Chaper 3 - The macro-economic environment

Question 1

Governments seek to manage national economy, this may include the following aims:

Answer 1

• to achieve economic growth
• to control price inflation
• to achieve full employment
• to achieve a balance between exports and imports

Question 2

Government influences diagram 1.3

Answer 2

+ Economic policy - Market demand; Cost of finance; Taxation
+ Industry policy - Protection vs Free Trade; Grants, incentives, sponsorship; Regulation; Entry barriers
+ Environment & Infrastructure - Distribution
+ Social policy - Workplace regulation;
+ Employment law; Labour supply, skills
+ Foreign policy - EU & GATT obligations; Export promotion to allies & aid recipients

Question 3

Fiscal Policy.

The formal planning of fiscal policy (i.e. tax and spending policy) is set out annually with three components:

Answer 3

1) Expenditure Planning
2) Revenue Raising
3) Borrowing

Question 4

What does PSNCR stand for?

Answer 4

Public Sector Net Cash Requirement

Question 5

Explain what is meant by a budget deficit and a budget surplus.

Answer 5

A budget deficit is when a government spends more than it earns. A budget surplus is when its income exceeds its expenditure.

Question 6

Governments can use fiscal policy to change the level of demand in the economy. They can increase demand by a) and decrease demand by b)

Answer 6

a) reducing taxation without changing spending, then demand is simulated.
or, spending more, but not altering tax

b) increasing taxation or reducing spending

Question 7

Taxation is a key source of a) it b) and c)

Answer 7

a) revenue raising
b) serves to discourage activities (e.g. tobacco)
c) redistributes income and wealth (e.g. income support)

Question 8

A good tax system should be what three things?

Answer 8

1) flexible
2) Efficient
3) Able to attain its purpose

Question 9

Taxes can be either direct or indirect. Explain each & provide examples.

Answer 9

Direct taxes are paid directly to the Revenue authority e.g income, capital gains and inheritance tax.

Indirect taxes are collected by the revenue authority via a third party (a ‘supplier) who passes on the tax to customers e.g. per unit tax on petrol, ad valorem/ fixed percentage tax like VAT

Question 10

Monetary policy uses money supply, interest rates, exchange rates and credit control to influence aggregate demand.

Answer 10

Instruments of monetary policy include:

• changing interest rates
• changing reserve requirements
• government intervention to influence to exchange rate

Question 11

National Income and Economic Growth

Answer 11

Key Terminology

Question 12

Equilibrium national income is where:

Answer 12

demand for goods and services is in balance with supply

Question 13

An inflationary gap occurs:

Answer 13

if a country is in full employment, then any further increase in demand will lead to inflation as output is at maximum (excess demand over supply)

Question 14

A deflationary gap occurs if:

Answer 14

there is unemployment of resources price and wages should go down. But because people do not want their wages to go down temporarily this creates a deflationary gap where prices stay fairly constant and output and demand change.

Question 15

And ‘Stagflation’ occurs when:

Answer 15

there is a combination of high unemployment and high inflation caused by a price shock and inflexibility in supply

Question 16

Phases in the business cycle.

What are the four main phases?

Answer 16

1) Recession
2) Depression
3) Recovery
4) Boom

Question 17

Occurring in the recession phase:

Answer 17

• Consumer demand/ confidence falls
• Investment projects begin to look unprofitable
• Orders are cut, inventory levels reduced
• Some companies unable to sell their inventories become insolvent

Question 18

if during the recession there is lack of stimulus to aggregate demand;

Answer 18

a period of depression will set in.

Question 19

Recovery is usually slow to begin with due to a general lack of confidence in the economy:

Answer 19

• Governments look to boost demand (using fiscal & monetary policy)
• Together with confidence, output, income, and employment rise
• Investment flows into the economy

Question 20

Once the actual output has risen above the trend line the ‘boom’ phase of the cycle is entered

Answer 20

• Capacity and labour become fully utilised
• Further rises in demand lead to price rises
• Business is profitable and high reward investment

Question 21

Inflation and its consequences

Answer 21

Inflation is the name given to an increase in prices

Question 22

High inflation is a problem because it leads to:

Answer 22

• Redistribution of income and wealth (rich get richer)
• Balance of payments effects - imports get cheaper so country buys more but export get more expensive so they sell less leading to debt
• Uncertainty of the value of money and prices
• Resource costs of changing prices- higher cost of living
• Lack of economic growth investment

Question 23

The rate of inflation is measured by price indices.

Answer 23

A ‘basket’ of items which represent average purchases around the country is priced regularly and this forms the basis of a price index

Question 24

In the UK there are now two key price indices:

Answer 24

RPI & CPI

Question 25

Retail Price Index (RPI)

Answer 25

This index includes the price for all goods and services (including housing costs) purchased by UK consumers

Question 26

Consumer Price Index (CPI)

Answer 26

This index, which excludes housing costs, is calculated on the same basis as the rest of Europe

Question 27

RPIX

Answer 27

This is the underlying rate of inflation excluding mortgage interest payments

Question 28

RPIY

Answer 28

This is the RPIX adjusted for the effects of any VAT changes

Question 29

Unemployment

Answer 29

The rate of unemployed is the number of unemployed/total workforce x 100

Question 30

What are the consequences of unemployment?

Answer 30

1) Loss of output - waste 2) Loss of human capital - people forget skills 3) Increases inequalities in income distribution - poor get poorer 4) Social costs - crime increases 5) Increased welfare payments - income support

Question 31

What are the six categories of unemployment?

Answer 31

1) Real wage unemployment 2) Frictional (short therm delays) 3) Seasonal (e.g. tourism) 4) Structural ( 5) Technological 6) Cyclical or demand deficient

Question 32

Economic growth is measured by increases in GNP per head. What factors contribute to growth?

Answer 32

1) New investment 2) Natural resources 3) Labour sources 4) Capital availability 5) Technological progress

Question 33

The balance of payments:

Answer 33

The UK's bank account with the rest of the world. It related to foreign exchange movements in a country. It consists of a current a/c for trading, a capital a/c and a financial a/c

Question 34

The current a/c is sub-divided into:

Answer 34

- Trade in goods - Trade in services - Income from remittance & capital return from other countries - Transfers from interest & NGO payments from bodies in other countries.

Question 35

The capital a/c comprises public sector flows of capital (e.g. gov loans to other countries)

Answer 35

The balance on the financial a/c comprises flows of capital to/from non government sector

Question 36

When commentators speak of a balance of payments surplus or deficit they are only referring to the current a/c, which is also known as the balance of trade

Answer 36

Deficit - importing more than exporting Surplus - Exporting more then importing