes of the self-employed, and taxes received by the government.

Components of GDP in detail:

·       Consumption (C): includes the goods and services purchased by households. 

·       Investment (I): the spending by firms on new equipment and new commercial buildings.

·       Government spending on goods and services (G): the consumption and investment purchases by the government. (transfers are not included in)

·       Net exports (X − M): is a deficit if the value of exports minus the value of imports is negative; it is called a trade surplus if it is positive.

Definitions of recession:

NBER definition: Output is declining. A recession is over once the economy begins to grow again.

Alternative definition: The level of output is below its normal level, even if the economy is growing. A recession is not over until output has grown enough to get back to normal.

How governments can moderate fluctuations?

Governments can use changes in taxes or government spending to stabilize the economy, but bad policy can destabilize it.

What is fiscal policy?

It‘s  government’s policies on taxes, spending, and borrowing. It can be used in an effort to mitigate fluctuations in the business cycle to soften the effects of those booms and busts.

Fiscal multiplier: when government increases spending for a new road during a recession, unemployed workers will be put to work.

Consumption function

Autonomous consumption: the fixed amount one will spend, independent of income

Slope of consumption function: marginal propensity to consume

Marginal tendency to consume varies across people:

Poor households with credit constraints react a lot to variation in current income, so their MPC is large. For wealthy households, current income matters little for current consumption, so their MPC is small

Expectations about future income are reflected in autonomous consumption.

Goods market equilibrium

Aggregate demand (AD) = consumption function + investment

Marginal propensity to import = The fraction of each additional unit of income that is spent on imports

The multiplier effect

The total change in output can be greater than the initial change in aggregate demand. This is because of the circular flow of expenditure, income, and output.

 multiplier = 1: the increase in GDP = the initial increase in spending

 multiplier > (<) 1: the total increase in GDP > (<) the initial increase in spending

The paradox of thrift: the aggregate attempt to increase savings leads to a fall in aggregate income.

Fallacy of composition: what is true for one part of the economy is not true of the whole economy.

 Government spending: exogenous; shifts AD curve upwards

 Consumption: household’s MPC is out of disposable income

 Investment: depends on the interest rate and after-tax rate of profit

The government stabilises economic fluctuations in several ways:

·       Higher tax rate lowers the multiplier

·       Unemployment insurance helps households’ smooth consumption

·       Deliberate intervention via fiscal policy

·       Fiscal stimulus

The rise in G operates via the multiplier, so the increase in Y will typically be greater than the increase in G.

The multiplier model again

AD = c0 + c1(1 - t)Y + I + G + X - mY

Saving, taxation and imports are referred to as leakages from the circular flow of income. They reduce the size of the multiplier.

Smaller multiplier = flatter AD curve.

Financing fiscal stimulus

·       Fiscal stimulus will result in a negative budget balance (government budget deficit).

·       If it is not reversed after the recession, it will increase government debt.

·       A government budget surplus is when tax revenue is greater than government spending.

The government’s finances

Primary budget deficit = G –T

Procyclical: the government must borrow to cover the gap between spending and revenue, by issuing bonds

Government debt: sum of all the bonds sold over time to finance budget deficit – matured bonds (repaid debt). The snowball. A large stock of debt relative to GDP can be a problem because the government has to pay interest on its debt.

Sovereign debt crisis: a situation in which government bonds come to be considered risky (default risk).

More analytically:   

Debt-to-GDP ratio

The level of indebtedness of a government is measured relative to the size of the economy (debt-to-GDP ratio).

Indebtedness can fall

·       if the primary budget balance is positive

·       if GDP is growing faster than government debt

·       if inflation is high (real value of debt falls)

Austerity policy: can reinforce a recession by further reducing aggregate demand.

The multiplier in practice: The multiplier depended on the marginal propensity to consume, the marginal propensity to import, and the tax rate. It also depends on rate of capacity utilisation (the phase of the business cycle): with fully employed resources, an increase in government spending would crowd out private spending

S = (Y - T - C) + (T - G) = Y - G - C

Expectations of the private sector: the multiplier could be negative if rising fiscal deficit erodes consumer confidence

Ricardian Equivalence: an economic hypothesis holding that consumers are forward-looking and so internalize the government's budget constraint when making their consumption decisions.

Lecture 8

Inflation and employment

Higher employment may result in inflation.

It increases workers’ bargaining position → higher wages → higher cost of production → higher prices

Inflation: An increase in the general price level

Zero inflation: A constant price level from year to year

Deflation: A decrease in the general price level

Disinflation: A decrease in the rate of inflation

Real interest rate = Nominal interest rate – Inflation rate

What’s wrong with inflation?

·       For people on fixed nominal income, higher inflation means lower real value of income.

·       Inflation reduces the real value of debt (good for borrowers, bad for creditors).

High rate of inflation makes the economy work less well:

High inflation is often volatile → uncertainty

What’s wrong with deflation?

·       Deflation could have even more dramatic consequences than high inflation.

When prices are falling, households will postpone consumption, which increases the real debt burden, which may lead households to cut consumption to return to their target wealth.

The bargaining gap: The difference between the real wage that firms wish to offer in order to provide workers with incentives to work, and the real wage that allows firms the markup on costs required to motivate them to continue in business.

Unemployment is above equilibrium: a negative bargaining gap and deflation.

Unemployment is below equilibrium: a positive bargaining gap and inflation.

Labour market equilibrium: the bargaining gap is zero and the price level is constant.

Unemployment below equilibrium: the real wage required so that workers will work hard increases so the claims of workers for wages and owners for profits are inconsistent:

Unemployment above equilibrium: workers are in a weaker bargaining position. The claims of workers and owners sum to less than labour productivity. → downward pressure on wages and prices

Phillips Curve: determines the feasible trade-offs between inflation and unemployment. (MRT)

Indifference curves: show policymaker’s preferred tradeoffs between inflation and unemployment. (MRS)

Optimal inflation rate where: MRS = MRT

Demand shocks: An unexpected change in aggregate demand

Governments can use both fiscal and monetary policy to stabilize the economy:

·       Monetary policy: decreasing the nominal interest rate

·       Fiscal policy: tax cuts and increased government spending

Inflation and aggregate demand

An upswing in the business cycle is often associated with rising inflation.

Higher aggregate demand → higher employment → higher wages → higher cost of production → higher prices

Supply shocks

Another cause of high and rising inflation is supply shock: unexpected change on the supply-side of the economy

Supply shocks shift the Phillips curve by affecting the labor market equilibrium.

Causes of inflation

·       Increases in bargaining power of firms over their consumers

·       Increases in the bargaining power of workers over firms

The role of expectations: Expectations of future prices can cause the Phillips curve to shift.

Inflation = expected inflation

                        + bargaining gap

The inflation-stabilizing rate is the unemployment rate which keeps inflation constant.

The Phillips Curve Over Time

Keeping unemployment “too low” leads to higher prices, but also rising inflation

To work out the inflation rate:

When inflation is not zero, we can summarize the causal chain from expected inflation and the bargaining gap to inflation like this:

The shifting Phillips curve

We can summarize the causal chain from the last period’s inflation rate to this period’s inflation rate like this:

Inflation targeting monetary policy regime where the central bank uses policy instruments to keep the economy close to an inflation target

Making the central bank independent from the government gives inflation targets credibility and prevents an inflation spiral by setting expectations.

Monetary policy in the European union

The main aim of the monetary policy in the EU: price stability

By maintaining price stability, monetary policy will make a significant contribution to general welfare, including high levels of economic activity and employment.

The Treaty establishing the European Community has assigned the Eurosystem the primary mandate of maintaining price stability.

The benefits of price stability

·       Supports higher living standards by helping to reduce uncertainty about general price developments  

·       Reduces inflation risk in interest rates

·       Reduces distortionary effects of tax systems and social security systems

·       Prevents the considerable economic, social and political problems related to the arbitrary redistribution of wealth and income associated