Test 2 Flashcards
(97 cards)
1
Q
What are the 3 factors that determine Real GDP?
A
- Quantity of Labour (L)
- Quantity of Capital (K)
- The state of technology (A)
Hence, Y = F(A, L, K)
2
Q
How can Y be increased?
A
If A, L or K increases.
3
Q
What are the 3 facts about economic fluctuations?
A
- Are irregular and unpredictable
- Most macroeconomic variables fluctuate together
- As output falls, unemployment rises
4
Q
Explain in more depth the economic fact of “Fluctuations are irregular and unpredictable”
A
- Often called the “Business cycle”
- Doesn’t follow a regular and predictable pattern
5
Q
What macroeconomic variable is one of the most volatile?
A
Investment spending
6
Q
Explain why, as output falls, unemployment rises
A
In a recession, unemployment rises a lot.
When a recession ends, and real GDP begins to grow again = the unemployment declines.
However, the unemployment rate never falls to 0; it fluctuates instead around its natural rate.
7
Q
What is the natural rate of unemployment?
A
5-6%
8
Q
Define the term AS
A
Aggregate supply. Its the quantity of goods/services (or, quantity of real GDP0 that firms choose to produce at each price level.
9
Q
Define the term AS curve
A
Shows the relationship between quantity of Real GDP supplied and the price level
10
Q
Define the term “Short run”
A
Period during which real GDP has fallen below or risen above potential GDP. At any given time, capital and the state of technology are fixed, but quantity of labour is VARIABLE
11
Q
Define the term “Long run”
A
Period that is sufficiently long so that these forces can adjust. Hence, real GDP therefore equals Potential GDP. = FULL EMPLOYMENT
12
Q
2 types of time frames for AS?
A
- SAS = Short run AS
- LAS = Long-run AS
13
Q
Explain the SAS
A
- Relationship between the quantity of real GDP supplied and the price level when prices and productivity of factor inputs (i.e. wage rates and state of technology) are held constant.
- The short-run aggregate supply curve is upward sloping.
- When price level rises but money wage rate and prices of all other factors of production remains same = quantity of real GDP supplied increases and there is a movement along the SAS curve.
14
Q
What are the 4 major theories of why the SAS is upward sloping?
A
- Sticky wage theory
- Sticky price theory
- Misperceptions Theory (Workers)
- Misperceptions Theory (Firms)
15
Q
Explain the Sticky Wage Theory
A
- Theory states that:
“Wages are slow to adjust to changing economic conditions, either because workers and firms sign long term contracts or because trade unions and/or laws and regulations set by the government make it difficult for firms to rapidly adjust the wages they pay.”
In the long run = firm will have to pay its workers higher wages to match for inflation and cost of living, but in short run = wages it pays are too low in real terms. - Since the firm could hire workers at relatively low wages – it hires more and produces more output. The unexpectedly high price level leads to an increase in output, and vice versa in the case of the price level being unexpectedly low.
16
Q
Explain the Sticky Price Theory
A
- Emphasises that prices of certain goods/services are slow to adjust to changing economic conditions.
- Hence = the unexpectedly high price level leads to an increase in output above its natural rate, and vice vera.
- In long run, prices will adjust, and output will return to its natural rate.
17
Q
Explain the Misperceptions Theory for Workers
A
- Assumption of workers having imperfect info regarding price level compared to the firms.
- When P goes up = firms offer an increase in nominal wage. When nominal wage increases, workers, due to misperceptions, believe that real wages also increase = hence, they provide more labour in return, thus increasing output for firm.
18
Q
Explain the Misperceptions Theory for Firms
A
- In short run, individual firms may mistakenly believe that it’s really just the price of their particular good that is rising, NOT the average of prices of all goods and services rising. Hence, they hire more workers, thinking that it’s the best good time to produce = hence, increase in output. Vice versa.
19
Q
What causes a movement along the SAS curve?
A
Price level change
20
Q
What causes a shift of the SAS curve?
A
When other factors aside from the price level changes.
21
Q
What are the 6 reasons for a shift in the SAS?
A
- Employment costs (wages etc)
- Prices of inputs or intermediate goods
- Government taxes, business regs
- A change in the full-employment quantity of labour
- A change in quantity of capital
- Technological advancement
22
Q
The higher the money wage rate, what happens? Explain
A
Higher the firm’s cost = smaller the quantity supplied at each price level = hence, an increase in the money wage rate decreases short-run AS
23
Q
What 2 reasons make the wage rate change?
A
- Departures from full employment:-
- If unemployment > natural rate = downward pressure on wages
- If unemployment < natural rate = upward pressure on wages - Expectations about inflation
- An expected increase in inflation rates = money wage rate rises faster, and vice versa.
24
Q
Explain the LAS
A
- LAS = relationship between the quantity of real GDP supplied and the price level when the economy is at full employment.
- The quantity of real GDP supplied at full employment is EQUAL TO Potential GDP. This quantity is independent of the price level, so the LRAS is VERTICAL at potential GDP.
- In layman’s terms = in long run, what a country produces/can produce does not depend on the price level.
- LAS = relationship between the quantity of real GDP supplied and the price level when the economy is at full employment.
- The quantity of real GDP supplied at full employment is EQUAL TO Potential GDP. This quantity is independent of the price level, so the LRAS is VERTICAL at potential GDP.
- In layman’s terms = in long run, what a country produces/can produce does not depend on the price level.
25
Explain the 3 factors that cause a shift of the LAS
1. A change in the full-employment quantity of labour
- i.e. changes in L or natural rate of unemployment. i.e. Baby-boomers retire etc.
2. A change in quantity of capital (K or H)
- i.e. Investment in factories and capital goods or increased university uptake
3. A technological advancement
- i.e. productivity improvements from innovation
The LAS will only shift if potential GDP increases.
26
What are the differences between short and long run AS?
- Short run AS = shows total output when prices can change, but the prices and productivity of factor inputs (i.e. wage rates) and the state of technology are held CONSTANT
- Long run AS = total planned output when both prices and average wage rates can change.
- SAS = affected by costs of production and quantity of factors of production and technology.
- LAS = affected by quantity of factors of production and technology.
27
Explain an increase in Price Level for the AS
- In short run, the quantity of real GDP supplied increases if the price level increases.
- A rise in the price level with no change in the money wage rate induces firms to increase production.
28
Explain a change in money wage rate for the AS
- A rise in the money wage rate: decreases short-run AS and shifts the SAS curve leftward. Has no effect on LRAS.
29
Explain a change in potential GDP for the AS
- An increase in Potential GDP shifts the LAS curve rightwards and the SAS curve shifts with the LAS curve.
30
Explain what is meant by AD
* The quantity of real GDP demanded, Y, is the total amount of final goods/services produced in the UK that people, businesses, governments, and foreigners plan to buy.
* The quantity of real GDP demanded is:
Y = C + I + G + X – M
* AD = relationship between the quantity of real GDP demanded and the price level.
* AD plots the quantity of real GDP demanded against the price level.
31
What are the 2 reasons for downward slope of AD curve?
1. Wealth effect
2. Substitution effects
32
Explain the Wealth effect for AD
→ A rise in the price level, other things remaining the same, decreases the quantity of real wealth (money, stocks etc.)
→ To restore their real wealth = increase savings and decrease spending, so that the quantity of real GDP demanded decreases.
→ A fall in price level, other things remaining same, increases real wealth.
→ With more real wealth, people decrease saving and increase spending, so that the quantity of real GDP demanded increases.
33
Name the 2 Substitution effects for the AD
1. Intertemporal (Inner country)
2. International
34
Explain the Intertemporal Substitution Effect
= a rise in price level decreases the real value of money and raises the interest rate.
Faced with a higher interest rate = people try to borrow and spend less = quantity of real GDP demanded decreases.
= a fall in price level increases the real value of money and lowers the interest rate.
Faced with a lower interest rate, people borrow and spend more = quantity of real GDP demanded increases.
- Decrease in real value of money = decrease in real money supply
35
Explain the International Substitution Effect
= a fall in price level, ceteris parabus = decreases the price of domestic goods relative to foreign goods = imports decrease and exports increase = increase in quantity of real GDP demanded.
* i.e. Suppose consumers in UK and USA buy both British and American goods. UK’s price level falls = UK goods are cheaper compared to American goods = Demand for UK goods > demand for American goods = UK exports to USA increase and imports from USA fall.
* Similarly = rise in the price level increases the price of domestic goods (UK) relative to foreign goods (USE) = imports increase and exports increase = decrease quantity of real GDP demanded. Then = UK goods are more expensive than American goods => UK exports fall, UK imports rise.
36
What are the determinants of AD?
1. The price level
2. Expectations
3. Fiscal policy and Monetary policy
4. The world economy
37
What happens to a price level change for AD?
Movement along curve
38
What happens when "Other factors" change for AD?
A shift of the curve
39
Explain what is meant by the "Expectations" factor for AD
- About future income, inflation, profits = all change AD
- Increases in expected future income increase people’s consumption today and increases AD
- A rise in the expected inflation rate makes buying goods cheaper today and increases AD
- An increase in expected future profits boosts firms’ investment = increases AD
40
Explain what is meant by the Fiscal Policy and Monetary Policy factor for AD
Fiscal Policy =
- The government’s attempt to influence the economy by setting and changing taxes and expenditure (or, spending)
- A tax cut increases household’s disposable income (disposable income = aggregate income – taxes)
- An increase in disposable income increases consumption expenditure and increases AD
- Because gov expenditure on goods/services is one component of AD, an increase in gov expenditure increases AD.
Monetary Policy =
- Is changes in interest rates and the quantity of money in the economy
- An increase in the quantity of money = increases buying power = increases AD
- A cut in interest rates = borrowing becomes cheaper = encourages more firms to invest and consumers to spend.
- If there is an increase in interest rates = reduction in investment and consumer spending
41
Explain what is meant by "World Economy" as a factor for AD?
- The world economy influences AD in 2 ways:
a) Via foreign exchange rate
b) Via Foreign income
- A fall in the foreign exchange rate lowers the price of domestic goods and services relative to foreign goods and services, increases exports, decreases imports and increases AD.
– i.e. Value of £ falls relative to € = UK goods cheaper than EU goods = UK exports to EU increase = AD increases
- An increase in foreign income increases demand for UK exports and increases AD
i.e. France experiences income growth = Purchasing power of French consumers increases = demand rises for both domestic (French) as well as foreign goods = UK exports rise.
42
Explain the Short-run macroeconomic equilibrium
Short-run Macroeconomic equilibrium:
- Occurs when quantity of real GDP demanded = quantity of real GDP supplied.
- Point of intersection of AD and SAS curves.
If real GDP is below the equilibrium GDP = firms increase production and raise prices. If real GDP is above equilibrium GDP = firms decrease production and lower prices.
* In short run equilibrium = real GDP can be greater than or less than potential GDP
43
Explain the macroeconomic fluctuations in the long run
Long-run Macroeconomic equilibrium:
- Occurs when:
1. Real GDP = Potential GDP
2. The economy is on its LAS curve
3. At the intersection of the AD and LAS curves.
Long-run equilibrium occurs when the money wage has adjusted to put the SAS curve through the long-run equilibrium point.
Real GDP< potential GDP...employmentpotential GDP...employment>natural rate of employment...Wages will rise...SAS would shift back
Because the quantity of labour grows, capital is accumulated and technology advances = potential GDP increases and the LAS curve shifts rightwards. Figure below shows ECONOMIC GROWTH
- If the quantity of money grows faster than potential GDP = AD increases by more than LAS = the AD curve shifts rightward faster than the rightward shift of the LAS curve.
44
Define the term Inflation
The persistent rise in the price level
45
Define the term Economic Growth
The persistent increase in Potential GDP
46
Explain the business cycle in the AS-AD model
* The business cycle occurs because AD and the SRAS fluctuate, but the money wage does not change rapidly enough to keep real GDP at potential GDP.
* An above full-employment equilibrium is an equilibrium in which real GDP exceeds potential GDP.
* A below full-employment equilibrium is an equilibrium in which potential GDP exceeds real GDP.
* A full-employment equilibrium is an equilibrium in which real GDP equals potential GDP.
47
Explain what is meant by output gaps - Inflationary
* The amount by which real GDP exceeds Potential GDP = OUTPUT GAP
* When real GDP exceeds Potential GDP = the output gap is called an INFLATIONARY GAP.
48
Explain what is meant by output gaps - Recessionary
* When Potential GDP exceeds real GDP, the output gap = RECESSIONARY GAP.
49
Define and explain the 2 types of shocks
1. Aggregate demand shocks = a negative demand shock tends to decrease AD, while positive demand shock tends to increase AD
2. Aggregate supply shocks = they alter production costs and affect the prices that firms charge. i.e. discovery of a new technology that reduces production costs.
50
Explain Negative Demand Shock
- Reduces real GDP and increases unemployment
- Gov may bring back the economy to its full employment position by increasing expenditures or reducing taxes. The central bank could achieve the same result by expanding money supply and/or reducing the interest rate.
51
Explain Negative Supply Shock
- i.e. increase in oil price
- reduces real GDP and increases the price level (Cost push inflation lead to Stagflation)
- The gov may bring back the economy to its full employment position by increasing expenditures or reducing taxes. (or the Central Bank could do the same by reducing interest rates). The result will be a higher real GDP, but also higher inflation. This is a solution to STAGFLATION.
52
Explain the Classical view of Macroeconomics
believes that the economy is self-regulating and always at full employment.
53
Explain the Keynesian view of Macro and gov intervention
believes that, left alone, the economy would rarely operate at full employment and that to achieve and maintain full employment, active help from fiscal policy and monetary policy is needed.
54
Explain the Monetarist view
believes that the economy is self-regulating and that it will normally operate at full employment, provided that monetary policy is not erratic and that the pace of money growth is kept steady.
55
What are the 2 groups that make up the workforce?
1. Working-age population = number of people aged 16-64 years, who aren’t in prison, hospital or some other form of institutional care
2. People under 16 years or in institutional care
56
What can the working age population be split into?
2 groups:
1. Economically active = have a job or are willing and able to take a job
2. Economically inactive = don’t want a job
57
What is the formula for Total employed and unemployed workers?
Economically active / Workforce
58
Define Unemployment
Is a state in which a person in which a person doesn’t have a job but is available for work, willing to work and has made some effort to find work within the previous four weeks
59
Define Unemployment rate
Percentage of people in the workforce who are unemployed
60
What is the unemployment rate formula?
Number of people unemployed / Workforce * 100
61
What is the employment rate formula?
Number of people employed/ Working age population * 100
62
What is the activity rate formula?
Workforce/ Working-age population * 100
63
What must a person be for them to be counted as unemployed?
people must be available for work within 2 weeks following their job interview + must be in one of 3 categories:
1. Without work but has made specific efforts to find a job within the previous 4 weeks.
2. Waiting to be called back to a job from which he/she has been laid off
3. Waiting to start a new job within 30 days
64
What is unemployment a problem?
1. ECONOMIC PROBLEMS:
- Lost production
- Lost income
- Lost human capital
- Welfare costs
2. SOCIAL PROBLEMS:
- Individual hardship
- Poverty
- Social deprivation
- Associated social problems
65
What are limitations of official measurement of unemployment?
It excludes: Discouraged workers + others who want a job
Unemployment rate measures unemployed persons rather than unemployed labour hours. Excludes people who have a part-time job but want a full-time job.
66
Define the term Discouraged worker
Person who is available and willing to work but who has stopped actively looking for a job because he/she believes that no job are available.
- Discouraged workers often temporarily leave the workforce during a recession and re-enter during an expansion
67
What are 3 types of unemployment?
1. Frictional Unemployment
2. Structural unemployment
3. cyclical unemployment
68
Explain Frictional Unemployment
- from normal labour market turnover – people entering and leaving the labour force (ongoing job creation and destruction).
- Permanent and healthy phenomenon in an economy
- Influenced by unemployment benefits
69
Explain Structural unemployment
- When changes in technology or international competition change the skills needed to perform jobs or change the locations of jobs.
- Last longer than the frictional: workers have to retrain/ relocate etc
70
Explain Cyclical unemployment
- From fluctuations in business cycle
- Increases during recessions, decreases during expansions
71
Define the natural rate of unemployment
Unemployment from frictions and structural change without cyclical unemployment
72
What is the formula for natural unemployment?
Frictional + Structural unemployment
73
When does full employment occur, and what happens in booms and recessions?
- Full employment occurs when there is NO CYCLICAL UNEMPLOYMENT, or, equivalently, when all unemployment is frictional and structural.
- Recession = actual unemployment rate RISES above natural rate
- Boom = actual unemployment rate FALLS below natural rate
74
What are the 3 key factors of changing the natural unemployment rate?
1. Age distribution of the population i.e. population is mainly older workers rather than young etc.
2. Real wage rate
3. Unemployment benefits
75
What are the 6 reasons for why there is always unemployment?
* Sticky wages = if demand for labour falls, surplus of labour wages doesn’t adjust as quick. The surplus persists and unemployment is temporarily high.
* Frictional reasons
* Demographic change
* Unemplotment benefit
* Technological Change – brings a structural slump.
* Job Rationing = the practise of paying a real wage rate above the equilibrium level (excess supply bring unemployment): two reasons why =>
Efficiency wage = set above the full employment equilibrium wage rate – incentive for the employee to perform or get fired.
Minimum wage = set above equilibrium, leads to surplus of labour.
76
Define the term "Structural slump"
if demand for labour falls, surplus of labour wages doesn’t adjust as quick. The surplus persists and unemployment is temporarily high.
77
Explain the efficiency wage theory
- Firms willingly pay above-equilibrium wages to raise productivity
- Higher wages increase worker productivity by:
1. Attracting higher quality job applicants
2. Increasing worker effort, reducing “shirking”
3. Reducing turnover, which is costly to firms
4. Improving health of workers
CAUSES STRUCTURAL UNEMPLOYMENT
78
Define price level
Average level of prices and the value of money
79
Define inflation
Persistently rising price level
80
Define deflation
Persistently falling price level
81
What is RPI?
shows how the average price of all goods/services bought by a typical household change from year to year.
82
Why is inflation and deflation problematic?
1. Shoe-leather cost = an increase in the amount of running around that people do to try and avoid incurring losses from the falling value of money
2. Menu cost = cost a firm incurs from changing the prices of its goods
83
What are the 5 factors for an economy due to inflation and deflation?
- Erodes the value of money and assets
- Redistributes income and wealth – between employers and workers and between borrowers and lenders
- Diverts resources from production to inflation forecasting
- Causes uncertainty and lowers investments
- Lowers Real GDP and employment.
At it’s worst: HYPERINFLATION = Where inflation rate is 50% per month or higher, resulting in economic freeze and societal collapse
84
Explain the price index (i.e. CPI and RPI)
* Both RPI and CPI measure the average of the prices paid by consumers for a ‘fixed’ basket of consumer goods/services.
* RPi is defined to equal 100 for the reference base period
85
What composes RPI basket?
1. Household and expenditure = largest weighting
2. Travel and leisure = next largest weighting
3. The last 3 components (personal expenditure, alcohol and tobacco, and food and catering) count as 20% total.
86
What composes the CPI basket?
- Transport, recreation and culture, housing and household services are the largest components.
- Restaurants and hotels, food and non-alcoholic beverages are the next largest.
- The CPI excludes a number of RPI series mainly relating to housing costs (for example, council tax), and in particular to owner occupiers' housing costs (including mortgage interest payments, house depreciation and buildings insurance) (ONS, 2023)
87
Formula for RPI? (Inflation rate)
Inflation Rate = RPI this year – RPI last year / RPI last year * 100
88
Formula for the GDP deflator?
GDP Deflator = Nominal GDP/ Real GDP * 100
89
Define the GDP deflator
Is an index of the prices of all the items in GDP. Better measurement due to comprehensive coverage of all items etc.
90
What is the differences between CPI, RPI and GDP deflator?
* RPI and CPI only are concerned about Consumption “C” in GDP formula.
* GDP Deflator is concerned with the entire formula of GDP.
* GDP deflator = least volatile
* RPI = fluctuates more often than the rest.
* RPI generally overestimates inflation as compared to CPI. CPI leaves household expenditure out of the basket – so rises in mortgage payments, rents, and council tax, which in real life you pay, don’t get reflected in it.
91
What are the 2 types of inflation?
1. Demand-pull
2. Cost-push
92
Explain demand-pull inflation
- Inflation that results from an initial increase in AD
- Can begin with any factor that increases AD, i.e.
1. Increase in quantity of money
2. Increase in gov expenditure
3. Increase in exports
= price level rises (hence inflation) as real GDP is increasing.
93
Explain cost-push inflation
Is the inflation that results from an initial increase in costs.
2 main sources of increased costs:
1. An increase in the money wage rate
2. An increase in the money price of a raw material i.e. oil
94
What is the relationship between inflation and unemployment? Explain
* Phillips curve = shows the relationship between the inflation rate and the unemployment rate
* 2 time frames for Phillips curves:
1. Short run
2. Long run
95
Explain short-run Phillips curve
- Shows the relationship between inflation and unemployment, holding constant:
1. The expected inflation rate
2. Natural unemployment rate
- Phillips curve in short run passes through the natural unemployment rate and the expected inflation rate.
- An unanticipated rise in AD causes the economy to move from A to B (higher inflation and lower unemployment) and vice versa in the opposite situation.
96
Explain the long run Phillips curve
- Vertical line at the natural rate of unemployment.
- Inflation and unemployment are hence unrelated in the long run.
97
Explain inflation and the business cycle
= during an expansion, AD increases and usually by more than potential GDP. Hence, AD curve shifts to AD1. Then the SAS curve shifts outwards If we assume that the price level was to rise to 110 and the money wage rate was set on that expectation = economy remains at full employment at point B. Price level rises as expected from 100 to 110. However, if AD increases more slowly than potential GDP = the AD curve shifts to AD2. The economy moves to point C and real GDP growth is slower; inflation is less than expected.
= but if AD increases more quickly than potential GDP = the AD curve shifts to AD3. The economy moves to point D. Real GDP growth is faster; inflation is higher than expected.
* Economic growth, inflation and business cycles arise from the relentless increases in potential GDP, faster (on average) increases in aggregate demand, and fluctuations in the pace of aggregate demand growth.
