Search for notes by fellow students, in your own course and all over the country.
Browse our notes for titles which look like what you need, you can preview any of the notes via a sample of the contents. After you're happy these are the notes you're after simply pop them into your shopping cart.
Document Preview
Extracts from the notes are below, to see the PDF you'll receive please use the links above
OCR A Level
Macro Economics
Copyright: Tejvan Pettinger, Economicshelp
...
No part of this publication may be reproduced, distributed, or
transmitted in any form or by any means, including photocopying, recording, or other
electronic or mechanical methods, without the prior written permission of the
Copyright owners
...
Table of Contents
Economic growth
...
5
Recessions
...
7
Measuring development
...
9
Economic growth and happiness
...
14
Aggregate demand
...
17
Investment (I)
...
18
Net trade (X-‐M)
...
19
Aggregate supply (AS)
...
20
Long-‐run aggregate supply (LRAS)
...
24
Economic growth
...
25
Long-‐run economic growth
...
28
The Multiplier
...
33
Trends in macroeconomic indicators
...
38
Measuring unemployment
...
40
The natural rate of unemployment
...
44
The Phillips curve
...
48
Effects and costs of inflation
...
51
Causes of inflation
...
55
Income distribution and welfare
...
58
Poverty
...
60
Evaluation of fiscal policy
...
63
Taxation
...
67
The National Debt
...
71
Evaluation of monetary policy
...
74
Liquidity trap
...
76
Market-‐oriented supply-‐side policies
...
77
2
Evaluation of supply-‐side policies
...
79
Approaches to macroeconomics
...
80
Keynesian approach
...
80
Globalisation
...
82
Causes of globalisation
...
83
Multinational companies
...
85
Trade
...
86
Restrictions on free trade
...
88
Arguments for restricting trade
...
89
Measures to increase competitiveness
...
91
Current account
...
92
Policies to reduce a balance of payments deficit
...
95
Factors that influence exchange rates
...
96
Advantages of fixed exchange rates
...
98
Euro/ Monetary union
...
99
Evaluation of an appreciation
...
101
Economic integration
...
103
Interest rates
...
104
Loanable funds theory
...
106
Financial sector in developing economies
...
109
Independent central bank
...
110
3
Economic growth
•
•
•
•
•
•
•
GDP (Gross Domestic Product) measures the value of goods and services
produced in an economy
...
Nominal GDP measures the monetary value of GDP (this may include the
effects of inflation in raising prices)
...
It measures the
actual purchasing power of consumers in an economy
...
o E
...
if real GDP increases by 3% and the population rises by 1%,
the real GDP per capita has increased by 2%
...
It refers to an increase
in the total value of goods and services produced in an economy
...
Sustainable economic growth requires economic growth to be
maintained for a long period
...
e
...
In Q2 2014, economic growth was 0
...
(approx
...
8%)
...
4
Macro-‐economic objectives of government
The primary economic objectives of a government are likely to be:
1
...
Most governments would try to
maximise sustainable economic growth to increase living standards and
help create employment
...
Low inflation
...
The government wishes to both avoid high inflation and also the threat
of deflation
...
Low unemployment
...
4
...
A large current
account deficit could be an economic concern (e
...
weak export growth,
reliance on capital flows, finance deficit), therefore, governments may
wish to have a reasonable low deficit/surplus
...
Low government borrowing
...
6
...
A rapid depreciation in the exchange rate could
cause inflationary pressures and instability, therefore, governments may
prefer a stable exchange rate
...
High economic growth may be at the expense of
income inequality
...
Environment
...
Looking after the
environment may require some sacrifice in terms of economic growth
...
Rising real GDP enables consumers to enjoy more goods
and services and enjoy better standards of living
...
Economic growth encourages firms to employ
more workers creating more employment
...
Economic growth creates higher tax
revenues and there is less need to spend money on benefits such as
unemployment benefit
...
Improved public services
...
Money can be spent on protecting the environment
...
5
Costs of economic growth
•
•
•
•
Inflation
...
If economic growth is too fast and unsustainable, it
can lead to boom and bust cycles
...
Higher growth can lead to more pollution and
environmental degradation
...
This graph shows that the EU economy experienced a recession in 2008/09 and
2012/13
...
Real incomes will fall, reducing living standards
...
Unemployment tends to rise
...
Also, with lower demand, firms
will have less demand for workers
...
Higher government borrowing
...
g
...
Also, the government will need to spend
more on benefits, such as unemployment benefits
...
Fall in asset prices, such as houses
...
Primary sector is the extraction of raw materials – mining, fishing and
agriculture
...
Secondary / manufacturing sector is concerned with producing
finished goods, e
...
factories making toys, cars, food, and clothes
...
Tertiary ‘service’ sector is concerned with offering intangible goods and
services to consumers
...
T
...
Economic development
Economic development is concerned with quality of life and a range of economic
indicators that affect economic welfare
...
Measuring development
1
...
GDP measures national output / national income/
national expenditure
...
•
GDP is useful for measuring the level of economic activity and average
incomes
...
Limitations of GDP as a measure of living standards
1
...
It is difficult to calculate the total output of an economy,
because GDP statistics will ignore the underground economy, as transactions
are not recorded
...
2
...
GDP includes negative externalities, such as
pollution and congestion; therefore, a rise in real GDP will often overestimate
living standards on this count
...
7
3
...
GDP per capita ignores distribution of income; some people may
be very poor, despite the country being rich
...
4
...
For
example, a country may have a high real GDP per capita, but if 40% of GDP is
spent on military expenditure, this has little impact on improving living
standards
...
Purchasing power parity
...
g
...
6
...
For example, if you increase your income by working longer
hours, does this improve living standards?
Evaluation
•
•
•
Although there are limitations to using GDP, don’t forget that it is a good
starting point
...
Higher GDP
enables better public services, such as health and education
...
Human development index (HDI)
The HDI is an alternative measure of economic welfare
...
HDI includes:
•
•
•
Life Expectancy Index
...
Education Index
o Mean years of schooling
o Expected years of schooling
Income Index
...
Advantages of using HDI
•
•
HDI can highlight countries with similar GDI per capita but different
levels of economic development
...
8
Limitations of Human Development Index
•
•
•
•
•
•
Divergence within countries
...
g
...
HDI reflects long-‐term changes (e
...
life expectancy) and may not respond
to recent short-‐term changes
...
Higher national wealth GDI may not necessarily increase economic
welfare, as it depends how that wealth is spent
...
Some countries with higher real GDI per capita have high levels
of inequality, e
...
Russia and Saudi Arabia
...
The Human Poverty Index (HPI)
This is like HDI but also takes into account the distribution of welfare within
a country, to try and measure relative poverty levels
...
GPI takes into account
•
•
•
resource depletion
pollution and long-‐term environmental damage
Poverty levels
Sustainable development
Sustainable development places greater stress on achieving long-‐term
improvements in economic and social indicators
...
For example, economic
development could involve burning more fossil fuels, but this may not be
sustainable because of the impact on the environment
...
This enables
higher labour capital and more potential for entrepreneurs to develop
businesses
...
A country could increase GDP by
extracting more raw materials, however this lacks sustainability because
raw materials are finite
...
9
Economic development and sustainability
This model (Kuznets environment diagram) states that the level of
environmental degradation depends on economic development
...
g
...
However, at a certain point, economies become less industrial and more
service sector oriented
...
Also, with higher incomes people have the luxury of becoming more
aware of the environment and are less concerned about increasing output
...
In fact, the opposite might occur
...
The biggest polluters are those countries with
high real GDP per capita
...
Some developed countries, like
Australia and Canada have continued to produce raw materials and
continue mining
...
It depends on policies adopted
...
10
Economic growth and happiness
The UK ONS now publishes a measure of ‘National well being’
...
•
•
•
•
•
The index includes positive statements, e
...
unemployment rate, voting
rates, crime rates
...
g
...
The index measures how these index tools change over time, e
...
the
overall index of national wellbeing would rise if more people responded
positively to questions about personal wellbeing
...
It is an attempt to move away from relying on purely financial indicators,
such as GDP – which on their own may not increase wellbeing
...
People’s perceptions of satisfaction may change
due to unexpected factors
...
Surveys could be influenced by temporary factors, such as an early World
Cup exit for the national team
...
Easterlin Paradox
This studied the relationship between happiness and real incomes and found:
•
High incomes do correlate with happiness, but in the long term, increased
income doesn't correlate with increased happiness
...
Evaluation
•
•
•
The paradox is disputed
...
Also, it is hard to measure happiness because it is such a normative factor
...
11
Limitations to economic growth and development
•
•
•
•
•
•
Poor infrastructure
...
Land-‐locked countries are at a disadvantage, because cost
of trade is much higher
...
Low levels of education and training limit
the range of goods and services that can be produced
...
Primary product dependency
...
) can limit economic development
...
Primary products may also
be finite and will at some time run out
...
Primary products have a low-‐income
elasticity of demand, so countries that rely on primary products don’t
benefit as much from global growth
...
When countries develop a lack of foreign
exchange, e
...
if they spend money on debt relief and imports of
commodities but struggle to export goods
...
Countries with a poor reputation may struggle to
attract and retain capital
...
Strategies to promote growth and development
1
...
Government spending to improve education
and training can lead to improved human capital and higher labour productivity
...
•
However, it can take several years to educate workers
...
2
...
Often, the biggest stumbling block to economic
development is infrastructure, such as transport
...
•
However, a developing economy may struggle to have the necessary tax
revenues to finance these investments and there is the danger of
government failure (poor information, corruption and inefficiency)
...
Protectionism / infant industry argument
...
To develop, they may need to use tariff protection and develop greater diversity
in their economy, such as protecting new manufacturing industries
...
12
•
However, this is controversial, as it breaks the desire to promote free
trade
...
4
...
(Overseas Development Assistance ODA) Aid can be used to
finance investment in infrastructure and human capital
...
•
However, it depends on the quality of the aid
...
There is also a danger
aid could be siphoned off, due to corruption
...
Foreign direct investment
...
China has gained access to raw materials and, in
return, has built roads and railways to transport the goods
...
•
However, the concern is that developing countries may have to pay a high
cost (losing rights to their own raw materials, in return for investment)
...
The IMF can
arrange a loan to bail out countries in difficulty
...
This may involve free market supply side policies, such as devaluation,
control of inflation, tightening of fiscal policy, and structural reforms such
as privatisation
...
World Bank
•
•
•
•
•
•
The World Bank is an international financial institution which gives loans
to developing economies
...
The World Bank is committed to facilitating free trade and foreign
investment
...
It has attracted criticism for encouraging laissez faire economics (e
...
privatisation) as conditions for loans
...
Others argue that structural reforms promoted by the World Bank can
also help the economy in the long-‐term
...
Then firms pay households wages to produce goods
...
The circular flow of income shows three ways to calculate GDP:
•
•
1
...
Total national expenditure (consumption and investment)
3
...
Real income is the value of GDP adjusted for inflation; therefore, it shows
the actual value of goods and services
...
Injections (J)
This is an increase of expenditure into the circular flow of income, leading to an
increase in aggregate demand (AD)
...
Withdrawals can include:
•
•
•
Saving (S) — depositing money in banks
Imports (M) — spending on foreign goods
Taxation (T) — the government raising money from consumers and firms
Physical and monetary flows
•
•
•
Physical flows involve the transfer of goods
...
For example, a consumer may buy an import from Germany
...
Once payment is
received the good is transferred to UK
...
g
...
Marginal propensity to save (MPS) is the % of extra income that is
saved (e
...
bank savings)
...
Marginal propensity to tax (MPT) is the % of extra income that goes in
tax payments
...
Marginal propensity to import (MPM) is the % of extra income that is
spent on imported goods (and leaves the UK economy)
...
Average propensity
•
•
Average propensity to consume (APC)
...
Average propensity to save (APS)
...
Calculation
If a person has income of £10,000 and he spends £8,000, saving £2,000
...
8
The APS is 0
...
•
The MPC is 0
...
g
...
•
•
•
At a higher price level, ceteris paribus, consumers have less disposable
income (money to spend)
...
A shift in the AD curve would occur if there was a change in factors like
real income; higher income would shift AD to the right
...
Shift in AD
•
•
If there was an increase in income, the AD curve would shift to the right
(AD2)
...
16
Determinants of aggregate demand: (AD) (C+I+G+X-‐M)
Consumer spending (C)
Consumer spending is the biggest component of AD (approx
...
Consumer spending is determined by:
•
•
•
•
•
•
•
Disposable income
...
Rising real
wages would increase the disposable income and shift AD to the right
...
The alternative to spending disposable income is to save
...
Consumer confidence
...
Low confidence will shift AD to the left
...
House prices/ wealth
...
In the UK, many people own
their houses
...
They will also feel
more confident if their house is worth more
...
A cut to income tax will increase the consumers’
disposable income, encouraging spending
...
Lower interest rates reduce the cost of borrowing,
encouraging spending
...
Cost of living
...
g
...
This factor causes movement along the AD curve
...
Investment affects both AD and AS
...
Factors that affect investment
1
...
If businesses are optimistic about future demand, they will
need to increase productive capacity and start to invest now
...
2
...
Keynes said investment was heavily influenced by the
‘animal spirits’ of businessmen — did people expect their business to
grow? This confidence can quickly change depending on the state of the
economy
...
Interest rates
...
Lower interest rates make it cheaper to finance investment and
make more projects worthwhile
...
Availability of finance
...
Banks may be reluctant to give a small
business a loan because it is a risky investment
...
5
...
Some businesses may be put off investment
because of the heavy cost of regulation, e
...
the need to meet
environmental standards and labour regulations
...
6
...
A key factor in determining investment is the rate of
economic growth
...
The demand from overseas and the demand for
exports are also important
...
g
...
In 2013/14, the UK
government spent a total of £722
...
Government spending is influenced by:
•
Fiscal policy
...
g
...
18
•
•
Economic cycle
...
Political cycle
...
Net trade (X-‐M)
The UK’s main trading partner is the EU (60% of trade), though the proportion of
trade with developing economies, such as China and India, is rising
...
Exchange rates
...
This will tend to increase
(X-‐M) and increase AD
...
Economic growth
...
But if there is strong growth in Europe, this will lead to higher (X-‐
M) and higher AD
...
Competitiveness
...
Improved
competitiveness could be due to lower wages or higher productivity
...
Non-‐price factors
...
If UK firms can produce better
quality goods and services with unique selling points, the demand for UK
exports will rise, and the demand will be more inelastic
...
Tariffs and protectionist measures
...
For example, if the UK left the EU, it
may find that there are higher costs/tariffs on exports to Europe
...
•
•
Thus, an increase in the rate of economic growth will have a
corresponding larger increase in the level of investment
...
An economic
downturn leads to a big drop in investment
...
•
•
There can be time lags between changes in rate of economic growth and
the decision to invest
...
19
Aggregate supply (AS)
Aggregate supply (AS) is the total productive capacity of the economy
...
The AS curve shows maximum potential output; there is a strong correlation
with a production possibility frontier (PPF) curve from unit 1, which also shows
the maximum potential of an economy
...
In the diagram on the right, there is a shift in AD
...
Short-‐run aggregate supply SRAS
•
•
In the short run, aggregate supply is elastic
...
For
example, firms can pay workers to do overtime
...
These include:
•
•
•
•
The price of raw materials, e
...
oil, metals, food, gas, food and electricity
...
A devaluation in the currency will increase the cost
of many imported raw materials, such as oil and shift SRAS to the left
...
A rise in VAT or excise duty will increase the cost of
goods and shift SRAS to the left
...
A rise in wages will increase the cost of firms and shift
SRAS to the left
...
This is sometimes known as a
supply side shock
...
Rise in the price of commodities, such as food or coffee
...
Examples of supply-‐side shocks
•
•
1970s: Oil prices trebled, leading to a double-‐digit inflation and the
recession of 1973/74
...
21
Long-‐run aggregate supply (LRAS)
In the long run, AS is determined by the quantity of factors of production and the
productivity of labour/capital
...
It may be referred to as ‘full capacity’ level of output
...
A rise in the number of working age people will increase the
labour force and increase productive capacity
...
The UK
labour force has increased due to net migration in the past decade
...
Technological improvements are one of the biggest factors
affecting labour productivity, e
...
the internet makes it easier for firms to
check costs and prices
...
If firms or the government invest in increasing the capital
stock, we will see higher AS in the long run
...
Improved education and vocational skills enable
workers to be more productive and offer higher added value, increasing
productive capacity
...
Improved transport links reduce the cost of transport
and encourage trade; this is important for boosting productive capacity
...
The government can affect the LRAS by its supply-‐
side policies on education, competitiveness and regulation
...
Attitudes to enterprise
...
Financial system
...
A fragile
banking system could damage LRAS
...
•
•
On the left, the classical view is that LRAS is inelastic
...
Economic growth requires LRAS to
shift to the right
...
g
...
Which AS curve to draw?
•
•
•
•
Many students ask — which curve should I draw? We have SRAS and two
LRAS
...
However, it can be important to distinguish between SRAS and LRAS
...
Capital investment would affect LRAS
...
23
Macroeconomic equilibrium
Equilibrium national income occurs where AD=AS
...
Real GDP falls from Y1 to Y2
...
For
example, a rise in export demand due to increased economic growth in Europe
...
24
Economic growth
Short-‐run economic growth
If there is spare capacity (e
...
at Y1) — in the short run, an increase in AD causes
an increase in real GDP
...
25
Causes of economic growth in the short term
Demand-‐side factors that can increase economic growth could include:
•
•
•
•
•
Lower interest rates — reducing the cost of borrowing and leading to
higher investment and higher consumption
...
Lower taxes — increasing disposable income
...
Rising exports — from higher growth in other countries
...
•
•
At Y2, the economy has reached full employment
...
26
Long-‐run economic growth
With long-‐run economic growth we see an increase in both LRAS and AD
...
Factors that could increase LRAS include:
•
•
•
•
•
•
Increased investment in productive capacity
Better education and training to increase labour productivity
Improvement in technology, leading to lower costs of production
Improvements in infrastructure, such as transport
Inward investment from overseas multinational firms
Net migration causing a rise in the labour supply
Long run economic growth using PPF
If the PPF shifts to the right, we get economic growth in the long run
...
This shows how the actual growth rate can vary from the long-‐run trend rate
...
This is the sustainable rate of
economic growth in an economy
...
5%
...
In 2008-‐12,
growth stagnated
...
If productive capacity increases 3%, then this enables economic growth of 3%,
with minimal inflation
...
g
...
Labour productivity, e
...
skills and motivation of workers
...
g
...
Size of labour force
...
For example, if the government increased G (government spending) by £10
billion, and this led to an increase in real GDP of £16bn, we say the multiplier
effect is 16/10 = 1
...
Suppose we have a depressed economy with spare capacity and
unemployed workers
...
Income and spending will rise by £10bn
...
But the unemployed will now have extra money to spend
...
3
...
There are knock-‐on effects
...
29
Initially, a rise in injections causes AD to increase to AD2
...
•
•
The multiplier effect will be bigger if consumers spend a high % of their
income
...
The multiplier effect will also be lower if most of the spending goes on
imports, because this is a leakage from economy
...
g
...
The alternative to spending money is that the money will be withdrawn from the
circular flow
...
30
Calculating the size of the multiplier
The multiplier effect is determined by the marginal propensity to consume
(MPC)
...
If consumers received extra money but none of this was spent directly in
the UK, there would be no multiplier effect
...
Example
If the government increased spending by £20bn (financed by borrowing), and:
•
•
•
Marginal propensity to consume (MPC) was = 0
...
3) = 1/0
...
42
The final increase in real GDP will be £20bn × 1
...
57bn
Boom phase of economic growth
A boom is a period of rapid growth
...
Rise in spending on imports, causing a current account deficit
...
Falling unemployment
...
Due to accelerator effect, rising growth, can
cause a bigger rise in investment, leading to higher growth
...
Due to rise in investment, we can also see a multiplier
effect, with the initial increase in investment causing knock on effects
...
Asset prices, like housing and shares are likely to be rising
...
The rise in house prices, in turn, creates a positive wealth effect and more
spending
...
High levels of consumer and business confidence
...
In a boom we often get a phenomenon known as ‘herding’
...
For example, if other people are
buying houses and shares, they give other people the confidence to also
buy houses and shares
...
It shows that economic
growth is often cyclical/volatile
...
Graph shows UK had recessions in 1980/81, 1991 and 2008/09
...
Features of a recession include:
•
•
•
•
•
•
•
Falling GDP — negative economic growth
Rising unemployment (demand-‐deficient/cyclical unemployment)
Improving the current account as import spending falls
Fall in investment
Falling asset prices, such as housing and shares
Negative confidence
Negative output gap
Balanced/stable period of economic growth
•
•
•
•
•
Growth rate close to long-‐run trend rate
...
AD growing at similar rate to AS, causing inflation rate to remain low
...
Low unemployment
...
32
Output gaps
An output gap is the difference between potential GDP and actual GDP
...
We can have positive
and negative output gaps
...
g
...
5%, but we have growth
of 4%
...
They have increased output in the short run (e
...
getting
workers to do overtime)
...
A positive output gap occurs when AD increases faster than AS
...
Lower unemployment due to greater demand for workers
...
The Central Bank may deal with the inflation by putting up interest rates
...
PPF curve: In a boom, output will be on the PPF curve, or just exceeding,
due to short-‐term extension in supply
...
g
...
5%,
or a recession with negative economic growth (-‐1
...
With a negative output gap, the real GDP will be less than potential
...
This will be due to low aggregate demand
...
34
Trends in macroeconomic indicators
UK economic growth since 1980
Graph showing economic growth and the recessions of 1980, 1991 and 2008
...
Graph showing UK productivity grew 30 percentage points from 1990 to 2005
...
Note: This shows relative change in that time period
...
35
UK Productivity
Since 2008, UK labour productivity growth has been poor – well below past trends
...
Graph showing correlation between UK economy growth and Eurozone
...
36
UK inflation and interest rates
Inflation has been relatively low in the UK in the past 20 years
...
Rising house prices creates a positive wealth effect
...
37
Unemployment and employment
Unemployment is defined as when someone is not working, but is actively
seeking work and willing to take a job
...
g
...
Economic inactivity occurs when people are not in the labour force
...
They could include
categories such as early retirement, disillusioned long-‐term unemployed,
long-‐term sickness, disability, etc
...
Full employment can also refer to the economy operating on the PPF
curve (at full capacity) so there is no demand deficient unemployment
...
Claimant count method
This is the official government method of calculating unemployment
...
38
Problems with claimant count
•
•
•
The claimant count excludes many who might be looking for work
...
Very strict rules mean that you can lose your Jobseeker’s Allowance if you
miss an interview or refuse to take certain jobs
...
2
...
It includes some people not eligible for
benefits but who still meet the criteria of being unemployed
...
It is only a sample; it depends on accurate profiling
...
People who are employed on temporary contracts, or working part-‐time
(underemployed) may be hard to classify as either working or employed
...
39
Economic costs of unemployment
•
•
•
•
•
•
Loss of earnings for the unemployed, leading to lower living standards
...
Stress and health problems of being unemployed
...
The government spends more on
unemployment and related benefits, and receives less income tax
...
Increased social division between the unemployed and employed
...
Frictional unemployment
...
g
...
There will always be some
frictional unemployment, as it takes time to find a job
...
Structural unemployment
...
It can be caused by:
•
•
Occupational immobility
...
For example, a former manual
labourer may find it hard to retrain in a new, high-‐tech industry
...
This refers to the difficulty in moving regions
to get a job, e
...
someone unemployed in South Wales may find it difficult
to move to London, where housing is expensive
...
3
...
This occurs when wages in a
competitive labour market are pushed above the equilibrium
...
In a competitive labour market, a minimum wage above the equilibrium will cause real-‐
wage unemployment of Q3-‐Q1
...
Demand-‐deficient or ‘cyclical unemployment’
...
For example, a European
recession would cause less demand for UK exports; therefore, UK firms will
employ fewer workers
...
With less output, firms demand fewer
workers
...
Voluntary unemployment
...
For example, generous
unemployment benefits may encourage people to stay on benefits rather than
take a job
...
For example, due to structural or
frictional unemployment
...
Seasonal unemployment
...
For example, in the tourist off-‐season unemployment
rates will be higher
...
41
The natural rate of unemployment
The natural rate of unemployment is the rate of unemployment when the labour
market is in equilibrium
...
The natural rate of unemployment includes frictional and structural
unemployment
...
What determines the natural rate of unemployment?
•
•
•
•
•
•
Availability of job information
...
Degree of geographical labour mobility, can workers move to where jobs
are available?
Flexibility of the labour market, e
...
powerful trade unions may be able to
restrict the supply of labour to certain labour markets
...
A rise in unemployment caused by a recession may cause the
natural rate of unemployment to increase
...
Monetarists believe that unemployment is primarily due to supply-‐side
factors — the natural rate of unemployment
...
42
Explaining the changing natural rate of unemployment
It has been argued that the UK has seen a fall in the natural rate of
unemployment since the 1980s
...
g
...
Privatisation has helped increase the competitiveness of the industry,
leading to more flexible labour markets
...
•
•
•
•
•
Unemployment peaked in 1983, 1993 and 2012; these were after the
economic recessions
...
During the 2010-‐13 recession, unemployment was lower (8
...
5%)
...
In the 2000s, there was more under-‐employment — people working part-‐
time and self-‐employed
...
43
Policies to reduce unemployment
1
...
Higher AD should lead to higher economic growth and should
encourage firms to take on more workers
...
2
...
This gives a better opportunity for the
unemployed to find work in new industries
...
3
...
4
...
This could reduce frictional
unemployment
...
5
...
•
However, demand for labour may be quite inelastic; cutting wages may
just make firms more profitable
...
Regional grants
These can help overcome geographical unemployment by encouraging firms to
set up in depressed areas, or helping workers to move to areas of high demand
...
Also, firms
may have a similar reluctance to set up in depressed areas because of a
lack of infrastructure
...
•
•
•
If the government increased spending (G), we would see an increase in
AD
...
As output rises, firms will hire more workers, and unemployment falls
...
Short-‐run Phillips Curve
Therefore, after a rise in AD we go from (A) -‐ unemployment (6%) and low inflation
(2%), and move to point (B) -‐ unemployment (3%) and higher inflation (5%)
...
•
•
•
•
•
•
In this model, the long-‐run Phillips curve gives a natural unemployment
rate of 6%
...
If there is an increase in AD, we get a temporary fall in unemployment to
4% (point B)
...
However, when inflation expectations adjust, the short-‐run Phillips Curve
(SRPC) shifts to the right
...
5%), and higher inflation
expectations
...
The natural rate is sometimes known
as the non-‐accelerating rate of unemployment
...
Therefore, Monetarists place greater stress on supply-‐side policies
...
However,
they would still have to be careful not to cause inflation
...
In some situations, e
...
deep recession, it is possible to
reduce unemployment without inflation
...
46
Avoiding conflict between inflation and unemployment
1
...
If the government introduced successful supply-‐side policies, we could see a fall
in structural and frictional unemployment
...
There is still a trade-‐off between unemployment and inflation, but after
the fall in the natural rate of unemployment there is a better trade-‐off
...
Economic growth close to long-‐run trend rate of growth
...
g
...
5%), then
the growth is sustainable
...
47
Inflation and deflation
•
•
•
•
•
Inflation
...
If
there is inflation, the value of money declines and there is an increase in
the cost of living
...
This means there is a fall in the price level (negative inflation
rate)
...
This means there is a falling inflation rate — prices are
increasing at a slower rate
...
A very high and accelerating inflation rate
...
UK has never experienced inflation over 30% since 1900
...
In the UK, the government has set an inflation target of
CPI = 2% +/-‐ 1
...
•
•
This shows the monthly CPI inflation rate compared to the government’s
target of 2%
...
This means that in this period, prices increased at a slower rate
...
This is calculated through different steps
...
This seeks to measure what people
spend their money on
...
The basket of goods is updated each year to
take into account changes in expenditure
...
The goods and services in the inflation
index are given a weighting depending on what percentage of spending
they generate
...
Bus travel will have a lower weighting of, say, 0
...
Price changes
...
The price changes are then multiplied by their weighting
and combined into a single index figure that shows the percentage change
...
The price rises are converted into an index
...
Problems with calculating CPI
•
•
•
•
The expenditure survey does not include everybody, e
...
pensioners are
excluded, but pensioners have different spending habits, e
...
heating is
more important
...
Changes in quality: Computers have many more features than 10 years
ago, so it is difficult to compare prices because they are different goods
...
It is impossible to measure all prices in the economy
...
Retail price index (RPI)
•
•
The RPI is another measure of inflation
...
RPI includes the cost of mortgage interest payments
...
For example, if interest rates rise, we will see RPI inflation
increase more than CPI, because mortgages are more expensive
...
A rise in oil prices would cause higher CPI inflation, but the core inflation
would be more stable
...
On consumers
•
•
•
Fall in the value of savings
...
If inflation is higher than interest
rates, savings will decrease in value
...
High inflation will reduce the value of debt,
making it easier for consumers and firms to pay back their debt
...
Fall in real wages
...
If
inflation is higher than the growth of nominal wages, real wages will fall
...
Between 2001 and 2008, wages grew at a faster rate than CPI inflation
...
Since 2008, wages have been mostly growing at a slower
rate than inflation, and therefore, real wages were falling
...
Inflation
could be caused by rising demand, where people are spending more
...
50
Effects of inflation on firms
•
•
Uncertainty
...
In periods of high inflation, firms may be less willing to invest
because they don’t know what their future costs and incomes will be
...
Menu costs
...
Firms and consumers may also spend more time
checking prices
...
If inflation is high, it can creates uncertainty about
future costs and therefore firms are likely to reduce investment, leading
to lower economic growth
...
Decline in competitiveness
...
Higher interest rates
...
The Central Bank (or the government) may feel the need to increase
interest rates
...
Problems of deflation
If prices fall, this can also cause problems for the economy
...
Falling prices may deter people from buying goods (they
wait for them to be cheaper later); this leads to lower aggregate demand
...
If prices and wages are falling, then deflation
causes the real value of debt to increase
...
This gives consumers less disposable
income and can cause lower AD
...
Interest rates cannot fall below
0%
...
Deflation
can become difficult for Central Banks to solve
...
Deflation can make it
more difficult for the government to reduce debt to GDP ratios
...
If prices fall, but wages stay the same ‘sticky
wages’, it will cause real-‐wage unemployment
...
Causes of deflation
1) Falling aggregate demand
...
2) Rising productivity
...
This
kind of deflation can also cause rising real GDP
...
Another potential benefit of deflation is that your economy may become
more internationally competitive, and it could lead to rising exports
...
52
Causes of inflation
1
...
Demand-‐pull inflation occurs if the economic growth is too fast, e
...
if the
growth is above the long-‐run trend rate
...
Demand-‐
pull inflation could occur due to various factors
...
A cut in interest rates reduces the cost of borrowing,
encouraging spending and investment
...
Boom in exports from a rising global demand, e
...
strong growth in
Europe
...
A rapid rise in the money supply, e
...
the Central Bank printing more
money
...
This growth proved unsustainable
...
Cost-‐push inflation
This occurs when there is a rise in the costs of firms, leading to short-‐run
aggregate supply (SRAS) shifting to the left
...
This would increase the costs of
most firms, due to higher transport costs
...
If wages are pushed higher by trade unions or a shortage
of workers, this will increase the costs of firms
...
)
Import prices
...
If there is a
depreciation in the exchange rate, then import prices will become more
expensive, leading to an increase in inflation
...
The inflation in 2011 was caused by higher taxes, depreciation in the
pound, and higher raw material/food prices
...
1
...
Cheaper exports increase export demand
...
Therefore, we see a rise in AD
...
Imports are more expensive
...
3
...
A devaluation makes firms cheaper without
much effort so that they may have less incentive to cut costs
...
If the money supply grows faster than the rate of growth of real
income, there will be inflation
...
The stock of money (cash + bank deposits)
V = velocity of circulation
...
Explaining the quantity theory of money
•
•
•
Monetarists believe that in the short term, velocity (V) is fixed
...
Therefore, an increase in the money supply (M) faster than the growth of
national income will lead to an increase in (P) inflation
...
This causes an increase in real
GDP and higher inflation
...
55
•
•
•
•
•
Initially, with low inflation expectations, workers see the nominal wage
increase as a real increase, therefore they do work more
...
Workers don’t want
to keep doing overtime permanently
...
With higher nominal wages, SRAS shifts to the left
...
Therefore, in this model, the increase in the money supply has not
changed real GDP in the long run, but it has caused a higher price level
...
Evidence in the 1980s showed
that the money supply could grow much faster than the price level,
suggesting the link was not true in the real world
...
In the great recession of
2008-‐13, even quantitative easing (increasing monetary base) didn’t lead
to higher inflation, because the economy was depressed
...
The velocity of circulation
can change due to factors such as an increase in the use of credit cards
...
g
...
Economy not always at full employment
...
In this depressed state, increasing the
money supply may not cause inflation
...
•
•
•
•
•
If workers expect low inflation, they will be more likely to accept low
wage increases
...
If inflation expectations rise, it can cause inflation — as firms push up
prices, and workers try to secure higher wages
...
This was partly caused by
rising oil prices, but also by strong wage growth
...
If a Central Bank has strong anti-‐inflation credibility, it can make it easier
to keep inflation low
...
56
Income distribution and welfare
Income and wealth
•
•
Wealth is a stock concept; it is the value of assets, such as savings, housing,
and shares
...
Income is the amount of money a person receives per time period, e
...
salary
...
g
...
Causes of income inequality
1
...
Workers with high levels of
skills will be able to gain higher wages
...
2
...
High levels of structural and long-‐term unemployment
are one of the biggest causes of poverty in the UK because the
unemployed rely on government benefits, which are substantially less
than wages
...
Monopsony / monopoly
...
Causes of wealth inequality
•
•
•
•
Opportunity to save
...
High income earners may have
substantial spare cash
...
Those who are wealthy (e
...
own a house) can
gain rentable income, which they can use to invest in the accumulation of
more assets
...
Wealth can be inherited, income cannot
...
Taxes on income tend to be higher than taxes on wealth
...
People need incentives
to take risks and make the effort of setting up a business
...
Therefore a degree of inequality is needed in a free market economy
...
g
...
Benefits to the
unemployed / low paid can discourage taking work (unemployment trap
/ poverty trap)
...
The wealthy can exploit their monopoly power to make
higher profits at the expense of others, e
...
landlords have a degree of
monopoly power in setting rents, especially in places like London
...
High levels of inequality can cause social friction and
resentment in society
...
Taking more tax from high-‐
income earners has little impact on living standards, taking tax from low
earners has a greater impact because they have to cut back on essentials
...
This measures the number of people living below a
certain income level which is necessary to be able to afford basic goods and
services
...
This occurs when the income of a household is low
compared to others, e
...
one definition of relative poverty is when a person
has income below 50% of the national average
...
This measures the degree of income inequality
...
In this diagram the
poorest 50% of the
population have 27%
of total income
...
2
...
The bigger area ‘a’ is, the more inequality exists
...
A Gini coefficient of 1
...
In the 1980s, the UK saw a significant rise in income inequality, which has been
maintained in the past two decades
...
It is tied to inequality within society
...
Inequality in wages and earnings growth
...
However, those with few skills or
qualifications will find themselves unemployed or in low-‐paid jobs
...
• Globalisation has increased pressure on firms to cut costs; this often
involves reducing wage costs for the lowest pay
...
g
...
• Decline of trades unions, and growth of monopsony power by firms,
leaves many workers unable to bargain for higher wages
...
Unemployment
...
3
...
If pensions and other welfare
benefits are index linked (increasing in line with inflation), then they
could fall behind real wages, which usually rise faster than inflation
...
Regressive taxes
...
There has been a shift in taxes from
progressive income tax to regressive indirect taxes, therefore causing an
increase in inequality
...
The aim of fiscal policy could be to:
1
...
2
...
•
For example, higher government spending on education can
increase AD, but may also help reduce structural unemployment
...
•
Expansionary fiscal policy (loose fiscal policy)
This involves lower tax rates and/or higher government spending, with the aim
to increase AD
...
It may also cause inflation, especially if economy is close to
full capacity
...
In a liquidity trap, monetary policy can become ineffective
...
60
Deflationary fiscal policy (tight fiscal policy)
•
•
•
This involves higher tax rates and/or lower government spending
...
Deflationary fiscal policy will also improve the budget deficit
...
Supply-‐side
...
For example, expansionary fiscal policy which involves higher
government spending could be targeted on education and infrastructure
spending
...
2
...
Therefore, the government may be unsure
whether they need to boost or reduce AD
...
But in major
recession, they may try expansionary fiscal policy
...
It depends on other components of AD
...
4
...
Higher income tax to reduce inflation can create
disincentives to work, reducing productivity and AS
...
Time lag involved in influencing AD
...
But there
will be delays in actually implementing higher spending, and then delays
in this spending affecting the wider economy
...
Budget deficits
...
This could lead to higher interest
rates in the long term, or even cause markets to lose confidence in
government debt levels
...
Crowding out
...
Therefore, there is no overall increase in AD
...
Resource crowding out – This occurs when government borrowing
causes the private sector to have less money to spend on investment
because the private sector has used these funds to lend to the
government
...
g
...
In a recession, there will be high
demand for saving and therefore government borrowing is making use of
otherwise idle resources
...
The main types of government spending are:
•
•
•
Capital expenditure
...
It is investment that increases the capital stock
of the economy
...
This capital spending can increase the
productive capacity of the economy in the future, because it helps
shift long-‐run aggregate supply to the right
...
This is government spending on items that are
recurring and only lasts a limited time, e
...
spending on public sector
wages and consumable products
...
g
...
Paying teachers’ wages and paying electric bills is current
spending
...
These are simple payments from the government to
individuals
...
Examples
of transfer payments include:
• Pensions
• Welfare payments, such as unemployment benefit and housing benefit
62
Levels of government spending
Real government spending — Spending levels adjusted for inflation
...
The government
can use tax revenues to overcome market failure in areas such as
transport, education, and health
...
It can also help improve
indices of economic development, such as literacy rates
...
The government can spend money to redistribute
income amongst people on low incomes
...
Countries with the highest
levels of government spending (Norway, France, UK) have the most
developed welfare states, which provide a safety net and healthcare for
the poorer members of society
...
In a recession, government spending may be effective in
stimulating the economy, e
...
government borrowing can offset a rise in
private sector saving, and increase AD
...
Between 2007 and 2010, the increase in
government spending as a % of GDP is a consequence of the recession,
causing a fall in GDP, but higher government spending on unemployment
and housing benefits
...
Higher income
tax rates could create disincentives to work
...
Potential inefficiency of government spending
...
Therefore, government
spending could be wasteful, misused, and inefficient
...
g
...
Efficiency
...
There is no reason government spending
has to be inefficient
...
An increase in the government sector has an opportunity
cost
...
Depends on the kind of spending
...
o Spending on transport links (capital spending) can help the
economy become more efficient and competitive in the long term
...
g
...
Regressive tax occurs when an increase in income leads to a smaller % of
their income going on the tax, e
...
excise duties and VAT take a bigger %
of low income earners
...
Direct taxation is taken from people’s earnings directly, e
...
income tax
and NI
...
g
...
The requirements of a good tax system
1
...
g
...
2
...
A degree of proportionality is important, e
...
progressive
income tax
...
Cheap to collect
...
Difficult to evade
...
Efficient, non-‐distorting, e
...
if income taxes are too high, people may be
put off working
...
Easy to understand
...
Higher income tax should increase tax revenues
...
Tax evasion
...
g
...
Therefore, an increase in tax revenues may be less than
expected
...
Higher marginal tax rates may reduce incentives
to work and do overtime
...
Redistribution
...
Aggregate demand
...
Ceteris paribus, this could lead
to lower economic growth and lower inflation
...
But other economists suggest evidence is mixed
...
It depends how tax revenue is used
...
If
income tax revenue is needed for welfare payments, there will be no
increase in productive capacity
...
Flat tax rate
A flat tax rate means there is one single, unified income tax rate, e
...
20% and
getting rid of tax allowances, and higher tax bands (e
...
40% marginal tax rate for
incomes over £40,000)
...
A disadvantage of flat tax is less redistribution from high income earners
...
It is the difference between government spending
(G) and tax revenue (T)
...
A balanced budget occurs if government spending equals tax revenue
...
g
...
Primary budget balance refers to budget position ignoring interest
payments
...
The overall budget includes interest payments and all types of spending
...
The government pays interest to encourage investors to buy
government bonds
...
This occurred in great recession of 2009-‐13
...
9% of GDP)
...
In 2009, the government also pursued expansionary fiscal policy
(cutting VAT rates to boost AD)
...
1
...
If people earn less, they
will pay less income tax
...
2
...
Structural deficit
This refers to a budget deficit, even if we ignore cyclical factors
...
Automatic fiscal stabilisers
•
•
•
•
This refers to how tax rates and government spending automatically have
an influence on the rate of economic growth and help to counter swings in
the economic cycle
...
With higher growth, the government will receive more tax revenues from
the same tax rates, people earn more and so pay more income tax
...
Discretionary fiscal policy
•
•
This is a deliberate effort by the government to influence aggregate
demand and the rate of economic growth
...
Factors influencing the size of the budget deficit
•
•
•
•
•
State of economy
...
Government spending decision
...
Fiscal policy
...
Demographics
...
This may cause a rise
in borrowing, to finance this rise in automatic spending
...
Countries in the Eurozone are obliged to
meet certain criteria to keep structural borrowing less than 3% of GDP
...
68
Economic effects of higher government borrowing
•
•
•
•
•
•
Higher debt interest payments
...
This increases the annual debt
interest payments; therefore, future generations may have to pay higher
taxes to pay these debt interest obligations
...
A budget deficit implies lower taxes
and increased government spending; ceteris paribus, this will increase AD
and may cause higher real GDP and inflation
...
In the future, the government may have
to increase taxes or cut spending in order to reduce the deficit
...
Increased interest rates
...
This is because they will need to
increase interest rates in order to attract investors to buy the extra debt
...
o This may not always occur
...
Crowding out
...
o However, if the economy is depressed and the private sector wants to
save, government borrowing may not cause crowding out, because the
government is using money which otherwise would just be saved
...
Countries with high levels of government borrowing
may struggle to attract foreign investors, e
...
some southern Eurozone
economies
...
1
...
If there is a downturn in the economy, there will automatically be
a fall in taxation and higher government spending on benefits, which will cause a
budget deficit
...
• In a recession, a government deficit is necessary to offset the rise in
private sector saving and to try and increase AD and, hence, improve
economic growth
...
• By borrowing, the government is compensating for the rapid rise in
private sector saving and therefore helping to make use of
unemployed resources
...
Investment
...
However, government spending may not necessarily increase
productivity
...
3
...
In the case of the banking sector, the government
thought it necessary to bailout banks, to prevent them from going bankrupt and
causing a possible loss of confidence in the banking system
...
It is measured using Public sector net debt (PSND)
...
3 billion, equating to 80% of GDP
...
It fell during the post-‐war period, as economic growth led to higher
GDP, making debt a smaller percentage
...
70
Monetary policy
Monetary policy involves changing the interest rate or manipulation of the
money supply by the monetary authorities
...
Aims of monetary policy
1
...
Inflation target for MPC is CPI -‐ 2
...
Maintain sustainable economic growth/low unemployment
3
...
If they feel the inflation rate is likely to go above the target (e
...
due to a
higher rate of economic growth), then they will increase interest rates to
moderate demand and keep inflation low
...
To determine future inflation, the MPC will look at various statistics, such as:
•
•
•
•
•
•
•
The rate of economic growth compared to the long-‐run trend rate
...
Wage growth
...
Temporary factors like tax rises and commodity price rises may be given
less importance because they do not indicate underlying inflation
...
High unemployment will tend to reduce wage inflation
and so the MPC is more likely to cut interest rates to boost AD
...
Exchange rate
...
Consumer confidence/ spending
...
If confidence is high and consumers are spending
more, it may lead to inflationary pressures, and the Bank will be more
likely to keep interest rates high
...
A rise in borrowing could indicate the economy is
getting close to full capacity and is in danger of over-‐heating
...
71
Effect of higher interest rates (tight monetary policy)
If inflation is forecast to rise above the inflation target, the MPC is likely to
increase interest rates
...
Make borrowing more expensive, therefore people spend less on credit
...
2
...
Therefore, AD decreases
...
Saving money in a bank is more attractive, therefore there is less
spending and relatively more saving
...
Exchange rate increases
...
This increases the demand for the British Pound and
increases the exchange rate
...
72
Evaluation of monetary policy
1
...
If the
economy is close to full employment, a cut in interest rates is likely to cause a
significant increase in inflation, but only a small increase in real GDP (AD3 to
AD4)
...
g
...
2
...
The effectiveness of monetary policy
depends upon other variables in the economy, for example:
•
•
•
If confidence is low, a reduction in interest rates may not increase
demand
...
If the world economy is slowing, this will reduce exports and AD; this
would keep spending low, even if there was a reduction in interest rates
...
Time lags
...
For example, higher interest rates may not reduce investment in the short term,
because firms will continue with existing investment projects
...
Conflicts of objectives
...
If the MPC reduces inflation, this may lead to lower
growth or higher unemployment
...
Worse trade-‐off
...
In 2008, they had to tolerate inflation being above target
...
Exchange rate effect
...
Quantitative easing
1
...
2
...
Increase the supply of money
2
...
Increase bank lending and increase economic growth
How quantitative easing works
•
•
•
•
•
•
The Central Bank creates money electronically (this is a similar effect to
printing money)
...
Commercial banks sell assets (bonds) to the Central Bank for cash
...
In theory, with more cash reserves, the bank will be more willing to lend
to customers
...
Buying assets reduces their interest rate
...
Higher lending should help
improve economic growth
...
It is hard to quantify the effect of QE
...
Perhaps,
without QE, the recession would have been deeper
...
Future inflation? Some fear that quantitative easing creates the
possibility of future inflation because, when the economy recovers, there
is excess money supply in the financial system, which may be hard to
remove
...
Economic growth was low/negative between 2009 and 2012, suggesting
QE was of limited effect in boosting economic growth
...
It may occur when an increase in the money supply fails to
translate into lower interest rates
...
Consequence of a liquidity trap
•
•
•
Central bank might try unconventional monetary policy, such as
quantitative easing
...
Demand likely to be depressed, leading to economic downturn
...
•
•
Symmetric inflation target is when Banks have to prevent inflation
going too high, but also prevent it going too low, e
...
Bank of England’s
target is 2% +/-‐1 (i
...
keep inflation between 1% and 3%)
...
g
...
The idea of inflation targeting is that:
•
•
•
It removes political pressures to cut interest rates before an election
...
If people have confidence in Central Bank to keep inflation low, workers
will not demand large wage increases to compensate for inflation
...
g
...
Inflation is not the only macro-‐economic objective
...
It can make the central bank inflexible, e
...
in 2011 when the ECB tried to
reduce inflation, but Eurozone was in recession
...
Supply-‐side
policies can be either:
1
...
g
...
2
...
g
...
Supply-‐side improvements
...
Supply-‐side improvements could be due to private
innovation, improved technology or government supply-‐side policies
...
Lower inflation
...
2
...
Supply-‐side policies can help reduce structural,
frictional, and real-‐wage unemployment
...
Improved economic growth
...
4
...
By making firms more
competitive, they will be able to export more, improving current account
on balance of payments
...
This involves selling state-‐owned assets to the private
sector
...
Deregulation
...
Greater competition creates incentives to
reduce prices and costs
...
Reducing taxes
...
Reducing state welfare benefits
...
o However, it could cause an increase in relative poverty
...
Some economists argue that many European
labour markets are too heavily regulated
...
o On the downside, greater labour market flexibility may lead to
greater job insecurity for workers
...
Allowing more immigration could help the economy
become more flexible and deal with labour shortages, such as nurses and
teachers
...
Raising retirement age to 67 over time
...
It means longer working life for new
generation of workers
...
Hoping to encourage more people into
work and reducing ‘benefit trap’ thus increasing the gap between work
and state benefits
...
Better education can improve labour
productivity and increase AS
...
Therefore, the
government may need to subsidise suitable training schemes
...
Improving transport and infrastructure
...
If the government
spent money to improve transport network, firms would benefit from
lower costs, e
...
the HS2 train link
...
Shortage of housing in popular
areas can cause geographical immobility
...
77
•
Raising minimum wage significantly to become a ‘living wage’
...
o However, on the other hand higher minimum wage could lead to
unemployment because firms can’t afford the workers
...
g
...
It will cost money to improve information and education, and therefore
taxes will need to rise
...
Government failure may occur
...
For example, the
government may finance the wrong kind of scheme, such as a new train
line that is not used very much
...
In a recession, policies to
increase aggregate demand are more important than supply-‐side policies
...
In this
situation, the economy needs an increase in AD (demand-‐side policies)
...
It is important to bear in
mind that technological improvements and productivity gains come
largely from the private sector
...
At best, the government can create a climate for private
sector innovation to occur
...
Higher economic growth may cause environmental problems, e
...
the
overuse of scarce (limited) resources acts as a constraint on future living
standards
...
Economic development may also lead to lower industrialisation
and a more service sector based economy
...
Higher growth, but higher inequality
...
o However, it depends on the nature of growth
...
3
...
Cutting down
welfare benefits may provide an incentive for the unemployed to get a job,
but it may cause increased inequality
...
Growth and balance of payments
...
g
...
5
...
If a government tried to reduce
current account deficit through devaluation, it could cause inflation, due
to higher import prices and rising AD
...
Growth and inflation
...
o However, if growth is sustainable and AS and AD increase at a
similar rate, growth does not need to be inflationary
...
The
classical view stressed the importance of free markets
...
Classical economists believe LRAS is inelastic
...
•
•
•
•
It appeared wages and prices were ‘sticky’ downwards
...
Keynes also argued that in the 1930s there was a deficiency of aggregate
demand (AD)
...
Keynesians believe LRAS can be elastic
...
1970s breakdown of Keynesian consensus
•
•
In the 1970s, we saw a break down in the stable trade-‐off between
unemployment and inflation
...
This was caused by rising oil prices and rising wages,
leading to cost-‐push inflation
...
They
believed to reduce inflation it is essential to control the money supply
...
They believed there would only be a short-‐run
trade-‐off between unemployment and inflation
...
It reduced inflation
but caused a deep recession and high unemployment
...
Monetarists also advocate free market supply side policies to reduce
structural unemployment and increase efficiency
...
The crisis exposed how problems in the financial system could have
serious adverse effects for the wider economy
...
The financial crisis also led to a prolonged recession
...
Cutting interest rates to zero was
insufficient to return the economy to normal economic growth
...
Many felt fiscal policy could play an
important role in overcoming the recession
...
Euro crisis
•
•
•
•
•
The recession of 2008 precipitated a crisis in the Eurozone
...
Many European countries, such as Ireland and Spain, saw a collapse in the
housing market, which caused further problems for banks
...
There was a trade imbalance between different
Eurozone countries, which worsened the recession
...
Austrian economics
Another economic view is that of “Austrian economics”
...
Government
intervention is inevitably inefficient
...
They believe recessions are caused by credit cycles, and usually blame the
central banks for keeping interest rates too low for too long
...
81
Globalisation
Globalisation refers to the process of how national economies are becoming
increasingly interdependent and integrated
...
Characteristics of globalisation
•
•
•
•
•
Growth in free trade between countries
Growth in movement of labour and capital across national borders
Increased importance of global financial systems
Growth in trading blocs (groups of countries, like EU)
Growth of multinational companies who operate around the world
Causes of globalisation
•
•
•
•
•
•
•
Growth of free trade
...
Economies increasingly rely on importing raw materials and
exporting goods to foreign markets
...
Multinational companies
...
Multinationals have different production processes across the globe
...
The development of technology, such as the internet, has
helped improve communication and made it easier to connect to all
corners of the world
...
Improved transport, especially air transport and shipping, has
helped to make trade cheaper, and also made it easier for labour to move
between different countries
...
Institutions like the WTO have helped reduce barriers to trade and
provide a forum for discussing global issues
...
Trading areas like the EU have considerably reduced
barriers to trade within Europe, and also raised the profile of
international co-‐operation
...
Since the1980s, China, India,
Brazil and Russia have become much more open to the global economy
...
g
...
82
Impact of globalisation
•
•
•
Global trade cycles
...
o On the other hand, countries can benefit from growth in other
countries through selling more exports
...
Globalisation has increased the importance
of reaching global agreements
...
Interdependence
...
China has
become reliant on Africa for raw materials
...
Impact of globalisation on workers
•
•
•
•
New opportunities
...
g
...
o However, this migration has created friction and problems, such as
housing shortages
...
Wages
...
For example, self-‐employed computer programmers in India can work for
US firms through the internet
...
Foreign direct investment has created manufacturing jobs in developing
countries, e
...
clothing retailers setting up in Asia
...
o On the other hand, the new jobs have helped give workers more
choice and may be better remunerated than working in agriculture
...
A key factor is whether workers have the sufficient skills
to thrive in a global economy
...
83
Impact of globalisation on firms
•
•
•
•
Uncompetitive domestic firms
...
The forces of globalisation can lead to
temporary, structural unemployment, as local firms become
uncompetitive
...
Lower costs for multinationals
...
This helps products to be cheaper
...
g
...
Economies of scale
...
This is significant for industries with
high fixed costs, like cars and aeroplanes
...
Impact on firms in the developing world
...
g
...
o But globalisation has also given new opportunities to firms in
developing countries, e
...
computer software firms in India can
effectively compete because of the internet
...
Globalisation has meant goods are increasingly
imported from across the planet, rather than using local produce
...
o Also, globalisation enables firms to switch production to countries
with weaker environmental legislation
...
Some aspects of globalisation have helped to improve the environment,
e
...
the media can make us more aware of the environmental costs
elsewhere in the world, and the internet has reduced need for some travel
...
g
...
Advantages of multi-‐national companies
•
•
•
•
Enable economies of scale, which is important for industries with high
fixed costs, such as car and aeroplane manufacturers
...
Create wealth and jobs around the world
...
Global companies can ensure minimum standards
...
g
...
Disadvantages of multi-‐national companies
•
•
•
•
They may take a high percentage of revenue from mining and other
operations in developing countries
...
Multinationals can also develop monopsony
power and exploit suppliers and workers
...
The environmental record of multinationals has been mixed
...
For example, China, Brazil, India
...
High economic growth in emerging economies leads to
increased demand for UK exports and services
...
o Currently, emerging economies are a small % of UK exports, but it
is growing and offers more potential in the future
...
China and India have helped keep costs of
exports low
...
o However, there is also increased demand for raw materials
...
This can cause cost-‐push
inflation (e
...
2008-‐09)
...
The growth of cheap manufacturing has led to a
decline in UK manufacturing, speeding up the change to a service sector
based economy, e
...
finance
...
85
Trade
•
•
•
•
International trade allows countries to specialise in goods and services
which they are relatively best at producing
...
This occurs when one country can produce a good
with fewer resources than another
...
A country has a comparative advantage if it can
produce a good at a lower opportunity cost, e
...
it has to forego less of
other goods in order to produce it
...
This states that trade can benefit all
countries if they specialise in the goods in which they have a comparative
advantage
...
Opportunity cost of producing clothes or computers
Clothes
Computers
UK
1
4
India
2
3
Total
3
7
•
•
•
For the UK to produce 1 unit of clothes, it has an opportunity cost of 4
computers
...
5
computers
...
Opportunity cost of producing books
•
•
•
If the UK produces a computer, the opportunity cost is 1/4 (0
...
If India produces a computer, the opportunity cost is 2/3 (0
...
Therefore, the UK has a comparative advantage in producing computers
...
Therefore, output of both goods has increased, illustrating the gains from
comparative advantage
...
Limitations of the theory of comparative advantage
•
•
•
•
Assumes no transport costs but, in reality, transport costs can prohibit
the benefits of trade
...
Governments may restrict trade through tariffs
...
For example, in the future, India could become
good at producing books if it made the necessary investment
...
A capital abundant country will specialise in producing and exporting
capital intensive goods, and import those labour intensive goods, in which
it does not have an advantage
...
A country like Germany may specialise in exporting goods which require
skilled labour
...
In essence the Heckscher-‐Ohlin theory is based on principles of
comparative advantage
...
This can involve:
•
•
•
•
•
•
Higher tariffs (type of tax on imports)
Non-‐tariff barriers, e
...
the US have charges on packages under grounds
of ‘aviation security’, and this increases the costs of imports
...
Voluntary export restraint is effectively a type of quota where
voluntary limits are placed on imports of goods
...
g
...
Government subsidy
...
This has often occurred with national
airlines
...
Keeping your currency artificially low makes
exports relatively more competitive
...
Reducing tariff barriers leads to trade creation
...
•
•
•
•
The removal of tariffs leads to lower prices for consumers (P1 – P2) and
an increase in consumer surplus (1+2+3+4)
...
Domestic firms will sell less and lose producer surplus of area 1
...
2
...
If UK firms have a comparative advantage then, with
lower tariffs, they will be able to export more, and create more jobs
...
Economies of scale
...
This is especially
true in industries with high fixed costs, or those that require high levels of
investment
...
Increased competition
...
It may prevent domestic monopolies from
charging too high prices
...
Trade is an engine of growth
...
6
...
Countries with large reserves of raw
materials need trade to benefit from their natural wealth
...
If developing countries have industries
that are relatively new then, at that moment, these industries would
struggle against international competition
...
•
The senile industry argument
...
Protection for these industries could act as an incentive for
firms to invest and reinvent themselves
...
Many developing countries rely on
producing primary products, in which they currently have a
comparative advantage
...
o Goods have a low income elasticity of demand
...
•
•
Protection against dumping
...
This caused
problems for world farmers because they saw a big fall in their market
prices
...
Environmental
...
International competitiveness
The UK’s international competitiveness measures the relative cost of British
exports
...
International competitiveness can be measured using
•
•
Unit labour costs – costs of employing workers to produce goods
Relative prices of exports and imports
...
Labour productivity (output per worker)
...
Labour productivity will depend on factors such as:
• Levels of education and training
...
High mobility will increase overall productivity
...
If workers enjoy work and feel part of the
process, productivity will be higher
...
2
...
If the UK experiences lower inflation than our
main competitors, this will reduce our relative costs and make us more
competitive
...
Unit labour costs
...
4
...
g
...
If a country
experiences transport bottlenecks, it will lead to higher costs of business
and lower competitiveness
...
Cost of business
...
High taxes and regulated
labour markets can reduce competitiveness
...
Exchange rate
...
Measures to increase competitiveness
•
•
•
•
•
Education and training
...
Education can take several years to have an
effect but is important for increasing long-‐term productivity
...
g
...
This helps
reduce costs for firms and improves productivity in the economy
...
g
...
Privatisation and deregulation
...
Devaluation in exchange rate
...
However, it doesn’t deal with
underlying issues of competitiveness, such as productivity and wage costs
...
Limiting wage growth
...
However, it can be difficult for the
government to limit wages
...
90
The balance of payments
The balance of payments is a record of a country’s transactions with the rest of
the world
...
•
Current account = financial + capital account
Current account
The current account is primarily concerned with the balance of trade in goods
and services
...
Trade in goods (visible), e
...
cars, computers, food
...
Trade in services (invisible), e
...
tourism, insurance, banking
...
Net income flows (interest, dividends and investment income from
abroad)
...
Net current transfers (e
...
government aid, payments to EU)
...
A deterioration in the current account means that we get a bigger deficit or
we go from a surplus to a deficit
...
91
Financial account
This is the other part of the balance of payments
...
It includes financial flows (e
...
saving in banks) and net
investment (e
...
foreign firms building factories in the UK)
...
It is
relatively small compared to the other components
...
Overvalued exchange rate
...
Exports will
become uncompetitive and therefore there will be a fall in the quantity of
exports
...
Economic growth
...
If domestic producers cannot meet the
domestic demand, consumers will import goods from abroad
...
3
...
If there is relatively high inflation in
the UK compared to our competitors, there will be less demand for UK exports
because British consumers will prefer buying cheaper imports
...
Policies to reduce a balance of payments deficit
1
...
This involves reducing the value
of the currency against others, and making exports cheaper and imports more
expensive
...
•
•
•
We would expect a devaluation to lead to an improvement in the current
account
...
Demand needs to be relatively elastic for a
devaluation to improve the current account
...
This
will reduce competitiveness in the long run, and will mean that the
improvement in the current account might only be temporary
...
2
...
The government
could pursue tight fiscal policy (higher tax to reduce consumer spending) or the
Bank of England could increase interest rates
...
92
•
•
•
The UK has a high marginal propensity to import; therefore, a reduction
in AD improves the current account significantly
...
However, this policy will conflict with other macroeconomic objectives
...
The government is likely to feel that growth and
employment are more important than the current account deficit
...
Supply-‐side policies
...
If successful, they will make UK exports more competitive and
export demand will rise
...
•
•
Supply-‐side policies will take a considerable time to have an effect (e
...
it
takes time to build new roads)
...
However, supply-‐side policies would help other areas of the economy like
economic growth and unemployment
...
Lower AD
...
Money is
being spent in other countries and, therefore, ceteris paribus, it reduces UK
aggregate demand
...
The deficit is often smaller
in a recession
...
2
...
A current account deficit could cause a depreciation in the
value of the exchange rate, because we are buying imports and, therefore, buying
foreign currency
...
If AD increases at the same rate as AS, we can get economic growth
without inflation
...
•
Some countries, such as China and Germany, have experienced a large
current account surplus
...
If one country runs a large current account surplus, it means other
countries will have a similar deficit
...
In the Eurozone, current account imbalances are more of a problem
because countries can’t rely on a depreciation to solve the imbalance
...
Encouraging consumer spending (e
...
lower income tax), leading to higher
import spending
...
Bilateral exchange rate measures the exchange rate for two countries,
e
...
the value of the Pound Sterling against the Dollar
...
g
...
5
...
The real exchange rate = nominal
exchange rate X (domestic price / foreign price)
...
The weighted average of a currency adjusted
for inflation, like real exchange rate
...
Depreciation/devaluation is the decrease in value of exchange rate
...
Fixed exchange rate is the government committed to keeping exchange
rate at set value
...
g
...
1 to €1
...
It is a mixture of floating exchange rates and fixed exchange rates
...
We give a weighting to the most important currencies (e
...
the Euro and
the US Dollar will have the biggest weighting because most trade is with
the Eurozone and then the US)
...
Factors that influence exchange rates
•
•
•
•
Inflation
...
Countries with lower
inflation rates tend to see an appreciation in the value of their currency
...
If UK interest rates rise relative to elsewhere, it will
become more attractive to deposit money in the UK
...
Higher interest
rates cause an appreciation
...
If foreign currency dealers become pessimistic about the
state of the UK economy, they may sell Sterling
...
Movements in exchange rates don’t always reflect fundamentals,
but reflect future forecasts
...
If a country has a large current account deficit, it
may cause depreciation because there is a net outflow of currency
...
It is a better guide to actual living standards, and a reflection of the value
of goods and services that people can buy in the economy
...
If you spend $10 in the US, you may be able to buy one meal
...
But with
these 600 Rupees you can perhaps purchase two meals, because living
costs are relatively cheaper
...
96
Big Mac Index
•
•
•
•
The Big Mac index, published by the Economist magazine, offers a rough
illustration of this difference in relative living costs
...
In theory,
the ingredients are the same, so a difference in price reflects different
exchange rates
...
50 in South Africa to $4
...
When making comparisons of living standards, we need to bear this in
mind
...
Evaluation of PPP
•
•
Different countries may not have the same range of goods to make
comparisons
...
Primary products more likely to be
close to PPP, expensive manufactured goods more likely to be close to
official exchange rate
...
Governments could use foreign currency
reserves to buy Pounds and increase the value of the Pound
...
Changing interest rates
...
Improving competitiveness
...
It could also
try supply-‐side policies to improve long-‐run competitiveness
...
g
...
Can help reduce inflation as countries have an added discipline to keep
inflation low, otherwise the currency would be weaker
...
97
Disadvantages of fixed exchange rates
•
•
•
May lead to the exchange rate being overvalued, this can harm exports
and economic growth
...
UK forced out of ERM in 1992, because markets felt they had joined at the
wrong rate
...
Euro/ Monetary union
Joining the Euro involves:
1
...
2
...
3
...
Interest rates are set by the ECB for the
whole Eurozone area
...
Rules about size of budget deficits The EU Fiscal stability pact includes a
rule that budget deficits should not exceed 3% of GDP during periods of
economic growth
...
)
Advantages of joining the Euro
•
•
•
•
•
Lower transaction costs
...
Lower costs have been estimated to be worth 1%
of GDP
...
If UK exporters experienced a
rising Pound Sterling it would make their exports less competitive
...
Increased inward investment
...
If we stay out of the Euro, we could lose out on this
...
With a common currency, it is easier to
compare prices in different EU countries
...
Also, it should be easier for firms to identify
the cheapest suppliers
...
The ECB has a strong tradition of keeping inflation low
...
In theory,
joining the Euro should give countries an incentive to remain competitive
and increase productivity, because they cannot rely on devaluation to
improve competitiveness
...
Countries will lose the ability to set interest rates
...
However, this may not be suitable for the UK
economy
...
This high interest rate would make
it difficult for the UK to recover and grow (e
...
as in 2008/09)
...
2
...
If the UK joined the Euro at an exchange
rate that is too high, it would make UK exports uncompetitive, because it is
not possible to devalue the exchange rate
...
Low inflation may conflict with other objectives
...
Rates of economic growth
have been very poor (especially in Southern Europe) in the past 10 years
...
Loss of independence over fiscal policy
...
Appreciation in the exchange rate
An appreciation means the value of a currency increases
...
Therefore, quantity of exports falls
...
Therefore, quantity of imports rises
...
Assuming demand is elastic, an appreciation will cause lower
aggregate demand and lower economic growth
...
This is due to 3 reasons:
1
...
g
...
2
...
3
...
Worsening of current account, e
...
bigger deficit, because of decline in
exports and rise in quantity of imports
...
A rise in the exchange rate may
discourage foreign direct investment (FDI), because it is now more
expensive for foreign firms to invest
...
The
Marshall Lerner condition (below) states an appreciation will only
worsen current account, if PEDX + PEDM >1
...
An appreciation won’t cause a
fall in AD, if consumer spending is growing strongly
...
Time lags
...
Therefore, an appreciation could have a bigger impact
over time
...
If the exchange rate appreciates
because firms are becoming more productive, then they will remain
competitive
...
o For example, countries like Germany and Japan have prospered,
even in periods of an appreciating currency
...
If the economy is growing
strongly and is near full capacity, a rise in the exchange rate could help
reduce inflationary pressure and keep growth sustainable
...
The effects of an appreciation depend on the state of the economy
...
But, at AD3 to AD4, there is
a big fall in real GDP
...
Competitiveness improves in the short term; in the long term it may not
improve due to higher inflation
...
•
•
If (PED x + PED m > 1), then a devaluation will improve the current
account
...
Essentially, if demand for exports and imports is elastic, then a depreciation will
improve the current account
...
Therefore, after a devaluation, the current account can get worse before it gets
better
...
Initially devaluation worsens current account because demand is inelastic, but over time
demand becomes more elastic and current account improves
...
A trading bloc is a group of countries who agree on common
rules for trade and tariffs
...
Free trade areas
...
g
...
An area of free trade with a common external tariff
...
Single European market -‐ Economic union
...
A single market involves:
•
•
•
•
Free trade area with common external tariffs
Free movement of labour and capital
Harmonisation of economic laws and regulations, e
...
common tax rates
Cross-‐border economic policies, e
...
EU competition and agricultural policy
Monetary union
...
g
...
Benefits of EU membership
1
...
For the UK the EU is
our main trading partner (roughly 60% of trade with EU)
...
Greater competition, increasing efficiency, and reducing prices
...
Lower costs for firms to have common rules and regulations, e
...
acceptance of educational qualifications
...
Increased direct investment, which helps promote better efficiency
...
Greater clout for international trade negotiations
...
Countries may benefit from more flexible labour markets, as workers can
migrate to fill labour shortages, e
...
UK benefited from Eastern European
workers filling in vacancies in the service sector
...
By staying out of the Eurozone, the UK has avoided problems of single
currency and common monetary policy
...
Countries with large agricultural sectors tend to benefit from large
agricultural subsidies
...
g
...
Some fear EU makes it more difficult to reach consensus because of the
large number of countries
...
Money supply
...
The
money supply includes cash (notes and coins), but also bank deposits (deposits
that can easily be withdrawn and converted into spending cash or used by debit
cards)
...
Narrow money
...
For example M0 = the level of notes and coins in
circulation + banks’ operational balances at the Bank of England
...
Broad money
...
For example M4
...
103
The graph shows
•
•
•
M0 = Narrow money supply
CPI = Inflation rate
M4 = Broad money
Interest rates
•
•
Interest rates set the cost of borrowing money
...
Real interest rates = nominal interest rates – inflation rate
...
Liquidity preference theory
•
•
•
•
This shows the demand for money that occurs at different interest rates
...
At lower interest rates, people have more demand for money because it is
not profitable to buy bonds (which give low return)
...
This suggests that an increase in the supply of money should reduce interest rates
...
•
•
Supply of loanable funds comes from saving
...
An increase in savings would shift S to the right and reduce interest rates
Interest rates and inflation
Typically nominal interest rates may be 1 or 2% points higher than inflation
...
Increasing interest rates also maintains positive real interest rates, so
savers don’t lose money
...
Generally
riskier borrowing will lead to higher interest rates to compensate for risk of
bank losing loan
...
Loan can extend to 40
years, they tend to have lower interest rates, e
...
perhaps 5%
...
Typical interest rate may be 7%
...
Debt on credit cards which is not paid off at the end of the
month can attract high interest rates of 15-‐18%
...
These are aimed at people without access to bank
accounts or the usual types of credit
...
They can have very high annual rates of
interest rates (1,000%)
...
Enabling the buying and selling of shares on listed stock
markets
...
Bond markets
...
Besides government bonds, there are also
private sector bond markets for firms
...
Offering firms the chance to save and borrow for
investment
...
Offering individuals the opportunity to save and
borrow
...
A wide range of financial markets which enable banks
and companies to borrow and lend for the short term
...
Banks often need to borrow from other financial
institutions to meet short-‐term liquidity requirements
...
Where individuals and firms can buy and
sell foreign exchange reserves
...
Investing on behalf of workers who saving for retirement
...
Role of financial markets
•
•
•
•
Saving
...
Consumers can also save through
buying bonds and other investment funds
...
Financial markets are critical to enable borrowing by firms and
consumers
...
Reducing risk
...
Forward market in commodities
...
It offers a way to ‘hedge’
(insure) against the risk of fluctuating prices
...
106
•
Shares
...
This can be beneficial for raising finance
for long-‐term investment
...
g
...
Importance of financial markets for wider economy
•
•
•
•
•
Enable firms to borrow for investment
...
Enable firms to reduce risk and uncertainty, e
...
reduce fluctuations in the
exchange rate to encourage more trade and investment
...
Enable firms and consumers to make productive use of savings
...
Central Banks usually set a minimum reserve ratio that commercial banks
must keep, so that banks have enough cash to meet withdrawal requests
...
If a bank received deposits of £1 million, the bank may lend out 90%,
creating £0
...
In turn, this loan may be deposited back in the banking system
...
9 million in
deposits
...
Money multiplier = 1/R
•
•
•
R = reserve ratio (e
...
10%)
If the reserve ratio is 10%, then the multiplier will be 1/0
...
107
Financial sector in developing economies
Financial capital is a major factor in enabling higher economic growth
...
Remittances
...
For example, workers from Nepal may move to the Middle East and send
money earned back home to their family
...
Direct foreign investment
...
Harod Domar model suggests that economic growth rates depend on two
things:
•
•
Level of savings (higher savings enable higher investment)
Capital Output Ratio (efficiency of investment)
In developing countries with low levels of savings, aid, or interest free loans can
help increase levels of investment and therefore development
...
Microfinance
...
Micro-‐finance is not aid, but a self-‐
financing scheme where people will pay back loans, but at low interest rates,
projects and avoid the excessive interest rates of moneylenders
...
Finance could be misused,
though default rates are generally low
...
Many developed countries have struggled to
keep up with high debt interest payments from previous loans (both
public and private sector)
...
Debt relief has been a major plank
of foreign aid and policy to help development
...
Large scale infrastructure and education
would require government intervention
...
108
The role of the central bank
Central Banks play an important role in a modern economy
...
Monetary policy
...
This involves changing interest rates to meet the government’s
target for inflation (and other macro-‐objectives)
...
Banker to the government
...
3
...
An important role is acting as the lender of last
resort, for both the government and private banks
...
They can also lend
money to commercial banks if they are temporarily short of liquidity
(money)
...
Printing money
...
5
...
With other financial watchdogs,
Central Banks can be responsible for regulating the financial sector
...
Independent central bank
•
•
•
An independent Central Bank has the autonomy to make decisions on
monetary policy without government interference
...
A Central Bank under government control will mean the government can
decide interest rates and the money supply, which may make inflation
more likely
...
Primary objective – low inflation
2
...
Advantages of central bank targeting macro-‐economic
indicators
•
•
Central Bank is not swayed by political pressure, e
...
it will not cut
interest rates before an election
...
People may have more confidence in an independent
Central Bank to keep inflation low and this may help reduce inflation
expectations, which in turn helps keep inflation low
...
With an inflation target, the Central Bank may place too much
emphasis on reducing inflation and ignore more pressing problems, such
as unemployment and growth
...
In 2008, economies experienced cost-‐push inflation
and a recession at the same time
...
Inflation not always highest priority
...
Lender of last resort
•
•
•
One role for the Central Bank is to act as the lender of last resort
...
This gives people confidence in the banking system and prevents bank
panics, where people try to withdraw their money
...
It can encourage
banks to take risks, because if things go badly, the Central Bank will bail
them out
...
Financial bodies may not be aware of the real
state of a company’s increasing likelihood of debt default
...
Moral hazard
...
• A Central Bank commits to guaranteeing all bank deposits
...
• Arguably, this bailout guarantee encourages commercial banks to take
more risks because, if they lose money, the Central Bank will step in
...
In the finance sector, we often see
‘market bubbles’ due to speculation and over-‐confidence
...
Due to over-‐confidence, the price of the asset can become
inflated above its true value
...
Irish house prices rose 30% in just two years, but fell 35% when the housing bubble ended
...
This occurs where those with inside knowledge are able
to manipulate financial markets
...
g
...
• Systemic risk
...
For example, if one bank went bust, it would
cause a loss of confidence, and customers would try to withdraw their
money, causing a panic
...
If one bank goes bankrupt, the
whole banking system will be negatively affected
...
Set liquidity ratio
The liquidity ratio is the ratio of short-‐term assets which can be used to pay
short-‐term debts
...
•
A higher liquidity ratio makes a bank have more cash reserves to be
able to in meet debt requirements
...
Set capital ratio (CAR)
...
It is the ratio of its
bank capital to the risk of its assets
...
•
A high capital adequacy ratio means that a bank has a higher level of
reserves to meet any potential risk from default on loans
...
Financial Policy Committee (FPC) at the Bank of England
...
The FPC
can:
•
•
•
•
Examine levels of debt or credit growth, and require banks to take less
risk
...
Examine levels of cash reserves (capitalization)
...
Functions of FPC
•
•
•
Warning banks of potential risks
...
The FPC can make banks hold more cash
during a boom
...
Setting sectoral capital requirements
...
g
...
4
...
Overseas financial bodies taking large
risks, such as insurance
...
Financial Conduct Authority FCA was set up to protect consumers from
misleading information or unsuitable financial products/services
...
IMF and World Bank attempt to give oversight to aspects of global financial
system and warn banks of excessive risks
...
Banks can often find ways around government regulation by devising new
complex instruments and derivatives
...
It is easy to be wise after the event
...
Though many bank regulations were removed in the
1980s and 1990s, making it easier for banks to reduce capital reserves
and take out more risky loans
...
Impact of financial risk on the wider economy
•
•
•
•
•
Confidence
...
If there is a serious fall in the stock market or bond
market, the negative news may reduce consumer and business confidence,
leading to lower spending and investment
...
If banks are reluctant to lend,
consumers will find it more difficult to finance consumer spending and
buy a house
...
Access to credit affects investment
...
Without access to sufficient loans, it will lead to
lower investment and curtail economic growth
...
Crisis in global financial markets
tends to spill over to all major economies, affecting growth in other
countries
...
Also, the UK
is more dependent on financial markets than other countries for service
sector earnings
...
Many people do not hold shares directly, but
indirectly through pension investments
...
This will reduce consumer spending