When starting our Macroeconomics Unit, we need to first familiarize ourselves with the terminology of what we are actually studying. What Macroeconomics is all about is the whole economy - all of it - and how well or poorly it is doing.
That's quite a lot to look at.
National Income = National Expenditure = National Value of Goods and Services.
|through National Income Statistics
How GDP under-emphasises welfare
How GDP over-emphasises welfare
GDP may be high but welfare may actually be lower for the following reasons:
Why GDP is misguided
1. Human Development Index. - This is a composite indicator that includes three aspects of living standards to create a score between 0 and 1. The closer the overall score to 1, the higher the living standards. The current three indicators are:
The HDI is followed by economist Amartya Sen, and uses the formula:
Aggregate Demand explained
Aggregate Demand is different to demand for just one good or service. Aggregate literally means 'overall' or 'composite'. When we talk of aggregate demand, we are looking at the whole economy, not just one good or service. We are looking at what demand is like for ALL goods and services over a given time period.
Because we are looking at aggregate demand, the axis for our demand diagram changes. We are not looking at price for one good or service, but prices for ALL goods and services. We call this the 'price level' in our economy.
Also, we change quantity into real GDP. This is because the value of all things produced in an economy over a given time period is not just quantity - it is GDP (as seen through the expenditure method).
Just as with normal demand, people in our economy will buy more goods and services when the price level is lower. AD thus has an inverse relationship with price levels.
Determinants of Aggregate Demand
Determinants of Aggregate Demand are simply factors that cause an entire economy to want to buy more goods and services. AD is split into four components, each of which has its own determinants
Aggregate Demand is thus calculated using the equation C+G+I+(X-M). If the components yield a positive number, Aggregate Demand shifts outwards. If they yield a negative number it shift inwards.
Aggregate Supply explained
Aggregate Supply is different to normal supply in that we are now looking at the total amount of goods and services willing and able to be produced in an economy by all firms.
Aggregate supply can be drawn as a straight line that has a direct relationship with price level (as prices for goods and services are higher, firms produce more) but can also be seen as a sloping upward curve because - at some point - resources run out so no more can be produced.
The nature of the Aggregate supply curve is controversial - different economists have different opinions on what it looks like and whether it can be split into two separate curves itself. This is explained in units below (Neoclassical vs Keynesian).
Determinants of Aggregate Supply
Factors that shift the supply-curve in the short-run occur when the price of factors of production change - if factors of production become cheap, firms can supply more at the same price (an outward shift). If they become more expensive, firms supply less at the same price (an inward shift). These changes may occur due to:
These changes in supply are generally true for the short-run. If we wish to permanantly increase supply we must achieve the following criteria:
You will notice these are the same criteria for increasing our PPC - essentially the idea of long-run supply and PPC are the same; they show us what we are able to produce.
AD and AS in Equilibrium
Short-run macroeconomic equilibrium occurs when the forces of aggregate demand are equal to those of aggregate supply. We are producing at a price society is willing to pay, and producers are willing to sell at.
This does not neccessarily mean we are using all of our available resources in the economy - that would be long-run macroeconomic equilibrium. This is explored more in the sub-headings below
"Real Estate" renjith krishna,, FreeDigitalPhotos.net";
Applied Economics - The New Classicalists
Freidrich Hayek is perhaps the most well-known of the neoclassical economists but his work built on the works of other notable names such as Alfred Marshall and Thorstein Veblan. Three assumptions (people act rationally, firms are profit maximizers and perfect information is obtainable) form the backbone of new classical thinking.
Born in Austria-Hungary, Hayek became a prominant economist in the twentieth century and based his ideas on the fact that price acted as a direct signal to firms to change wages. In the 1980s, after stagflation had left Keynesian economists bewildered (see Keyens in drop-down box below), both the USA and the UK (major world powers) adopted Hayek's free-market thinking.
The main ideas Hayek advocated was that governments needed to do less, not more, to help economies grow. The less involvement a government had, the more prices would be able to send signals to firms, which would lead to wage changes so that long run equilibrium could be maintained (see below). Margerat Thatcher certainly followed this advice by closing down the UK's mines and by deregulating many industries, famously saying "competition works".
Hayek and Keynes (discussed below) clashed many times but always held a healthy respect for one another. Hayek's ideas have formed the major thinking of post-1980s Western economics, though the banking crisis and major recessions of recent decades have led to the beginnings of a distancing from his theories.
Neoclassical economists build upon the work of the 'Father of Economics' - Adam Smith. They claim that, if left alone, the economy will always swing back into producing at potential GDP.
To understand this we must understand the following steps:
1) Aggregate Demand is more likely to fluctuate than Aggregate Supply in an economy
2) When it does move, AD changes prices
3) Prices are linked to wages
4) Wages are a cost of production
5) Wages thus influence the Short-Run Aggregate Supply curve
6) Aggregate Demand thus is intrinsictly linked to Short-Run Aggregate Supply
This relationship can be expressed below:
Take Diagram 1, above. We were at equilibrium (where AD met SRAS). Then, Aggregate Demand rose (for whatever reason). Prices therefore rose to P2. If Q1 was our Potential GDP, we now enter an inflationary gap. Workers therefore began to feel that life was a bit too expensive, and asked for a wage increase. If prices rose by - say - 10%, they asked for a 10% wage increase. This made it more expensive for producers to produce, so SRAS fell. We end up at P3 and Q3. Notice that Q3 is the same as Q1!
Because Q1 and Q3 are the same, neoclassicalists say that that quantity represents potential GDP, or the amount we always end up producing in the long run, no matter what happens in the economy. Or... our Long Run Aggregate Supply (LRAS). This takes us to Diagram 2 where we reinterpret the first Diagram. LRAS is our potential GDP. Even if AD increases, we end up at our potential GDP in the long run because wages change too.
AD does not influence our long run production even if it falls, as seen below.
Applied Economics - John Maynard Keynes
After the horrors of the First World War, Keynes saw for himself the destruction Man coul cause. The sweeping poverty, rationing, disease and disjointed economies of Europe moulded his economic thinking. Born in Cambridge, Keynes went to the prestigious Eton College before returning to Cambridge to study at its university. There, he formed a close circle of liberal-thinking friends in what became known as the Cambridge Apostles. After leaving university, Keynes became a respected economist, though his views were ignored at the Treaty of Versailles - the peace treaty after WW1. He would continue to insist that Germany needed not punishment but subsidizing if another war was to be avoided. After it, he claaimed "vengeance, I dare predict, will not limp." He was right.
The subsequent Great Depression that followed the First World War really crystalized Keynes' developing views on how economies work and neccessary solutions to combat the ills he saw. With unemployment soaring, economic growth collapsing and investment almost non-existant, Keynes believed the solution was to abandon the New Classical way of thinking - instead, an almost total reversal of policy was in need. Instead of less government spending, more. Instead of laissez-fair, interventionism. It was a government's moral and economic duty to revive countries that had fallen into deep recessions - so deep that they would not be naturally righted.
In 1936 he published his groundbreaking work entitled A General Theory of Employment, Interest and Money in which he exorted governments "Let us be up and doing"! The Second World War would interupt the progress of his policies, but after it had ended Keynesian ideas were not abandoned; instead, the USA and the UK both undertook them - Atlee in the UK created the National Health Service (NHS) whilst the Hoover Dam in the USA (completed in 1935) showed the US' commitment to Keynesian ideas.
Keynes' ideas formed the backbone of economic policies around the world from the 30's to the 70's and revolutionized the hands-off approach to New Classicalism. It would not be until the arrival of Friedman that this would all change...
Based on the works of John Meynard Keynes in the inter-war years, economists who follow this understanding of the economy have a very different view.
Their disagreement with the New Classical economists starts with recessionary gaps. Supposedly, when AD falls, prices fall and so - therefore - do wages. "Rubbish!," say the Keynesians. Wages rarely really fall in the economy - trade unions, laws and just general common sense prevent them from doing so. No, the Keynesians prefer to break the economy up into 'stages' instead of having a SRAS and a LRAS.
Below we can see the Keynesian view of the economy
What's going on here? Don't panic. Diagram 1 above helps explain this. In the blue section on the diagram, we can see that the supply curve is horizontal. If we imagine AD was on this flat segment, and we increased AD (by shifting it to the right) there would be no change in prices. This is the opposite to what neoclassical economists say! Why is this?
Keynesians claim that in the flat section, resources are abundant, and not being used. There is plenty of land, labour, capital and enterprise lying around unused. In fact, so much is not being used that even when we demand more, the price remains low (as its abundance makes it have less value).
Only when we approach the pink section can we see prices begin to rise. Along this section, resources begin to run out (called 'bottlenecks'). As AD increases on this section, we use up our factors of production - if you want more stuff, you start to have to pay more for it, as its no longer abundant. Somewhere on this section we have our potential GDP (which includes natural unemployment).
Finally, when approaching the yellow section, we are using ALL of our resources. We cannot increase production at this point. If AD keeps increasing then we will produce beyond our potential GDP and thus enter an inflationary gap. On this section, Keynesians agree that increasing AD will only lead to increasing prices.
So, what the Keynesians believe, overall that if we are in a recessionary gap (producing below p.GDP) then we can get stuck there if the government doesn't intervene to boost aggregate demand. This is shown in diagram 1 below, whilst if AD is above pGDP then we are in an inflationary gap and AD needs to be reduced, as seen in diagram 2
The Multiplier Effect
This attempts to explain the relationship between expansionary fiscal policy and the knock-on effects in the economy.
If the government decides to spend in the economy, their initial expenditure is known as autonomous spending. For example, if the government decided to build a road, the autonomous spending would be the amount (say, $10m) spent on that round. This would increase AD by the orange segment on the diagram to the right.
Induced spending, however, is the amount of money spent in the economy after the inital autonomous spending. In this example, after the government had spent the $10m, the road workers would take home their wages and spend it on food or clothes, or anything else. The amount they collectively spend is thus known as induced spending. This would further increase AD by the pink segment on the diagram to the right.
It is clear then, that adding a little money into the economy causes a greater increase in economic growth. In our example above, the government may have only put $10m in, but this $10m could have been spent through the economy four more times, creating total economic growth of $10+$40m = $50m
How much induced spending is created, depends though on our Marginal Propensity to Consume. This is simply how much of the next unit of income we earn, we spend. If our MPC was 1, that would mean that we would spend all of the money given to us.
When we know our MPC, we can use the Keynesian Multiplier Equation to work out how great an increase in GDP will be caused when a government injects money into the economy. The formula is: 1/1-MPC
Once we know the Multiplier, we can then multiply it by our autonomous spending to find out how much economic growth is created overall.
Keynesians see this as useful compared to Neoclassical economists because they beleive AD can create economic growth, not just inflation.
Unemployment can be defined as the amount of people actively seeking a job but who are without one.
The unemployment rate is the percentage of the labour force (those that are willing and able to work) that are without a job. It is calculated by dividing the unemployed by the labour force x100.
Difficulties in measuring unemployment
- Statistical discrepencies
- Hidden unemployment / Informal Economy
- Does not account for geographical differences
- Is all-inclusive (does not divide age, gender, ethnicity)
Types of unemployment
- Structural - when the skills of the workforce do not match the jobs available in the economy
- Frictional - the type of unemployment caused as workers move between jobs
- Seasonal- when workers have a job reliant on the weather and are unemployed in the off-season
- Cyclical / Demand-deficient - when Aggregate Demand falls due to any reason (e.g. higher taxes) and so less workers are needed
- Real-wage - when wages are set too high and so firms demand less of them then they would do otherwise
Causes of unemployment
- Technological changes - when new technology is introduced that can do the work previously done by workers (or when human capital becomes outdated) then workers have skills that are no longer needed in society.
- Sunset industries - industries that previously were very large (such as the mining industry in the UK or the car industry in the USA) provided many jobs. However, foreign competition or a lack of demand for the goods provided by these industries forces them to close, causing wokers to have skills that are not needed.
- Geographical changes - if a firm decides to move from one part of the country to another, few workers will follow. This will leave many workers stranded with uneccessary skills.
- Changes in demand - if a country moves out of one sector of society and into another (ie from the primary to secondary sector) then the primary industry skills will no longer be needed.
- Lack of information - if workers are unaware of available jobs they will be unable to move between them quickly or easily. Countries with low internet access or poor job centre provision often suffer from this.
- Lack of infrastructure - if workers are unable to move between jobs due to poor roads or poor communication there will be higher rates of frictional unemployment
- Lack of information
- Lack of infrastructure
In any economy these 3 types of unemployment are common and - to some extent - unavoidable. They will always exist to some degree, even when we are producing at long-run unemployment (as this includes the natural rate of unemployment too). As a result we call them 'natural unemployment' or 'equilibrium unemployment'.
- Fall in AD due to government policies (deflationary fiscal/monetary policy)
- Fall in AD due to fall in determinants of C, I, G, X-M
- Minimum wage set above equilibrium - when the government sets minimum wage above equilibrium then there is an excess of supply of labour in the labour market. Firms hire less workers as they are more expensive, and so produce less. SRAS shifts inwards.
- Trade union power - has the same effect as above
- Legislation - if it is difficult to hire labour the effects will be the same as above.
These two types of unemployment are not natural in an economy and are avoidable through government policy. They occur when we are not producing at long-run equilibrium and are thus known as 'disequilibrium unemployment'.
Cyclical is shown on the first diagram below, whilst real wage is shown in the last two diagrams.
Consequences of unemployment
- Social problems - crime, stress, depression
- Loss of GDP
- Deflation (if cyclical)
- Loss of tax revenue
- Budget deficit (loss of tax revenue AND increase in benefit spending)
- Increased debt
- Worsening income distribution
Solutions to unemployment
Solutions to unemployment depend on the type of unemployment it is. To identify solutions we must first identify the cause. This is the reason why knowing the type of unemployment is so important.
Applied Economics: Spanish Unemployment
Since 2008, the Spanish fiscal crisis has gown exponentially. The reasons for this lie in the fact that despite enjoying a balanced budget before 2008, banks invested far too much money into 'toxic assets' such as housing. As European banks happily provided the money, Spainish banks happily spent it. When the rosy-looking house market turned rotten, the government was then forced to intervene and prop up the banks to avoid a bank-run and widescale economic turmoil. This instantly put them into debt.
Meanwhile, regional governments acted irresponsibly with the wealth they had created before 2009 - large-scale projects were built - including a new airport in Valencia, and a new arts museum in Barcelona. This would have been fine except for one thing: the projects were not sustainable. Valencia's airport cost a whopping 150 million euros but has yet to take off. Literally. No flights have gone too or from the airport, as it was both unneccessary and too expensive for airliners.
The cost of all this mis-management, which started with financial sector irresponsibility (how, as a government, do you deal with organisations that get paid to fail?!) is enormous unemployment. With austerity measures in place to pay back large debts, jobs have been sacrificed. The banks are also no longer splashing the cash, meaning nothing is trickling through to small and medium size enterprises. The housing market - and all the industry (glass makers, cement mixers, builders, real-estate agents, insurors) that comes with it - now lies dormant. Unemployment in Spain has rocketed from 7% in 2007 to 21% in 2013.
As nothing is being created, it is the young that are feeling the hit the most. Spanish youth unemployment stands at 46%. This translates into a huge cost for the government who, after spending years (at a considerable cost) educating and training their young, are simply leaving them high and dry once their education is complete. The opportunity cost is immense. And yet, the government - torn between being able to pay back its debt in order not to fall into economic ruin and being able to provide jobs through fiscal policy - are left in a sticky situation. The end result? A whole of angry, disatisfied youths (crime is on the rise) and a whole lot emigration. Germany is seen as the number one destination for the unemployed Spanish youth - followed by the UK.
Definitions of inflation
Inflation is a sustained increase in the prices of goods and services in an economy over a given time frame.
Inflation rate is the percentage rise in the prices of goods and services in an economy over a given time frame. Even if it falls, this still shows us prices are rising, but at a slower pace.
Disinflation is a slowdown in the rate of inflation (prices of goods and services are still rising but at a slower rate or perecentage) per time frame.
Deflation is a sustained decrease in the prices of goods and services in an ecnomy over a given time frame.
The inflation or deflation rate (from which disinflation may also be calculated) is a percentage increase or decrease in the prices of goods and services in an economy over a given time frame.
CPI (Consumer Price Index)- This is the main way inflation is calculated. To do this, the government collects around 500 essential goods and services and puts them into a hyperthetical 'basket'. The year in which it assembles the basket is known as the base year. This is usually a normal year where prices have not been fluctuating greatly
Once this is done, the prices of all these goods and services are added up but a price index is set for 100 at the base year. All this does is make it easier to compare how prices have changed over time. The following year, the prices are added up again and divided by the original price value for the base year, to work out the percentage change. If this came to - say - 10% change, the new price index for year 2 would be 110 (the orignal price index of 100 plus the new 10 percent increase). This allows us to see inflation over time easily.
There are other issues that are taken into account. Obviously, some goods and services are more important than others and affect us to a greater extent. As a result, there are different weightings given to different goods. For example, petrol/gas is given a greater weight than i-pad apps. The way weightings are worked out are simply by finding out how much of each good/service is consumed as a proportion of their income (this involves complicated economic forumlaes).
For example, if the average household buys 3 i-pad apps at an average price of $2, then the final value that goes into the basket for i-pad apps would be 3 x $2 = $6.
Similarly, if the average household buys 30 units of petrol at an avarege price of $50, the final value that enters the basket would be 30 x $50 = $1500.
Consequently, any change in petrol will affect the basket to a greater degree than any change in i-pad apps. It is only once this is done, that the final price indices can be calculated.
Be careful: economists measure inflation relative to the base year. It is possible to measure it relative to the previous year. To do this, we would simply take the price index for Year 2, divide it by the price index for the previous year and multiply this by 100.
Imagine a country that puts two goods in its basket: bread and cheese
|Bread||Price $||Qty||Value $|
|Cheese||Price $||Qty||Value $|
|Basket||Value of Basket||Calculations||Price Index|
|Base Year||1000 + 500 = 1500||1500-1500/1500 x 100 = 0||100|
|2002||1200 + 800 = 2000||
2000-1500/1500 x 100 = 33
|2003||1500 + 1000 = 2500||2500-1500/1500 x 100 = 66||166.66|
Be very careful when looking at inflation; the price index tells you inflation relative to the base year ONLY. If you wanted to calculated it between 2002-3, you would have to use the figures from 2002 as your initial value.
Using the information above, calculate:
- The rate of inflation relative to the base year for 2003:
- The rate of inflation relative to the previous year for 2003:
- What weighting do bread and cheese have in this example?
- What would the table look like if bread was weighted as more important than cheese?
- Construct your own 2-good basket over 3 years, where one good is weighted 3 times more important than the other.
Producer Price Index
Producer Price Indices measure changes in the price of factors of production. They work in an identical manner to the CPI, but instead of having a basket of goods and services that are regularly consumed by the average household, they have a basket of factors of production that are neccessarily used by the average business. This can be useful for predicting future inflation but its importance to developed countries is declining due to the decline of many manufacturing industries therein.
Problems with measuring inflation
- Does not show quality
- Is an average - does not reflect impact on certain groups (e.g. poor, young etc)
- Does not take into account initial purchasing power
- Goods and services change in demand/supply - the bastket, however, stays the same until base year changes
- Cannot be compared internationally due to differing baskets
Types of inflation
1. Demand Pull - this is caused when aggregate demand rises due to an increase in any of its components (C, I, G, X-M). For example, if the government built houses (G), more workers would be needed in the construction industry, causing more people to have more money, which they then spend in the economy. Seeing a greater expenditure, shops then raise their prices to sell off their goods and services. A rise in AD has thus caused a rise in prices.
2. Cost-Push (and imported) - this is when aggregate supply falls, owing to a negative change in the determinants of supply. This usally means the factors of production become more expensive and so firms scale back production in order not to make a loss. This causes SRAS (or KAS) to fall. Less goods and services are available but demand is unchanged; firms can thus charge a higher price as they are more scarce.
Imported inflation is similar but occurs when factors of production are imported from abroad and become more expensive. A good example is oil. This has teh same effects as above.
3. Monetary/ Printed Inflation - this is when the government uses monetary policy to increase the money supply. Interest rates thus fall, causing more people to borrow (as the price of money is cheap), and so they spend this borrowed money in the economy. AD has increased due to an increase in C and I and so prices rise.
Consequences of inflation
- Loss of purchasing power
- Unemployment (if cost-push)
- Decreased exports and thus worsening budget
- Depreciation of currency
- Loss of savings (if interest rates remain low)
Consequences of hyperinflation
- Loss of value of money
- People switch the barter
- Savers lose all money
- Investors stop investing in the country
- Exchange rate collapses (demand for currency falls)
- Wage-price or inflationary spiral (consumers spend all their money as it's not worth saving = AD increase, but workers also ask for wage increases to afford to survive = SRAS increase).
- Lenders lose all their money (as the sum to be paid back is minimal if it is not inflation-linked)
- Social uprisings - when food and essentials become scarce, social problems begin
Causes of Deflation
Deflation is found in two ways:
1. Demand-Deficient deflation - when AD falls due to a fall in any of its determinants, this leaves people with less disposable income, and so they spend less on goods and services, meaning that firms have to lower their prices in order to sell their goods and services. This is generally seen as the 'bad' type of deflation. (see diagram 1 accross)
2. Supply-Increase deflation - when AS increases due to a change in any of its determinants, this now means more can be supplied at the same price. In order to sell this increased output, firms must lower their prices. This is generally seen as the 'good' type of deflation as it creates jobs and increases GDP. (see diagram 2 accross)
Consequences of Deflation
- Lack of investment from business
- Menu costs
- Rise in purchasing power if wages are not inflation-linked
- Loss of income for lenders if loans are not inflation-linked
- Potentially increased exports in the long run
- Rise in purchasing power if wages are sticky downwards
Relationship between Inflation and Unemployment
The Phillips Curve shows the relationship between unemployment and inflation. Moving along a curve shows us what happens when Aggregate Demand changes in an economy. For example, if AD fell, we would find that we have higher unemployment but lower inflation on an AD and AS diagram. This corresponds to a movement from A to B on a Phillips Curve.
However, to show an increase in both unemployment and inflation we would have to shift Aggregate Supply inwards (or outwards to show a decrease in both). This corresponds to a shift of the Phillips Curve from PC to PC2 and from point B to point C.
The Long Run Phillips Curve (diagram 2 on the right hand side) explains the differences between monetarists/neoclassicals and Keynesians. Remember, monetarists argue that changes in AD always lead us back to our original output in the long run, because wages change to reflect the new prices. In this way, if AD increased and so unemployment fell but inflation rose (A-B), then in the long run - according to monetarists - wages would increase to reflect the increase in prices. As a result, SRAS would decrease (as costs of production are now greater) and so inflation and unemployment would rise. This would be a shift of the Phillips Curve to a point where unemployment was at its previous rate but inflation was higher (Point C). For monetarists we always end up along the LRPC. The Natural Rate of Unemployment is therefore any inflation rate at the same level of output (the LRPC)
Keynesians, however, believe in the non-accelerating inflation rate of unemployment (NAIRU). They claim that the natural rate of unemployment only occurs at one rate of inflation, not at many rates, unlike the NRU.
This is because wages do not change in the long run, and are sticky downwards.
When AD increases from the potential GDP level of output, we enter an inflationary gap. Wages do not necessarily change
Unemployment is less than the natural rate.
In order to get back to the natural rate of unemployment we need to be at the point in our economy where potential GDP was. This point has one inflation rate linked to it (in our example 5%). Deflationary fiscal policy is needed here. The differences between the two ideas stem from the differing shape of their supply curves.
Applied Economics: Zimbabwe's Hyperinflation
From the breadbasket of Africa, to a starving nation, Zimbabwe's story is a tragic one. Zimbabwe is a nation rich in mineral resources, with fertile land for production. As a former colony of Great Britain, Zimbabwe had a sizeable white minority who had control over much of agricultural production.
Explaining Economic Growth on a PPC
PPC diagrams help to show us opportunity cost and choice for an economy in a hyperthetical situation. They can also shown economic growth. If economic growth is defined as a long-term increase in the value of goods and services within an economy, this is usually achieved
We can illustrate this by shifting our PPC outwards, indicating we can produce more of any two types of goods.
Causes of Economic Growth
Short-Term Economic Growth (these measures move us closer towards our PPC)
- Reducing unemployment
- Increasing productive efficiency
Long-Term Economic Growth (these measures increase our PPC)
- Increase in Factors of Production
- Increase in Quality of Factors of Production
- Increase in Investment in:
- Physical Capital
- Human Capital
- Natural Capital
The GDP Deflator
- The GDP deflator attempts to take changes in prices of goods and services into consideration when measuring GDP in order to arrive at a real GDP value. This is very much like the CPI except that there are differences in the ways price changes are calculated.
- If, for example, South Africa's GDP rose from R21billion to R28billion the next year and there was a deflator of 12%, then we know that the last figure is inflated by 12%. By subtracting 12% of R28 we can thus come to a real GDP value.
- The easiest way to find real GDP is thus with the formula: nominal GDP / price deflator x 100
Consequences of Economic Growth
- Living Standards
- May decrease if large negative externalities arise
- Depending on the cause of economic growth, unemployment will usually fall. However, if growth is caused by capital-intensive industries this may not be as true.
- Distribution of Income
- Current Account (Balance of Payments)
Unfortunately resources are not allocated fairly. As a result, some people get paid more from their resources than others. Some reasons why resources are not allocated fairly include:
- Ownership of key resources - some people own resources that are in high demand. Examples include oil.
- Inheritance - some people are given profitable businesses ore capital to start up.
- Education and Training - enable people to get paid more for their labour.
As a result, the free market does not neccessarily allocate resources fairly. We thus distinguish between:
- Equity of distribution which means that all people should be able to have a chance at reaching a high income. (a 'fair chance')
- Equality of distribution which refers to the idea that all resources should be shared out equally (not 'fairly')
Methods to help redistribute income more fairly include:
- Transfer Benefits
- Provision of merit/public goods
Types of tax
- Direct Tax - This is a tax on income or wealth e.g. income tax, inheritance tax
- Indirect Tax - This is a tax on consumption or expenditure. e.g. VAT (value added tax)
1. Progressive Taxation
- This is when the government charges a higher rate (percentage) of tax, the higher your income is. Usually this means splitting incomes into different 'tax bands'. Imagine there are three different people on 3 different incomes
- Tom: $14 000
- Jane: $25 000
- Bill: $48 000
- The government may have 3 different tax bands in its economy. If they are progressive they look like this
- Income Tax Band 1($15 000 or less) = 10%
- Income Tax Band 2 ($15 000 - $30 000) = 20%
- Income Tax Band 3 ($30 000 +) = 50%
- Now let's take Tom. He earns $14 000 a year. He must thus pay only 10% of his income ($1400/100 x10) as tax. This equates to $1400.
- Jane on the other hand, earns $25 000. On the first $15 000 she earns she must pay 10%. This is therefore $1500. On the remaining $10 000 she has left, she has to pay Income Tax Band 2 (as she does not earn more than $30 000 she does not enter Tax Band 3). 20% of $10 000 is $2000 ($10 000/100 x 20). Her total tax due is therefore: $1500 + $2000 = $3500.
- Bill's situation is similar. He pays 10% on the first $15 000, 20% on the next $15 000 and 50% on the remaining $18000. When calculated this comes out as $1500 + $3000 + $9000 =$13 500
- Clearly, Bill has paid the most tax, as he has had the highest income. This is a progressive taxation system. As a percentage of his income, he also pays the most tax. We calculate this by dividing the tax they pay by their original income and multiplying it by 100
- Tom's Tax = $1400
- Tom's Income = $14000
- Tom's Tax as a percentage of his income = 10 % (1400 / 14000 x 100)
- Jane's Tax = $3500
- Jane's Income = $25 000
- Jane's Tax as a perecentage of his income = 14% (35000 / 25000 x 100)
- Bill's Tax = $13500
- Bill's Income = $48 000
- Bill's Tax as a percentage of his income = 28% (13500 / 48000 x 100)
We call the individual tax band proportions the marginal rate of tax whereas the tax as a proportion of a person's income is known as the average rate of tax - see 'taxing terms' below for a more thorough explanation.
2. Regressive Taxation
- This is the opposite to a progressive tax. In this case, as incomes rise, the percentage paid in tax falls. Do not get confused though: the amount paid is still greater, the higher your income. Take the situation below
- Tom: $14 000
- Jane: $25 000
- Bill: $48 000
- The government may have 3 different tax bands in its economy. If they are regressive they look like this
- Income Tax Band 1($15 000 or less) = 10%
- Income Tax Band 2 ($15 000 - $30 000) = 5%
- Income Tax Band 3 ($30 000 +) = 2%
- Tom would pay 10% of his income in tax: $1400 ($14 000 / 100 x 10)
- Total Tax = $1400
- Jane would pay 10% of her first $15 000: $1500 AND 5% of her remaining $10 000 ($500)
- Total Tax = $2000
- Bill would pay 10% of his first $15 000 : $1500 AND 5% of the next $15 000 ($750) AND 2% of the next $18 000 ($360).
- Total Tax = $2610
We can see that as an overall percentage of their incomes, Bill pays the least tax . We calculate this by dividing the tax they pay by their original income and multiplying it by 100. However, Bill pays the most tax in numerical terms.
- Tom's Tax = $1400
- Tom's Income = $14000
- Tom's Tax as a percentage of his income = 10 % (1400 / 14000 x 100)
- Jane's Tax = $2000
- Jane's Income = $25 000
- Jane's Tax as a perecentage of his income = 8% (2000 / 25000 x 100)
- Bill's Tax = $2610
- Bill's Income = $48 000
- Bill's Tax as a percentage of his income = 5.44% (2610 / 48000 x 100)
3. Proportional Taxation
This is when as incomes rise, the percentage paid in tax remains the same. Be careful: this means that the amount paid by the high income earners is more but the percentage of their income paid is the same as low income earners. There is only one tax band in a proportional system - e.g. 10%
- Tom: $14 000
- Jane: $25 000
- Bill: $48 000
If the tax band is 10%
- Tom's Tax = $1400 (14000/10 x 100)
- Tom's Tax as a % of his income = 10%
- Jane's Tax = $2500 (2500/10 x 100)
- Jane's Tax as a % of her income = 10% (2500 / 25 000 x 100)
- Bill's Tax = $4800
- Bill's Tax as a % of his income = 10% (48000 / 48000 x 100)
Tax Rate: the percentage of your income or spending paid in tax.
Average Rate of Tax: This is the average percentage of tax that you pay on your income. It is calculated by value of total tax paid divided by total income x 100
Marginal Rate of Tax can be defined as the rate of tax you pay on the next, or additioanl dollar of income. This is often higher than the average tax rate in a progressive taxation system. For example, if you earn $100 and are in Tax Band 1 (set at, say 10%) but then next year enter Tax Band 2 because your income has gone up to $101, the marginal tax rate could be 85% at this band.
Marginal Tax Rates are important as they are linked to incentives - such as with the Laffer Curve Theory
Definitions of poverty
- Absolute poverty - refers to a set standard within a country that people fail to live above. For example, living on less than $1 a day is generally considered absolute poverty. It indicates that you find it hard to meet the basic neccessities of life.
- Relative poverty -refers to the idea that a person can face social exclusion as - compared to the rest of the people in that country - they cannot afford the same goods and services. Not being able to afford an iron in the UK would be relative poverty. This does not mean they cannot meet their basic needs though.
Measuring Income Inequalities
The Lorenz Curve: The Lorenz Curve demonstrates how equal different sectors of the population are in terms of income. It does this by plotting the cumulative percentage of income earned on the Y axis, and the cumulative percentage of population on the X axis. This then can be used to see which percentage of the population earn which percentage of the income.
The Line of Perfect Income Equality (LoPIE) is represented as a straight line, as every percentage of the population earns an equal percentage of the income (e.g. the first 20% earn 20% of national income). This would be perfect income equality.
We can then split the X axis into segments (such as Quintiles - 5) and make more general observations such as 'the poorest 20% of the population only earn 5% of national income.'
The closer a country's Lorenz Curve is to the LoPIE, the more equal its income distribution.
Methods to shift the Lorenz Curve closer to LoPIE redistribution of income through:
- Provision of Merit Goods and Public Goods
- Transfer Payments
The Gini Co-efficient
The Gini Co-efficient is a mathematical representation of the Lorenz Curve. It seeks to illustrate income inequalities through the provision of numerical data, which can be used to compare countries easily.
The way this is achieved is by calculating the area between LoPIE and the country's Lorenz Curve and dividing this by the area beneath LoPIE.
This leaves us with a figure between 0 and 1. As LoPIE has a gradient of 1, the closer the figure is to 1, the more equal income distribution is in that country.
Tax Image courtesy of renjith krishnan, FreeDigitalPhotos.net
Tax Returns image courtesy of Arvind Balaraman, FreeDigitalPhotos.net
Calculator image courtesy of adamr, FreeDigitalPhotos.net
Povertywealth image courtesy of Stuart Miles, FreeDigitalPhotos.net
Applied Economics: Income Inequalities In India
On the face of things, India's economy is taking off. As a BRIC economy (Brazil, Russia, India and China), it is often celebrated as an economic giant that is awakening from its slumbers. GDP is rising. Life then, is surely getting better. Yes... for some. India's economic growth has not been a collective increase but rather an top-led rich-are-getting-richer kind of growth.
Perhaps the starkest reminder of this is the Antilia building in Mumbai. Costing around US$1billion to construct according to Forbes Magazine, it has over 40 000 square feet, six levels of underground parking, twenty seven stories in total and needs 600 permanant staff just to run it.
Nevermind that it looks over some of the poorest slums in India then...
Where do governments get their money from?
Sources of government revenue
- Taxation - this is the main form of government revenue. It can be through direct or indirect taxation (see unit 2.3 Distribution of Income)
- Sales - any public company (a public company is one that is owned by the government) that sells goods and services generates revenue for the government. Key industries such as oil are good examples.
- Asset-selling - if a government sells off assets it previously owns (such as land or by privatising previously national industries like railways in the UK) it can generate short-term revenue.
- Selling Bonds -these are forms of loans given by the government to the public, guaranteed by the government in power.
Where does the government spend its money?
- Current expenditure - this is spending by the government on goods and services in the economy. For example, if a government decides to purchase $4million worth of oil.
- Capital expenditure - this is spending by the government on infrastructure, investment and research and development.
- Transfer Payments - this is the amount the government spends on welfare payments such as unemployment benefit, sick benefit, disabled benefit etc.
- Debt repayment - this is the amount the government sets aside to repay money it owes other countries or individuals.
The budget is a record of all government spending and revenue. It is used to forecast government policy and calculate how much money the government should or should not spend.
The budget helps allocate government revenue. If a government spends more than it receives, it is said to have a budget deficit.
If a government receives more revenue than it spends, it is said to have a budget surplus.
If a government has a budget deficit and continues to spend, it will lead to greater government debt.
Demand-side Policies aim to manipulate AD to achieve government aims. There are two demand-side policies: fiscal (this unit) and monetary (unit 2.5)
Contractionary fiscal policy
This includes the following two tools:
- Decreasing government spending
- Increasing taxation
The idea is simply that by decreasing government spending (by, for example, cutting public sector jobs or stopping building projects), fewer people will have jobs and so people will have less disposable income. As a result they spend less on goods and services. Aggregate Demand thus falls (as consumption, government spending and investment all fall)
In the case of increasing taxation; when direct taxes are increased, people have less disposable income to spend and so reduce their consumption. This causes a fall in AD.
This is important in correcting:
a) Inflationary gaps
b) High inflation
c) A budget deficit
d) A poor distribution of income (taxes)
e) Expensive exports
Expansionary Fiscal Policy
This includes the following two tools:
- Increasing government spending
- Decreasing taxation
The idea is simply that by increasing government spending (by, for example, providing public sector jobs or starting building projects), more people will have jobs and so people will have more disposable income. As a result they spend more on goods and services. Aggregate Demand thus increases (as consumption, government spending and investment all increase)
In the case of reducing taxation; when direct taxes are reduced, people have more disposable income to spend and so increase their consumption. This causes a rise in AD.
This is important in correcting:
a) Deflationary gaps
b) Deflation / Low inflation
c) A budget surplus
d) Low economic growth
Advantages of Fiscal Policy
For government expendiutre
- Leads to employment (expansionary)
- Multiplier Effect (expansionary)
- Can ultimately lead to economic growth - by providing the infrastructure neccessary for improvements in factors of production, quality of factors of production or technology
- Ability to target sectors of the economy (e.g. expenditure by increasing unemployment benefits)
- Sustained increase in government revenue
- Ability to target sectors of the economy
Disadvantages of Fiscal Policy
- Expensive - can lead to budget deficit (expansionary)
- Inflation (expansionary)
- Leads to unemployment (deflationary)
- Time lags
- Political constraints
- Crowding out (expansionary)
- Does not change AS
- It is unpopular politically (expansionary)
- May lead to demotivation - Laffer Theory (expansionary)
Applied Economics: Japan's Olympic dream
In 2013, Japan launched a successful bid for the 2022 Olympics. With a stagnating economy, Japan has undertaken many measures to try and re-ingnite ecnoomic growth. The idea behind hosting the Olympics is simple: that the tourism and building of infrastructure will act as a strong expansionary fiscal policy to boost real GDP. Certainly, there is an argument to say that tourism will incraese in 2022. However, others argue that it is a bit of an illusion.
The reason for this is that most countries' aggregate demand is boosted by an enormous increase in government spending on infrastructure when sporting events come to town. South Africa, for example, invested hugely in transport and the building of new stadiums when it hosted the 2010 World Cup. This resulted in a lot of job creation and corresponding economic growth. However, Japan already has the infrastructure and stadiums needed to host the Olympics. There will thus be little to do in terms of building and government spending. In fact, some argue that it is a relatively cheap option for the Japanese government, and a victory that won't bring about the benefits it presupposes.
The Role of the Central Bank
- Acts as a regulator to commercial banks
- Sets base interest rate
- Holds gold reserves
- Holds foreign currency reserves
- Manipulates Exchange Rates
How interest rates manipulate the economy
Money is a good. All goods have a price. The price of money is how cheap or expensive it is to borrow or save it.
This is known as the interest rate. When interest rates are low, this means money is cheap and encourages people to take out loans and spend them. This thus increases consumption and investment in the econonmy, so increases AD.
When interest rates are high, this means money is expensive and encourages people to save their money (as they receive payment from the bank for keeping it within the bank). This thus decreases consumption and investment in the economy so decreases AD.
The Central Bank is in control of the interest rate. It sets a base value, though commercial banks can deviate from this. The Central Bank is set up as a national bank, and is supposed to be detached from political interferance.
Cash Machine Image courtesy of , Victor Habbick, FreeDigitalPhotos.net
Expansionary monetary policy
Expansionary monteary policy occurs when a government wishes to increase Aggregate Demand through the use of interest rates. As money is a good, and interest rates are the price of money, the government thus wishes to make money cheaper (or reduce the interest rate) to encourage more borrowing and spending.
The way to do this is the same way to make anything cheaper - increase the supply of it. However, there is a fixed supply of money in the economy as only the Central Bank can print money. The supply curve for money is thus vertical. By printing more money, supply of money increase (S-S1) and so interest rates fall (r-r1) as banks compete with each other to get rid of their loans.
People who then take out these cheap loans can go and spend them on goods and services. As a result consumption and investment increase (components of AD), so AD increases. The economy is re-inflated.
- Quick to implement
- Invisible (thus politically easy)
- Lower interest rates
- Statistically trackable
- Gets rid of deflationary gaps
- Time-lags once implemented
- Initial imperfect information
- Crowding out (only if money is borrowed)
- Loss of purchasing power - prices increase
Contractionary monetary policy
Contractionary monteary policy (Sm1 - Sm) occurs when a government wishes to decrease Aggregate Demand through the use of interest rates. As money is a good, and interest rates are the price of money, the government thus wishes to make money more exepnsive (or increase the interest rate) to encourage more saving and less spending.
The way to do this is the same way to make anything more expensive - restrict the supply of it. However, there is a fixed supply of money in the economy as only the Central Bank can print money. The supply curve for money is thus vertical. By printing less money (or not replacing old money), supply of money falls (S-S1) and so interest rates rise (r-r1).
People then put their money in the bank with the best interest rate instead of spending it. As a result consumption and investment decrease (components of AD), so AD decreases. The economy is deflated.
- Quick to implement
- Invisible (thus politically easy)
- Encourages investment from banks (as they use savings)
- Statistically trackable
- Gets rid of inflationary gaps
- Can lead to exchange rate appreciation (demand for currency increases as foreigners save in your county)
- Time-lags once implemented
- Initial imperfect information
- Crowding out is the method by which a government does not achieve its own targets due to the relationship between borrowing money and interest rates.
- If a government borrows money to finance expansionary fiscal policy then it increases the demand for money within that country.
- As a result, interest rates increase. The government spends the money it has borrowed but instead of multiplying out throughout the economy, more people may choose instead to save their money as interest rates have risen.
- If all the money injected were saved, this would be total crowding out - the government would not have achieved its targets. If a portion is saved, it is partial crowding out.
Applied Economics: Abenomics
Shinzo Abe swept to office in 2012 vowing to reform slow rates of economic growth that has plagued the Japanese economy for decades. His ideas became termed 'Abenomics' and invovled the heavy use of demand-side monetary policies. Essentially, the crux of the policy relies on low interest rates, through quantitative easing. QE is the increase in the supply of money. By printing money and setting 'negative interest rates' (when the rate of interest is below the rate of inflation) Abe is seeking to seriously boost Aggregate Demand.
Abenomics also involves continued government spending, but it is hoped that by continuing to inject more money into the economy, and by combining this with inflation-targetting (where the government gets involved to ensure - no matter the cost - that inflation does not rise above a certain limit), that growth will be encouraged.
"Image courtesy of Vichaya Kiatying-Angsulee, FreeDigitalPhotos.net;
Money image courtesy of cooldesign, FreeDigitalPhotos.net;
Supply-side policies are aimed at manipulating aggregate supply to achieve government aims. As supply is the willingness and ability to produce it is very unlikely that governments seek to reduce the means to supply, thus leaving us mainly with only expansionary supply-side policies
As neoclassicalists seperate short and long-run supply, we assume that if long-run supply (the potential to produce) is increased, short-run (the actual production) increases too. For example, if you find more land (long-run), then we assume you will farm it (short-run)
Market-oriented supply-side policies are favoured by neoclassicalists. They claim that SRAS will increase if the free market is freed of any restrictions that are preventing it from doing so. The idea is for the government to free the market in the following ways:
- Getting rid of red-tape and jurisdiction
- Privatisation / Deregulation
- Reducing benefits
- Anti-monopoly regulation
- Less protectionism
If competition is encouraged, firms will have to produce at their lowest costs and offer the lowest price in order to capture the market. This will lead to less inefficiency and an increase in supply.
Labour Market Reforms -
- Removing trade union power
- Reducing benefits
- Removing the minimum wage
These will mean that demand and supply will be free of constraining floors and businesses can pay the real price for labour, thus reducing costs and increasing supply.
Incentive-related policies -
- Reducing income tax: if income tax is reduced, people may work harder to get a promotion (Laffer Theory),
- If business tax is reduced, firms face less costs of production
- If capital gains tax is reduced there is more incetive for investment.
Advantages of Market Policies
- They are generally cheap and easy to implement
- Quick implementation time
- Allocatively efficient (e.g. privatising often reduces costs as government firms are generally inefficient)
- Leads to less government spending which helps the budget (especially privatisation and reduced benefits)
Disadvantages of Market Policies
- Often seen as unethical (especially reducing trade unions and minimum wage)
- Can lead to greater negative externalities owing to less government control
- Can lead to unemployment (if trade unions power is reduced, more people can get sacked, if privatisation is encouraged less people will be needed)
Interventionist supply-side policies are favoured by Keynesians. These claim that the government must take responsibility for increasing supply by getting involved in the economy rather than just freeing it up. Examples of how this is done are below:
- Investment in human capital by improving healthcare or providing training and education
- Investment in new technology by improving research and development
- Investment in infrastructure by improving roads and communication lines
- Industrial policies through subsidies or tax cuts
Interventionist policies often create shifts in AD in the short term before shifting LRAS in the long-term. This is because facilities have to be built and created, thus raising incomes for some people, leading to greater consumption. They may also have a multiplier effect.
Advantages of Interventionist policies
- Often have AD effects too (e.g. building a school...)
- Can be directed to specific goals (e.g. subsidies for food production)
- Subsidies protect infant or sunset industries from foreign competition and promote employment
- Often has positive externalities (e.g. heallthcare, research and development and increased infrastructure such as the road in the picture to the right)
- Seen as socially responsible unlike some market-oriented - is it a governments responsibility to provide jobs?
Disadvantages of Interventionist policies
- Generally expensive - can lead to budget deficit
- Allocative inefficiency (in case of subsidies)
- Take a long time to implement (especially education)
- Politically unpopular (you sow what others reap)
Applied Economics: The UK's HS2 Project
London produces a disproportionately high percentage of the UK's national income. In order to combat this problem, the UK has adopted an interventionist supply side policy known as teh HS2 project. Though also an expansionary fiscal project in the short term, in the long run it is designed to bring about an increase in the factors of production by making sectors of the workforce more accessible.
The way this is proposed is by building a high-speed railway between London and Birmingham (with future plans to expand all the way up to Scotland), known as High Speedrail 2. This then, will allow large amounts of skilled workers able to access jobs in London, but still live at home. This thus makes productivity rise, without having to change the structure of the economy. Instead of it taking 3 or 4 hours for someone in Birmingham to get to London, it will now only take 45 minutes. This then, should see more wealth relocate to other parts of the UK, as they can work where the money is, and still live where they always have.
The cost at the moment is forecast to be around 50 billion pounds, and critics argue this is too great a price to pay, especially since the project will not be complete until 2015 either.