AS Unit 4: The Macroeconomy

Question 1

National income statistics

Answer 1

National income is a country’s total output. People earn an income from producing output. This is spent on the output. Total output should equal total income and total expenditure
National income statistics measures an economies economic activity in terms of its output, income and expenditure. A government measures output to assess the economies performance. It is doing well if growing at a sustained and sustainable way. Can also be used to compare different countries
Higher output can increase living standards. If growing slowly a government may introduce policies to stimulate the economy

Question 2

Gross domestic product

Answer 2

Used by economists, governments and international organisations to assess what is produced, earned and spent in an economy

Question 3

Gross national income

Answer 3

It changes focus from output to income earned by the country’s residents and firms regardless of where it is earned. It adds net property income from abroad. These payments are not receipts of compensation of employees and net taxes less subsidies on products
Compensation of employees is wages earned by workers who are resident in 1 country but work abroad for short periods
Some tax revenue on products may be paid to other countries and international organisations and some production subsidies may be received by others
Governments also measure gross national disposable income which includes income sent home to relatives minus income sent by foreigners working in the country to abroad

Question 4

Differences in GDP and GNI

Answer 4

Mostly they are similar. Some have a higher GDP than GNI because foreign MNC’s and foreign workers make an important contribution to output. This can be due to foreign investment but can lead to a net outflow of profits and other income
Countries may have a higher GNI than GDP because they receive a net inflow of property income from abroad

Question 5

Methods of measuring GDP

Answer 5

The output, income and expenditure methods. Should all give the same total because they all measure the circular flow of income in an economy. The value of output is equal to the incomes earned producing it

Question 6

The output methods

Answer 6

Measures the value of output produced by industries. Avoid counting the same output twice. To avoid double counting, output is measured either by totalling the value of the final goods and services produced or by adding the value added at each production stage. Value added is the difference between the price a firm pays for the goods and services it buys from other firms and the price it sells its product for

Question 7

The income method

Answer 7

The value of an output produced based on the costs involved in producing that output. The costs include wages, rent, interest and profits. These represent income paid to factors of production. Transfer payments are not included

Question 8

The expenditure method

Answer 8

GDP is calculated by adding up consumer expenditure, government spending on goods and services, total investment, changes in stocks and the difference between exports and imports. Transfer payments are not included. Add expenditure on exports and deduct expenditure on imports

Question 9

Market prices and basic prices

Answer 9

GDP and GNI are measured in market prices and basic prices. Market prices are the prices charged to consumers. They include any taxes on products and deduct any subsidies given to producers
Basic prices are the prices which would be charged without government intervention and which equal the income paid to the factors of production for making the output. To get from market prices to basic prices, taxes are deducted and subsidies are added

Question 10

Gross values and net values

Answer 10

GDP and GNI include gross investment. This includes the output of capital goods that have worn out or become out of date due to advances in technology and capital goods required to expand capacity
Net domestic product and net national income only include net investment. They deduct the value of replacement capital goods. This is depreciation or capital consumption
Net investment shows if a country’s ability to produce goods and services in the future will increase, stay the same or decrease

Question 11

The circular flow of income

Answer 11

Shows how income, spending and output move around an economy

Question 12

Open and closed economies

Answer 12

An open economy takes part in international trade. A closed economy does not export or import goods or services.

Question 13

The impact of injections and leakages

Answer 13

Some income is saved, some is taxed and some is spent on imports. Some expenditure is also additional to the spending that comes from the incomes generated by domestic output. These extra items of spending (injections) are investment, government spending and spending by foreigners on a country’s export

Question 14

Equilibrium and disequilibrium income

Answer 14

For income to be unchanged, injections of extra spending must equal leakages
If injections are greater than leakages, there will be extra spending in the economy causing income to rise. If leakages exceed injections more spending will leave the circular flow and income will fall.
A rise in investment will cause a rise in GDP. The higher investment results in an increase in production, income and spending
A fall in saving will have the same effect. An increase in saving will mean some products will be unsold so production will fall. Equilibrium income is where investment + government spending + exports = saving + taxation + inmports
Income will move to a higher equilibrium if any injection rises or withdrawal falls. More tax revenue collected from households and firms will reduce the amounts they have available for spending
A rise in saving or imports will also cause GDP to fall

Question 15

Links between injections and leakages

Answer 15

An increase in investment will raise incomes. As people get richer, they tend to save more. Extra savings can finance more investment. Higher government spending may raise tax revenue by increasing incomes. A greater value of exports will also increase incomes. As incomes rise, more tends to be spent not only on domestically produced products but also on imports

Question 16

Aggregate demand

Answer 16

Describes the total spending of consumers, firms and the government + foreigners spending on the country’s exports-spending by the country’s consumers, firms and government on imports
Consumer expenditure: consists of spending by households on goods and services
Investment: spending by private sector firms on capital goods
Government spending: on goods and services
Net exports: the difference between the value of exports of goods and services and the value of imports of goods and services

Question 17

Determinants of the components of AD

Answer 17

Consumer expenditure
Investment
Government spending
Net exports

Question 18

Consumer expenditure

Answer 18

Spending by households on goods and services to satisfy current wants. The main influence is the level of disposable income. Consumer expenditure may exceed income by drawing on past savings or borrowing (dissaving). Some income can be saved when they rise (disposable income-expenditure). Other factors include the distribution of income, interest rates, availability of credit, expectations and wealth. More equal distribution of income will increase spending since the rich losing income are unlikely to cut back on spending and vice versa. Spending rises when interest rates are low since returns from saving will be reduced, buying on credit is cheaper and hose who have borrowed have more to spending. If it is easier to get loans, spending will rise. When people are optimistic that jobs are secure and incomes will rise, spending will rise as will a rise in wealth

Question 19

Investment

Answer 19

Private sector spending by firms on capital goods. The amount of this is influenced by changes in consumer demand, interest rates, technology, cost of capital, expectations and government policy. If demand rises, firms will buy more to expand capacity. A fall in interest rates will stimulate a rise in investment since the cost will fall. Firms that borrow to buy capital will dins it cheaper and the opportunity cost of investment may fall. These also raise demand. Advances in technology will rise capitals productivity and more investment. When optimistic that the economy is improving, investment is encouraged. Government can cut corporate tax and provide subsidies

Question 20

Government spending

Answer 20

Expenditure on providing merit goods and public goods. This is influenced by government policy, tax revenue and demographic changes. If a government wants to raise growth, it will raise spending. Higher revenue will enable more spending. Pressure for a rise in spending may come from a rise in the number of children and/or the elderly

Question 21

Net exports

Answer 21

Influenced by the country’s GDP and other countries, the price and quality of competitiveness of the products and the exchange rate. When a country’s GDP rises, demand for imports rises. Some may be diverted to the domestic market. When incomes rise abroad, demand for exports will rise which may also have resulted from an improvement in competitiveness. If the exchange rate falls in value, exports will be cheaper and imports will be more expensive. If demand for these is elastic, export revenue will rise, imports expenditure will fall causing net exports to fall

Question 22

The AD curve

Answer 22

Shows the different quantities of total demand for the economy’s products at different prices. A demand curve for a product assumes that the prices of other products have not changes. More is purchased when price falls partly from people changing from other firms. In the AD curve the prices of most products are changing the the same direction

Question 23

Why does AD fall when price rises?

Answer 23

The wealth effect: A rise in the price level will reduce the amounts of product wealth can buy. The purchasing power of savings held in bank accounts and other financial assets will fall
The international effect: A rise in the price level will reduce demand for net exports as exports will be less price competitive while imports will become more price competitive
The interest rate effect: A rise in the price level will increase demand for money to pay the higher prices. This increases the interest rate. This results in a fall in consumption and investment

Question 24

Shifts in the AD curve

Answer 24

A change in price causes movement along the curve. If any non-price influence causes AD to change, the curve will shift. Left = a decrease in AD, right = an increase in AD
A change in any non-price level influence on consumption, investment, government spending and net exports will fist AD
A rise in consumer confidence, cut in income tax, increase in wealth, rise in money supply, rise in population
Rise in business confidence, cut in corporate tax, advances in technology
Desire to stimulate economic activity, desire to win political support
Fall in exchange rate, rise in quality of domestic products, increase in incomes abroad

Question 25

Aggregate supply

Answer 25

The total planned supply of all the producers in the country. SRAS is the output that will be supplied in a period of time when the prices of factors of production have not has time to adjust to changes in AD and price level. LRAS is the output that will be supplied in the time period when the prices of the factors of production have fully adjusted to changes in AD and the prices level

Question 26

SRAS

Answer 26

A price rises producers are willing and able to supply more goods and services due to:
The profit effect: As price increases, the prices of factors do not change so the gap between output and input prices widens, increasing profit
The cost effect: It is assumed that input prices remain unchanged but average costs may rise as output increases so to cover this, producer will require higher prices
The misinterpretation effect: Producers may confuse changes in the price level with changes in relative price and that a rise in price they receive means it is more popular so produce more

Question 27

Shifts in SRAS

Answer 27

Change in price of factors: A rise in wages not matched by an increase in productivity and raw material costs will decreases SRAS, shifting it to the left
Change in taxes: A reduction in corporation or indirect taxes will increase SRAS
Change in productivity/quality: A rise in labour or capital productivity will cause an increase in AS in the short and long run
Change in quantity: In the short run, supply of inputs may be influenced by supply-side shocks, may not have significant impact on productive potential in the long run

Question 28

LRAS

Answer 28

Shows the relationship between real GDP and changes in price when there has been time for input prices to adjust to changes in AD. Keynesians represent it as perfectly elastic at low output then finally perfectly inelastic. This emphasises the view that in the long run an economy can operate ay any output and not at full capacity. When output is low, firms can attract more resource without raising prices. There is time for input prices to change but due to low AD, they don’t. As output rises, there are input shortages so prices increase. New classical economists have LRAS as a vertical line because they think that in the long run the economy will operate at full capacity. They think a rise in AD may increase putout in the short run by encouraging firms to make use of resources. In the long run, more intensive use of resources will raise production costs. The economy will move to a new SRAS and back to the LRAS curve. Output will return to the initial level but at a higher price.

Question 29

Shifts in the LRAS

Answer 29

Net immigration will increase the size of the labour force if of working age
Raising retirement age will increase the size of the labour force
More women entering the labour force
If gross investment exceeds depreciation there will be additions to the capital stock
The discovery of new resources can increase a country’s productive potential
Land reclamation

Question 30

What are the main causes of an increase in the quality of resources?

Answer 30

Improved education and training = rises labour productivity
Advances in technology - reduce costs and increase productive capacity

Question 31

Macro equilibrium and disequilibrium

Answer 31

If price level was initially below P, there would be macro disequilibrium. The excess demand would push the price level back to the equilibrium later. If above P, some goods and services would not be sold and firms would have to cut prices. Changes in AD and AS will move the economy to a new macroeconomic position. Where that position is depends on the direction of the change, the size of the change and the initial level of economic activity

Question 32

Economic growth

Answer 32

Is an increase in an economy’s output. Ir is the annual percentage change in output. For people to enjoy more goods and services, output has to increase more than any growth in population. GDP per head would increase. Economic growth does not result in a rise in the living standards an quality of life. It is possible for a high proportion of people to achieve an improvement and living standards even if economic growth does not occur. Economic development is the process of improving peoples economic well-being and quality of life

Question 33

Measurements of economic growth

Answer 33

Measured in terms of changes in real GDP. The economic growth rate is the percentage change in real GDP from one time period to another

Question 34

Nominal and real GDP

Answer 34

Nominal GDP is measured in terms of the prices operating in the year in which the output is produced. Is a measure not adjusted for changes in price. May be misleading because the value may rise not because more goods and services are being produced but because prices have risen
To calculate real GDP, GDP is measured at constant prices. This ensures the effect of inflation that distorts nominal GDP is removed
The price index used to convert nominal to real GDP is the GDP deflator which measures the prices of products produced rather than consumed. It includes the prices of capital goods as well as consumer products and includes the price of exports but excludes the price of imports

Question 35

Nominal and real GDP calculation

Answer 35

Real GDP = Nominal GDP x price index in base year/price index in current year

Question 36

Causes and consequences of economic growth

Answer 36

If there is spare capacity, output may increase as a result of an increase in AD. Higher consumer confidence may lead to higher expenditure increasing AD. An increase in government spending and a cut in taxes and interest rates may cause more factors to be employed an output rising. To achieve economic growth that can be sustained over time, productive capacity an AS needs to increase

Question 37

Increase in quantity of resources

Answer 37

Supply of labour could increase as a result of natural population increase. Net immigration of people of working age leads to a greater availability of workers. This can also rise as a result of government policy 9retirement age, deregulation, privatisation). Supply of capital will increase if there is net investment and land by discoveries

Question 38

Increase in quality of resources

Answer 38

Will increase productivity of factors. Quality of labour can be improved through education, training and healthcare, capital by technology advances. Fertilisers, irrigation and drainage can increase the quality of land (LRAS curve to the right). For an increase in productive capacity to lead to higher output, this capacity must be put to use (right shift of AD and LRAS). Maximum output if AD cuts LRAS at the vertical part
Economic growth can b negative if GDP falls. A decline in real GDP over 2 consecutive quarters (6 months) is a recession. Could be due to a fall in AD or AS

Question 39

Economic growth in low income countries

Answer 39

The main obstacle is the opportunity cost of allocating resources from current use. Research development can result in technology so resources have alternate uses

Question 40

Costs of economic growth

Answer 40

To produce more capital, to increase productive capacity, some resources have to be moved away from consumer goods. Consumption of goods and services will have to be reduced. This is only short-run since increased investment will increase output of capital and consumer goods. Some costs may exist in the short and long run. A growing economy undergoes structural changes. Workers may have to learn new skills and change occupation or where they live. Leads to increased working hours and pressure for ideas/improvements. Economic growth may lead to the depletion of natural resources and damages to the environment

Question 41

Benefits of economic growth

Answer 41

Main benefit is the increase in goods and services for consumers. Can rise living standards. Economic growth makes it easier to help the poor. Higher incomes and more spending and increase tax revenue which can be used for higher benefits, housing, education and healthcare. Without an increase in output or income, a government may have to raise taxes on higher income groups, reducing living standards to help the poor. May cause a rise in employment. A rise in real GDP due to higher AD creates extra jobs. An increase in AS may make products more internationally competitive so may generate more jobs. A stable economic growth rate leads to greater confidence, encouraging investment. Can increase international prestige and power. In higher income countries costs may outweigh benefits. In low income countries it is essential to bring people out of poverty

Question 42

Unemployment

Answer 42

Occurs when people who are willing and able to work cannot find a job. Not all who are not working are unemployed (children, elderly). Some adults of working age are not seeking jobs (university, homemakers, those not well enough to work). People who are not working and trying to find employment are economically inactive and are not part of the labour force. The unemployed are part of the labour force. They are an economic resource not being used. Anyone in the labour force is economically active

Question 43

The labour force

Answer 43

The total number of workers available for work. It is all people who can contribute to the production of goods and services. Depends on demographic, economic, social and cultural factors:
School leaving age
Number of people who remain in full time education above school leaving age
Retirement age
Proportion of women in the labour force
Higher number of people of working age will cause a larger labour force. Also influenced by the labour force participation rate. This is the percentage of the total population of working age who are actually part of the labour force. This may be due to a large participation in higher education and more people taking early retirement. The contribution of women may be constrained by social and cultural factors

Question 44

Level and rate of unemployment

Answer 44

The level of unemployment is the total number of workers who are unemployed. The unemployment rate is the number of unemployed as a percentage of the labour force. Can move in the same direction. If the labour force increases by a greater percentage than the level of unemployment, unemployment rate will fall. The government can also measure the employment rate and the labour force participation rate. These do not add up to 100% since the employment rate is the proportion of the working age population who are in work and not the proportion of the labour force in work

Question 45

Unemployment rate calculation

Answer 45

Number of unemployed/number in labour force x 100

Question 46

The stock and flow of unemployment

Answer 46

A stock is measured at a particular time period, a flow is measured over time. The level and rate of unemployment show it at a particular time period. They don’t show the exact situation as people move in and out of unemployment. The number of unemployed may stay the same over months. May not be the same people. Some may leave the labour force because they become discouraged workers, giving up chances of finding a job

Question 47

Reasons why people may become unemployed

Answer 47

Left school/university
Made redundant
Voluntarily left job
Improved health
Stopped being a homemaker
Migrated into a country

Question 48

Reasons why people may leave unemployment

Answer 48

Entered higher education
Found employment
Became ill
Became homemaker
Became discouraged
Emigrated

Question 49

Measures of unemployment

Answer 49

Claimant count counts as unemployed those who register to claim benefits
Labour force survey involves conduction a survey asking people if they are employed, unemployed or economically inactive

Question 50

Claimant count measure

Answer 50

Cheap and quick to calculate as based on information the government collects as it pays benefits. May over or underestimate. May include some who are not really unemployed and emit those genuinely unemployed. Some receiving benefits may not actively be seeking employment and some may be working and claiming benefits illegally. Some may be actively seeking employment but don’t appear in figures. Can be those too young or old to claim benefits, those who choose not the claim, those who are full time students looking for work and those whose non-employment income is too high

Question 51

Labour force survey measure

Answer 51

More widely used. Conducts a survey usually with the International Labour Organisation definition of unemployment. This is all people of working age who in a specific period are without work but available for work in the next 2 weeks and seeking paid employment. Picks up some groups not in the claimant count. based on internationally agreed concepts and definitions so comparisons are easier. More expensive and time-consuming. Subject to sampling error and practical problems of data collection

Question 52

Frictional unemployment

Answer 52

Arises when workers are between jobs. Could be voluntary unemployment which is when workers are not willing to accept jobs at the current wage rate and working conditions. They may be influenced by how unemployment benefits compare to low wages. The benefit may fall over time. Search unemployment arises when workers do not accept the first job on offer but look for a better paid one. Better information may reduce this. Casual unemployment is workers out of work between employment. In seasonal unemployment demand for workers fluctuates

Question 53

Structural unemployment

Answer 53

Arises due to changes in the structure of the economy. Demand and supply change. Methods of production change may cause a mismatch between vacancies and skills, qualifications and experience of workers. If workers can’t mov industries, they may be unemployed for time. Regional unemployment is where declining industries may be concentrated in an area. Technological unemployment is where people are out of work due to labour-saving techniques. International unemployment occurs when workers lose jobs because demand switches from domestic to more competitive foreign industries

Question 54

Cyclical unemployment

Answer 54

Arises due to a lack of AD. Affects the whole economy over a range of industries. Firms may reduce output and AD for labour decreases. If workers resist wage cuts, cyclical unemployment will exist. Even if wages falls, unemployment may persists. This is because a cut in wages could reduce demand for goods and services as people have less money to spend causing output to be reduced further and less jobs

Question 55

Consequences of unemployment

Answer 55

Workers will experience a fall in income. Will find it harder to get a job the longer they are without one because they miss training and don’t know advances in technology. May be a decline in physical and mental well-being. May give people a change to find jobs they enjoy more in frictional and structural. Firms wanting to expand may have a greater choice of workers. Frictional unemployment allows the economy to respond quicker to changes in demand and supply with workers moving from declining to expanding industries. Firms may benefit from workers not requesting wage rises for fear of losing jobs. Firms may suffer from lower demand. Economy will experience opportunity cost. Output is below potential level. If the unemployed were working, more would be produced and living standards would be higher. Tax revenue will be lower. If benefits are paid by the government, there is an increase in government spending.

Question 56

Significance of unemployment

Answer 56

Effects depend on rate, duration and type. High unemployment means the economy is producing well in its PPC. More signifiant the longer people are unemployed. Income of long term will be low. May suffer poor mental health due to stress
Chances of gaining employment falls with time. Skills may be outdated, lose confidence and become discouraged. Employers may be reluctant to employ the long-term unemployed.
Frictional is the least serious and can be unavoidable. Cyclical is more serious and may be of a high rate and last a long time
Costs generally outweigh benefits. Governments try to keep it as low as possible (not 0). Demand and supply of labour is always changing with some having time gaps between jobs. Government try to avoid structural and cyclical and frictional as low as possible.
Low unemployment foes not always indicate a strong economy. Some may be in low paid or insecure jobs. Underemployment may occur. May be in part-time when they want full time or in jobs that don’t match talents. If a fall results form previously unemployed gaining good jobs it is beneficial. This is unlikely if the reduction is caused by the unemployed giving up of finding work
Not equally spread. Can vary between genders, age groups, ethnic background, regions and skills

Question 57

Price stability

Answer 57

Occurs when prices rise by only a small percentage and there are few fluctuations. A low and stable inflation rate is advantageous so governments want price stability. Some countries experience a high inflation rate with price level rising by a significant percentage

Question 58

Inflation

Answer 58

Does not mean that every price is rising or at the same rate. Means that on average prices are rising at a particular rate. When price level increases, the value of money falls and its purchasing power declines

Question 59

Degrees of inflation

Answer 59

A low and stable inflation rate is not generally a problem. May encourage firms to produce more (creeping inflation). Hyperinflation (over 50% per month) occurs when inflation is out of control. People resort to barter instead of money. Currency usually has to be replaced by a new currency unit

Question 60

Deflation and disinflation

Answer 60

Deflation is a sustained fall in price level. Rise in value of money with each unit having greater purchasing power. Negative inflation rate
Disinflation is when inflation rate falls but is still positive. Price level is still rising but at a slower rate

Question 61

Calculating inflation

Answer 61

Is the percentage change in pice level from 1 period to another (month or quarter). The most used comparisons are the annual average and year-on-year method
The annual average method compares the average level of prices in 12 months
The year-on-year is calculated as the percentage change in price level for a given month with that of the same month in the previous year

Question 62

Measurement of inflation and deflation

Answer 62

Price level indicates how much it costs to live. A rise means cost of living has increased. To asses changes in the cost of living the consumer price index (CPI) is used
1. Select base year: a year in which nothing unusual has occurred. Given a value of 100. Changed regularly
2. Spending survey: A sample of households are asked to keep a record of what they buy. Placed in categories
3. Attach weights: weights are based on the proportion of total expenditure on the categories
4. Find price changes: prices in a range of retail outlets and other sources are recorded
5. Multiply weights by price changes: total will give change in CPI

Question 63

Difficulties of measuring changes in price level due to the base year

Answer 63

Can be difficult to select. If inflation was unusually high, may give the impression that later changes were unusually low

Question 64

Difficulties of measuring changes in price level due to the survey

Answer 64

Problems are whether the people selected are representative of the whole population and whether it was completed accurately. Even if it is representative it does not means that the inflation rate represents price changes each person experiences. Different groups have different spending patterns so different inflation rates

Question 65

Difficulties of measuring changes in price level due to the basket

Answer 65

Can become out of date. Most government update it regularly to align with current spending patterns. Within the period before calculating, remains fixed. Consumers may react during this time to changes in relative prices by altering purchases
Most government assume in measurements some substitution from a relatively expensive brand or type to less of one. Does not allow for substitution between different product types. Therefore the CPI does not fully reflect how consumers react to changes in relative price
The basket takes time to include new and remove old products
Mat have a quality bias. Goods may rise in price but be of better quality so can be argued more value for money
Price may not change but quality and size may decline (shrink-inflation). Some government put a monetary value on changes in quality. If product improves, value is removed and vice vera. Difficult to estimate value of quality changes
CPI accuracy determined by sampling errors, how update the basket is and the extent to which the government can avoid substitution and quality bias

Question 66

Differences between money values and real data

Answer 66

Money or nominal values are the values of the prices operating at the time. Real data has been adjusted for inflation. To convert money values to real data, multiply by the price index in the base year and divide ny the price index in the current year. Changes in real data can be estimated by deducting the change in inflation rate from the change in money value

Question 67

Cost-push inflation

Answer 67

Occurs when prices are pushed up by increases in the cost of production. A decrease in AS caused by higher costs of production pushes ip the price level causing a contraction in AD and reduces real GDP
Wages may increase more than labour productivity causing a rise in labour costs. Higher wages can cause a wage-price spiral. Workers gain a wage rise, prices rise, workers seek higher wages to restore real value. Increases in raw material costs also push up prices. May be caused by a fall in exchange rate. An increase in firms profit margins will increase costs of production or by damage or depletion of resources

Question 68

Demand-pull inflation

Answer 68

Occurs when prices are pulled up by increases in AD not matched by equivalent increases in AS. Any components of AD may increase (consumer expenditure, government spending, investment or net exports). A rise in AD will have a greater impact on price level the closer the economy is to full capacity. Rises in government spending and investment may not be inflationary in the long run because it increases productive capacity. Monetarists argue that they key cause of higher AD is rises in money supply. If money supply grows faster than output, rice level will rise. Monetary inflation can be viewed as a specific cause. Keynesians argue that inflation causes an increased in money supply. If costs rise, firms borrow more casing an increase the the quantity of money

Question 69

Link between demand-pull and cost-push inflation

Answer 69

Some changes will both increase AD and costs of production. Fall in exchange rate will raise price of imported materials and increase export revenue
Once inflation occurs where is an inflationary spiral risk. Demand-pull and cost-push factors may interact causing a spiral. Higher government spending may increase AD> The higher prices may encourage workers to call for higher wages. Costs of production may increase causing AS to decrease. Higher wages may increase consumer expenditure so upward pressure on prices continues

Question 70

Costs of inflation

Answer 70

Reduction in net exports. May reduce international competitiveness so increase import expenditure and lower export revenue. Balance of payments problems
Redistribution of income. If interest rate does not rise with inflation, borrowers gain and lender lose. Borrowers pay back less. Real value of savings for savers falls
Menu costs involved in change prices. Affects firms, takes time, unpopular (barcodes, tags etc)
Shoe leather costs involved in moving money from 1 financial institution to another
Fiscal drag occurs when the income levels corresponding to different tax rates are not adjusted with inflation. People/firms pulled into higher taxes
Discouragement of investment. Creates uncertainty and harder to plan
Inflationary noise when consumers and firms confuse price signals. Hard to assess relative prices. Price may have risen by less than inflation so less expensive in real terms. Wrong decisions are made. Misallocation
Inflation causing inflation. Consumers, workers and firms expect prices to rise so may act in a way that causes inflation (higher wages=raise prices=consumers buy more before prices rise again). Hard for government to change expectations

Question 71

Benefits of inflation

Answer 71

Stimulates output. Low and stable due to increased demand makes firm optimistic. If prices rise by more than costs, profits increase providing funds for investment. Investment also encouraged as real interest may fall and consumer expenditure rises (feel richer)
Reduces burden of debt. Real interest may fall or become negative since money interest rates don’t rise in line with inflation. Debt burden falls. Stimulates consumer spending leading to higher output and employment
Prevent some unemployment. Firms may have to reduce costs to survive. Wages are a significant portion of total costs. Labour force may have to be cut with 0 inflation. Inflation allows real costs of labour to be reduced. During inflation, workers with strong bargaining power can resist wage cuts in real terms

Question 72

Factors affecting consequences of inflation

Answer 72

Cause: demand-pull less harmful that cost-push. Demand-pull is associated with rises output. Cost-push is associated with falling output
Rate: higher rate is more harmful than low rate especially if the high rate becomes hyperinflation. This could cause households and firms to lose faith in currency, brings down government
Accelerating or stable: accelerating or fluctuating will cause uncertainty and discourage investment. Devote more to estimated inflation rates in the future will increase costs
Expectation; unanticipated inflation occurs when inflation is different than expected creating uncertainty and discouraging consumer expenditure and investment. If inflation is correctly anticipated, households, firms and government can adapt and avoid harmful effects
Comparison with other countries: a country may have a high inflation rate but if below that of competing countries its products may be more internationally competitive

Question 73

Recent inflation reductions

Answer 73

Reasons for this is advances in technology which keeps costs down and enables higher AD to be met by higher AS. Another reason is increased international competition. There have also been changes in the labour market in many countries. Trade union membership has fallen and a growth in casual unemployment. Reduced ability to call for wage rises

Question 74

Causes and consequences of deflation

Answer 74

Deflation will increase the debt burden, increase real rate if interest and cause menu costs. Effects are largely influenced by the cause (good or bad)
Good deflation occurs as a result of an increase in AS causing a fall in price and GDP to rise
Advances in technology may lower costs of production. As well as a rise in output, employment may rise and international competitiveness may increase
Bad deflation occurs when price is driven down by a fall in AD. Output falls causing higher unemployment. May cause a deflationary spiral. Consumers may delay purchases expecting prices to fall further in the future. Firms seeing lower demand may not invest and reduce the number of workers employment. Some debtors in difficulty pay put banks in difficulty with some going out of business, losing customers money. Reduces demand further and economic activity will decline again.

Question 75

Inflation vs deflation

Answer 75

Most governments aim for low and stable inflation rather than a fall in price. This is first because there is a belief that low demand-pull inflation may promote economic growth. Second, measures of inflation tend to overstate the rate because the take full account of quality improvements and the effect of switching to cheaper products