Equality and Equity

• Equity → income inequalities are needed to create incentive

• Equality → equal distribution of income (minimizing income gap)

• Market is unable to achieve equity

  • Equity → concept/idea of fairness; normative, means different things to different people

  • inequity is not inequality → distribution of wealth, income, or human opportunity

National Income Accounting

• used to measure amount of economic activity in a country

  • money value of all goods and services produced in a year

  • can be measured through things like GDP

1. output method

   • actual value of all finished goods and services produced each year

   • prevents double counting

   • measures level of economic activity

2. income method

   • calculates the value of all factor incomes earned in the economy

     • sum of wages and salaries (labour), rent (land), interest (capital), profits (enterprise) → factors of production

   • national income (Y) → households receive factor incomes for output produced

3. expenditure method

   • total value of all spending

     • total spending on all newly produced goods and services

   • comprising C, I, G, and (X-M)

     • C → spending by individuals and households (largest component)

     • I → spending by all firms (gross fixed capital formation)

     • G → spending of the public sector

     • (X-M) → import expenditure

Circular flow of income

• injections → add money to increase size (inc. in G, I, X)

• leakages → remove money to reduce size (inc. in savings, tax, import)

• 

Gross National Income (GNI)

• GNI = GDP + (income earned abroad) - (income sent abroad)

Aggregate Demand (AD)

• AD is the total demand for all goods and services in an economy at any given average price level

• value often calculated using expenditure approach

  • AD = C+I+G+(X-M)

• if AD has increased, economic growth has occured (and vice versa)

• a 1% increase in C or G is much more significant than a 1% increase in (X-M)

• AD curve is downward sloping

• whenever there is a change in average price level, there is movement along the AD curve

• if there is a change in any non-price determinants of AD, the AD curve shifts

• increase in the non-price determinants results in a rightward shift

  • at every price level, real GDP has increased

Factors of Aggregate Demand

• consumption (C)

  • consumer confidence →

  • interest rates ←

  • wealth →

  • income taxes ←

  • level of household debt ←

  • expectations of future price levels →

• investment (I)

  • interest rates ←

  • business confidence →

  • technology →

  • business taxes ←

  • level of corporate debt ←

• government spending (G)

  • political priorities

  • economic priorities

• net exports (X-M)

  • income of trading partners →

  • exchange rates ←

  • trade policies

Real GDP and GNI

• adjusted for inflation

  • calculated using a price deflator (GDP deflator)

• converts current prices to constant prices

• Real GDP = (nominal GDP / GDP deflator) * 100

• Real GNI = Real GDP + net income earned abroad

• Real GDP per capita = Real GDP / population

• Real GNI per capita = Real GNI / population

• purchasing power parity (ppp)

  • used to calculate relative purchasing power of different currencies

  • shows number of units of a country’s currency that are required to buy a product in the local economy, as $1 would buy the same product in the USA

Business Cycle

• 

• Recession

  • two or more consecutive quarters (6 months) of negative economic growth

  • increasing/high unemployment

  • increasing negative output gap and spare production capacity

  • low confidence for firms and households

  • low inflation

  • increase in government expenditure (great budget deficit)

• Boom

  • increasing/high rates of economic growth

  • decreasing unemployment, increasing job vacancies

  • reduction of negative output gap or creation of positive output gap

  • spare capacity reduced/eliminated

  • high confidence = riskier decisions

  • increasing rates of inflation → usually demand-pull

Alternative Measures of Well-being

• OECD Better Life Index → 11 factors

  • Housing

  • Jobs

  • Income

  • community

  • education

  • environment

  • civil engagement

  • health

  • life satisfaction

  • safety

  • work-life balance

• The Happiness Index → 14 factors (scale from 0-10)

  • business and economic

  • citizen engagement

  • communications and technology

  • diversity (social issues)

  • education and families

  • emotional well-being

  • environment and energy

  • food and shelter

  • government and politics

  • law and order (safety)

  • health

  • religion and ethics

  • transportation

  • work (employment)

• The Happy Planet Index → 4 factors

  • well-being → how citizens feel about their life overall (0-10)

  • life-expectancy → number of years a person is expected to live

  • inequality of outcomes → inequalities of people in a country (well-being, etc.)

  • ecological footprint → impact a person has on an environment

Aggregate Demand (AD) Curve

• negative relationship between price levels and real GDP

1. wealth effect

   • when price levels increase, real value of wealth decreases, decreasing consumer confidence thus reducing demand/output

2. interest rate effect

   • increase in price levels leads to a fall in output demanded due to interest rates increasing because of an increased need for money

3. international trade effect

   • rising price level causes a fall in exports and a rise in imports due to domestic price increasing but others stay the same

Short Run (SR) and Long Run (LR)

• SR in macroeconomics in the period of time when prices of resources are rougly constant/inflexible, in spite of changes in the price level

• LR in macroeconomics is the period of time where prices of all resources (labour/wages) are flexible and change with changes in the price level

  • wages account for the largest part of the firm’s costs of production

• SRAS - short run aggregate supply

  • profitability causes positive relationship between price levels and real GDP (increase in price = increase in output) and with unchanging resource prices, profits increase

  • Determinants of SRAS:

    • costs of factors of production

    • indirect taxes/potential subsidies/supply shocks

• LRAS - long run aggregate supply

  • Monetarist/Neoclassical model

    • price mechanism

    • competitive market equilibrium

    • economy as a harmonious system (automatically tends to full employment)

  • LRAS is vertical due to changing resource prices

  • located at Yp (potential GDP) at the full employment level of real GDP

  • in the LR, economy produces potential GDP, which is independant of the price level

• inflationary/deflationary gap - difference between SR and LR equilibrium

  • inflationary → SR>LR

  • deflationary → SR<LR

• market corrections → either SRAS or AD curve shifts (different price levels, same GDP)

  • inflationary gap:

    • 

  • deflationary gap:

    • 

Keynesian model

• 

• equilibrium at different sections means different things (where AD=AS)

• Ymax is where there is full employment

• economy can be below full employment level, even in the long run

• section 1 → AS is perfectly elastic as there is spare capacity (any increase in demand has no direct impact on general price levels)

• section 2 → AS is relatively price elastic (upward sloping) as there is pressure of scarce resources as the economy grows

• section 3 → AS is perfectly inelastic as there is no longer any spare capacity (all factor resources are fully employed)

  • any increase in AD beyond full employment level is inflationary

Shifts of the AS curve

• Short run

  • costs of factors of production / indirect taxes

  • labour costs - wages/salaries account for a significant portion

  • raw material costs - increase means increase in costs of production

  • exchange rate - rise means domestic firms can buy imports at a lower price

  • interest rates - borrowing

  • bureaucracy and administration - legal procedures and policies

• Long run

  • changes in economy’s quantity of factors of production

  • improvements in technology

  • increases in efficiency

  • changes in institutions

  • reductions in natural rate of employment

Long Run Equilibria

• full employment is not zero unemployment (unemployment always exists)

  • frictional → certain number of people are in between jobs

  • seasonal → redundancies are caused by cyclical factors in the year

  • structural → skills mismatch in certain industries

• Monetarist/Neoclassical model

  • occurs at full employment level of output (potential output)

• Keynesian model

  • increase in AD increases national output without changing the general price level

  • increased demand for scarce resources and labour shortages cause general price levels to rise as national output increases

  • full employment level of output

  • firms compete for highly limited resources

  • general price increases but GDP is at its max

Macroeconomic objectives

• economic growth

• low unemployment

• inflation

Economic Growth

• maximization of the factors of production → quality + quantity

• 

  1. long-term economic growth

  2. above potential level → something is wrong

  3. short-term economic growth

• actual output → current level fo real GDP

  • represented by any point on PPF diagram

• actual growth → rate at which actual moves towards potential

  • short-term → below full level of unemployment

  • annual percentage change of a country’s output

• short-run economic growth

  • increase in AD (rightrward shift) → Keynesian + Monetarist

  • increase in SRAS (rightward shift) → Monetarist

• long-run economic growth

  • increase in potential output

    • achieves both economic growth and full employment

  • shift of the AS → monetarist + Keynesian

• measurements of economic growth

  • nominal: rate of change in monetary value of GDP

  • real: accounts for inflation

Consequences of economic growth

• living standards

  • generally leads to higher living standards

    • higher real income per capita

  • reduction/elimination of absolute poverty (not able to purchase essential goods)

  • raises consumption → encourages investment in capital → sustains growth

  • increased tax revenues (for taxes on expenditure/income) enable government to fund more merit goods

  • increased consumer spending → higher sales revenue (firms) → greater profits

  • spending on demerit goods increase → in long run, causes social welfare loss

  • risk of inflation increases → excessive aggregate demand → negative consequences

• environment

  • creates negative externalities that cause problems to the environment

  • creates market failures caused by resource depletion

    • damages social and economic well-being in the long run

  • resource depletion not always sustainable → intergenerational equities

  • green GDP → adjustment of a country’s GDP to take into account environment degradation

• income distribution

  • often generates greater disparities in distribution of income/wealth

    • not everyone benefits from economic growth

      • example: rich get richer, poor get relatively poorer

  • greater tax revenues = government redistribution of income/wealth in the economy

Low Unemployment

• employment - use of factors of production in the production process

  • use of labour resources

  • governments want all available and willing to be employed

• formal sector employment → officially recorded employment → workers paying income taxes and contributing to the country’s official GDP

• unemployment → exists when forces of demand and supply are in disequilibrium

  • people are available and willing, seeking work but cannot find a job

  • inefficiency, non-use of scarce resources in the production process

• 

  • ADL → aggregate demand for labour

  • ASL → aggregate supply for labour

  • those who are able and willing to work at the prevailing market equilibrium wage rate (Wc)

  • A = employer surplus, B+C = employee surplus, D+E = welfare loss, F = welfare supply

• complements economic growth → higher employment = greater national expenditure

  • raises economic well-being and living standards

• increases tax revenues for government expenditure on education/healthcare/infrastructure

• prevents workers from leaving the country to find better opportunities (brain drain)

Measuring unemployment and unemployment rate

• using number of people officialy unemployed as a percentage of the workforce per time period

• unemployment rate = (number of employed / labour force) * 100

  • labour force - employed + self-employed + unemployed

• difficulties of measuring unemployment

  • hidden unemployment / disguised unemployment → not included in the calculation

  • discouraged workers → unwilling to work but able to

  • voluntarily unemployed → not actively searching for work

Underemployment

• people are inadequately employed → underutilization of labour force

  • although technically employed, the underemployed are not at their most efficient

    • cannot fully use their skills/abilities

Disparities

• measure of unemployment ignores disparities such as:

  • regional → different regions have different rates of unemployment

  • ethnic → ethnic minority groups struggle more to find a job (higher unemployment)

  • age → unemployment rates are higher for the young/old

  • gender → females face a higher rate of unemployment

Cyclical Unemployment

• unemployment derived from a downturn in the business cycle (recession)

  • lack of aggregate demand → fall in national real output → job losses

  • also referred to as demand deficient unemployment

  • most severe type of unemployment

• results in mass job losses

  • firms try to control costs, protect profitability, and prevent business failure

• represented through a deflationary gap / recessionary gap / negative output gap

  • difference between full employment and actual level of output (short-run)

  • closing the gap reduces cyclical unemployment

• 

• 

Natural Rate of Unemployment

• equilibrium rate of unemployment

  • calculating level of unemployment when labour market is in equilibrium

• NRU: no involuntary unemployment

  • some voluntary → some poeple remain out of a job

  • NRU = structural + seasonal + frictional

Costs of unemployment

• personal costs

  • stress (depression, suicide)

  • low self-esteem

  • poverty

  • family breakdowns

• social costs

  • crime / anti-social behaviour

  • indebtedness

  • social deprivation

• economic costs

  • loss of GDP → negative economic growth

  • loss of tax revenues

  • increased cost of unemployment benefits

  • loss of income for individuals

  • greater disparities in distribution of income and wealth

Low and Stable rate of Inflation

• inflation → sustained rise in general price level over time

  • people spend more to get the same amount

  • reduces purchasing power and country’s international competitiveness

• price stability → general price levels remain broadly constant

  • net zero inflation, but a low and stable rate

Measuring rate of inflation

• consumer price index (CPI) - change in average consumer prices over time

  • measured on a monthly basis but reported for a twelve month period

    • collects price data from a range of retail locations

    • assigns statistical weights (volume + value of quantities purchased)

Limitations of the CPI

• atypical households → CPI measures the ‘average’ household

• regional/international disparities → prices vary between countries + average household

• different income earners → CPI measures average; high income less affected by inflation

• changes in product quality → CPI ignores quality

• different patterns of consumption → difficult to apply statistical weights in historical data

• time lags → due to huge amount of data needed to construct the CPI

• volume / value of quantities purchased → uses quantities purchased instead of percentage of income

Causes of inflation

• Keynesian - increase in aggregate demand

• Monetarist - money supply

• demand-pull → AD must be controlled

  • example: deflationary fiscal policy → prevents rise in consumption and investment

• 

  • higher levels of AD

  • drives up general price levels

  • excessive aggregate demand (AD increases faster than AS)

  • might be due to higher GDP per capita, lower unemployment, increase in exports, lower interest rates, cuts in income tax

  • shown by AD1 → AD2

• cost-push → rise in general price level

• 

  • higher costs of production

  • shift from SRAS1 → SRAS2

  • increase in general price levels

  • reduces national output

  • higher production costs = raised prices

Costs of a high inflation rate

• diminishes ability of money to function as a medium of exchange

• uncertainty → reducing consumer and business confidence levels (lowers long run economic growth)

• redistributive effects → costs are not equally distributed (ex: people with fixed income)

• savings → real value of savings decrease over time (borrowers, lenders)

• export competitiveness → exports become more expensive

• economic growth → lowers expected real rates of return on capital investments

• inefficient resource allocation → higher costs of production

• shoe leather costs → customers spend more time looking for the best deals

• REUSER → redistributive effects, export competitiveness, uncertainty, savings, economic growth, resource allocation

Causes of deflation

• deflation → persistent fall in general price levels over time (inflation rate is negative)

  • either continual decline in AD or increase in SRAS

• Benign deflation → positive effect as economy can produce more (rightwards shift of the SRAS curve) → boosts rational output + employment without raising general price level

• deflation can be caused by lower production costs, higher productivity, or higher efficiency

• 

  • Benign deflation - SRAS1 → SRAS2

  • also called non-threatening deflation

  • greater number and variety of goods and services

• 

  • malign deflation → negative effect (leftwards shift of AD)

    • AD1 → AD2

  • associated with recessions and unemployment

  • harmful to the economy as there is a fall in real GDP

Disinflation

• fall in the rate of inflation but prices are still rising

  • occurs when inflation rate is negative

  • leads to deflation if not controlled

• shown by smaller proportional increase in average prices

• 

Costs of deflation (malign)

• uncertainty → increase in value of debts reduces confidence levels

• redistributive effects → fall in value of assets and wealth

• deferred consumption → postpones consumption (deflationary spiral)

• cyclical unemployment / bankruptedness → falling prices/wages = falling AD/confidence

• increase in real value of debt

• inefficient resource allocation

• policy ineffectiveness

Sustainable level of government (national) debt

• budget deficit → value of government spending exceeds its revenue (G>T) per time period

  • government debt = accumulated budget deficits over the years

• sustainable level - debt is affordable → paid in the long term

Measurement of government debt

• uses percentage of GDP (debt to GDP ratio)

• different from nominal/absolute value of debt

Costs of government debt

• debt servicing costs - loan repayment plus interest rates incurred in the debt

• credit ratings - measure of borrower’s ability to repay a loan

• future taxation / government spending - austerity measures

• budget deficits are not sustainable in the long run, there must be budget surpluses (G<T) to balance it out

Potential conflict between macroeconomic objectives

• low unemployment and low inflatioon

• high economic growth and low inflation

• high economic growth and environmental sustainability

• high economic growth and equity in income distribution

Low unemployment and low inflation

• more employment = inflationary pressures

  • low unemployment creates demand-pull inflation due to increase in AD

  • full employment creates cost-push inflation due to wage inflation

• short run Philips curve (SRPC) shows relationship between inflation and unemployment

• 

  • demonstrates opportunity cost, either low unemployment or low inflation

  • trade-off only exists in the short run

• stagflation → employment / GDP falls as there is inflation

  • stagflation and short run Philips curve

• 

  • increased natural rate of unemployment

  • stagflation creates a worse trade-off between low unemployment and low inflation

• 

  • long-run Philips curve (LRPC) is vertical at the natural rate of unemployment (NRU) → no trade-off

  • attempts to reduce NRU will be inflationary in the long run ((A→B) will cause (B→C))

  • the increase in costs of production shifts SRPC reverting the unemployment rate back to NRU

High economic growth and low inflation

• economic growth → increase in AD in a country

  • if AD rises faster than AS, there is demand-pull inflation

• 

  • increase in price levels caused by increase in AD

  • graph also represents trade-off between low unemployment and low inflation

• cost-push inflation can also occur due to the full employment level being reached

  • firms try to attract the more scarce skilled labour, leading to wage inflation

• monetary policy → reduces inflation by raising interest rates or increasing economic growth by cutting interest rates

  • conflict in use of interest rates, therefore conflict in objectives

• sustainable economic growth can exist with low/stable rate of inflation

  • AS increases with AD

  • when inflation rises too quickly, it harms consumption and investment

• controlled inflation can be helpful for economic growth (increases certainty)

• high economic growth leads to an inflationary gap

High economic growth and environmental sustainability

• as an economy grows, increased levels of production and consumption can create negative externalities that harm the environment

• increased consumption of demerit goods (ex: cigarettes)

• increased carbon footprint from increased income because of economic growth

• environmentally sustainable economic growth is possible

  • use of green technologies and renewable energy sources

High economic growth and equity in income distribution

• rapid economic growth leads to greater disparities in the distribution of the wealth/income in a country

  • widening the gap between the rich and the poor

• although everyone in the country benefits from economic growth, not everyone benefits in the same way

  • minimum wage builds less wealth than billionaires

• economic growth increases tax revenues, allowing the government to use the revenues to re-distribute income

  • so long as the tax system is progressive and equitable, there is not necessarily a conflict between economic growth and distribution of wealth

Unequal distribution of income/wealth

• income

  • imbalances of income distributions → very few members of the society enjoying a high concentration of the nation’s income

  • to compare nations → GDP per capita or GDP in terms of purchasing power parity

• wealth

  • imbalances in the spread of a country’s wealth → very few members account for a disproportionately large proportion of the wealth in a society

  • wealth → accumulation of assets with a monetary value

Factors that influence difference in wealth

• economic factors → high national debt

• natural resources → increases GDP per capita

• environment → reduces wealth (ex: floods, droughts, etc.)

• physical factors → reduces wealth (ex: hot/dry climates)

• social factors → limits ability to produce wealth (ex: education)

• political factors → determines economic prosperity (ex: war)

Measuring economic inequality

• income inequality → relative share of national income earned by given percentages of a population (deciles / quintiles)

• uses Lorenz curve and Gini coefficient

Lorenz curve

• graphical representation of income/wealth distribution in a country

• shows proportion of overall income/wealth accounted by each quintile or decile

• 

  • this example shows that the bottom 60% of the population holds 20% of the wealth (B)

    • means the top 40% holds 80% of the wealth

  • data is cumulative → adds up to 1/100%

Gini coefficient

• measures income/wealth inequality by calculating a numerical value of the Lorenz curve

• G is between 0 and 1

  • the higher the value, the greater inequality

• 

  • A = shaded area, B = area under Lorenz curve

  • Gini coefficient = A/(A+B)

  • line of equality has a 45° angle

Poverty

• condition of an individual, household, or community/country being extremely poor

  • not having money to meet basic human needs

    • food, clothing, shelter, healthcare, education

• absolute poverty → unable to afford basic needs for survival

• relative poverty → income/consumption level below social norm within a country

  • differs from country to country

Measuring poverty

• international poverty lines (poverty threshold) → minimum level of income to afford basic needs for human survival (below $1.90 a day)

  • does not take into account access to sanitation/water/electricity

• a more accurate measure would be a national poverty line

  • line value depends on the country (higher national income = higher poverty line)

• multidimensional poverty index (MPI)

  • uses health, education, and standards of living

  • considers multiple factors that reduce quality of life

    • ex: sanitation, child mortality rate, average years of school

Minimum Income Standards (MIS)

• lowest amount of income needed for an acceptable standard of living

  • varies by a country’s people’s standards and economic state

  • helps people live in a socially acceptable way

• in the UK, MIS is used for:

  • calculating the living wage (minimum wage)

  • quantitative benchmark for NGO/charities to determine who is in need

  • calculating costs of bearing/raising a child

  • helps governments determine level of social security and transfer payments

Difficulties in measuring poverty

• how would the national poverty line of very poor countries translate to the IPL?

• relative poverty is highly subjective

• a permanently low income creates a poverty trap

• PPP highly differs with location

Causes of economic inequality and poverty

1. inequality of opportunity

2. different levels of resource ownership

3. different levels of human capital

4. discrimination (gender, race, etc.)

5. unequal status and power

6. government tax and benefit policies

7. globalization and technological change

8. market-based supply-side policies

Impact of high income/wealth inequality

• brings possibility of higher income for those who work hard which creates incentives for people to work harder → improving labour effort

• prospect of earning higher incomes encourages people to invest in education and skill development → imporves labour productivity

• entrepreneurial instincts are encouraged as a result of potential to earn higher profits

• greater incentives and wealth creation can lead to a higher savings ratio

  • can be used to fund investments which creates an increase in the economy’s long-term growth and development

• creates more social tensions in the form of demonstrations, protests, political unrest, and crime which leads to less investment and labour participation rates

• more government spending on transfer payments to sustain the economy

  • adds to government debt, not directly to the national income

• discourages workers from joining labour foce and entrepreneurs from investing

  • increases voluntary unemployment

• affects standard of living

• affects social stability

Taxation

• progressive tax → higher incomes = higher percentage of tax paid

  • tax threshold → workers earn a certain amount of income per year before they can be taxed

• proportional taxes → percentage of tax paid stays the same irrespective of taxpayer’s income

  • also called flat rate taxes

• regressive taxes → those with a higher ability to pay are charged a lower rate of tax

• used to combat inequality in wealth and income

Monetary policy

• control and use of interest rates and money supply to influence level of AD and economic activity

  • overseen by the central bank or designated money authority

  • interest rates → price of money

Functions of a central bank

• executor of monetary policy

• government’s bank

• banker’s bank

• sole issue of legal tender (bank notes or coins)

• lender of last resort

• credit control

Goals of monetary policy

• low and stable rate of inflation (inflation targeting)

  • inflation target rate → transparent goal to help control inflation

• low unemployment

  • lower interest rates = economic activity increases = increase in AD

    • reduces borrowing costs so consumer confidence increases

• reduce business cycle fluctuations

  • lower interest rates in a downturn and higher interest rates in booms

• promote a stable economic environment for long-term growth

  • greater degree of certainty and confidence

• external balance (imports = exports)

  • influence the exchange rate

    • lower interest rates = reducing exchange rate

Money creation

• credit creation → banks create money from deposits of savers and borrowers

  • 

• minimum reserve ratio → limit on amount commercial banks can lend

  • to limit growth in money supply

  • money multiplier = 1/reserve ratio (how much deposit increases money supply)

• if the central bank wants to limit economic activity and suppress inflationary pressures, the minimum reserve ratio is increased to limit growth in money supply

Tools of monetary policy

• Open Market Operations (OMO)

  • buying/selling of government securities by a country’s central bank

    • government securities - type of public sector debt to finance government

    • sale of bonds with promise to repay borrowed money with fixed rate of interest

  • government securities sold when money supply needs to fall

    • increased interest (return) rate attracts buyers/investors

    • contractionary monetary policy → withdraws money from economy

  • opposite is true (not sold but purchased by central banks)

• Minimum Reserve Requirements (MRR)

  • commerical banks generally want to lend more to profit more, but the central banks require them to keep a certain percentage of their deposits at the central bank

    • called the minimum reserve ratio or minimum reserve requirement (MRR)

  • ensures the commercial banks have enough cash for their daily transactions

    • bank run → most customers withdraw all their cash deposits on any given day

  • raising MRR limits growth → 1/MRR = money multiplier

• Changes in central bank Minimum Lending Rate (MLR)

  • official rate of interest charged by central bank or loans to commercial banks

    • also known as base rate, discount rate, and refinancing rate

    • influences interest rates from commerical banks for lending

  • if MLR increases, the lending rates increase too → contractionary

• Quantitative Easing (QE)

  • central banks purchase corporate bonds to directly inject money into the economy

    • the institutions have “new” money and see an increase in liquidity

  • boosts money supply and promotes lending (increase in AD)

  1. central bank creates money

  2. central bank buys bonds from financial institutions

  3. interest rates reduced

  4. businesses/people borrow more money

  5. businesses/people spend more and create jobs

  6. boosts the eocnomy

Demand and Supply of money

• interest rate → return for lenders or price for borrowing (price of money)

• 

  • Dm → desire to hold money rather than saving it

  • Sm → total amount of money in the economy

• supply is vertical because supply of money is fixed at any given time by central banks

• opportunity cost of holding money varies directly with interest rate → fall in interest rates = reduction in opportunity cost of holding money

• central banks consider these when deciding supply of money:

  • state of economy (ex: deflationary gap = reduction in interest rates)

  • rate of growth of nominal wages (ex: higher labour cost = higher prices = inflation)

  • business confidence levels (lower interest rates = more incentive for investment)

  • house prices (most valuable asset)

  • exchange rate

Real VS Nominal interest rates

• interest rate → price of money (cost of credit or return on savings)

• nominal interest rate → actual rate agreed on between bank and customer

• real interest rate → accounts for inflation

  • real IR = nominal IR - inflation rate

    • IR = interest rate

Expansionary monetary policy (loose/easy)

• 

  • lower interest rates → shifts AD rightwards to close a deflationary gap

  • AD = C+I+G+(X-M)

    • C, I, G rise due to cheaper borrowing cost

    • (X-M) rise due to fall in exchange rate

Contractionary monetary policy (tight)

• 

  • closes an inflationary gap by increasing interest rates

  • opposite of expansionary

Effectiveness of monetary policy

• limited scope of reducing interest rates when close to zero

• low consumer and business confidence

• incremental + flexible + easily revertible

• short time lags

Fiscal policy

• use of taxation and government expenditure strategies to influence level of economic activity

  • to achieve low unemployment, sustainable economic growth, and low inflation

• promotes long-term economic growth and low unemployment through:

  • government spending on physical capital goods (ex: machinery, buildings, vehicles)

  • government spending on human capital formation (ex: education, training)

  • provision of incentives for firms to invest (ex: tax breaks, tax incentives)

Sources of government revenue

• taxation → direct and indirect

• sale of goods/services from state-owned enterprises

• privitization proceeds from sale of government assets

Taxation

• government levy on income or expenditure

• direct → imposed on income, wealth, or pfoits of individuals/firms

  • ex: on wages/salaries, inheritance, and company profits

• indirect → expenditure taxes on spending of goods/serivces in economy

  • ex: GST/VAT

Sale of goods and services from state-owned enterprises

• state-owned enterprises/nationalized industries → postal, airports, broadcasting

• government odes not aim to earn profits so revenue sources go toward paying the costs of providing the good or service

Sale of government assets

• selling government-owned assets/enterprises to shareholders in the private sector

  • hence the alternate name privitization

• short-lived policy → limited amount of assets to be sold

Government expenditures

• current → spending on goods and services consumed within the current year

  • also called consumption expenditure

  • for immediate operations and benefits

    • ex: wages/salaries, healthcare/education, subsidies, interest repayments

• capital → long-term items of spending (public sector investments) that boosts economy’s productivity

  • spending large amount of money to increase nation’s capital stock

  • also called fixed capital formation

  • intended to create future benefits for all members of society

    • ex: physical infrastructure: roads, tunnels, harbours, airports, schools, hospitals

  • ideally, the government would borrow money only to fund capital expenditure

    • fund investment expenditure in the economy

• transfer payments → welfare expenses from government to redistribute income

  • done through funding essential public services

    • ex: state education, housing, healthcare, social housing, postal services

  • no corresponding exchange of goods and services (unlike current/capital)

    • ex: unemployment benefits, state pensions, housing benefits, disability allowances

Goals of fiscal policy

• low and stable rate of inflation

  • using taxation policies to promote price stability

    • ex: higher tax rates + running a budget surplus = reduction in C+I+G

• low unemployment

  • prevents cyclical unemployment during recessions

    • reduction in tax rates and/or increasing government expenditure (G)

• promote a stable economic environment for long-term growth

  • promotes long-term economic growth by enabling low taxation

• reduce business cycle fluctuations

  • to reduce impacts of a recession, a budget deficit can be run (expenditure > revenue)

  • opposite is true with a budget surplus and higher tax rates for a boom

• equitable income distribution

  • done by using high marginal tax rates in a progressive tax system

  • also can use transfer payments

• external balance

  • X=M

    • ex: indirect taxers imposed on imports and/or government subsidies for domestic exporters will generally increase external balance: (X-M) → positive, increases GDP

      • opposite is true creating less external balance

Expansionary/reflationary fiscal policy

• used to stimulate economy during a recession

  • by increasing government expenditure and/or lowering taxes

    • boosts consumption and investment → rightward shift in AD

• Keynesian → no LRAS, believes government intervention is effective and needed

• Monetarist → LRAS shows no change in real GDP but increase in price levels (vertical)

Contractionary fiscal policy

• reduces economic activity by decreasing government spending and/or raising taxes

  • limits consumption (C) and investment (I)

• used to reduce inflationary pressures during a boom → closes inflationary gap

Keynesian multiplier

• shows any increase in value of injections results in proportionally larger increase in AD

  • any increase in any of the injections will increase value of the Keynesian multiplier

• injections → stimulates further rounds of spending (spending → income for another person)

  • ex: government spends money on social housing, leads to many other industries benefitting

    • the initial money generates a far greater value of final output

• leakages → reduce value of Keynesian multiplier: takes money out of the economy

  • negative multiplier effect → initial leakage leads to greater than proportionate fall in GDP

• determinants of Keynesian multiplier: MPC, MPM, MPS, MPT

  • marginal propensity to consume (MPC) → proportion of increase in household income that is spent on goods and services rather than saved (MPC = ∆C + ∆Y)

  • marginal propensity to import (MPM) → proportion of increase in household income that is spent on imports rather than on domestically produced goods/services (MPM = ∆M + ∆Y)

  • marginal propensity to save (MPS) → proportion of increase in household income saved rather than spent on consumption or imports (MPS = ∆S + ∆Y)

  • marginal propensity to tax (MPT) → proportion of each extra dollar of income earned that is taxed by the government (MPT = ∆T + ∆Y)

• Keynesian multiplier = 1/(1-MPC)

• Keynesian multiplier = 1/(MPS+MPT+MPM)

  • MPC + MPS + MPT + MPM = 1

Effectiveness of fiscal policy

• constriants on fiscal policy

  • political pressures

  • time lags

  • sustainable debt

  • crowding out

    • when increased government borrowing increases interest rates and creates a reduction in the private sector investment expenditure

      • G increases but I decreases

• strengths of fiscal policy

  • targeting of specific economic sectors

  • government spending effective in deep recession

  • automatic stabilizers

    • progressive taxes and unemployment benefits

Supply-side policies