Chapter 4= macroeconomic policies and impact on firms and individuals Flashcards Preview

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1

economic cycle

AD= C + I +G + (X-M)

2

Full capacity output

is the maximum output that can be produced when all available resources are fully employed. This can happen when AD is rising, unemployment is low and the economy is growing.

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actual output

Will be determined by AD. In a recession there will be under-utilised resources because AD has shifted left and firms have cut production.

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Impact of changes in AD and AS on inflation and unemployment

(vacancies and rising AD)

= as AD gets close to full output, shortages will develop. Skilled people will be scarce, the number of job vacancies will rise and wages will rise as employers recruit the people they need. Inflation will accelerate.
= once output grows beyond the point where the AS curve turns upwards, inflation rises, accelerating further as skills shortages develop.
=imports may rise as incomes are relatively high; exports may fall when businesses find they can sell more to domestic market.
=strength of demand means people can raise prices (more profit)
=unemployment will be very low
=once AD reaches the output line, out put cannot increase any further.

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Impact of changes in AD and AS on inflation and unemployment

(turning point and slowing AD)

=At the point of full capacity, the economy will hit a turning point and implement contractionary policies.
=higher taxes will reduce spending on domestic products and imports
=high interest rates will discourage development.
=nervous people may try to save more. Falling injections and rising leakages will reduce AD.
=Falling demand will lead to redundancies.
=inflation will reduce, real incomes will fall, consumers will spend less and businesses will cut prices
=unemployment will be a big problem, government policies will become more expansionary.

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the multiplier effect

when an economy is growing, rising injections have a knock on effect, leading to a further increase in aggregate demand. This continues as increased spending an generates more income and more spending.

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how the AS/AD model sheds light on the economy as a whole

can help explain the factors that influence economic growth, incomes, inflation and employment. The model can be used to predict the short or long run changes.

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the AS/AD model can....

-show the effect of a change in an injection or a leakage
-predict the impact of a change in output, employment and prices.
-explain the effect of changes in technology or even natural disasters
-illustrate aspects of the economic cycle.

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to get the full picture of the AS/AD model we must also consider:

-the impact of globalisation and changes in trading relationships.
-business reactions to uncertainty
-changing levels of inequality
-abrupt changes (eg falling or rising oil prices)
changes in fiscal and monetary policies.

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demand side policies

directly affect the level of aggregate demand:
-if the economy is in a recession, increased AD will stimulate business activity and foster economic growth
-if skill shortages are a problem, and inflation is on the rise, then AD can be reduced so that the economy can grow more slowly.

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fiscal policy

-can be used to address short term problems
-may require changes to taxation or government expenditure. Changes in indirect and direct taxes influence AD
-the govt. can stimulate the economy by tax cuts/increased government expenditure or reduce inflation risks by rising taxes and cutting government expenditure.
-fiscal policies can also be used to help fund new research and technologies, to build infrastructure, address problems relating to inequality, health care and education.

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monetary policy

-is determined by the monetary policy committee which is part of the Bank of England
-removes political influence from these technical decisions. The government cannot reduce interest rates in the run up to the election.
-uses interest rates to keep inflation close to the target. The government decides the target percentage. The Bank of England sets the base rate accordingly. When the base rate changes, the effect ripples across all interest rates.

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the base rate

is the interest rate at which the bank of England lends to the banks whenever they are short of cash and need overnight or very short term loans.

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Quantitive easing

is an alternative monetary policy that allows the Bank of England to buy bonds from the banks, so they can provide more finance for investment. It is designed solely to stimulate the economy when interest rates are generally very low.

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expansionary policies

include both fiscal and monetary policies that can increase AD.
=individuals get more disposable income, through lower taxes, lower mortgages and maybe higher welfare benefits.
=increased government expenditure will fund government investment and public services, low interest rates will encourage private investment, creating more jobs and raising incomes
=the multiplier effect will encourage faster growth. Imports may increase due to higher incomes. Inflation may accelerate.

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when are contractionary policies used?

if the economy is growing unsustainably fast, these policies may be introduced. Tight fiscal and monetary policies will cause AD to fall; the economy will grow more slowly.

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what might contractionary policies do?

-some employees will be made redundant. Their income and consumer spending will fall
-new investment may look risky. business will become more cautious as profits fall
-exporters may try harder to sell abroad because of the weak home market
-government expenditure cuts, will also reduce employment and spending
-downward multiplier effect

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how can inflation be controlled

can be controlled by reducing aggregate demand. If it is accelerating fast, the fiscal policy must be used because swift action is required. However, it is much better to act earlier, when economic growth is easier to slow.

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how unemployment can be controlled

can be cut by increasing aggregate demand. This works well if unemployment is cyclical (demand deficiency unemployment). If structural unemployment is the problem, increasing AD will not work. The unemployed need retraining.

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strengths of demand side policies

-tax cuts can be implemented quickly
-can stimulate the economy if AD is smaller than AS
-contractionary policies can prevent AD being bigger than AS

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weakness of demand side policies

-it's difficult to stimulate the economy or slow it down with exactly the right amount of policy change
-time lags make it hard to predict the outcome
-may be unwise to cut taxes or increase public spending if the government has a big public sector deficit.
-if unemployment is structural, demand side policies will not help

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the problem with the four main economic objectives for government

sustainable, economic growth, low unemployment, low inflation, and low balance of payments are all incompatible with each other. There are policy conflicts.

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trade offs

occur when two objectives cannot both be achieved at once. The more you have of one variable, the less you have of another.

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policy objective: to increase the economic growth rate with expansionary policies

1) What is the intended result?

2) What are the possible dangers?

1) AD increases, unemployment falls, the multiplier effect leads to higher output and more jobs.

2) growth may cause inflation to accelerate. As AD and incomes increase, imports may increase and lead to a balance of trade deficit.

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policy objective: to reduce inflation with contractionary policies

1) What is the intended result?

2) What are the possible dangers?

1) inflation slows, exports may increase as they become more competitive; the balance of trade improves.

2) contractionary policies slow down economic growth so that unemployment increases

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policy objective: to reduce unemployment with expansionary policies

1) What is the intended result?

2) What are the possible dangers?

1) increased AD reduces unemployment. With more people working, AD may increase further.

2) growth may cause inflation to accelerate. As AD and incomes increase, imports may rise and worsen the balance of trade.

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why might demand side policies be better?

all supply side measures take time to have an effect. So if the economy needs action now, or over the next two years, demand side policies will be more useful.

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what are supply side policies designed to increase

productive capacity and use resources more efficiently. They aim to raise productivity levels. They help AS growing.

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supply side policies are suited to a...

market based economy

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interventionist policies...

involved government decisions and policies that seek to have direct influence on the wellbeing of both people and businesses.

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supply side objective: increasing incentives

market based policies and interventionist policies

cutting taxes and reducing welfare benefits to create an incentive to work and using tax credits to ensure that everyone is better off in work

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supply side objective: promoting competition

1) market based policies

2) interventionist policies

1) reducing trade barriers, de-regulation

2) implementing competition policy to reduce restrictive practices and market power

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supply side objective: reforming the labour market

1) market based policies

2) interventionist policies

1) reducing unemployment protection and trade union power; privatisation

2) regulating business practices. Helping unemployed people to find appropriate jobs.

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supply side objective: improving employees skills

1) market based policies

2) interventionist policies

1) training within the business

2) training in colleges

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supply side objective: improving infrastructure

1) market based policies

2) interventionist policies

1) using private sector funds

2) increasing public expenditure

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Liquidity trap

The liquidity trap is the situation in which the current interest rates are low and savings rates are high, rendering monetary policy ineffective. In a liquidity trap, consumers choose to avoid bonds and keep their funds in savings because of the prevailing belief that interest rates will soon rise.