question

Five major objectives of macroeconomic policies.

answer

•Economic growth: A steady rate of increase of national output •Full Employment: A low level of unemployment •Price stability: A low and stable rate of inflation •Satisfactory balance of payments •Equal Income distribution : An equitable distribution of income

question

Describe, using a diagram, the circular flow of income between households and firms in a closed economy with no government.

answer

See notes

question

Identify the four factors of production and their respective payments and explain that these constitute the income flow in the model.

answer

•factors of production households provide to firms: →land →labour →capital →enterprise. •The firms, in return pay the factors of production: →wages →rent →interest →profit

question

Relationship between income flow, expenditure flow and output flow.

answer

Income flow=expenditure flow + output flow

question

Describe, using a diagram, the circular flow of income in an open economy with government and financial markets, referring to leakages/ withdrawals (savings, taxes and import expenditure) and injections (investment, government expenditure and export revenue).

answer

See notes

question

Define national income.

answer

Measures the monetary value of the flow of output of goods and services produced in an economy over a period of time.

question

3 measures of national income.

answer

Most commonly used measure of countries national income is GDP. 3 different methods to calculate this: 1. The output method (measures actual value of goods and services produced) 2. The income method (value of all incomes earned in economy) 3. Expenditure method (measures value of all spending on goods and services)

question

Distinguish between GDP and GNP/GNI as measures of economic activity.

answer

GROSS DOMESTIC PRODUCT (GDP): •value of final goods and services produced within a country in a given period •It is the total of all activities in a country, regardless of who owns the productive asset. GROSS NATIONAL PRODUCT (GNP/GNI): •market value of all products and services produced in one year by labour and property supplied by the residents of a country.

question

Define and distinguish between gross national product (GNP) and gross domestic product (GDP).

answer

GNP=GDP+net property income from abroad (income earned from assets overseas) GDP= C+I+G+(X-M) Unlike Gross Domestic Product (GDP), which defines production based on the geographical location of production, GNP allocates production based on ownership. It is the total income that is earned by a country's factors of production regardless of where the assets are located.

question

Define and distinguish between gross national product(GNP) and net national product (NNP).

answer

NNP=GNP-Depreciation (capital consumption)

question

Define and distinguish between nominal GDP and real GDP.

answer

Real GDP=Nominal GDP adjusted for inflation.

question

Explain the uses of national income statistics.

answer

Shows: •economic growth (is an increase in national income over time) •develop policies •develop models of economy to make forecasts •performance •identifying changes in consumption, investment •evaluate living standards •basis for comparing different countries

question

Explain the limitations of using national income statistics.

answer

•Inaccuracies unrecorded or under-recorded economic activity •external costs (resource depletion, pollution) •other quality of life concerns (people may be earning higher incomes but not enjoy higher standards of living, not account free activities such as volunteer work) •composition of outputs (large part of countries output is in goods that do not benefit consumers such as defence or capital goods)

question

Evaluating National income statistics.

answer

•GDP is a measure of the value of production in terms of market prices •indicator of economic activity, not a measure of a nations overall welfare •unreliable show of an economies health as it: →excludes nonmarket production (household services of homemakers) →legal versus illegal activities →not necessarily a good measure of well being of nation →says little about environmental quality of life →not necessarily reflect purchasing power →different countries have different conventions

question

Explain the meaning and significance of "green GDP".

answer

Green GDP= GDP-environmental costs of production. Measure of GDP that takes into account any environmental costs from the production of goods and services.

question

Explain and illustrate the business cycle and its phases.

answer

•In developed country economies generally see a pattern where there are periods of rising growth, followed by periods of slowing growth and even falling growth. •Cycle periodic fluctuations in economic activity measured by changes in real GDP. •The long term growth trend is the potential output of the economy. •Phases: boom, trough, recovery, recession •RECOVERY PHASE: →economic expansion with GDP increasing at a rising rate →mainly driven by increase in AD •BOOMS: →increase in demand can result in increase price, can lead to increase in AD hence increase in average prices →inflationary pressure will build up and rate of growth of GDP will fall as economy nears its potential output •RECESSION: →defined as two consecutive quarters of negative GDP growth that is falling GDP →Fall in AD, fall in employment, low demand leads to lower inflation rates (even deflation) •TROUGH: →output cannot continue to fall for ever as always be some people with jobs to maintain a given level of consumption

question

Distinguish between a decrease in GDP and a decrease in GDP growth.

answer

Decrease in GDP where the economy actually gets smaller, decrease in GDP growth where the economy continues to grow but at a slower rate.

question

Define aggregate demand

answer

Total spending on goods and services in a period of time at a given price AD=C+I+G+(x-m).

question

Define components of AD.

answer

•C=consumption on durable (consumed over long period of time) and non durable goods (consumed over short period of time) •I=Investment on replacement investment (spend on capital in order to maintain productivity) and induced investment (spend on capital in order to increase output) •G=Government spending •x-m=net exports=exports (domestic goods bought by foreigners)-imports(goods and services bought from foreign producers)

question

Changes in components of aggregate demand.

answer

CONSUMPTION: •changes in personal income taxes (and hence disposable income) •changes in interest rates •changes in wealth •consumer confidence •level of household indebtedness INVESTMENT: •interest rates •technological changes •business expectations •business taxes •level of profit •levels of corporate indebtedness NET EXPORTS: •income of trading partners •exchange rates •level of protectionism •rate of economic growth •domestic producer efficiency GOVERNMENT SPENDING: •political priorities (improve public services, defence) •economic priorities •rate of economic growth •unemployment/inflation •tax revenue

question

Explain how governments monetary and fiscal policy to alter level of AD in economy.

answer

FISCAL: set policies relating to spending and taxation rates, direct taxes(taxes on income), indirect taxes(on goods and services) MONETARY: set of official policies governing supply of money in economy and level of interest rates in economy.

question

Illustrate AD movements and shifts.

answer

Movement: change in average price levels Shift: change in any of components of AD.

question

Define Aggregate supply.

answer

Total amount of goods and services economies produce at every given price level.

question

Define short run aggregate supply SRAS.

answer

Total amount of goods and services produced at every given price level when the price factors of production do not change. Upward sloping.

question

Explain the causes of shifts in SRAS.

answer

•resource prices •changes in business taxes, subsidies and supply shocks

question

State the 3 phases of the Keynesian LRAS.

answer

1. AS perfectly elastic due to existing spare capacity 2. As economy reaches potential output and spare capacity is used up, production becomes more expensive, upwards sloping (smooth curve) 3. When economy reaches full capacity, impossible to increase factors, LRAS perfectly inelastic.

question

Neo-classical LRAS.

answer

LRAS curve is perfectly inelastic at full employment level of output. Output depends on quantity and quality not pricing.

question

Shifts in LRAS.

answer

Curve will shift to right if there is an improvement in the quality of the factors of production or an increase in the quantity of the factors of production →improvements in efficiency →new technology →reductions in unemployment →institutional changes

question

Supply-side policies

answer

Reduction in income taxes, reductions in corporation taxes, reduction in trade union power, reduction or elimination of minimum wages, reduction in unemployment benefits, deregulation, privatisation, education and training, research and development, provision of infrastructure, improved information.

question

Identify the equilibrium level of national income/output.

answer

Aggregate demand is equal to aggregate supply.

question

Use a diagram to explain the determination of equilibrium output in the short run.

answer

See notes.

question

New classical economists view of macroeconomic equilibrium in the long run.

answer

Economy will always move towards its long-run equilibrium at the full employment level of output. Impact of any changes in aggregate demand will be on the price level only. Initially economy is at long-run equilibrium at Yf. When AD increase from AD1 to AD2 in short run, increase in output from A to B. Experience Inflationary gap where economy is in equilibrium at level of output that is greater than full employment level of output. However this is only possible in short run. This causes the price level to increase from P1 to P2. Means all prices in economy have risen as firms bid up prices of factors of production. Cost of production rises. Shift in short-run AS from SRAS1 to SRAS2. So reduce output back to Yf. Return to full employment level but at higher price level P3.

question

Keynesian economists view of macroeconomic equilibrium in the long run.

answer

Equilibrium level of output may occur at different levels. Believe that the economy may be in long-run equilibrium at a level of output below the full employment level of national income (Yf). When AD is AD1 equilibrium will occur at a real output level Y1 and average price level P1.

question

Discuss why, in contrast to the monetarist/new classical model, the economy can remain stuck in a deflationary (recessionary) gap in the Keynesian model.

answer

In keynesian model, market can have equilibrium level output below full employment level output. In New classical, long run equilibrium always returns to full employment level of output.

question

Changes in long-run aggregate supply.

answer

As economic growth occurs the LRAS curve shifts to the right representing an increase in the potential output of the economy. For Keynesian economists, increasing LRAS depends on initial equilibrium position of the economy. An increase in LRAS for New classical viewpoint will cause increase in full employment level and a fall in the price.

question

Discuss why, in contrast to the monetarist/new classical model, increases in aggregate demand in the Keynesian AD/AS model need not be inflationary, unless the economy is operating close to, or at, the level of full employment.

answer

AD can increase such that there is an increase in level of real output without increase in price level as the spare capacity in economy is used up. (See diagram).

question

Define unemployment.

answer

People of working age who are without work, available for work, and actively seeking employment.

question

How unemployment rate is calculated.

answer

Rate of unemployment is the number of people who are unemployed expressed as a percentage of the total labour force.

question

Difficulties in measuring unemployment.

answer

Hidden unemployment: 1.Consists of people who have been unemployed for long periods of time and have given up the search for work 2.Those who have part-time work but would prefer to work full time 3.Those who are woking in jobs for which they are greatly over-qualified.

question

Distribution of unemployment.

answer

Typical disparities between: graphical, age, ethnic differences, gender.

question

Costs of unemployment.

answer

TO UNEMPLOYED PERSON: receive less income, lower standards of living, person who remains unemployed for long periods of time subject to high levels of stress, anxiety and depression, relationship break downs, suicides. Deterioration of human capital as they lose skills and become demotivated. TO SOCIETY: places where high levels of unemployment can see in form of poverty, homelessness, higher rates of crime and vandalism, increase gang activities TO ECONOMY AS A WHOLE: Production possibilities curve can be used to illustrate key problem, possible output operating at point within its production possibility curve. Opportunity cost of the government's spending on unemployed benefits, if more unemployed people government earns less in direct and less taxes and will need to spend more money to solve the social problems created by unemployed. Less investment.

question

Consequences of unemployment.

answer

•Loss of GDP •loss of tax revenue •increased cost of unemployment benefits •loss of income for individuals •greater disparities in the distribution of income.

question

Define the two main categories of unemployment.

answer

DISEQUILIBRIUM: occurs when there are conditions that prevent market from "clearing"(reaching the labour market equilibrium). EQUILIBRIUM: (natural unemployment) number of job vacancies in economy =number of people looking for work. Jobs exist but people are either unwilling or unable to take jobs available

question

Describe using examples the meaning, causes and solutions of frictional unemployment.

answer

Short term unemployment when people are in between jobs or have left education. Natural unemployment. SOLUTIONS: •Lower unemployment benefits to encourage unemployed workers to take jobs available •making unemployed more willing to work shifting AS to right •Improve information from potential employers to people looking for jobs.

question

Describe using examples the meaning, causes and solutions of structural unemployment.

answer

•Permanent fall in demand for a particular type of labour •often results in long term unemployment as people do not have necessary skills to take on new jobs •People could be living in a different area to where the jobs are (lack of graphic mobility) CAUSES: •New technologies •lower cost labour in foreign countries •change in consumer tastes SOLUTIONS: •Long term education system training people to be more occupationally flexible •spending on adult retraining programs •give subsidies to firms to provide training •government provide subsidies or tax breaks to encourage people to move to other areas •Reduce unemployment benefits.

question

Describe using examples the meaning, causes and solutions of seasonal unemployment.

answer

Demand for certain workers falls at certain times of year mainly due to climatic seasons. •Encouraging people to take different jobs in their "off season"

question

Describe using a diagram the meaning, causes and solutions of cyclical (demand deficient) unemployment.

answer

•Cyclical downturn in the economy CAUSE: •In slower periods, AD fall as consumer spends less causing demand of labour to fall (see diagram) SOLUTIONS: •Government can intervene to bring about an increase in aggregate demand through the use of fiscal or monetary policies ••Increase AD by increasing government spending, or lower direct or indirect taxes to increase consumption of households.

question

Describe using a diagram the meaning, causes and solutions of real wage(classical) unemployment.

answer

•Trade unions and government interfere with minimum wages where trade unions negotiate wages higher than equilibrium •causes unemployment of a-b. (see diagram). SOLUTIONS: •Government reduces the ability of unions to negotiate higher wages (hard to do) •Minimum wages should be reduced or abolished (reduce income and living standards of workers who are already earning low wages, worsening distribution of income).

question

Evaluate Government policies to deal with different types of unemployment.

answer

•Depends upon the type of unemployment involved. •frictional, structural and seasonal unemployment ONLY be solved by supply-side policies. •Demand-deficient unemployment may be fixed by expansionary demand-side policies. •Use of demand-side policies may have bad effects elsewhere in the economy,e.g. if interest rates are lowered, may lead to inflation and fall in exchange rate. •no guarantee that expansionary monetary policy will be effective in raising AD •If consumer and business expectations about the future are pessimistic, then lower interest rates may not necessarily lead to increased AD.

question

Define Inflation.

answer

Persistent increase in the average price level in the economy usually measured through the calculation of a consumer price index (CPI).

question

Define disinflation.

answer

Reduction in the rate of inflation.

question

Define deflation.

answer

Persistent fall in the average level of prices in the economy. Two types "good" (improvements in the supply side of economy and/or increase in productivity. Increase in long-run AS, increase in real output and fall in price level) and "bad" (fall in AD/AS illustrate fall in AD resulting in a decrease in price level and a decrease in real output).

question

How to measure inflation.

answer

Consumer price index (CPI). Choose what is known as a representative "basket" of consumer goods and services and measure how this basket changes over time. These baskets are put into categories. Categories are given a weight in the index to reflect their importance.

question

Problems in measuring inflation.

answer

• different income earners may experience different rates of inflation when their pattern of consumption is not accurately reflected by CPI •do not accurately reflect changes in consumption patterns and the quality of the products purchased • Could be errors in the collection of data as impossible to collect prices of all items bought by all households in all possible locations. • Statisticians try to take into account changes in consumption habits, making it hard to compare different time periods. • Countries measure it in different ways • Prices may change for variety of reasons that are not sustained e.g. seasons.

question

Why is rate of inflation measured?

answer

To eliminate the effect of sudden swings in the prices of food and oil for example.

question

What is a producer price index?

answer

Measures changes in the prices of factors of production in order to predict future inflation.

question

Consequences of inflation.

answer

•LESS SAVING →if interest rate adjusted for inflation, real rate of interest will be negative, better to spend as saving has less purchasing power •DAMAGE TO EXPORT COMPETITIVENESS •GREATER UNCERTAINTY: →firms be discourages from investing due to uncertainty associated with inflation •REDISTRIBUTIVE EFFECTS: →Misallocation of resources away from productive assets. →Labour unrest (occurs if workers feel that their wages and salaries are not keeping up with inflation)

question

Costs of deflation.

answer

•HIGH LEVELS OF CYCLICAL UNEMPLOYMENT: →AD is low businesses likely let workers go, may lead to deflationary spiral as prices fall consumers put off purchase of durable goods i.e. deferred consumption, further reducing AD •BANKRUPTCIES: →Higher costs to debtors →value of debt rises, if profits low make difficult for business to pay back loans •OTHERS: →Reduce consumer confidence →Less investment (business make less profit, lay off workers, low business confidence)

question

What are the types of causes of inflation?

answer

•Demand pull •Cost push •Demand and cost push together •Due to excess monetary growth

question

Describe using a diagram, demand pull inflation.

answer

Result of increasing AD. Due to changes in components of AD (see notes for diagram).

question

Describe using a diagram, cost push inflation.

answer

•Result of an increase in costs of production. •Increase in costs results in a fall in SRAS, causing an increase in average price level and a fall in level of real output (see notes for diagram).

question

Describe using a diagram, demand pull and cost push inflation together.

answer

•Economy near full employment, increase AD results demand pull inflation, increase price level. •Higher price means higher costs of production, workers negotiate higher wages further increasing costs of production shifting SRAS (see notes for diagram).

question

Describe using a diagram, inflation due to excess monetary growth.

answer

•Excessive increases in money supply by government are cause. •Increase in money supply results in higher AD. •Since economy rests at full employment, such increase causes price level to increase (see notes for diagram).

question

Evaluate government demand side policies to deal with demand pull inflation.

answer

•These policies highly unpopular DEFLATIONARY FISCAL POLICY: •involves an increase in taxes and lowering of government spending •Increasing taxes will result in lower disposable income for household and thus less consumption. •increased taxes will result in lower profits for firms and thus less investment by firms •lower the AD in the economy. DEFLATIONARY MONETARY POLICY: •involves rising of interest rates and reducing money supply •Higher interest rates mean higher loan and mortgage repayments •This will discourage households and firms to borrow, leading to fall in consumption and investment respectively

question

Evaluate government supply side policies to deal with cost push inflation.

answer

All aim at improving the efficient supply of goods and services. These might include: •Privatisation •Imparting training and improving the education level of the workforce resulting in higher skills. •Increase competition in all industries by removing entry barriers, thus leading to more efficiency.

question

Consequences of government policies to deal with inflation.

answer

DEFLATIONARY FISCAL: •Time lags •difficulty of fine tuning. DEFLATIONARY MONETARY: •increase in interest rates slows economic growth and negatively affects exports due to increase in exchange rates SUPPLY SIDE: •aim increase long term competitiveness and productivity (only long run).

question

Evaluate government exchange rate policies to deal with imported inflation.

answer

This involves increasing the value of currency to reduce imported inflation. Increase currency rate will also lead to fall in demand for exports (component of AD).

question

Define economic growth.

answer

Increase in real GDP over time

question

Causes of economic growth.

answer

•reduction in unemployment •increase in productivity •increase in quantity and quality of resources

question

Use PPC curve to explain how a movement from a point inside a PPC curve to a point on a PPC curve illustrates economic growth.

answer

•At a, economies resources are not being used to fullest extent. •If increase in AD then deflationary gap would be removed and there would be an increase in real output. •This is the equivalent of movement from a to b. •Increase in real output is an increase in real GDP, so there has been economic growth. •Caused by factors including reduction in unemployment and increases in productive efficiency. (SEE DIAGRAMS IN NOTES)

question

Use PPC curve to explain how an outwards shift in a PPC curve and an outward shift in LRAS illustrates economic growth.

answer

•Economic growth established through increasing the full employment level of output or potential output. •Increase in GDP as result in LRAS equivalent to outward shift of PPC. •Caused by increase in quantity and quality of resources. (SEE DIAGRAMS IN NOTES)

question

Explain the importance of investment for economic growth.

answer

•Investment in PHYSICAL CAPITAL key to economic growth as it enables workforce to produce consumer goods more efficiently. •Improvement in technology will lead to more goods being produced from available resources. The country will have achieved a higher gross domestic product. •Investment in HUMAN CAPITAL by improving quality of existing workforce leads to increase in productivity and optimum utilisation of resources. Done through education, training and healthcare. •Investment in NATURAL CAPITAL by discovering new sources will add to the total output of the country.

question

Explain the importance of improved productivity for economic growth.

answer

Increases real output.

question

Advantages of Economic growth.

answer

•LIVING STANDARDS: →better →Less unemployment, growth stimulates more jobs •CURRENT ACCOUNT OF BALANCE OF PAYMENTS: →sustained GDP growth boosts tax revenues and provides the government with extra money to improve public services such as education and healthcare →It makes it easier for a government to reduce the size of a budget deficit •INCREASE INVESTMENT: →rising demand and output encourages investment - this sustains growth by increasing long run aggregate supply •INCREASE CONFIDENCE •SUSTAINABILITY: →innovation and research and development, resulting in more efficient production processes to reduce costs (increase sustainability) •VIRTUOUS CIRCLE OF GROWTH

question

Disadvantages of economic growth.

answer

•INFLATION RISKS: →demand greater than supply causing prices to increase •LIVING STANDARDS: →Longer working hours due to increase in demand •DISTRIBUTION OF INCOME: →Inequalities may widen →some industries will be benefiting while others are suffering •SUSTAINABILITY: →Environment, negative externalities of production arise from producing a higher output of goods and services

question

Distinguish between equity and equality.

answer

Equity- fairness taking into account their circumstances Equality- where everyone is treated the same no matter what their circumstances

question

Reason for market system not distributing income equally.

answer

Due to unequal ownership of factors of production.

question

Distinguish between absolute and relative poverty.

answer

•Absolute poverty: does not have access to the basic necessities needed to sustain life •Relative poverty: living standards are well below an observed "average" in an economy

question

Causes and consequences of poverty.

answer

CAUSES: •low incomes (situation tends to be cyclical) •Unemployment •lack of human capital CONSEQUENCES: •Low living standards. •Lack of access to sufficient health care. •Low levels of education. •Excluded from economic, social and cultural activities.

question

Explain and draw a Lorenz curve.

answer

Line of absolute equality indicates a perfectly equal distribution of income where N% if the population earns N% of the income. The further away a country's curve is from the line of absolute equality, the more unequal the distribution. (see diagram in notes)

question

Define Gini coefficient.

answer

Derived from the Lorenz curve and is a ratio of the area between the line of equalit and a country's Lorenz curve A and the total area under the line of equality A+B. The higher the Gini coefficient, the more unequal is the distribution of income.

question

What is taxation used for?

answer

•Reduce consumption of goods that create negative externalities. •Reduce consumption of imported goods. •Raised or lowered to manage level of AD. •Control income inequality. •Finance government expenditure.

question

Distinguish and give examples of direct and indirect taxes.

answer

DIRECT: •imposed on peoples income or wealth or firms' profits. •Form of employment income, interests on savings and dividends from the ownership of shares. •Such taxes are unavoidable. Can be used as a mechanism to redistribute income. INDIRECT: •also known as expenditure taxes, or consumption based taxes. •Tax on goods and services. •Vary the rate with necessity and value of goods.

question

Distinguish and give examples of progressive, regressive and proportional taxation.

answer

PROGRESSIVE: •main way to redistribute income from higher to lower income earners. •As income rises, people pay a higher proportion of income in taxes. •Usually certain amount of income that is non-taxed. Amount over, % of income paid to gov. •Tax deductions allow people to reduce their "taxable income" REGRESSIVE: •proportion of income paid in tax falls as income rises. •Indirect taxes are regressive taxes. •Good source of government revenue and might discourage consumption of demerit goods •worsen income inequality PROPORTIONAL: •proportion of income paid in tax is constant for all income levels. •Makes it simpler to not have huge complex tax system. •reduces error and manipulation which cause gov. earning less revenue than expected. •disincentive effects of taxes on working •high tax rates discourage people from working hard, moving into higher paid jobs as reluctant to lose own gains to higher taxes.

question

Explain how government can use tax revenue to provide goods and services for those on low incomes.

answer

•Provide directly, or subsidize a number of goods and services that are socially desirable. •Tend to be goods and services that have positive externalities of consumption (healthcare, education, sanitation, water supplies). •Provision to ensure poorer embers of economy have access to essential goods and services.

question

Explain how governments can alter the distribution of income through the use of transfer payments.

answer

•Provide different types of assistance to groups in the economy to improve their living standards. •Payments made to increase income of particular groups within economy (child support, pension, unemployment benefit, payments to disabled people, subsidies to producers).

question

Evaluate the use of government policies to redistribute income.

answer

•Many agree government's obligation to ensure citizens enjoy a "reasonable" standard of living. •Some argue against government active role as interferes with market forces and results in inefficiencies in allocation of resources. •If firms have to pay insurances and social security costs for workers then this will encourage firms to hire fewer workers, thus contributing to unemployment. •High taxes discourage entrepreneurial activity and have negative effects on overall growth in economy due to disincentive effect.

question

What is the source of government revenue?

answer

Primarily from taxes (direct and indirect), as well as from the sale of goods and services and the sale of state-owned (government owned) enterprises.

question

Types of government expenditures.

answer

CAPITAL EXPENDITURE: spending on goods and services intended to create future benefits, such as infrastructure investment or research spending. CURRENT EXPENDITURE: expenditure of the government which does not result in the creation of assets or reduction in the value of its liabilities. For the normal running of government departments and maintenance of services. TRANSFER PAYMENTS: financial assistance given to sections of the society in order to uplift or maintain their standard of living.Governments use such payments as means of income redistribution by giving out money under social welfare programs such as social security, old age or disability pensions, student grants, unemployment compensation, etc.

question

Distinguish between a budget deficit, a budget surplus and a balanced budget.

answer

DEFICIT: more spending than revenue SURPLUS: more revenue than spending BALANCE: equal spending and revenue

question

How to fix budget deficits.

answer

•Cutting spending and/or •raising taxes •Deficits must be financed by borrowing money. •Interest must be paid on borrowed funds, which worsens the deficit.

question

Define fiscal policy.

answer

Government policy that attempts to influence the direction of the economy through changes in government taxes or through some spending.

question

Two main instruments of fiscal policy.

answer

Government spending and taxation.

question

Factors affected by fiscal policy.

answer

•AD and level of economic activity AD=C+G+I+(X-M) •Pattern of resource allocation •Distribution of income

question

Describe expansionary fiscal policy using a diagram.

answer

•Used to increase the AD in the economy. •If the economy is having a deflationary gap(resources are not being used in the optimum level and they are idle resulting in unemployment and low level of output) the government can use expansionary fiscal policy to reduce the gap or totally eliminate it. •Government will either increase spending (result in more projects funded increasing employment and output) or reduce taxes(more disposable income).(see diagram in notes)

question

Describe contractionary fiscal policy using a diagram.

answer

•Reduction of government spending and increase taxes as a measure to control inflation/AD. •Reduced government spending, AD fall reducing pressure on economic resources and the average price level come down. •Increased taxes takes away excess disposable income from households resulting in a fall in AD. •Used to reduce the inflationary gap(aggregate demand exceeds the productive potential of the economy.)

question

Impact of automatic stabilizers.

answer

Progressive tax system and unemployment benefits, which are influenced by the level of economic activity and national income, automatically help stabilize short-term fluctuations.

question

Impact of fiscal policy on potential output.

answer

Used to promote long-term economic growth (increases in potential output) indirectly by creating an economic environment that is favourable to private investment, and directly through government spending on physical capital goods and human capital formation, as well as provision of incentives for firms to invest.

question

Evaluate use of fiscal policy.

answer

•ability to target sectors of the economy •direct impact on AD •effectiveness of promoting economic activity in a recession •time lags •political constraints →may conflict with other policies or political business cycles •"Crowding out" effect →when fiscal policy reduces investment spending •inability to deal with supply-side causes of instability •May cause inflation. •May cause change in interest rates.

question

Describe the role of central banks as regulators of commercial banks and bankers to governments.

answer

•Control nation's money supply, availability and cost of credit, and foreign-exchange value of its currency. •Regulation of availability and cost of credit altered to influence distribution of credit among competing uses. •Principal objectives to maintain monetary and credit conditions at high level of employment and production, reasonably stable level of domestic prices, and adequate level of international reserves. •Setting official interest rates

question

Explain, using a demand and supply of money diagram, how equilibrium interest rates are determined, outlining the role of the central bank in influencing the supply of money.

answer

•Increasing or decreasing money supply influences interest rates in a nation, and therefore over level of investment and consumption among firms and households. THREE TOOLS: •The reserve requirement •the open market purchase or sale of government bonds •the discount rate.

question

Define monetary policy.

answer

Process by which the government, central bank, or monetary authority of a country controls the supply of money, availability of money, and cost of money or rate of interest, in order to attain growth and stability of the economy.

question

Define interest rates.

answer

The cost of borrowing money or the return for investing money

question

Explain how changes in interest rates can influence the level of aggregate demand in an economy.

answer

Interest rates will affect consumption and investment AD=I+C+G+(x-m)

question

Describe the mechanism, using a diagram, through which easy (expansionary) monetary policy can help an economy close a deflationary (recessionary) gap.

answer

•An expansionary policy increases the total supply of money in the economy and is traditionally used to combat unemployment in a recession by lowering interest rates. •Lowered interest rates encourage the household and the firms to increase their consumption and investment respectively. •This will shift the AD to the right and result in higher real output and more employment. (See diagram in notes)

question

Describe the mechanism, using a diagram, through which tight (contractionary) monetary policy can help an economy close an inflationary gap.

answer

Contractionary policy decreases the total money supply and involves raising interest rates in order to combat inflation. The result will be that investment will fall, and consumption will fall. All of these changes will shift the AD to the left.

question

Monetary policy and inflation targeting.

answer

•Increase in the money supply causes an increase in the rate of inflation. •Maintaining a low and stable inflation is one of the main macroeconomic objectives of the Government. •Government does so by controlling the supply of money to the economy. •Central banks of certain countries, rather than focusing on the maintenance of both full employment and a low rate of inflation, are guided in their monetary policy by the objective to achieve an explicit or implicit inflation rate target.

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Evaluate the effectiveness of monetary policy.

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•the independence of the central bank •the ability to adjust interest rates incrementally •the ability to implement changes in interest rates relatively quickly •time lags •limited effectiveness in increasing aggregate demand if the economy is in deep recession •conflict among government economic objectives.

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Define Supply side policies.

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Policies to do with supply.

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Affect if supply side policies.

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Aim at positively affecting the production side of an economy by improving the institutional framework and the capacity to produce (that is, by changing the quantity and/or quality of factors of production).

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Types of supply side policies.

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Market-based or interventionist, and that in either case they aim to shift the LRAS curve to the right, achieving growth in potential output.

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Different interventionist supply side policies.

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Investment in: •human capital •new technology •infrastructure •industrial policies.

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Describe investment in human capital.

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Investment in education and training will raise the levels of human capital and have a short-term impact on aggregate demand, but more importantly will increase LRAS. Labour becomes more skilled and efficient.

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Describe investment in new technology.

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Policies that encourage research and development will have a short-term impact on aggregate demand, but more importantly will result in new technologies and will increase LRAS.

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Describe investment in infrastructure.

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•Increased and improved infrastructure will have a short-term impact on aggregate demand, but more importantly will increase LRAS. •Facilitates the firms to produce more and at a more cost efficient manner. •Better infrastructure attracts more investment both domestic and foreign. • fuels inflation

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Describe industrial policies.

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•Targeting specific industries through policies including: →tax cuts →tax allowances →subsidized •lending promotes growth in key areas of the economy and will have a short-term impact on aggregate demand but, more importantly, will increase LRAS.

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Different market-based supply side policies.

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•Policies to encourage competition •labour market reforms •incentive-related policies.

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Describe policies to encourage competition.

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Competition leads to increased efficiency and eliminates market failure. •Deregulation: The reduction or elimination of government power in a particular industry •Privatization: The transfer of ownership of property or businesses from a government to a privately owned entity. greater efficiency as private owners tend concentrate on profit maximization •Trade liberalization: removal or reduction of restrictions or barriers on the free exchange of goods between nations. Lowers consumer costs, increases efficiency and fosters economic growth.

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Describe labour market reforms.

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•reducing the power of labour unions •reducing unemployment benefits •abolishing minimum wages used to make the labour market more flexible (more responsive to supply and demand).

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Describe incentive-related policies.

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•personal income tax cuts are used to increase the incentive to work •cuts in business tax and capital gains tax are used to increase the incentive to invest

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Evaluate the effectiveness of supply side policies.

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ADVANTAGES: •create employment •reduce inflationary pressure •increase in economic growth DISADVANTAGES: •Time lags •reduce government budget or careful planning needed •have negative affect on distribution of income in short run •affect nature as lead to exploitation of natural resources and environment •labour unrest

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