Economic growth
*GDP
*understanding of economic growth
*consequences of economic growth
*
-What accounts for variations in economic activity overtime and why is it
important?
The conditions of the demand side and the supply side of the economy are subject to
continuous change, which causes variation in economic activity over time.
Fluctuations in economic activity have major e ects on the economic well-being of
societies and the individuals within them
Di erent schools of thought o er di erent explanations of macro problems and suggest
di erent solutions for dealing with these.
How economic activity is measured
1. The income method- the sum of the incomes earned through the production of
goods and services.
It adds up all income earned by the factors of production within a country over a time
period (usually a year): wages earned by labour, rent earned by land, interest earned by
capital and pro ts earned by entrepreneurship.
This is GDP=R+W+C+P
Note: only those incomes that are come from the production of goods and services are
include in the calculation in GDP.
-factors will NOT be included in the income
method:
Transfer payments
Private transfers of money
Income not registered with the tax authorities
Subsistence farming and barter
transactions(以物换物).
2.expenditure approach
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the total amount of spending to buy nal
goods and services in a country (usually within a year).
3.The output approach
output approach measures the value of each good and service produced in the
economy over a particular time period (usually a year) and then sums them up to obtain
the total value of output produced
Understanding of economic growth
Economic growth is the increase in the amount of the goods and services produced by an
economy over time.
It is usually expressed as:
-A percentage change in real GDP over a period of time, or
-A percentage change in real GDP per capita over a period of time.
Real GDP per capita is a better indicator of the standard of living of a population, since it
measures the amount of real GDP corresponding to each person on average.
GDP per capita measures the total GDP of a nation divided by the total population
The distinction between total and per capita measures is very important for two reasons:
1.di ering population sizes across countries.
2.population growth
The distinction btw nominal GDP and real GDP, nominal GNI and real GNI
What is nominal GDP, it is money value, or value measured in terms of prices that prevail
at the time of measurement.
Real GDP is a measure of value that takes into account changes in prices over time.
Nominal GDP and nominal GNI are measured in terms of current prices (prices at the time
of measurement, which does not account for changes in prices. Real GDP and real GNI
are measures of economic activity that have eliminated the in uence of changes in prices.
When a variable is being compared over time it is important to use real values
How to calculate the price de ator and economic growth
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Economic growth=the real GDP of current year-the real GDP of
previous year/ the real GDP of previous year
Distinguish the di erence btw GDP and GNI
Is the total value of goods and
services produced by a country per
year plus net income earned aboard
by its nationals; formerly called”gross
national product”.
The term “national”means that the
income it measures is the income of
the country’s residents, regardless
where this income comes from
The di erence between GNI and GDP
is the value of any net property
income from abroad.
What is national income statistics?
National income is the value of goods & services produced by an economy over a period
of time.
Purchasing Power Parities(PPP)means “buying power equivalence”
It is the amount of a country’s currency that is needed to buy the same quantity of local
goods and services that can be bough with $1in the US.
Convert the currency in the same value, make the good comparison.
Evaluate the use of national income statistics, including their use for making
comparisons over time, their use for making comparisons between countries and
their use for making conclusions about standards of living.
Good side about GDP
GDP is essentially a measure of how much buying power a nation has over a given time
period
Limitation of using GDP per capita over time
* Changes in the distribution of income
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* Di erences in hours worked
* Price changes
* Negative externalities (the quality of life may su er
as GDP increases, although this is not included in GDP
statistics) *Changes in the quality of products
Limitations of using GDP statistics for international
comparisons
Di erences in the distribution of income
Di erences in hours worked
International price di erences (this is signi cant
because an individuals phrasing power is based on
price in relation to income. The purchasing power of a
currency refers to the quantity of the currency needed
to purchases a given unit of good , or common basket
of goods and services. Achieving purchasing power
parity means equalizing the purchasing power of two
currencies by taking in to account cost of living and
in ation di erences)
Di culty of assessing true values
The uno cial economy Currency conversion(GDP
gures for di erent countries must be converted to a
common currency)
But on the other hand,
Why national income statistics do not accurately
measure the true value of output
*GDP and GNI do not include non-marketed output
*GDP and GNI do not include output sold in underground markets
*GDP and GNI do not take into account quality improvements in goods and services
* GDP and GNI do not account for the value of negative externalities
Why measure of the value of output(GDP/GNI)cannot accurately measure economic wellbeing
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*GDP and GNI make no distinctions about the composition of output
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* Unpaid work is not record
*GDP and GNI cannot re ect achievements in levels of education, health and life
expectancy
*GDP and GNI provide no information on the distribution of income and output.
*GDP and GNI do not take into account increased leisure
*GDP and GNI do not account for quality of life factors(A society’s well-being depends
upon a number of non-economic factors, such as the crime rate)
Average income=Total GDP/ population
Happiness Index
Based on the following dimensions
Real GDP per capita
Social support
Healthy life expectancy
Freedom to make life choices
Generosity(慷慨⼤⽅的)
Perceptions of corruption(贪污)
Happy Planet Index
Is a measure of sustainable well-bing
HPI=(life expectancy*well-bing*inequality of outcomes)/ecological footprint
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Ecological footprint: the amount of land needed to provide for all people’s requirements
and the amount of land needed to absorb CO2 emissions.
The business cycle
What is business cycle?
business cycles consist of short term uctuation in the growth of real output, which are
alternating period of expansion(increasing real output )and contraction(decreasing real
output)
Long-term growth trend
Expansion- where there’s positive growth in real GDP.
Peak-represents the cycles maximum real GDP and marks and end of expansion
Contraction:when the economy begins to experience falling real GDP(Negative growth) (if
contraction lasts six months(two consecutive quarters))
Trough- represent the cycles minimum real GDP
Potential real gross domestic product
The total real output(real gross domestic product )that the economy can produce if
resources are fully employed
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In theory this means that the economy is operation on the production possibilities
frontier.
What is the de nition of Full employment?
It is when the economy achieve potential output. When the actual output is larger than the
potential output, then there will have an in ationary gap, when the actual output is smaller
than the potential output, then there will have a recessionary gap.
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Full employment is generally indicated by achieving what is termed the natural
unemployment rate. It is meaning that unemployment is equal to the natural rate of
unemployment. But when actual GDP is greater than potential GDP, unemployment is
lower than the natural rate(full employment); when actual GDP is less than potential GDP,
unemployment is greater than the natural rate
Aggregate demand and Aggregate supply
What is AD?
Aggregate demand is the total quantity of aggregate (total) output, or real GDP, that all
buyers in an economy want to buy at di erent possible price levels, ceteris paribus.
The aggregate demand (AD) curve shows the relationship between the aggregate output
buyers want to buy, or real GDP demanded and the economy's price level, ceteris
paribus.
The factors that cause the AD curve shift to left and right
It is assumed that the AD curve will slope down from left to right. This is because all the
components of AD, except imports, are inversely related to the price level.
Four component of AD?
Consumption, investment, government spending, net export
The determinants of AD?
Consumption:*consumer con dence *interest rates(monetary policy) *wealth *personal
income taxes( scal policy)*level of household indebtedness
The reasons for why the AD curve has a negative slope.
-The wealth e ect(value of assets)
Price level increases, fewer output demanded, the real value of wealth falls.
-The interest rate e ect
Price level increase(borrowing increase), forces banks to increase interest rates.
(encourage saving)(price level increase, the interest rate increase, cost of borrowing
increase, the quantity of borrowing decreases)
-The international trade e ect
Price level increases, net exports fall.(exports will become more expensive, imports
will become cheaper)
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Impact of changes in short-run equilibrium(AD)
The increase in aggregate supply, will lead to the aggregate demand shift to the
right,Suppose there occurs an increase in aggregate demand, due to any of the factors
discussed earlier (such as an increase in national income abroad, or an increase in
investment spending).resulting in an increase in the price level and an increase in real GDP.
These changes also lead to a fall in unemployment since rms hire more labour in order to
produce more output.
If there is a decrease in aggregate demand (due,
for example, to pessimism among rms or a fall in
net exports), the price level and real GDP fall,
while unemployment increases since rms now
need less labour.
Shifts of AD curve
Shifts in AD: a change in any of the components of aggregate demand
will cause a shift in aggregate demand curve.
An increase in AD, such as that caused by an increase in household
spending, is shown by a rightward shift in the whole AD curve. The
shift in demand will have an e ect on the price level and national
output, but the e ects may not be uniform because aggregate supply
(AS) may not be linear.
Aggregate supply
What is AS?
Total quantity of goods and services that being produce in the particular time.
What is short-run AS?
The short-run aggregate supply curve (SRAS) shows the relationship between the price
level and
the quantity of real output (real GDP) produced by rms when resource prices (especially
wages) do not change
The short-run in macroeconomics is the period of time when prices of resource are
roughly constant or in exible(especially wages)
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The long-run in macroeconomics is the period of time when the prices of all resources
including the price of labor are exible and change along with changes in price levels.
(binding contract)
The distinction btw the short-run and the long-run in macroeconomics does not a ect
aggregate demand, but is very important for aggregate supply.
Why SRAS curve is upward sloping?
The SRAS is upward sloping curve is because as the price level increase the GDP will
also increase, because producer are willing to produce more good to earn more pro t.
over short periods of time, the SRAS curve shifts to the left or to the right mainly as a
result of factors that in uence rms such as change in wages cost of production, input,
subsidies, technology, business tax(tax on pro t)(if gov reduce the business tax, which is
the producers can earn more pro t to reinvest the technology or increase the incentive of
the production),
What factors will in uence the shifts of SRAS curve?
Changes in resources price(any change in the price of the gators of production include
wages will cause the cost of production either rise or fall)
Change in supply shocks (are the event that have a sudden and strong impact on the SRAS)
*Negative supply side, like a war, violent con ict or Unfavorable weather can lead to lower
output produced and a leftward shift of the SRAS curve.
*Positive supply shocks such as unusually good weather conditions, better use of resources
or better technology can also lead to a rightward shift of the SRAS curve.
Classical model and keynesian model
Monetarist/ new classical economists builds on the work of the classical economics of the
19th century. both schools of thought are built on the following principles:
`the importance of the price mechanism in coordinating economic actives
`the concept of competitive market equilibrium
They believe that the potential output of the economy is dependent on the quantity and
quality of the factors of production, not on the price level. The factors will a ect the LRAS
curve have availability of using resources and technology.
This is the long-run aggregate supply curve
According to the monetarist/new classical perspective, the longrun aggregate supply (LRAS) curve is vertical at the full
employment level of output, indicating that in the long run the
economy produces potential GDP, which is independent of the
price level.
Why the aggregate supply curve is vertical?
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Since wages are now changing to match output price changes,
Firms costs of production remain constant even as the price level changes. Therefore, as
the price level increases or decreases, with constant real costs. And also rms pro ts are
A monetarist/new classical long run aggregate supply (LRAS) is perfectly inelastic at the
level of potential output (full employment level of output). They believe that the potential
output of the economy is dependent on the quantity and quality (productivity) of the
factors of production, not on the price level. Thus the LAS curve is independent of the
price level. Short-run equilibrium positions in relation to long-run equilibrium:
(a)Recessionary gap equilibrium real GDP, Ye, lies to the left of potential GDP, Yp. When
real GDP is less than potential GDP, a recessionary gap exists. It is a situation where real
GDP is less than potential GDP (and unemployment is greater than the natural rate of
unemployment) due to insu cient aggregate demand.
(b)In ationary gap equilibrium . In part (b), equilibrium real GDP, Ye, lies to the right of
potential GDP, Yp. When real GDP is larger than potential GDP, the economy is
experiencing an in ationary gap, and unemployment is less than the natural rate of
unemployment.
In ationary gap which is means that there is too much total demand in the economy, and
rms respond by producing a greater quantity of real GDP than potential GDP. To produce
more output, rms labour needs to increase, and unemployment falls to become less than
the natural rate of unemployment.
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(c)full employment level of real GDP, showing long-run equilibrium, where equilibrium real
GDP is equal to full employment or potential GDP. When the economy is producing its
potential GDP, unemployment is equal to the natural rate of unemployment and there is
no de ationary or in ationary gap.
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also constant, and rms no longer have any incentive to increase or decrease their output
levels.
Automatic adjustment to full employment equilibrium at the level of potential
GDP(why in ationary and de ationary gaps cannot persists in the long run)
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-Keynesian model of as curve
It is base their ideas on the work of John Maynard Keynes.
He questioned the monetarist view of the economic system as a harmonious system
that automatically tends towards full employment, and showed that it is possible for
economies to remain in a position of short-run equilibrium for long periods of time.( he
was born is raised in great depression )
In the Keynesian model, in exible wages and prices mean that the economy cannot
move into the long-run. In exible wages are mainly due to labor contracts, minimum
wage legislation, worker and union resistance to wage cuts.
-the sticky-wage theory
Workers’ wages remain at the same rate, regardless of changes in the AD.
-the sticky-price theory
Prices are falling so low that will not de ate any further, rms won’t be willing to sell
their products at lower prices.
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In the horizontal range (section I) there is low levels of
economic activity. There is excess/spare capacity so very
little price pressure and high unemployment, Firms can
easily increase their output by employing the unemployed
capital and other unemployed resources, without having to
bid up wages and other resource prices. The horizontal
part of the curve is based on the Keynesian idea that
wages and prices do not move downward.
The factors shifting LRAS curve
* increases in quantities of the factors of production. (If the quantity of a factor of
production increases, the LRAS curve and Keynesian AS curve shift to the right.)
* Improvements in the quality of factors of production resources.(improvements in
resource quality shift the LRAS and AS curves to the right.)
* Improvements in technology. (An improved technology of production means that the
factors of production using it can produce more output, and the AS curves shift to the
right)
* Increase in e ciency.(when an economy increases its e ciency introduction, it makes
better use of its scarce resources, and can as a result produce a greater quantity of
output.)
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The relationship of LRAS and SRAS on classical model and Keynesian model
Low unemployment, low and stable rate of in ation
What is the de nition of unemployment?
It refers to people of working age who are activity looking for a job but who are not
employed.
What is underemployment?
It is referring to people of working age with part-time jobs when they would rather work
full time, or with jobs that do not make full use of their skills and education.
Both unemployment and underemployment means that an economy is waisting scarce
resources by not using them fully.
Potential con icts btw macro objectives
Con icting macroeconomic objectives means that it is not always possible for a gov to
simultaneously achieve all of its macroeconomics objectives owing to potential trade-o s.
Potential con icts
*low unemployment and low in ation(di cult to achieve)
*high economic growth and low in ation
*high economic growth and environmental sustainability
*high economic growth and equity in income distribution
Unemployment (or joblessness) occurs when
people of working age are without work and actively
seeking work.
Unemployment means that the economy is wasting
scarce resources by not using them fully.
Explain how the unemployment rate is
calculated.
The unemployment rate is the number of people looking for work divided by
the total number of people in the labor force. It is expressed as % of the
labor force.
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The labor force is de ned as those of 16 years of age or older who are
employed plus all those who are unemployed seeking work.
• Calculating the Unemployment Rate:
(Number of unemployed)/(Labor force) X 100 = unemployment rate
What is the 'Civilian Labor Force”?
It refers to employed or unemployed individuals, military personnel, federal
government employees, retirees, handicapped or discouraged workers are not
part of the civilian labor force.
Explain the di culties in measuring unemployment.
The existence of underemployment:
• Underemployment refers to those workers that are highly skilled but work in low skill
jobs and part-time workers that would prefer to be full-time. So individual is working but
isn’t working at their full capability. & Ex. Engineers work as waiters, taxi drivers, pizza
delivery man
• A national unemployment rate establishes an average for a whole country,
and this is very likely to mask inequalities among di erent groups within an economy. It
ignores regional, ethnic, age and gender disparities:
• Region with declining industries may have higher unemployment rates than other
regions (ex. Rural vs. urban).
• Ethnic groups may be disadvantaged due to discrimination, or due to
low levels of education and training.
• Age as youth unemployment is often higher than older age groups because they would
have lower skill levels as a group.
• Gender as women sometimes face higher unemployment rates than men.
Economic consequences of unemployment
• A loss of real output (real GDP)
• A loss of tax revenue for the government
Budget de cit, reduce government spending on public/merit goods for ex.
• Costs to the government of unemployment bene ts may increase
• Loss of income for individuals
• Greater disparities in the distribution of income
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• Unemployed people may have di culties nding work in the future
Personal/Social consequences of unemployment
• Decreased household income and purchasing power
• Increased indebtedness as people borrow to survive
• Increased levels of psychological and physical illness i.e. stress, depression
• Family tension and family breakdown
• Lower quality of life
• Lower self-esteem
• Downward pressure on wages for the employed (supply of workers increase)
• Increased poverty, crime, violence, drug use and homelessness
8 types of unemployment:
Cyclical Unemployment
as the term suggests, occurs during the downturns of the business cycle, when the
economy is in a de ationary/recessionary gap. As real GDP falls due to a fall in AD,
unemployment increases because rms lay o workers. In the upturn of the business
cycle, as real GDP increases, the de ationary/recessionary gap becomes smaller and
cyclical unemployment falls.
Frictional unemployment
Frictional Unemployment occurs when workers are between jobs. Workers may leave
their job because they have been red, or because they are in search of a better job, or
they may be waiting to start a new job. Frictional unemployment tends to be short term,
and does not involve a lack of skills that are in demand. It is therefore less serious than
structural unemployment.
Structural Unemployment
Structural unemployment occurs as a result of changes in demand for particular types of
labour skills, changes in the geographical location of industries and therefore jobs, and
labour market rigidities.
Natural Unemployment
is the minimum unemployment rate resulting from real or voluntary economic forces.
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Long-Term Unemployment
Long-term unemployment is when workers are jobless for 27 weeks or more.
Seasonal Unemployment
occurs when the demand for labour in certain industries changes on a seasonal basis
because of variations in needs.
Classical Unemployment
Classical unemployment occurs when real wages are kept above the market-clearing wage rate,
leading to a surplus of labour supplied.
Underemployment
It is referring to people of working age with part-time jobs when they would rather work
full time, or with jobs that do not make full use of their skills and education.
Causes of cyclical/demand-de cient unemployment.
It's a type that Keynesian economists focus on particular, as they believe it happens when
there's a disequilibrium in the economy.
* Vary with business cycle- booming economy, demand-de cient unemployment will at
this stage of the cycle be fairly low
*Classical economist emphasis supply side factors as the main
cause of unemployment.
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- They argue demand-de cient unemployment tends to be only Short term
Explain, using a diagram, that cyclical unemployment is caused by a fall in
aggregate demand.
Labor demand decreases from DL1 to DL2
But wages are sticky, it takes time for wages to adjust to a new situation.
*Due to contracts determine wages over a longer time period or people who are already
employed won't take a lower wage: they remain at W1 instead of falling to W2.
There is a surplus of labour: supply of labour is at point 1, demand for labour at point 2.
Cyclical/Demand-de cient:
Unemployment resulting from business recessions that occur when total demand is
insu cient to create full employment.
Causes of frictional/seasonal unemployment.
Inevitable due to imperfect information between employers and workers regarding job
vacancies and required quali cation. It takes time to for the right applicant to get matched
with the right job.
• Unavoidable because certain industries only produce or distribute their products at
certain times of the year
*Part of the nations natural rate of unemployment.
Causes of structural unemployment.
Due to mismatch of skills in the labor market:
* Geographical immobility - di culty in moving to regions for a job, usually due to the
family ties and perhaps di erent costs of living.
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* Occupational immobility = di culty in attaining new skills to a new industry (lack of
transferable skills)
*Technological Change - capitals replace labor, thus the demand of labor will fall
*Labor market rigidities - min wage, labor union, employment protection laws, generous
unemployment bene ts etc.
*Also part of the nations natural rate of unemployment.
Explain, using a diagram, that structural unemployment is caused by changes in the
demand for particular labor skills, changes in the geographical location of
industries, and labor market rigidities.
Evaluate government policies to deal with the di erent types of unemployment.
*Demand side policies to reduce cyclical/demand- de cient unemployment
(unemployment occurs during recession)
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*Supply side policies to reduce structural, frictional, & seasonal unemployment / (the
natural rate of unemployment)
low and stable rate of in ation
What is in ation?
In ation is de ned as a sustained rise in the average price level and a fall in the
value(internal value)of money.
What is de ation?
De ation is de ned as a sustained fall in the average price level and a rise in the value of
money. De ation tends to occurs when the economy’s capacity as indicated by the
position of the AS curve, grows at a faster rate than AD.
What is consumers price index?
Measures of in ation (and de ation) are obtained by use of price indices (indices is the
plural of index) A price index is a measure of average prices in one period relative to
average prices in a reference period called a base period. One of the most commonly
used price indices to measure in ation is the consumer price index (CPI).
The de nition of CPI:is a measure of the cost of living for the typical household, and
compares the value of a basket of goods and services in one year with the value of the
same basket in a base year. In ation (and de ation) are measured as a percentage
change in the value of the basket from one year to another. A positive percentage change
indicates in ation. A negative percentage change indicates de ation.
Explain that in ation and de ation are typically measured by calculating a consumer
price index (CPI), which measures the change in prices of a basket of goods and
services consumed by the average household.
In ation is measured by the use of price indices.
CPI is a measure of the cost of living for the typical household, and compares the value
of a basket of goods and services in one year with the value of the same basket in a base
year.
In ation and de ation are measured as a percentage change in the value of the basket
from one year to another.
A positive percentage change indicates in ation.
A negative percentage change indicates de ation.
Explain that in ation gures may not accurately re ect changes in consumption
patterns and the quality of the products purchased.
The CPI only looks at one characteristic of the consumer goods it records: the price.
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What is not accounted for is the quality or the technology behind the products.
however, is the improvement in consumer happiness resulting from improved quality and
technology of newer and better products that increase in both price and quantity,
Explain that economists measure a core/underlying rate of in ation to eliminate the
e ect of sudden swings in the prices of food and oil, for example
In many countries, what is reported most often to households by the government is
what's known as the core CPI.
This price index does not include changes in the price of food and fuel, which
economists ignore because of the frequent dramatic swings in price from one
period to the next. (inelastic)
It represents the most accurate picture of underlying in ation trends.
However, for many households food and fuel make up a signi cant proportion
of their expenditures.
A CPI that does not account for these goods may not accurately re ect the
e ect that in ation is having on the typical household.
Explain that a producer price index measuring changes in the prices of factors of
production may be useful in predicting future in ation.
The Producer Price Index is a family of indexes that measures the average change over
time in the selling prices received by domestic producers of goods and services.
Producer Price Index (PPI) measure price change from the perspective of the seller. This
contrasts with other measures, such as the Consumer Price Index (CPI), that measure
price change from the purchaser's perspective.
Price level changes measured by PP are considered to be predictors of changes in the
CPI and hence predictors of the rate of in ation, because they measure price changes at
an earlier stage in the production process.
Limitation associated with the measurement of CPI
Di erent rates of in ation for di erent income earners.
Di erent rates of in ation depending on regional and cultural factors
Changes in consumption patterns due to consumer substitutions when relative price
change
Changes in consumption patterns due to introduction of new product
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International quality
Types of in ation:
Cost-push in ation
Demand-pull in ation
Demand-pull in ation
It is caused by by an increase in aggregate demand and
results from an excess of aggregate demand over
aggregate supply, when the economy is at full employment
level of output.
Note that demand-pull in ation is associated with in
in ationary gap: real GDP is greater than full employment
GDP, and unemployment falls to a level below the natural
rate of unemployment.
Explain, using a diagram, that demand-pull in ation is caused by changes in the
determinants of AD, resulting in an increase in AD.
Main Causes of Demand-Pull In ation
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*A depreciation of the exchange rate increases the price of imports and reduces the
foreign price of a country's exports. If consumers buy fewer imports, while exports grow,
AD in will rise - and there may be a multiplier e ect on the level of demand and output
*higher demand from a scal stimulus, e.g lower direct or indirect taxes or higher
government spending. If direct taxes are reduced, consumers have more disposable
income causing demand to rise. Higher government spending and increased borrowing
creates extra demand in the circular ow
*Monetary stimulus to the economy: a fall in interest rate(cost of borrowing decrease,
investment increase, consumer spending increase, AD increase, demand pull in ation)
may stimulate too much demand for example in raising demand for loans or in leading to
house price in ation. Monetarist economists believe that in ation is caused by "too much
money chasing too few goods" and that governments can lose control of in ation if they
allow the nancial system to expand the money supply too quickly.
*Fast growth in other countries - providing a boost to UK exports overseas. Export sales
provide an extra ow of income and spending into the UK circular ow - so what is
happening to the economic cycles of other countries de nitely a ects the UK
Cost-push in ation
results from an increase in the cost of production (energy,
prices of other inputs, or wages of labor mostly) or supplyside shocks.
Seen by an leftward shift of the aggregate supply. A shift
inward of the SRAS leads to both in ation and a fall in real
GDP with more unemployment.
Explain, using a diagram, that cost-push in ation is caused by an increase in the
costs of factors of production, resulting in a decrease in SRAS.
Causes of Cost Push In ation*Higher Price of Commodities. A rise in the price of oil would lead to higher petrol prices
and higher transport costs. All rms would see some rise in costs. As the most important
commodity, higher oil prices often lead to cost push in ation (e.g. 1970s, 2008, 2010-11)
*Imported In ation. A devaluation will increase the domestic price of imports. Therefore,
after a devaluation we often get an increase in in ation due to rising cost of imports.
*Higher Wages. Wages are one of the main costs facing rms. Rising wages will push up
prices as rms have to pay higher costs (higher wages may also cause rising demand)
*Higher Taxes. Higher VAT and Excise duties will increase the prices of goods. This price
increase will be a temporary increase.
*Higher Food Prices. In western economies food is a smaller % of overall spending, but in
developing countries, it plays a bigger role. (food in ation)
Consequences of in ation
Menu costs(price level increase, food cost increase)
Boom and bust economic cycle
Potential fall in real incomes
Fall in real value of savings
Decline in competitiveness
Uncertainty/less investment
Costs of reducing in ation
Consequences of in ation-redistributive e ects
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Redistribution arises in situations where certain groups lose some of their purchasing
power and become worse o , while other groups gain purchasing power and become
better of o .
Groups who lose from in ation include:
-people who receive xed incomes or wages
-people who receive incomes or wages that increase less rapidly than the rate of
in ation
-holders of cash
-savers/lenders(creditors)
Groups who gain from in ation include:
-borrowers(debtors)
-payers of xed incomes or wages
-payers of incomes or wages that increase less rapidly than the rate of in ation
Consequences of in ation-greater uncertainty
Greater uncertainty
High in ation-people are uncertain what to spend money on/ rms are less willing to
invest due to uncertainties about future pro ts and cost - lower rates of economic growth
over the long term
Menu costs
This is the cost of changing price lists. When in ation is high, prices need changing
frequently which incurs a cost. However modern technology has helped to reduce this
cost.
Money illusion
This refers to the idea that some people are under the illusion and feel better o when
their nominal income increases, even though the price level may increase at the same rate
and possibly even faster.
Consequences of in ation-damage to export competitiveness
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When the price level in a country increases more rapidly than the price level in other
countries with which it trades, its exports become more expensive to foreign buyers. The
country's international competitiveness, or its ability to compete with foreign countries, is
reduced. The result is that the quantity of exports falls, and the quantity of imports
increases. This in turn may create di culties for the country's balance of payments.
Consequences of de ation:
Redistribution e ects
Increase in the real value of debt
Uncertainty
Risk of bankruptcies and a nancial crisis
Ine cient resource allocation
Discuss the possible consequences of de ation, including high levels of cyclical
unemployment and bankruptcies.
Risk of a de ationary spiral with high levels of cyclical
unemployment
De ation discourages spending by consumers,
because they postpone making purchases as they
expect that prices will continue to fall.
De ation also discourages borrowing by both
consumers and rms because as the real value of
debt increases as price levels fall.
The result is that consumers and business spending falls, causing aggregate demand to
fall.
Falling AD causes an increase in cyclical unemployment causing further downward
pressure on prices and leading to an ever increasing downward spiral.
Discuss the possible consequences of de ation, including high levels of cyclical
unemployment and bankruptcies.
Risk of bankruptcies and a nancial crisis
- With incomes falling while real value of debt is increasing, results will most likely be
bankruptcies of rms and consumers who are unable to pay back their debts. This could
lead to widespread, bank and nancial institutions crisis.
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- No de ation is ever good, because it discourage spending, reduces borrowing,
consumers postpone purchases with the expectations that prices will fall. De ation is
generally feared more than in ation because of these factors.
Distinguish between in ation, disin ation and de ation.
(Stag ation& Hyperin ation) Stag ation:
In economics, the term stag ation refers to the situation when
both the in ation rate and the unemployment rate are high.
It is a di cult economic condition for a country, as both
in ation and economic stagnation occur simultaneously and
no macroeconomic policy can address both of these
problems at the same time.
Why is high in ation an Economic problem?
*inequality
*falling real incomes
*negative real interest rates:
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*cost of borrowing
Economic growth and equity in the distribution of income
PPC & AD/AS & business cycle
The PPC model and the causes of economics
growth
The factors that lead to outward shifts of the PPC,
or increases in production possibilities are:
Increases in the quantity of resources (FOPs) in
the economy
improvements in quality of resources (for
example, through more education labor, or improved physical capital through
technological
change).
Reduction of unemployment and ine ciencies can only result in a limited amount of
economic growth.
As the economy moves moves closer to the PPC, the ability to achieve more growth is
exhausted, and more growth can only occur if there is an increase in production
possibilities.
Explain the importance of investment for economic growth, referring to investment
in physical capital, human capital and natural capital
Sources of long-run economic Growth(how to increase quantity and quality of FOPs)
Though investment in the three factors of production,
Physical capital depends on technological advances
Human capital(it is not the labour, it is the skills, abilities, knowledge and levels of
health of workers) includes spending on education, providing vocational training, medical
services and provision of sanitation etc.
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Natural capital Marketable commodities (they are economics goods)vs common
access resources(non rival and is excludible)
Explain the importance of improved productivity for economic growth.
Productivity refers to the quantity of output produced for each hour of work
What factors will increase productivity?
Improvements in quantity and quality of physical capital
Improvements in the quality of labor
Improvements in the quantity and quality of ecological
Describe using an LRAS diagram, economic growth as an increase in potential
output caused by factors including increases in the quantity and quality of
resources,
Increase in living standards, due to higher GDP per capita, increase in wealth and more
output to be enjoyed per person.
Decrease in unemployment, more workers needed for the increased production
Possible reduction in inequality(using taxation). Governments can increase their tax
revenue and redistribute more.
Increases in exports and imports: more production may lead to a higher export
potential, more demand may lead to a higher import potential
Possible increase in sustainability, where GDP is growing there is more money available
to work unsustainable technologies.
Consequences of economics growth
increase in living standards, due to higher GDP per capita, increase in wealth and more
output to be enjoyed per person.
Decrease in unemployment, more workers needed for the increased production.
Possible reduction in inequality (using taxation). Governments can increase their tax
revenue and redistribute more.
increase in exports and imports: more production may lead to a higher export potential,
more demand may lead to a higher import potential.
Possible increase in sustainability. When GDP is growing there is more money available
to work on sustainable technologies.
Possible increase in in ation: when caused by a higher demand prices may rise due to
demand pull in ation
Possible decrease in environment: a higher GDP means production has increased.
Production may be polluting the environment.
Economic growth may also lead to higher income inequality. There is no guarantee that
the bene ts of growth will be fairly distributed.if growth is driven by only a handful of
industries, concentrated uncertain regions, or relies only on certain skills income
inequality may widen.
Equity in the distribution of income
Equity- fair distribution of income
Equality- equal distribution of income
The opposite of equity is inequality. Equity in the distribution of income is usually
interpreted as the pursuit of greater equality(or less inequality) relative to what would be
achieved by the free market
Explain that due to unequal ownership of factors of production, the market system
may not result in an equitable distribution of income.
In a market economy the amount of goods and services that households receive
depends on their income, as this determines how much they can buy.
Their income, in turn, depends on payments they receive by selling the factors of
production they own. Therefore, output and income distribution in a market economy
depend on how many resources consumers own and are able to sell in the resource
market, as well as on the prices of the factors of production they sell.
Measurement of wealth inequality :
*quintiles
*Lorenz curve
*Gini coe cients
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Quantile is a 20% portion of a country’s population, we can divide a population in to ve
quantiles, the lowest quantile is the poorest 20% of the population, the highest quantile is
the highest 20%of the population is the richest.
lf income were equally distributed, everyone would receive exactly the same income, in
which case every quintile would receive 20% of income. However, in the real world this is
a virtual impossibility. Deciles is a 10% portion of a country’s population.
The higher the Gini coe cient means that the more unequal of the income distribution
Draw a Lorenz curve and explain its signi cance
A Lorenz curve is used to show the degree of income inequality in an economy.
The vertical axis measure the total amount of income in an economy in cumulative
percentages and the horizontal axis plots the total population
of the economy also in cumulative percentages.
The diagonal line in the diagram represents perfect equality
in income distribution
The Lorenz curve plots the actual relationship between
percentage of the population and the share of income they
receive
Draw a Lorenz curve and explain its signi cance
With the Lorenz curve a “perfect” income distribution would be one where each
percentage received the same percentages of income
Perfect equality would be for example where 60% of the population gain 60% of
national income
Draw a Lorenz curve and explain its signi cance
With the Lorenz curve a “perfect” income
distribution would be one where each percentage
received the same percentages of income
Perfect equality would be for example where 60%
of the population gain 60% of national income
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Perfect equality would be, for example, where 60%
of the population gain 60% of national income. In the
Lorenz curve shown, 60% of the population gain only 20% of the income, hence the
curve diverges from the line of perfect equality of income.
*The further the Lorenz curve is from the 45 degree line, the less equal is the distribution
of income, and the closer the Lorenz curve to the 45 degree line, the more equal.
Explain how the Gini coe cient is derived and
interpreted.
*The Gini coe cient or index is a mathematical device
used to compare income distributions over time and
between economies.
*The Gini coe cient can be used in conjunction with the
Lorenz curve.
*It is calculated by comparing the area under the Lorenz
curve and the area, from the 45° line to the right hand and
'x' axis.
*Gini coe cient = (area between diagonal and Lorenz curve) / (entire area under diagonal)
*Gini Index & A/ (A + B)
Greater wealth inequality is due to
Limited growth in wages(more di cult for low-income people to save and accumulate
wealth)
High income people tend to consume a smaller fraction of income
Greater income, lead to greater possibilities for accumulating wealth.
Distinguish btw absolute poverty and relative poverty
Absolute poverty refers to the inability of people to satisfy their basic needs in an
absolute sense that is constant and unchanging.
A “poverty line” is a level of income that is considered minimally su cient to sustain a
family in terms of food, housing(shelters),clothing, medical needs etc
The world bank has de ned internationally determined poverty lines used mainly less
developed countries as:
Living on less than $1.25 a day extreme poverty
Living on less than $2.00 a day, de ned as moderate poverty
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The poverty rate is the percentage of the population whose family income falls below an
absolute level called the poverty line.
Distinguish btw absolute poverty and relative poverty
Relative poverty is the state of earning an income that puts one in the lowest income
level within his or her own country.
Unlike absolute poverty, it exists everywhere, since within even the richest nations a
proportion of the population earns relatively less than the top income earners.
If income were equally distributed, there would be no relative poverty, since no one
would be poor relative to some one else.
In general the more unequal the distribution of income, the greater is the degree of
relative poverty.
Explain possible causes of poverty, including low incomes, unemployment and lack
of human capital.
Primary factors that may lead to poverty include
*overpopulation, the unequal distribution of resources in the world economy, inability
to meet high standards of living and costs of living and costs of living, inadequate
eduction and employment opportunities environmental degradation, certain economic
and demographic trends, and welfare incentives.
*low incomes
*unemployment
People who are unemployed long-term like structural, lack skills to obtain jobs and thus
receive no income but very limited
*low levels of human capital
*Low levels of capital or land ownership
People in poverty usually have very little in assets and not much collateral, thus they
may nd it hard to nance an education or a business. They usually are forced to pay a
large share of their income on rent and food and thus lack savings.
Poverty may be causes by numerous factors:
*discrimination-di erent racial and ethnic groups or women may face discrimination on
the job market. This results in lower wages, a barrier to advancement, job entry and skill
achievement.
*Geography-people live in remote geographical regions, with limited
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possibilities for employment, and limited possibilities to move to a more
economically active regions. (This leads to problems in over crowding in
urban centers)
*Age - if older people who live in less developed countries who lack pension
systems.
*Limited social services (merit goods) - people in low incomes must rely
heavily on social services (health care, education, housing) provided or
subsidized by the government.
*Poverty - poverty itself may become a cause of further poverty. This selfperpetuating cycle may be set into motion where low incomes leads to low
human capital, and further to low incomes (poverty cycle).
Possible consequences of poverty
Low living standards- such as greater levels of psychological stress, alcoholism, poor
nutrition and poor levels of health, all leading to poorer job and income-earning
prospects.
Lack of access to health care and education- leading to lower human capital formation,
lower productivity and lower incomes.
Higher infant, child and maternal mortality-the inability to access needed health care
services, as well as poor nutrition for mother and children lead to large numbers of
unnecessary deaths among infants, children and women.
Higher level of preventable diseases- poor hygiene and nutrition make both children
and adults more prone to(more likely to) illnesses.
Social problems- such as higher crime rates, drug use, family breakdowns and
homelessness.(increase the gov’s spending)
Inability to realize one’s full potential-leading to a waste of human talent, and in addition
to the personal costs, may result in lower economic growth.(increase the gov’s spending)
Methods that can be used to promote equity (redistribute income and output)
Transfer payments
Direct provision of merit goods
Government intervention(indirect tax, price controls. Subsidies, policies, )
Taxation
Explain the term transfer payments, and provide examples, including old age
pensions, unemployment bene ts and child allowances
A transfer payment is a payment from the gov to an individual for which no good or
services is exchanged
In order to be eligible to receive them, an individual has to fall below a certain income
threshold or to be experiencing economic hardship(such as older people, sick people,
very poor people etc.)
Transfer payment existing in most developed countries include:
Unemployment bene ts
Social security bene ts-pensions
Higher education grants and tuition subsidies
Welfare bene ts-nutritional subsidies(maternity bene ts, child allowances), housing
bene ts for the poor.
Explain that gov undertake expenditures to provide directly, or to subsidize a variety
of socially desirable goods and services, thereby making them available to those on
low incomes
Recall merit goods
How does gov undertake expenditures
Why need to provide merit and public goods?
How does provision of merit goods and public goods help redistribute income and
promote equity?
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Explain that governments undertake expenditures to provide directly, or to
subsidize, a variety of socially desirable goods and services, thereby making them
available to those on low incomes.
Infrastructure, often quasi-public goods, such as water and sewage
services, transport infrastructure, and social housing are provided
by the government.
*The government either provides these goods or services directly or they
government pays subsidies to rms in the private sector to provide them.
*The governments provide these goods and services because if they were left to the free
market people on low incomes would not have enough money to buy them.
Government intervention
Governments often intervene in markets in ways to promote equity, reduce inequality
and poverty.
*minimum wage legislation - The long-term aim of a minimum wage is to remove the
problem of poverty pay, which exists when the earnings from paid work do not result in a
living wage and fail to push people out of poverty.
*food price ceilings
*price oors for farmers
Distinguish between direct and indirect taxes, providing examples of each and explain
that direct taxes may be used as a mechanism to redistribute income.
Two major categories of taxes: direct taxes vs. indirect taxes.
*Direct Taxes are taxes paid directly to the government tax authorities by the taxpayer.
*Indirect Taxes are taxes paid indirectly by consumers on spending on goods and
services.
Direct taxes
*Personal income taxes
Taxes paid by households or individual and are on all forms of income, including
wages, rental income, interest income, and dividends
*Corporate income taxes
Corporations are businesses ( rms)that have formed a legal body and is legally
separated from its owners. Corporate income taxes are paid on the pro ts of the
corporations
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*Wealth taxes
These are taxes on the ownership of assets. Examples include, property taxes and
inheritance taxes.
*Social insurance contribution/payroll taxes
Paid by employer and worker to nance speci c expenditures, such as pensions,
heath care, insurance etc.
Indirect taxes
*sales taxes these are taxes on spending or sale of goods services. In the USA they are
a xed percentage of the retail price of the good or services. (Ad valorem or percentage
tax). In the EU, they have a value added tax'(VAT), which is a tax paid on the value added
by each producer in the production process.
*Excise taxes
These are taxes paid on speci c goods or services, such as cigarettes
and gasoline (Speci c or per unit tax).
*Customs duties (tari s)
These are taxes placed on imports of foreign goods into a country.
*Utility Charges*
Why direct taxes may be used as a mechanism to redistribute income?
Taxation makes redistribution possible through transfer payments and subsidized
provision of merit goods since they are paid out of the tax revenues.(transfer payment)
Taxation is itself an important instrument for redistribution, because it can lower
incomes inequalities by taking more taxes from the rich than from the poor.
Progressive tax(direct tax): increase in income the fraction of income paid as taxes
increases, there is an increasing tax rate. For example: income tax.
Regressive tax(most of the indirect tax):as income increases, the fraction of income paid
as taxes decreases; there is a “decreasing tax rate”(the poor people will give the larger
proportion than the rich people). Example:sales tax
Proportional tax(direct tax):as income increase, the fraction of income paid as taxes
remains constant; there is a constant tax rate. Example: at tax
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The more progressive a tax system, the more equal is the after-tax distribution of
income compared to the pre-tax distribution of income.
Evaluate gov policies to promote equity on e ciency in the allocation of resources.
A tax system that punishes innovation, productivity and hard work is clearly
undesirable and should therefor be avoided.
However, a tax system including progressive income taxes combined with regressive
indirect taxes ensures that both the rich and the poor share a portion of the nation’s tax
burden.
Yet it also ensures that those with the greatest ability to pay bear the largest burden
while those whose ability to pay the lowest bene t from the public and transfer payments
that the government provides.
This reduces the inequality of income distribution and corrects for market failure that
results in a free market system.
Taxes and allocative e ciency
*when taxes are used to correct market failures, they are intended to move the
economy toward a more e cient allocation of resources.
*however most taxes levied by the gov are not implemented with the intention of
correcting market failure. Many economists argue that a variety of taxes worsen the
allocation of resources, causing allocative ine ciency.
Income taxes, equity and e ciency in resource markets.
*High income taxes act as a disincentive to work as well as to save, particularly among
high-income earners. Income taxes reduce after-tax income, and as a result reduce the
quantity of of labor o ered in the market, and also reuse savings.
*Lower savings has a negative e ect on investment, and therefore on the production of
new capital goods, which translate into lower rate of growth of the economy.
Indirect taxes(sales tax), equity and e ciency in product market.
*Expenditure taxes/sales taxes are commonly used around the world on the grounds
that when a tax is levied on all goods and services at the same percentage, then there is
no changes in the relative prices, and therefore no impact on resource allocation.
*However, these tax are regressive, thus leading to a more unequal distribution on
income
*Excise tax intended to correct negative externalities have the e ect of improving
e ciency in the allocation of resources, but are still regressive.
*If excise taxes levied that are not for correcting market failure, they worsen both the
allocation of resources and the distribution of income.
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Countering the trade-o btw income equality and e ciency
*some believe that the greater the progressively of income taxes, the greater the the
potential contribution to making recessions and in ation less severe. This means that
fewer resources are wasted due to unemployment, and hence a smaller reduction in
output. Also, a less of a negative e ect of in ation on investment spending.
Transfer payments and allocative e ciency
*one argument is that transfer payments such as unemployment bene ts and other
bene ts for the poor act as a disincentive for unemployed people and poor people to
accept work.
*a counter-argument, is that the transfer payment system is needed to o er
protection to vulnerable groups in need who might otherwise face extreme poverty and
distribution.
*transfer payments like unemployment bene ts act as automatic stabilizers that
reduce the e ects of short-term uctuation in economic activity. They can reduce the time
lags that plague scal policy changes.
Government expenditures on merit goods and allocative e ciency
* the government spending on merit goods is a burden on the government budget,
and always entails opportunity costs
*But on the other hand, government spending on merit goods can increase allocative
e ciency, since it is correcting for the under production and consumptions of merit
goods.
Government intervention in market and allocative e ciency
*Government intervention in market intended to produce a more equitable
distribution of income clearly con ict with resource allocation objectives, by creating
allocative ine ciencies and a loss of social surplus.
Potential con icts btw Macro objectives
Con icting macroeconomic objectives means that it is not always possible for a
government to simultaneously achieve all of its macroeconomics objectives owing to
potential trade-o s.
Low unemployment and low in ation
More people are in employment-likely to raise in ationary
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Trade-o between unemployment and in ation (HL)
*The short run Philips curve
Philips Curve shows a potential trade-o
btw low unemployment and low in ation as
macroeconomics objectives.
The lower the rate of in ation, the higher
the unemployment rate; vice versa.
Policy implication(consequences) of short-run Phillips curve.
The Phillips curve seemed to present government with a simple policy choice.
The could trade o in ation against unemployment
Lower unemployment could be bought at the cost of higher in ation, and vice versa.
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However, later studies showed that the trade-o btw unemployment and in ation
seemed to exist only in the short run.
Demand-side policy and supply-side policy
Why government need to prioritize certain choices over others?
Important and urgent
Introduction to demand-side policies
Demand-side policies, focus on changing aggregate demand, or shifting the aggregate
demand curve in the AD-AS model, to achieve the ve main macro goals.
Demand-side policies can also impact economic growth by contributing to increases in
potential GDP.
Active and purposeful gov intervention in the economy to in uence aggregate demand
is termed discretionary policy, meaning that the policy is at the discretion of the gov.
There are two types of discretionary demand-side policies:
* scal policy(taxes and gov spending )
*Monetary policy(interest rate, money supply)
Aggregate demand can be in uenced by
automatic stabilizers, which work to
reduce the size of economic uctuations.
Since they operate automatically, they are
termed non-discretionary policy.
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Fiscal and monetary policies that attempt
to reduce the short-run uctuations of the
business cycle, called stabilization
policies, because they try to “stabilize ”
the economy.
Main source of government revenue:
Taxes are the most important source of gov revenues, and provided the funds for many
purposes, such as public goods, transfer payments and merit goods, correcting
externalities, providing subsidies, changing the allocation of resources, changing the
distribution of income, and many more.
Direct taxes and indirect taxes
Explain that the government earns revenue primarily from taxes (direct and
indirect), as well as from the sale of goods and services and the sale of state-owned
(government owned) enterprise.
From the sale of gods and services:
may include such services as transportation, electricity, water and many more. The
revenues from these sales usually go toward covering the government's cost of providing
them.
From the sale of government-owned enterprises, or property. Such sales are known as
privatization, which involves the transfer of ownership from the government to private
owners. When the government sells enterprises it owns, it receives funds from the buyer
equivalent to the price of the enterprise.
Types of gov expenditure
Current expenditures or operating expenditure(OPEX),is an ongoing cost for running a
product, business or system. They are spending day-to-day items that are recurring and
items that are recurring and items that are used up.
Examples: wages, salaries and spending on supplies
Capital expenditures are expenditures creating future bene ts. It includes public
investments or the production of physical capital. Examples: reads, airports, buildings,
bridges, machines etc.
Transfer payment is a redistribution of income in the market system.
Examples: certain transfer payments include welfare ( nancial aid),social security, and
unemployment bene ts.
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Explain how changes in the level of gov expenditure and taxes can in uence the
level of aggregate demand in an economy.
Fiscal policy is the used of gov revenue collection(taxation)and expenditure(spending)
to in uence the economy/ AD.The two main instruments of scal policy are government
taxation and expenditure: (since this is purposeful policy, it is *discretionary*)
Food for thought:
How does Fiscal policy a ect the components of aggregate demand?
The level of the government's own spending, (G).
The level of consumption spending, (C), can be in uenced if the government changes
taxes on consumers (personal income taxes), changing their level of disposable income.
The level of investment spending, (I), can also be in uenced it the government changes
faxes on business pro ts.
Expansionary scal policy
Fiscal policy undertaken to eliminate a recessionary gap is called expansionary scal
policy, because it works to expand aggregate demand and the level of economic activity.
How does expansionary scal policy work?
Expansionary scal policy may consists of:
Increasing gov spending
Decreasing personal income taxes(direct tax)
An increase in gov spending impacts directly on aggregate demand(injection)
If government decrease taxes(leakage), aggregate demand is a ected in two-step
process(indirectly)
If income taxes are cut, the result is rise in spending of consumption, which is then
likely to lead to an increase in aggregate demand, causing AD curve to shift to the right.
Expansionary scal policy usually leads to a government budget de cit. This will need
to be covered by borrowing, adding to the national debt.
Construct a diagram to show the potential e ects of expansionary scal policy,
outlining the importance of the shape of the aggregate supply curve.
The increase in real GDP will be smaller in the monetarist new/classical model, the
increase in AD always results in a rise in the price level because of the upward-sloping
SRAS curve.
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In the Keynesian model, the increase in AD may result in no increase in the price level at
all if the AD shift occurs entirely within the horizontal section of the AS curve.
If the AD shift reaches into the upward sloping part of the Keynesian AS curve, then there
will be a increase in the price levels.
Explain
the
mechanism
through which contractionary scal policy can help an economy close an
in ationary gap.
Contractionary scal policy consists of:
Decreasing government spending
Increasing personal income taxes
Increasing business taxes, or
A combination of decreasing spending and increasing taxes.
A decrease in government spending (injection) has a direct in uence on the aggregate
demand curve, causing it to shift to the left.
Construct a diagram to show the potential e ects of contractionary scal policy,
outlining the importance of the shape of the aggregate
supply curve.
If AD falls in the upward-slopping part of the AS curve in the
Keynesian model; the e ects on the price level and real GDP
are similar in the two models, because the slope/of the two
curves is similar.
However, if AD were to decrease into the horizontal part of the
AS curve, the fall in real GDR will be larger, and the drop in the
price level smaller (or none at all) compared with the
monetarist/new classical model.
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Reminder:in Keynesian model only have Keynesian AS
curve don’t have LRAS!!!
Automatic stabilizers(HL)
Automatic stabilizers are factors/a form of
nondiscretionary scal policy that do not require
explicit action by the gov sector to address the
ups and downs of the business cycle and the
problems of unemployment and in ation
Taxes and transfer payment that depend on the
level of aggregate production and income such
that they automatically dampen business-cycle
instability without the need for discretionary policy
action.
Explain how factors including the progressive tax system and unemployment
bene ts, which are in uenced by the level of economic activity and national income,
automatically help stabilize short-term uctuations.
Progressive Income Taxes:
When there's economic growth (upswing of the business cycle) = real GDP and income
rise.
With progressive income tax, disposable income to be lower & government tax revenues
automatically increases -> to dampen AD & counteract the economic expansion (or make
it smaller)
The more progressive income tax system, the more stabilized the economy will be (due to
average tax rate increases as income/real GDP increases.)
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Progressive Income Taxes:
When there's recession, the opposite will occur -> real GDP and income fall ->
government tax revenues automatically decline->causing disposable income to be higher.
Exerting an upward pressure on aggregate demand, which reduces the severity of the
recession.
Explain how factors including the progressive tax system and unemployment
bene ts, which are in uenced by the level of economic activity and national income,
automatically help stabilize short-term uctuations.
An increase in aggregate production and income associated with a business-cycle
expansion causes an increase in taxes and a decrease in transfer payments, both of
which limit the increase in disposable income and
-thus also limit the expansion.
Evaluate the view that scal policy can be good to promote long-term economic
growth(increase an potential output)indirectly by creating an economic environment
that is favorable to private investment, and directly through gov spending on
physical capital goods and human capital formation, as well as provision of
incentives for rms to invest.
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Governments that have focus on getting the fundamentals of economic management
right can promote long-term economics growth
Demand-side policies have not only demand-side but also supply-side e ects, and can
therefore a ect long-term economic growth by increasing potential output.
Indirect e ect on potential output:
To be in a position to plan over long periods of times, rms need economic stability,
consisting of avoidance of sharp economic upturns(in ation)and downturns(recession and
unemployment).
Fiscal policy aiming at economic stabilization is therefore important in creating the
macroeconomic environment that encourage long-term economic growth.
Direct e ect on potential output:
To gov can fund development of physical capital goods, such as infrastructure and on
R&D, which improves technology, and therefore improves the quality of capital goods and
improves the productivity of labor.
Can fund development of human capital(skills and experiences, train that labour will
obtained) such as training and education programs that increase the quality of the labor
force and improve the productivity of labor.
Provide incentives to encourage investment by rms(e ects of AD) through lower
business taxes and other gov tools.
Strengths of scal policy:
*direct impact of gov spending on AD
*pulling an economy out of a deep recession(gov spending to increase AD)
*dealing with rapid and escalating(fast increasing) in ation.(lower the PL, lower AD)
*ability to target sectors of the economy.(eg.health-care by gov’t spending)
*ability to indirectly a ect potential output.
*automatic stabilizers(HL ONLY)
Fiscal policy can target speci c sectors by making changes in the composition of gov
spending depending on gov priorities,
Weakness of scal policy:
Problems of time lags
Political constraints(restriction)
Crowding out(HL)&Net export e ect.
Inability to deal with supply-side causes of instability.
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In a recession, tax cuts may not be very e ective in increasing AD
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They can worked to reduce their debt and control in ation and put in place sustainable
scal policies
Crowding out
If increased gov borrowing (expansionary scal
policy)results in a higher rate of interest, this could reduce private investment spending by
rms, thus reversing the impacts of the gov expansionary scal policy.
Monetary policy
it is carried out by the central bank of each country.
A central bank, reserve bank, or monetary authority is a public institution that manages a
state’s currency, money supply, and interest rate.
In contrast to a commercial bank, a central bank possesses a monopoly on increasing
the nation’s monetary base, and usually also prints the national currency, which usually
serves as the nation’s legal tender.
Examples include the European central bank(ECB), the Federal Reserve of the United
States, and the People’s Bank of China.
Central bank’s main responsibilities:
Banker to the gov
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It holds the government's cash and receives payments for the government. Is also
manages the government's borrowing by selling bonds to commercial banks and the
public, acts as an adviser to the government on nancial and banking matters.
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Inability to “ ne tune” the economy.
Also acts as a banker to commercial banks by holding deposits for them and can also
make loans to them in times of need.
Regulator of commercial banks.
Makes sure they operate with appropriate levels of cash and according to rules that
ensure the safety of the nancial system. This is intended to prevent bank runs and to
reduce the risk that commercial banks and other nancial institutions engage in reckless
or fraudulent behavior.
Conduct monetary policy.
The primary function of a central bank is to manage the nation’s money supply(monetary
policy)
“Monetary policy”involves management of money supply and interest rate and is the
demand side economic policy used by the gov of a country to achieve macroeconomic
objective like low and stable rate of in ation, low unemployment, reduce business cycle
uctuations, promote a stable economic environment for long-term growth, and external
balance
Besides money supply or the rate of interest. The central bank is also usually
responsible for the determination of exchange rates because of the close relationship btw
interest rates and exchange rates.
Central banks in most developed nations are institutionally designed to be independent
from political interference.
Explain how changes in interest rates can in uence the level of AD
Interest rate increase, cost of borrowing increase, lower borrowing-investment decrease,
lower spending-cost decrease.then AD decrease.
The drop in interest rates means a lower cost of borrowing.
Therefore consumers and rms*
Describe the mechanism through which easy (expansionary) monetary policy can
help an economy close a de ationary (recessionary) gap.
If there's a recessionary gap due to insu cient aggregate demand,
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central bank may decide to increase the money supply,
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Banker to commercial banks.
shifts the money supply curve to the right.
With the demand for money constant, the interest rates
will fall (depending on the slope of the money demand
curve)
The drop in interest rates means a lower cost of borrowing;
Therefore, consumers and rms are likely to borrow more
and spend more, so that consumption spending (C) and
investment spending (I) increase.The e ect is to increase
aggregate demand and cause a rightward shift of the AD
curve.
Note that, just like with scal policy, the e ect of the AD
increase are di erent depending on the shape of the AS
curve. In the monetarist/new classical model, there is a
smaller increase in real GDP and a large increase in the price level compared to the
Keynesian model.
Describe the mechanism through which tight monetary policy can help an economy
close an economy close an in ationary gap.
If there’s a in ationary gap caused by excess aggregate demand.
central bank may decide to decrease the money supply
this shifts the money supply curve to the left
With the demand for money constant, the interest rates will increase (depending on the
slope of the money demand curve).
Increase in interest rates -> higher cost of borrowing ->consumers/ rms are likely to
borrow less and spend less -> C&l decrease.
The e ect is to decrease AD and cause a leftward shift of the AD curve.
Describe the mechanism through which tight(contractionary) monetary policy can
help an economy close an in ationary gap.
Ratchet e ect
Is a mechanical analogy in economics that refers to a process that moves easily in one
direction but not the other.
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Refers to an economic process that is di cult to reverse once it is underway or has
already occurred, from political economy to consumer and labor market.
As in the case of scal policy, if AD falls within the upward-sloping part of the AS curve in
the Keynesian model, the e ect on the price level and real GDP are similar to those in the
monetarist/new classical model. But, if AD were to decrease into the horizontal part of the
AS curve, there would be a larger fall in real GDP and a smaller fall in the price level in the
Keynesian model.
Note also the ratchet e ect, which takes into account the unlikelihood of the price level in
the Keynesian model as AD decreases.
Explain that central banks of certain countries, rather than focusing on the
macroeconomics of both full employment and a low rate of in ation, are guided in
their monetary policy by the objective to achieve an explicit or implicit in ation rate
target.
In ation targeting is an economic policy in which a central bank estimates and makes
public a projected, or "target", in ation rate and then attempts to steer actual in ation
towards the target through the use of interest rate changes and other monetary tools.
Because interest rates and the in ation rate tend to be inversely related, the likely moves
of the central bank to raise or lower interest rates become more transparent under the
policy of in ation targeting. Examples:
if in ation appears to be above the target, the bank is likely to raise interest rates. This
usually (but not always) has the e ect over time of cooling the economy and bringing
down in ation.
if in ation appears to be below the target, the bank is likely to lower interest rates. This
usually (again, not always) has the e ect over time of accelerating the economy and
raising in ation.
Advantages of in ation targeting:
* a lower rate of in ation.
* a more stable rate of in ation
* improve ability of economic decision-makers( rms, consumers)to anticipate the future
rate of in ation
* greater co-ordination btw monetary and scal policy.
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* greater central bank transparency and accountability.
Disadvantage of in ation targeting:
* reduced ability of the central bank to pursue other macroeconomic objectives.
* reduced ability of the central bank to respond to supply-side shocks
* reduced ability of the central bank to deal with unexpected events, such as nancial
crises.
* nding a appropriate in ation target.
Many of the central bank is isolated to the government and it is independence, so
compare with the scal policy, it can decrease the political restriction. And also it can put
forward by the monitories is that the crowding out e ect is avoided.
Time lag: lags in monetary policy
Monetary policy typically has a short policy lag (the time it takes to create and implement
policy) and a long expenditure tag (the time it takes businesses and consumers to adjust
to the new interest rates).
The total lag time is usually 9-12 months.
Reasons:
Businesses and consumers do not normally change their spending plans immediately
upon an interest rate change. Businesses must re-evaluate, make new decisions and
order reductions or expansions in production and expenditures. This means that months
pass before spending is a ected.
Strengths of monetary policy
The ability to adjust interest rates incrementally:
Policy makers to monitor the e ectiveness of monetary policy. It is common for interest
rates to change in increments of 0.25%, thus reducing the risk of causing huge
disruptions to the economy.
The ability to implement changes in interest rates relatively quickly:
This means that monetary policy can be uséd to in uence and ne-tune macroeconomic
objectives.
Central banks review the state of the economy and adjust interest rates accordingly,
often on a monthly basis.
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No political constraints
No crowding out
Weakness of monetary policy:
Time lags: (lags in monetary policy)
Monetary policy typically has a short policy lag (the time it takes to create and
implement policy) and a long expenditure lag (the time it takes businesses and consumers
to adjust to the new interest rates).
The total lag time is usually 9-12 months.
Reasons: Businesses and consumers do not normally change their spending plans
immediately upon an interest rate change.
Businesses must re-evaluate, make new decisions and order reductions or expansions in
production and expenditures. This means that months pass before spending is a ected.
Limited e ectiveness in increasing aggregate demand if the economy is in deep
recession:
*recall recession de nition.
*during deep recessions central banks will have lowered interest rates to ght possible
de ation.
*the problem is that when money supply has increased to the point where interest rates
hit zero, there is nowhere left to go.
* when con dence levels are low rms will not borrow money to invest even at low rates
of interest, if the demand for products remain low.
Bank may be reluctant(勉强) to lend when they feel that the borrowers will be unable to
repay.
Con ict among government economic objectives:
“Hot money”(the ow of money into the country to gain from higher rates of interest)will
increase the exchange rate. This makes exports more expensive and so worsen the trade
balance.
Easy monetary policy can con ict with other macroeconomic objectives, such as
in ation(price stability)
Monetary policy in uences aggregate demand rather than having a direct”impact on the
economy’s long-run aggregate supply”
What is interest?
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Interest is the payment for a loan in addition to repaying the principal (the amount of a
loan)
Interest is expressed as % of the principal to be paid per year.
Di erent interest rate depends on:
The level of risk of a loan (higher risk, interest rate higher)
The amount of time over which the loan must be repaid(long period, lot more
uncertainties, higher interest rate )
The size of a loan(larger the loan, the credit loan will be good, the lower the interest
rate)
The degree of market power of the lender(greater market power, higher the interest
rate)
Determination of the interest rate(HL)
In the money market, interest rate is determined by the money demand and money
supply.
Money is anything which is acceptable payment for goods and services. It include
currency(notes and coin) in circulation and checking account.
The supply of money is controlled by the central bank but not
determined by the rate of interest.
Money supply is constant at each level of interest rate,
therefore, the supply curve for money for money is perfectly
inelastic with respect to interest rates.
The demand curve for money illustrates the quantity of money
demanded at given interest rate.
household & rms demand
Money for transaction purpose, or hold money instead of bond and stocks, as an
asset.
Ceteris paribus, the higher the interest rate, the higher the opportunity cost of holding
cash, and the lower the quantity demand for money.
The central bank decides upon a target interest rate it wants
to achieve, then takes steps to adjust the money supply, so
the market equilibrium interest rate equals to the targeted
interest rate.
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Increase in supply of money leads to a fall int he rate of
interest. Vice versa.
How government control the money supply?
Commercial banks can create new money through making.
Suppose a bank receives a deposits of $1000, it will lend out a good portion of it to other
people who want to borrow.
Assume the required reserve ratio is 20%, a bank lend 80% out every time it receive a
deposit, and every one receives the cash then deposit it all in the bank, then the total
loans can be created will be $800.
20%of money for yourself, 80% for government to lend to other people to increase the
money value.
How to calculate the money multiplier:
Money multiplier=1/required reserve ratio=1/20%=5
Total loans(new money)created=($1000*0.8)*5=4000
When banks make loans, they are actually creating new money.
The lower the minimum reserve requirement, the greater the excess reserves, the more
loans can be made by commercial banks, and the more new money can be created.
The minimum reserve requirement determines the maximum amount of new money that
can be created.
How central bank changes money supply(HL only)
Tool of monetary policy
Open market operation
Required reserve ratios
Changes in the central bank’s minimum lending rate
Quantitative easing
Open Market Operation(HL)
The central bank buys and sells old(pre-existing)gov bonds to conduct its monetary
policy.
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Old gov bonds are bonds which were previously
issued by the gov, in the primary bond market, to
pay for excess gov spending,(a budget de cit), and
which were purchased by the private sectors.
Once purchased these bonds are now known as secondary bonds which can be
trade(bought or sold )in the secondary bond market. Banks and other nancial institutions
trade a lot of these bonds.
If gov want to increase the money supply, lower the interest rate, they will buying the old
bonds from the private sectors.
If gov want to decrease the money supply, higher the interest rate, they will selling the
old bonds to the private sectors.(because the gov want to collect the money back, that
will decrease money loan, that will increase the interest rate)
To increase money supply in the market and lower the interest rate--buying old bonds
Change in the central bank’s minimum lending rate
Central bank sometimes lends to commercial banks.
When it does this it charge commercial banks an interest rate, know as minimum lending
rate
It has di erent names in di erent countries, e.g. re nancing rate(France)
If commercial banks want reserves to increase their lending they can borrow from the
central bank.
The higher the minimum lending rate, the more costly it is for commercial banks to
borrow.
Quantitative easing(most convention)
It’s similar to buying bonds in open market operations, but on a much larger scale,
involving more types of nancial assets and larger quantities of these.
It is an unconventional type of monetary policy that was rst used by Japan in 2001, and
later by other central banks due to the global nancial crisis, e.g. US in 2008, and
European Central Bank in 2015. The objective is to increase reserves in commercial
banks which they can make more loans to increase AD.
The Keynesian multiplier
When AD rise, this will cause national income to rise
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But national income will rise by more than the initial rise in injections
Multiplier e ect: an initial change in aggregate demand can have a much greater nal
impact on the level of equilibrium national income. This is commonly known as the
multiplier e ect.
multiplier=change unreal GDP/initial change in expenditure.
The multiplier is usually given by the letter k, k=delta Y/deltaJ
The factors that in uence the size of multiplier:
Marginal propensity to consume (MPC)-the fraction of additional income that households
spend on domestically produced products
Marginal propensity to save (MPS) fraction of additional income saved
Marginal propensity to tax (MPT) fraction of additional income taxed
Marginal propensity to import (MPM)-fraction of additional income spent on imported
goods and services
Calculation of national income:
National income is either spent or withdrew:
Y=Cd+W
So MPC+MPW=1 or multiplier=1/1-MPC or
=1/MPS+MPT+MPM(MPW=MPC+MPS+MPT+MPM=1)
The larger the MPC, the larger the multiplier
Increase in MPS, MPT, or MPM will reduce the value of multiplier
The e ect of any of gov spending and tax on the economy should consider the value of
multiplier
Government spending cuts led to far greater decrease in real GDP, and vice versa
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Aggregate demand, real GDP and the multiplier in the Keynesian model
Autonomous spending means an initial increase in spending which is not caused by a
change in income. E.g. the $8 initial increase in investment spending.
Induced spending means the spending caused by changes in come.
E ects of multiplier
When AD increase from AD1 to AD2 at the
horizontal part of the AS curve where the
price level is constant. increase in real GDP is
exactly equal to the increase in AD
The shift from AD2 to AD3 occurs in the
upward-sloping part of the AS curve, where
increase in real GDP is smaller because of the
increases in the price level.
The shifts from AD3 to AD4 occurs in the
vertical part of the AS curve, and results in no
change at all in real GDP. The increasing price
level has absorbed the entire multiplier e ect,
which here is zero
The changes in Keynesians model
Multiplier e ect and scal policy in practice, may not have the full e ect because
It’s di cult to identity how much injection is need to achieve full employment,
It is hard to estimate the value of multiplier
It is hard to determine the size of autonomous injection needed
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It is di cult to predict the resulting multiplied e ect on national income
Focus on on the production and factors aimed at shifting the LRAS to the right, to
increase potential output and achieve long-term economic growth
They do not attempt to stabilize the economy by reducing the severity of business
cycle.
Focus on stabilize economy, quality and quantity
Explain that supply-side policies aim at positively a ecting the production side of
an economy by improving the institutional framework and the capacity to produce
Policies aimed at increasing LRAS aim to:
Promote long-term growth by increasing the productive capacity(potential output)of the
economy.
Improve competition and e ciency via privatization and ease of start-ups.
Reduce costs of labor and reduce unemployment through greater labor market
exibility(increase the mobility of labor-both btw jobs and btw regions)
Increase incentives of rms to invest in innovation by lowering costs of production e.g.
increase the physical capital stock
Reduce in ation to improve international competitiveness. (Increase foreign direct)
investment (FDI) - both abroad and at home)
All the above aim to increase growth over the long run without experiencing the trade-o s
common to demand side policies
Major categories of supply-side policy
Market based emphasize the importance of well-functioning competitive markets in
achieving growth in potential output, and are usually favored by classical model.
They believe the economy will be able to achieve rapid growth, price stability and full
employment all at the same time.
Market-based supply-side policies can be grouped under three heading: encouraging
competition; labor market reform(changing labor market by trade union, minimum wages);
incentives-related policies(tax exemption, tax relief)
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Interventionist:rely on gov intervention to achieve growth in potential output. And are
usually favored by keynesians model
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Supply side policies
Various forms of interventionist such as increased gov investment in infrastructure and
education, and training themes and regional support in depressed area/sectors
Market-base supply side policies:
Cutting government spending and taxes and policies to cut government borrowing.
Laws to control trade union powers
Reducing red-tape to cut the costs of doing business
Measures to improve the exibility of the labor market / reforming employment laws
Policies to boost competition such as deregulation and tough anti-monopoly and anticartel laws
Privatization of state assets (selling o public sector businesses into the private sector)
Opening up an economy to overseas trade and investment
Opening up an economy to inward labor migration
Interventionist supply side policies:
Investing the public services and building critical infrastructure
Tax incentives and welfare reforms can encourage more people into work
A commitment to a fair minimum wage / living wage to improve work incentives
Active regional policy to boost under-performing areas / areas of high unemployment
Some case for selective impart controls to allow domestic industries to expand
Management of the exchange rate to improve competitiveness of export industries
Nationalization of some key industries
Stronger regulation of industries including nance and transport
Explain how investment in education and training will raise the levels of human
capital and have a short-term impact on aggregate demand, but more importantly
will increase LRAS.
Training and education (human capital): Improve in the quality of labor resources,
increasing the productivity of labor, reduce natural rate of unemployment.
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Improved health care services and access to these:When workers become healthier and
more productive. This has the potential to increasing the economy's potential output.
Both, education and healthcare are merit goods and thus have positive externalities
which justi es government intervention.
Encouraging competition
Deregulation-the reduction or removal of statutory barriers to entry into certain
industries thereby allowing markets to operate more competitively and e ciently.
Ex.USA deregulated its airline industry in the late 1970s.
Ex.UK deregulated many of its industries in the 1980s, such as gas, steel
Advantages: increased competition lead to lower prices and greater choices for
consumers.
Regulation often involves excessive costs of bureaucracy(time consuming to administer)
Privatization:a transfer of ownership of a rm from the public to the private sector due
to higher e ciency.
This is based on the argument that government enterprises are often ine cient as they
have bureaucratic procedures, high administrative costs and unproductive workers,
because they do not face incentives to lower costs and maximize pro ts.
Therefore, to break-up state monopolies and create more competition. For examples,
utility regulations in area like gas and electricity supply and telecommunications.
Advantages: encourage rms to become more e cient in order to survive and earn
pro t.
Selling o state-owned assets helps to raise government revenue.
Disadvantages: this can create a private sectors monopolist
Trade-o (opportunity cost)as state-owned enterprises provide social bene ts and
merit goods.
To protect the public interest, privatization may still require government regulation and
intervention.
According to the Guardian, the UK spent around 20% of its GDP on banks bailouts
following the 2008 global nancial crisis making nationalized industries popular as
method to correct market failure
Trade liberalization:
Free or freer trade increases competition between rms both domestically and globally,
resulting in greater e ciency in production and an improves allocation of resources.
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This is brought about through specialization, economics of scale in production, better
able to acquire needed resources and the absents of government intervention with trade
restrictions.
Can Increase competition by enforcing anti-monopoly legislation, by breaking up large
rms into smaller units that will behave more competitively, and by preventing mergers
between rms that might result in too much monopoly power. Greater scope for the
forces of supply and demand may result in increased e ciency, lower costs and
improved quality.
Market-based supply-side policies:
Labor market reforms
Labor market reforms are sometimes referred to as ‘increasing labor market exibility',
or reducing labor market “rigidities" These are intended to make labor market more
competitive, to make wages respond to the forces of supply and demand, to lowering the
labor costs and increase employment by lowering the natural rate of unemployment.
Any examples of labor market reform policies?
Weakening the power of labor (trade) unions Organizations aim to protect the interests of
its worker members, that is the terms and conditions of employment,
such as worker's pay and bene ts. However, there's often a con ict between the aims of
employees and employers, therefore cause labor market imperfections.
Increase rms demand of workers
Explain how factors including reducing the power of labor unions, reducing
unemployment bene ts and abolishing minimum wages are used to make the labor
market more exible (more responsive to supply and demand).
Weakening the power of labor (trade) unions
Organizations aim to protect the interests of its worker members, that is the terms and
conditions of employment, such as worker's pay and bene ts.
However, there's often a con ict between the aims of employees and employers,
therefore cause labor market imperfections.
Reducing unemployment bene ts
Reduce welfare transfer payments, increase greater exibility and e ciency in the labor
market, that force people become proactive in searching for job opportunities.
Abolishing minimum wage legislation
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Reducing job security many countries have laws that protect workers against being
red, making it costly for rms to re workers because of high levels of compensation that
must be paid to the worker being laid o .
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Anti-monopoly regulation
Incentive-related policies involve cutting various types of taxes, so that change the
incentives faced by taxpayers, whether rms or consumers. Lowering personal income
taxes (Direct taxes) > higher disposable incomes, creating an incentive for people to
provide more work. This can happen through:
an increase in the number of hours worked per week;
an increase in the number of people interested in nding work;
an increase in the number of years worked, as people may decide to retire later; a
decrease in unemployment
A decrease in unemployment
Capital gains tax and interest income:
In many countries, people must pay taxes on 'capital gains', which are pro ts from
nancial investments (such as stocks and bonds) or form buying and selling real estate. In
addition, they may have to pay taxes on income from interest on savings deposits. If the
taxes they must pay on these sources of income are reduced, they may be more
motivated to invest.
Lowering business taxes (Direct taxes) and capital gains lax (GST):
Besides increasing AD through an increase in investment spending, supply-side
economist argue that cutting taxes on rms' pro ts is a supply-side measure because
increases in the level of after-tax pro ts means that rms have greater nancial resources
for investment and for pursuing technological innovations through more R&D.
Plus, lower corporate tax rate might increase the rate of new business start ups and
attract more foreign direct investment spending due to the lower barriers to entry.
Interventionist supply side policies:
Are the deliberate attempts by a government to in uence AS and the productive capacity
of the economy, include
Education and training
Improving the quality and quantity of FOPs
Access to healthcare services
Research and development (R&D)
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Provision of infrastructure and industrial policies
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Incentive-related policies
Interventionist supply-side policies reply on an e ciently functioning institutional
framework - the established system, structures and contexts that shape the economic
behavior in a country, including the legal system.
Training and eduction(human capital)
Human capital - the stock of knowledge, skills, expertise and experiences of the labor
forces.
Improve in the quality of labor resources, increasing the productivity and mobility of labor,
reduce natural rate of unemployment.
Advantages:
Short run: increases the national income (higher AD)
Long run: improves the productive capacity of the economy.
Research and development(R&B)
Refers to the process of business activities to improve, introduce and innovate products,
processes and procedures.
Is the foundation of new technologies, resulting in new or improved capital goods
(physical capital).
R&D also has positive externalities, thereby justifying government intervention.
Government often provide incentives to private sector rms to engage in R&D activities;
usually through tax incentives and the granting of patents for the protection of inventions.
Explain how increased and improved infrastructure will have a short-term impact on
aggregate demand, but more importantly will increase LRAS.
Better infrastructure attracts more investment both domestic and foreign.
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In the short run increase government expenditures of infrastructure will lead to rise in AD
and could fuel in ation, however in the long run it will lead to greater e ciencies and
output thus shifting the LAS to the right.
Investing the public services and building critical infrastructure
Tax incentives and welfare reforms can encourage more people into work
A commitment to a fair minimum wage / living wage to improve work incentives
Active regional policy to boost under-performing areas / areas of high unemployment
Some case for selective impart controls to allow domestic industries to expand
Management of the exchange rate to improve competitiveness of export industries
Nationalization of some key industries
Stronger regulation of industries including nance and transport
Lower cost of production will directly a ect the SRAS, and long term will a ect the LRAS.
Subsidy will directly a ect the SRAS rst, then a ect in long run.
Explain that targeting speci c industries through policies including fax cuts, tax
allowances and subsidized lending promotes growth in key areas of the economy
and will have a short-term impact on aggregate demand but, more importantly, will
increase LRAS.
Industrial policies are that target speci c key industries to promote economic growth - for
example, tax allowance can be used to protect domestic infant industries from larger,
well-known foreign rivals.
Tax cuts targeted at strategic industries can help to revive these industries, helping them
to grow in the long run. A combination of fax breaks and subsidies on commercial loans
can create incentives for rms to locate in less prosperous areas of a country, thus
reducing unemployment and increasing the economy’s LRAS.
Explain how investment in education and training will raise the levels of human
capital and have a short-term impact on aggregate demand, but
more importantly will increase LRAS.
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With an educated and healthy workforce, AD has the potential to
grow. Household: higher incomes, more consumption, Businesses:
productivity increases will reduce cost, sales and pro ts increase, grow
in Investment spending. Government spending: also will increase,
result in a rightward shift of the AD curve. Since productivity has
increase, this leads to more output, so in the long-term, the LRAS
curve will also shift right as economic growth occurs.
Government spending in support of
new technology development leads to
increases in AD over the short term and
increases in potential output over the
longer term shifting the LAS curve to the
right.
Market-based policies involving labor
market reforms may contribute to reducing the natural rate at unemployment by forcing
on making the labor market more responsive to supply and demand.
Examples include: Lower unemployment bene ts to increase the incentive to get a job.
Reduced Power of Trades Unions. Trades unions con cause real wage/classical
unemployment (where wages are pushed above the equilibrium). If you reduce the power
of unions, wages will fall to equilibrium levels leading to less unemployment.
Also reducing minimum wages should have similar e ect.
However, this could leave workers without protection against monopsonist employers
leading to lower wages.
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Summary of supply side
policies
Demand-side policies can also have a direct impact on the economy's LRAS.
Ex. Expansionary monetary policy in the form of lower interest rate (demand-side policy),
but it can in uence AS by creating incentives for domestic rms to invest and attract
foreign direct investments.
In reality, AD and AS do not work in isolation.
Evaluation of supply policies:
Time lags:
Both interventionist and market-based, work after signi cant time lags, making their
e ects on the supply side of the economy over the long term.
Ex, improving the quality of human capital is unlikely to yield quick results. Educational
spending is a continuous process, as it takes years to show results.
However, interventionist policies also have an e ect on AD over the short term, but would
most likely add to the in ationary pressure.
The ability to create employment:
Supply-side policies are not designed to address cyclical unemployment, arising from
business cycle uctuations (demand-side policies). Supply-side policies are designed to
address the natural rate of unemployment (structural, frictional & seasonal).
Interventionist can help reduce unemployment by:
Better education and training can enabling workers to acquire the skills, training and
retraining necessary to meet the need of employment (structural) However, it depends
whether the government can provide skills that employers really need; there is no
guarantee that government spending will be able to solve the skills gap.
Provide assistance to workers to relocate (structural)
Providing information that reduces unemployment when workers are between jobs or
seasons (frictional & seasonal)
Market-based policies by encouraging competition, may actually increase
unemployment, at least in the short term. Privatization can try to make their operations
more e cient, they often try to cut cost by ring workers.
Outsourcing labor to other counties to lower cost would also increase unemployment
domestically.
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Economic deregulation can led to increase unemployment, due to increased competitive
pressures that cause rms to re workers in order to lower their costs.
Overall, market-based can help create real jobs and sustainable growth through their
positive e ect on labor productivity and competitiveness.
Evaluate government policies to deal with the di erent types of unemployment.
Cyclical unemployment - expansionary demand-side policies
Natural Unemployment - supply side policies
Structural - retaining program, direct government hiring, rants to rms o ering training,
subsidies on assisting relocation, provide more information on the job in various
geographical areas, government projects etc.
Frictional - improving info ows between employers and employees, reducing the time
spends searching for jobs through agencies or websites.
Seasonal - provision of information on jobs during o -peak seasons
Advantages: of interventionist supply side policies
Direct positive impact on employment creation without increasing income inequalities
and loss of job security.
Disadvantages:
Negative impact on government budget (de cit)
Opportunity cost
Natural unemployment
Reduce minimum wage to reduce unemployment
Weaken trade unions to reduce upward pressure on wages
Reduce unemployment bene ts
Advantages of market-based supply side policies
Without negatively impact on government budget
Disadvantages
Greater income inequality
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Loss of protection for low income workers
Evaluate government policies to deal with the di erent types of in ation.
Demand pull in ation - contractionary demand side policy
Cost push in ation - no general solutions. Why?
- If is due to increases in wages -> market based supply side policies
If is due to rms with monopoly power -> market based policies
If is due to increases in imported raw materials expenditure switching policies (demandside)
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In ation targeting - monetary policy