Unit 2 Managing the Economy Macro economy

Indicators or measures of economic performance or macro economy objectives: Core (BIGU), Others (PEEL)

1) Economic growth: a shift of LRAS curve and production possibility frontier curve to the right; another method can be by an increase in Real GDP .i.e. total goods and services produced in an economy in one financial year after adjustment of inflation. Nominal GDP Is GDP at current year price i.e. monetary GDP and the way to convert real GDP into nominal GDP is given below and (Re-arrange in other cases): Real GDP Real GDP Nominal GDP= --------------- X Current Index GDP per capita = ------------------ Base year index (100) Population Size Economic Growth Rate Measure: The % change in Change in GDPThe Real GDP over the period of time. EGR = ------------------- X100If economic growth is a percentage and positive, then Original GDPIt is always increasing or increasing at a slower rate but if it is negative then it’s decreasing. Economic growth can be measured by production method, income method and expenditure method. Overall, it can be expressed in volume or value (volume x Price level).

Growth (GDP): This method does not tell us about the living standard and the externalities or even the distribution of wealth, or if people are having enough leisure time. 2) Inflation is an increase in general average Price level when cost of living becomes expensive. There are numerous ways of measuring inflation: Retail Price Index (RPI)-Basket Method surveys of 7000 families using 650 goods & compare with previous year and calculate the increase in price level; and Consumer Price Index (CPI): Weighted measure of inflation when all household goods are provided weights (values/ importance). CPI is used in the UK and can be used to compare the inflation across the international economies.RPIx: RPI - Mortgage interest repayments RPIy: RPIx – Net Indirect tax (VAT) a more accurate method

Inflation (RPI): Not everyone uses the exact same goods used in the basket method of surveying inflation rates, and the demand pattern changes for people, and the quality of the product is not taken into consideration.3) Unemployment: People who are seeking for a job in the last four weeks, and are prepared to start work in the next two weeks, and are not working. (Able and available). Following two are the measures of unemployment: -Claimant count (Jobs Seeker Allowance) -International Labour Organization (ILO) Survey

Unemployment (JSA/ILO): Jobs seeker allowance doesn’t tell the factual evident data as many claim the benefit and work, whilst many don’t work and reluctant to claim the benefit. (JSA can be extended for maximum six months). The international labour organization could have bias results (in favour of a particular thing), or even outdated data of surveys, or false information and it can be subjective also.

4) Balance Of Payments (BOP): The differences between monetary inflows and outflows of one country with abroad within one financial year. The way Bop is measured is by keeping record in two accounts and they are:The Current Account (recurring nature) Good (visible), services (invisible), transfer and investment income Capital Account (non-recurring nature) Foreign Direct Investment

Balance of Payments (Current Account and Capital Account): It does not take into account things like the Black market, and error and omissions account is allocated for all mistakes.

Other objectives- Other indicators that can be used are the following: High Living standards can be measured by black market, choice of goods and services and leisure time.No –ve Externality and fuller utilization of scare resources: No third Party cost (MSC=MSB)

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Equality (Distribution of Wealth): No wider gap of income and wealth between the rich and poor.Low level of Poverty: poverty means when one can’t afford the basics of the life and living under poverty line.

Aggregate Demand: Total goods and services demanded within an economy in one financial year. The AD is:AD= C+I+G+(X-M), C=Consumer Expenditure i.e. the major proportion of the AD, I=Investment, G=Govt. Expenditure, X=Exports, M=Imports (X-M is net exports); (AD can be known as GDP i.e. National Income).C is affected by interest rate, Confidence, wealth effect (house and share value), employment and income levelI is affected by interest rate, risk, confidence level, risk and government regulationG is affected by state of economy, National Debt, level of employment etc through Fiscal policy.X-M is affected by exchange rate, international competitiveness, non price factors and non price factors.

Change: Shifts and Movement in AD: PL PL (Inc.) L (Dec.)AD has a negative relationship betweenPrice level and real output shown in the AD AD AD1 AD1 ADDiagrams, as the price level Increases Real output decreases and vice –versa (other things being equal). RO RO ROAbove change could take place if any component of AD or interest rate, exchange rate changes etc. PL SRAS PL LRAS PL LRAS Aggregate Supply: Quite the opposite of the demand curve, the supply curve shows a positive relationship, so as the Price level increases so does the real output and vice-versa. RO (KENS.) RO (Classical)Change in Movement and shifting: Shift in AS: AS may shift due to interest rate, spare capacity SRAS AS1 LRAS Subsidy, technology advancement or Even supply side policies in the long run RO RO ROEQUILIBRIUM: AD1 AS1

AS1 AD AS AD AS PL PL AS PL AS1 PL AD1

AD1

AS AD AD

RO RO RO RO

Above shows equilibrium at macro level where AS meets AD. Changes in equilibrium would change Price level and Real Output. Remember when AD or AS shifts, it can be only AD, AS or BOTH e.g. interest rate, investment, subsidy etc. change both AD and AS together. (It’s an exam style question).

Multiplier Effect: This is known as the Synergy

effect when elements of AD bring about greaterchange in real output than expected e.g. 2+2=5 1 K= ---------------------

1-MPCMPC= Marginal Propensity to consumeExample Given: If multiplier is 2 and wants to Increase GDP by 50 million, the investment can be calculated by doing the following: 50----- = 25 Million Injection is needed 2

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However if there is a negative multiplier the government will be losing the money injected so it will be losing 25 x 2 million = 50 million or leakages also decrease AD with multiplier rate. K is affected by MPC and C is affected by interest rate, Confidence level, wealth effect (house value), employment and income level etc.How to use: e.g. Increase in investment will increase in the GDP at multiplier rate however it also depends on the magnitude or the rate of multiplier.

Causes and Effects:Unemployment: You must remember a shorter period of unemployment is better, for example it’s better to have 4 people unemployed for 2 weeks rather than 2 people unemployed for four weeks. There are many causes of unemployment in which they are described on the next page:Frictional Unemployment: When you are moving from one job to another (Between jobs).Structural Unemployment: When technological advancements makes the employee redundant.Cyclical Unemployment: it results in the recession period of the business cycle.Increase in Job Seeker Allowance: Results in more people claiming and not working.Increased Taxation: force people to work for more hours and become more de-motivated, and leave their jobs as a result. Too high JSA, level of skills, qualification, discrimination etc also can be the cause of unemployment.

Negative Effects of Unemployment: Decreases Production in economy, Decreases in GDP, Increases Crime Rates, Results in Low international competitiveness, Lower tax revenue and high govt spending.Positive Effects of unemployment: Wider pool of workers available, more chances to gain new skills. Inflation: There are following two types of inflation: Cost-Push Inflation: Higher cost of production would decrease supply and Increase in the general price level Shown by the following diagram:

Demand Pull Inflation: This is when excessive demand leads to an Increase in price level, shown by the following diagram:

Negative Effects of Inflation: Depression in the economy, Menu Cost (when companies have to update catalogues and websites), Shoe-Leather Cost (when the consumer has to shop around for the lowest price due to high inflation causing opportunity cost of time i.e. bargaining cost), Inflationary noise, A decrease in economy GDP, A decrease in the economy living standard, Less ProductionPositives of Inflation: Businesses increases efficiency to tackle inflation, In case of inelastic product the sales revenue increase for businesses.

Balance Of Payments: It includes Capital Account and Current Account:Capital account: This includes foreign direct investment (FDI), (changes in holdings of stocks, bonds, loans, bank accounts, and currencies).Current account: Trade in Goods (tangible), services (intangible), transfers and Investment income.

Causes of a Deficit Current Account/ (opposites are Causes of a Surplus Current Account): high price (expensive), high Exchange Rate, Low Productivity , Low level of training and skills, Increased amount of imports, Low level of quality goods are produced, less marketing in abroad.

Economic Growth:Indicators of economic growth are, if Production possibility frontier shifts to the right, LRAS shifts to the right and increase in Real GDP. Positives: Increased Living standard, Increase in real output, Lower Unemployment, Increased government tax revenue, More money to spend on public services e.g. transportation, More money on national security due to less dependence on trade, attract more FDI, Lower absolute poverty.

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Negatives of Economic Growth: Negative externalities e.g. pollution, Over utilization of resources, Less leisure time, Could be inequality, demand pull inflation

Inequality: Wider gap of income or wealth which causes the rich to get richer and poor to get poorer.Causes: Qualifications, Government intervention, Corruption, Low benefits, Dependence ratio, Inherited, Wealth, Laziness, Skills level or discrimination.

Negatives of Inequality: Low Motivation, Lower growth, Poverty, Lower opportunity to invest, Increase in crime rate, Decrease in economy GDP

Government Policies to solve inequality in the economy: Minimum wage, Progressive taxation, Free education and training, Job seekers allowance, Discrimination acts, cash and non-cash benefits.

Government policies can be used to achieve above objectives in the short run (when at least one factor of production is fixed and other are variable) and in the long run (all FOP are variable):First we shall discuss the Short run policies called the ‘Demand Side policies’. Demand policies can be subdivided into two groups: -Fiscal Policies - Monetary Policy (Governed by the Monetary Policy Committee)

Fiscal Policy: This is again subdivided into two actions which can be applied and they are: Taxation & Subsidy

Taxation: Increase in Direct tax (imposed directly on income), which means the consumer has less disposable income available, which in turn decreases consumer spending, decreasing Aggregate Demand and Vice-versa with converse argument for decreasing tax.

Increase in Indirect Tax (Value Added Tax): this will increase the cost of production and decrease the supply so increases price level and decreases real output, finally higher price level would result in lower purchasing power and lower Aggregate demand ; vice-versa for converse argument of decrease in VAT.

Subsidy: Subsidy is a component of Aggregate Demand, if increased it would increase AD and vice-versa or alternatively, the higher subsidy means lower cost of production and lower price level so it will increase AD.For a budget deficit to occur the following would have to be the situation: Subsidy>Taxation whilst a budget Surplus is: Tax revenue>Subsidy. Satisfactory Budget means tax revenue is equal to Govt spending, (subsidy).

Fiscal Policy: A decrease in VAT might not increase aggregate demand due to inelastic products or if an increase in subsidy might be financed by taxation which means it has no overall effect, change in working hours also adjust the disposal income if income tax is changed.

Monetary Policy: The Monetary Policy Committee has the power to increase or decrease the rates of interest, which can indirectly affect the exchange rate.MPC considers various factors before determining the interest rate: Housing market, Inflation Target, Confidence level, International Competitiveness, Stock market and output etc.

An increase in the interest rate means people save more money, decreasing consumer expenditure and since consumer expenditure is an element of AD, AD will decrease, and vice-versa. Also if interest rates are increased so will the exchange rate (due to high attraction to FDI), which means less international competiveness, and decreases exports with other countries, and increases imports decreasing AD as a results or vice-versa.

Monetary Policy: Increase in interest rates might not affect those who don’t take out loans to demand or if confidence level changes. A decrease or increase in exchange rates may be unaffected due to quality of goods or real exchange rate, other international competitive factors.

IMPORTANT: Remember Fiscal Policy, taxation is a leakage and subsidy is an injection. Exchange rate policy, Import is a leakage and exports are injection. Interest rate policy, saving is a leakage and investment is an injection and both are affected by interest rate. (Refer Multiplier effect in the circular flow of income)

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Secondly, we have the Long Run Policies named the ‘Supply Side Policies’: These are government policies to increase the Long-run aggregate supply and these are the following policies which can be applied:

Investment into education and training (Skills level) Decreasing in the JSA (More motivation to work) Decrease income tax (More motivation to work) Deregulation (More competition , Less barrier) Privatisation (More competition) Dec. in trade union power (Cheaper & flexible labour)

For Supply Side Policies: An increase in education and training may add up cost more relatively or might increase white collar unemployment, or a decrease in job seekers allowance will have a negative effect on real seekers, privatisation and deregulation might ignore social benefits or may result in a monopoly, decrease in come tax might decrease working hours. Lower trade union may have adverse effect on the productivity. NB. Students are expected to illustrate the spare capacity and full utilisation on the LRAS.

How to use the above policies to achieve macro-objectives:Growth: For short run: increase of Aggregate demand by- Fiscal policy: -Decreasing direct tax meaning consumers have more disposable income, increasing consumer expenditure and aggregate demand as a result. -Decrease in indirect tax which reduces production cost and lower price level that increases aggregate demand due to higher purchasing power. (Same with higher subsidy due to lower cost of production and lower price level OR being a component of AD)Monetary policy: Decreasing interest rates, which increases consumer expenditure and as a result increases aggregate demand, lower interest rate and lower exchange rate increases export and AD as a result. (Diagram)For the Long Run: Any of the factors for supply side policy can be applied to increase Long-Run aggregate supply as a result real output increases and lead to economic growth)

Business Cycle: The business cycle is often expressed as a diagram like the one below: Boom (too high AD), Bust (Too low AD), Decline is lowering Ad and Recovery is Increasing AD. Output gap (+/-) is the gap of actual Growth and Trend Growth (Sustainable increase in Growth without inflation).

Economic Growth vs. Economic Development: Economic growth shows increase in real GDP only whereas development shows sustainability, quality of life and human capital development. Economic development can be measured by HDI (Human Development Index): 1/3rd Increase in Real GDP, 1/3rd access to education and knowledge/learning, 1/3rd access to medical facility and clean water.Positives: very comprehensive analysis, International comparison, its not only Income increase/Growth.Negatives: Information Lag, Quality of teaching and Quality of doctors is also not considered, External Factors.However there are various other measures to assess the development of an economy e.g. Big Mac index, life expectancy rate, mobile phones per person, infant mortality rate etc.Constraints of economic growth: Migration, Birth Rate, absence of capital market, labour market problems, imbalanced Export and Import, Population, Government corruption and external factors such as other countries.

Low Unemployment: For Short Run- Increase in Aggregate Demand once again as more goods will be demanded and higher real output therefore create more jobs and lower unemployment- same policies as growth.For Long Run: SSP, same as said in growth, higher LRAS to increase GDP i.e. creates more jobs and skills

Satisfactory Balance of Payments: For short run- Fiscal Policy: A decrease in domestic demand by decrease the import and increase the export, this can be done by increasing indirect tax and or /either direct tax to reduce consumer expenditure and aggregate demand as a result.

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Monetary policies, interest rates can also be decreased to decrease the exchange rate and increase exports producing a surplus BOP once again. However they can also increase interest rates to attract more foreign direct investment. Long Run Policies: Same supply side policies to increase LRAS and increase real output which decreases imports and increases exports causing a surplus BOP. It would also decrease the price level and increase in the international competitiveness in the market.

LOW Inflation: If it is Demand Pull Inflation: Govt. would need to decrease the aggregate demand by monetary or fiscal mentioned as above.

If it is Cost push inflation, a reduction in the cost of production is needed so decreases in indirect tax (Fiscal Policy) is needed, or decrease interest rates (Monetary Policy) for producer to decrease cost of production which can be put to reducing factor costs and price level. Demand - pull inflation (opposite)In the Long Run: An increase in LRAS that would increase Real GDP and reduce the price level, using SSP.

Objectives Conflicts: 1) Increase in economic growth may result in increase in demand pull inflation due to high demand. 2) Decreasing unemployment may increase inflation due to increased AD (Philips curve- there is negative but non linear relationship between level of unemployment and inflation level) higher AD would increase employment i.e. lower unemployment, therefore higher AD in the economy so demand pull inflation But in the Long run, higher wage has to be offered to attract more employees i.e. cost push inflation in economy3) Growth might increase inequality 4) Satisfactory BOP may decrease standard of living. 5) Increase in economic growth will have an increase in negative externality 6) Decrease in externality will lead to a decrease in economic growth.

Special Notes: Fiscal policy works as supply side policy in the long run e.g. lower income tax and lower JSA.Conflicts of Policies: To discourage AD contractionary fiscal or deflationary fiscal is used which conflicts with SSPs. Other side higher interest rate by MPC (Discourage production) conflicts with SSPs such as deregulation and privatisation (encourage production). These conflicts can be used as evaluation e.g. the success of one policy also depends on the overall coordination of other government policies.

Effect of high interest rate: Inequality may increase as rich with huge saving will have high returns but poor with high borrowing will have to pay back more. So poor will be poorer and rich will be richer. Income inequality will be adverse and it will also wider the gap of wealth inequality as well. However time lag or other policy measure at the same time neutralise the effect.

The circular relationship of AD and Investment is expressed by accelerator; Higher Investment means higher AD and therefore higher investment ……. So on. (Not in Detail- AS Level. But students are expected to show spare capacity, bottleneck and Full employment on LRAS curve.

Keynesian view- Fiscal Policy (Government spending and Tax) is a powerful tool in shifting AD (at multiplier rate); whereas classical view is that government spending is same as printing new notes-Its only Inflationary.

Productivity means output per worker, if productivity increases production will also increase. Higher the productivity of UK means narrow productivity gap with other trading partners. Productivity can be increased by more education and training, more health spending, better technology and better quality raw material.

NB. Students are expected to know the general information about the real economy and trend in the UK economy. 1) www.hsbcukeconomyexplained.co.uk 2) www.bankofengland.gov.ukOwn Notes: ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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