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# L1 flash cards economics (ss5)

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## L1 flash cards economics (ss5)Presentation Transcript

• Gross Domestic Product (GDP)Using the Expenditure Approach The Expenditures Approach measures the market value of allthe goods and services produced in an economy in a giventime period. GDP under the Expenditure Approach can be calculated as:GDP=C+I+G+(X-M) where: C= Consumption usually the biggest factorI= business investment it includes equipmentG= government spendingX= exportsM= importsStudy Session 5, Reading 17
• Gross Domestic Product (GDP)Using the Income Approach The Income Approach measures the aggregate income earnedby all households, companies and governments in an economyduring a period. GDP under the Income Approach can be calculated as:GDP = R + I + P + SA + W Components of income include: Wages, salaries, and supplementary labor income Corporate profits Interest and miscellaneous investment incomeStudy Session 5, Reading 17
• Methods of Calculating GDP: Value-of-Final-Output Under the Value of Final Output, only the value of the lastproduct is considered. As a result, the value of intermediate products is ignored. It measures the value of final goods and services.Study Session 5, Reading 17
• Methods of Calculating GDP: Sum-of-Value-Output The Sum of Value Added approach finds the sum of valueaddition during the production process. Value addition also considers value added at the distributionlevel.Study Session 5, Reading 17
• Nominal GDP Nominal GDP measures the value of goods and services atcurrent price levels. It is calculated as:GDPt = Pt * Qt where Pt is price in year t and Qt is quantity in year tStudy Session 5, Reading 17
• Real GDP Real GDP is adjusted for inflation/deflation. Real GDP can be calculated as:GDPt = Pb * Qt where Pb is price in base year and Qt is the quantity in theyear t Real GDP per Capita, is Real GDP divided by population. It canbe used as a measure of the standard of living in a particularcountry.Study Session 5, Reading 17
• GDP Deflator The GDP Deflator is used to calculate Real GDP, given NominalGDP. GDP Deflator = (value of current year output at current yearprices/value of current year output at base year prices)* 100 The GDP Deflator measures the aggregate change in prices inthe economy. Changes in the deflator are a good indicator of inflation in theeconomy.Study Session 5, Reading 17
• National Income National Income is the compensation paid to all factors ofproduction. National Income comprises of: Employee compensation Interest received net of interest paid Rental income Royalties paid for the use of intellectual property andextractable natural resources.Study Session 5, Reading 17
• Personal Income Personal Income is a broad measure of household income. It is a gauge for changes in the ability of consumers to spend. Personal Income measures all income received by thehousehold sector (earned or unearned). Personal Income= National Income- indirect business taxes -corporate income taxes - undistributed corporate profits +transfer paymentsStudy Session 5, Reading 17
• Personal Disposable Income Disposable Income is calculated as personal income lesspersonal taxes. Disposable Income measures income remaining to spend orsave after personal taxes. Disposable Income is the most relevant measure of householdspending and saving power.Study Session 5, Reading 17
• Saving and Investment There is a positive relationship between saving andinvestment. The higher the savings rate, the more money is available forinvestment spending. Investment spending is undertaken to improve technology ornew equipment.Study Session 5, Reading 17
• Fiscal Balance Fiscal Balance is a measure of Fiscal Policy. It measuresGovernment outflows and inflows. It measures the extent to which government receipts differfrom government outlays. If outlays exceed receipts, then the fiscal balance is negative. If receipts exceed outlays, then the balance is positive. For a negative fiscal balance, the government must borrow tomeet the shortfall.Study Session 5, Reading 17
• Trade Balance Trade Balance is a measure of an economy’s transactions withother economies. The Trade Balance measures the difference between acountrys imports and its exports. A country has a trade deficit if it imports more than it exports. A trade surplus occurs when a country’s exports exceed itsimports.Study Session 5, Reading 17
• Aggregate Demand Four Sources Consumption Investment Government spending Net exportsStudy Session 5, Reading 17
• Income/Saving and LiquidityPreference/Money Supply Curves The Income/Savings and Liquidity Preference Money SupplyCurve demonstrates the relationship between interest ratesand real output in the goods and services market and themoney market. Each point on the curve represents a certain level ofequilibrium in the money market.Study Session 5, Reading 17
• Aggregate Demand Curve The aggregate demand curve represents the total quantity ofall goods and services demanded by the economy atdifferent price levels. The vertical axis represents the price level of all final goodsand services. The aggregate price level is measured by eitherthe GDP deflator or CPI. The horizontal axis represents the real quantity of all goodsand services purchased as measured by the level of real GDP.Study Session 5, Reading 17
• Aggregate Demand CurveStudy Session 5, Reading 17
• Aggregate Supply Curve in theShort and Long Run The Aggregate Supply Curve illustrates the level of domesticoutput. In the short run, output can be changed but the prices remainconstant. Strong demand results in higher profits for producers. As aresult, producers increase supply. This leads to an upward sloping Aggregate Supply curve in thelong run. Aggregate Supply can be measured as:Y=F(K,L)Study Session 5, Reading 17
• Aggregate Supply Curve in theShort and Long RunStudy Session 5, Reading 17
• Shifts in the Aggregate DemandCurveStudy Session 5, Reading 17
• Shifts in the Aggregate DemandCurveStudy Session 5, Reading 17 Changes in the level of spending by households, companies,government and foreigners will cause the Aggregate Demandcurve to shift. An increase in aggregate demand at any price level will causethe Aggregate Demand curve to shift to the right. A decrease in aggregate demand at any price level will causethe Aggregate Demand curve to shift to the left.
• Shifts in the Aggregate SupplyCurveStudy Session 5, Reading 17
• Shifts in the Aggregate SupplyCurveStudy Session 5, Reading 17 Changes in the factors affecting the cost of production willshift the short run aggregate supply curve. The SRAS curve will shift by the same magnitude as the LRAS.That is, changes in the same underlying resources andtechnology have the same effect on LRAS and SRAS.
• Shifts in the Aggregate SupplyCurveStudy Session 5, Reading 17
• Economic Growth Sources Labour supply Human capital Physical capital Technology Natural resources (renewable and non-renewable)Study Session 5, Reading 17
• Economic Growth Measures The Growth Accounting Equation measures the growth inpotential GDP. It is calculated as:Growth in potential GDP = Growth in technology + WL(growthin labour) + WC(growth in capital) There is no observed data on potential GDP or totalproductivity. Labour Productivity = Real GDP/Aggregate Hours Labour productivity is an important measure of the health ofan economy.Study Session 5, Reading 17
• Production Functions The Production Function specifies the output of an economyfor all combinations of inputs. A production function can be expressed as:Q = f(X1,X2,X3,...,Xn) where: Q = quantity of output; X1,X2,X3,...,Xn = quantities of factorinputs Output per worker is a measure of labour productivity. It iscalculated as:Y/L=AF(1,K/L)Y/LStudy Session 5, Reading 17
• Input Growth and Total FactorProductivity Increases in the quantity of inputs lead to increases ineconomic activity. In addition to this, Total Factor Productivity also boostseconomic activity. Labour productivity depends on both TFP and combination ofinputs. Increase in TFP or capital to labour ratio increaseslabour productivity.Study Session 5, Reading 17
• The Business Cycle and Its Phases The Business Cycle is a series of fluctuations in the level ofgrowth in economic activity. There are typically 4 phases of the Business Cycle: trough expansion peak contractionStudy Session 5, Reading 18
• Business Cycle: Impact onInventories As the Business Cycle enters the contraction stage, AggregateDemand shifts to left resulting in the accumulation ofinventories. As the Business Cycle enters the expansion stage, AggregateDemand shifts to right resulting in a reduction of inventories.Study Session 5, Reading 18
• Business Cycle: Impact on Labour The Business Cycle has a significant impact on employmentmarkets. As economic conditions slow, firms reduce output.Therefore, they require less labour inputs which results inhigher unemployment of labour. As economic conditions strengthen, firms increase output.Study Session 5, Reading 18
• Impact on Physical CapitalUtilization Capacity utilisation fluctuates with different stages of thebusiness cycle. As economic conditions slow, firms reduce output whichlowers capacity utilization. At this stage of the economic cycle there is very littleinvestment in physical capital. Additionally, an economic slowdown often results in lessaccess to finance, which further restricts investment spendingby producers.Study Session 5, Reading 18
• Impact on Physical CapitalUtilizationStudy Session 5, Reading 18
• Theories of the Business CycleNeoclassical and Austrian Schools Markets will reach equilibrium because of the invisible hand orfree market. Market prices are found at the point where demand = supply. The free market ensures that resources are used efficiently. No involuntary unemployment or labour or capital. Equilibrium is reached as the point where MR = MC. Fluctuation in the aggregate economy is ignored.Study Session 5, Reading 18
• Theories of the Business CycleNeoclassical and Austrian Schools Markets will reach equilibrium because of the invisible hand orfree market. Market prices are found at the point where demand = supply. The free market ensures that resources are used efficiently. No involuntary unemployment or labour or capital. Equilibrium is reached as the point where MR = MC. Fluctuation in the aggregate economy is ignored.Study Session 5, Reading 18
• Theories of the Business CycleKeynesian and Monetarist Schools Generalized price and wage reduction is hard to attain. The policies used to reduce inflation will cause AggregateDemand to shift to the left. Keynesian economics supports government intervention inform of fiscal policy. It argues that lower interest rates may not reignite growth ifbusiness confidence is too low. When this occurs, a larger fiscal deficit should be borne bygovernment in order to bring equilibrium back.Study Session 5, Reading 18
• Theories of the Business CycleNew Classical Schools The New Classic School suggests that actions of economicagents should be shown with the utility function and budgetconstraints. Agents are assumed to be roughly alike. It is a dynamic model for describing fluctuations over manyperiods.Study Session 5, Reading 18
• Theories of the Business CycleModels without Money - RealBusiness Cycle Theory Cycles have real causes. Monetary variables such as inflation are assumed to have noeffect on GDP and unemployment. External real shocks cause contractions and expansions. It argues for no intervention from the government. Unemployment can only be short term. Aggregate supply is given a more prominent role.Study Session 5, Reading 18
• Theories of the Business CycleModels with Money Inflation often a cause of business cycle. Central bank intervention to control inflation throughmonetary policy. Neo-Keynesians put more focus on sound macroeconomicfoundations.Study Session 5, Reading 18
• Types of Unemployment Structural unemployment arises due to an absence ofdemand for the workers that are available. Frictional unemployment comes from people movingbetween jobs, careers, and locations . Cyclical unemployment occurs when the unemploymentrate changes due to fluctuations in economic activity. Long Term Unemployment: People who have been out ofjob for long time.Study Session 5, Reading 18
• Measures of Unemployment The Unemployment Rate is the most commonly used measureof labour market conditions. The Participation Rate is the ratio of the labour force to thetotal working age population. Underemployment occurs when a person has a job, but theirskill set is underemployed in their current role. A discouraged worker is a person who has stopped looking fora job due to the difficulty in gaining employment.Study Session 5, Reading 18
• Inflation Inflation is a sustained rise in price levels. It causes a fall in purchasing power, because one unit ofcurrency is now tradeable to less goods and services. As a result, central banks try to control inflation. The inflation rate is measured as a percentage change in aprice index.Study Session 5, Reading 18
• Disinflation Disinflation is a decline in the inflation rate. Disinflation is different from deflation. After the period of disinflation, inflation remains positive.Study Session 5, Reading 18
• Deflation Deflation is a sustained decline in price levels. Deflation is often caused by a decrease in money supply orcredit. Deflation can also be caused by a decrease in spending.Study Session 5, Reading 18
• Construction of Indices to MeasureInflationLaspeyres Index Under a Paspeyres Index, the composition of the consumptionbasket for measuring a price index is unchanged. Inflation under a Paspeyres Index can be calculated as:PL=∑Pnqo/∑Poqo As a result, these price indices can suffer from three biases: 1)substitution bias, 2) quality bias, and 3) new product bias.Study Session 5, Reading 18
• Construction of Indices to MeasureInflationPaasche’s Index Paasche’s Index is a ratio of the total purchase cost of aspecified bundle of commodities at current prices, with thevalue of those same commodities at base period prices. Thisratio is multiplied by 100. It is calculated as: Pp=∑Pnqn/∑Poqn This index tends to understate the price increasesStudy Session 5, Reading 18
• Construction of Indices to MeasureInflationFisher’s Index Fisher’s Index is the geometric mean of a Laspeyre’s andPaasche’s index. It is calculated as:Pb=√PLPpStudy Session 5, Reading 18
• Comparison of Inflation Measures The Consumer Price Index (CPI) is a commonly used measureof inflation. However, when comparing across countries, a user needs toconsider the different weights assigned to products within theconsumer basket of goods. Price data can be collected from both urban and rural areas, orjust from urban areas. Personal Consumption Expenditures (PCE) and the ProducerPrice Index (PPI) can also be used to measure inflation.Study Session 5, Reading 18
• Uses and Limitations Weight differences may cause an understatement of prices in aWholesale Price Index. Laspeyres Index has an upward bias because of thesubstitution effect. The Private Consumption Expenditures Index (PCE) covers thecomplete range of goods and services purchased byconsumers. Price indices can also be used to deflate GDP.Study Session 5, Reading 18
• Factors That Affect Price LevelsCost Push Inflation Cost Push Inflation occurs when prices rises due to an increasein costs. Higher unemployment can decrease wages cost, and hencereduce cost push inflation pressures. Productivity per hour an important factor in limiting cost pushinflation. Unit Labour Costs can be calculated as:ULC = W/O where w is total labour compensation per hour and O isoutput.Study Session 5, Reading 18
• Factors That Affect Price LevelsDemand Pull Inflation Demand Pull Inflation refers to the increase in prices due to anincrease in demand. Higher rate of capacity utilization due to higher demand can bea driver of demand pull inflation. A surplus of money in an economy may inflate prices. Money supply indicators can be used to track the impact thatmonetary policy may have on demand pull inflation.Study Session 5, Reading 18
• Factors That Affect Price LevelsInflation Expectations Inflationary expectations can become self fulfilling. Therefore, it is important for central banks to gain creditabilityregarding their ability to manage inflation. Some surveys can be undertaken to measure inflationexpectations, however, typically it is not easy to measure. Past inflation trends tend to provide a gauge for expectations.Study Session 5, Reading 18
• Types of Economic IndicatorsThere are 3 broad classes of economic indicators: Leading economic indicators have turning points whichprecede changes in the overall economy. Coincident indicators change broadly simultaneously to theoverall economy. Lagging indicators highlight trends in economic activity laterthan the overall economy.Study Session 5, Reading 18
• Aggregate Indicators Economists often consider aggregate leading, lagging andcoincident indicators when getting a feel for underlyingeconomic conditions. The exact components of aggregate indicators vary fordifferent economies. One example if the Index of Leading Economic Indicators (LEI)in the US which has 10 components.Study Session 5, Reading 18
• Monetary Policy Monetary Policy is uses changes in the money supply andcredit in the economy to control economic growth. It is undertaken by the central bank and often the focus is tocontrol inflation. Interest rates in the economy are impacted by changes in themoney supply. Monetary Policy can be either expansionary (lower interestrates designed to increase economic activity) or contractionery(higher interest rates designed to decrease economic activity).Study Session 5, Reading 19
• Fiscal Policy Fiscal Policy involves government decisions about taxation andspending. It can be used to redistribute wealth and income, as well as tocontrol fluctuations in the business cycle. Aggregate demand and the level of economic activity can beimpacted by fiscal policy. Fiscal Policy can take neutral, expansionary and contractionerystances.Study Session 5, Reading 19
• Money Money is any object or record that is generally acceptedas payment for goods and services and repayment of debts. Money supply can be measured by either: M1 –Includes all physical denominations of coins andcurrency, demand deposits, and traveller’s checks M2 – This category adds M1 to all time-related deposits,savings deposits, and non-institutional money-market funds M3 – The broadest class of money, M3 combines all moneyincluded in the definition of M2 and adds to it all large timedeposits, institutional money-market fundsStudy Session 5, Reading 19
• Characteristics of Money Is easily divisible Is difficult to be counterfeit Has a known value Is readily acceptable Has a high value relative to its weightStudy Session 5, Reading 19
• Functions of Money Medium of exchange Store of value Unit of accountStudy Session 5, Reading 19
• Money Creation Money creation is the process by which the money supply ofan economy is increased. There are two principal stages of money creation: The central bank introduces new money into the economyby purchasing financial assets or lending money to financialinstitutions. The new money introduced by the central bank ismultiplied by commercial banks so that it is a multiple ofthe amount originally created by the central bank.Study Session 5, Reading 19
• Demand and Supply for Money The Quantity Theory of Money suggests that total spending isproportional to the money supply, as stated in the followingformula:In the case of Money Neutrality, an increase in the moneysupply will not affect real output. Demand for Money is the amount of wealth that citizens wantto hold. The amount of money that citizens was to hold can be drivenby transactions, a precautionary measure, or a speculativemeasure.Study Session 5, Reading 10
• Demand and Supply for MoneyStudy Session 5, Reading 10
• The Fisher Effect The Fisher Effect that the real rate of interest remains stable inan economy over time. Nominal rates comprise of three components: The required real return Expected inflation (inflation premium) Risk premium for uncertaintyStudy Session 5, Reading 10
• Roles of Central Banks Supplies currency in an economy. Banker to the government. Lender of last resort. Banker’s bank Provides regulation and supervision of the payments system. Conducts monetary policy. The gold standard was used in the past, whereby money wasexchanged for gold by the central bank.Study Session 5, Reading 19
• Objectives of Central Banks Regulate the financial system. Stimulate economic growth. Implement monetary policy. Manage a country’s foreign reserves. Supply money and control credit.Study Session 5, Reading 19
• Implementation of Monetary Policy Open Market Operations Policy Rate Reserves RequirementStudy Session 5, Reading 19
• Qualities of an Effective CentralBank Central banks are given degree of freedom from government. Credibility of the ability to influence inflation is a key quality,as is the transparency of its actions. Central banks should adopt and disclose a good decisionmaking framework comprising of a wide range of economicand financial market indicators. Central banks should have a clear forward looking inflationtarget.Study Session 5, Reading 19
• Relationships between MonetaryPolicy and EconomicGrowth, Inflation, InterestRates, and Exchange Rates Inflation - controlled by monetary policy. Economic Growth - impact interest rates in an economy Interest Rates - The money supply in an economy can bedecreased through open market operations, leading to anincrease in interest rates. Exchange Rates - Some central banks attempt to manipulateexchange rates as part of its monetary policy stance.Study Session 5, Reading 19
• Expansionary Monetary Policy An increase in the money supply will result in a decrease ininterest rates which encourages economic growth andinvestment. An increase in money supply is caused by the purchase ofsecurities in the open market. A central bank may lower the reserves requirement The lower interest rates make domestic bonds less attractive,hence demand for domestic bonds falls, and demand forforeign bonds rises.Study Session 5, Reading 19
• Contractionary Monetary Policy A central bank will control monetary policy by selling securitieson the open market. Additionally, a central bank may raise the reserve requirementwhich restricts the amount of capital that a bank can lend,therefore decreasing the money supply. Contractionary monetary policy lowers inflation. Contractionary monetary policy causes a decrease in bondprices and an increase in interest rates. Higher interest rates lead to lower levels of capital investment.Study Session 5, Reading 19
• Limitations of Monetary Policy Interest rate adjustments may not be seen by the market as acentral bank intends. Rate rises to control inflation may actually cause long termborrowing to be cheap. If the central bank is not credible enough, an increase in ratescan cause economic expansion. Money desposited by households and corporations in thebanks as deposits cannot be controlled Increasing the willingness of institutions to expand credit in anattempt to increase money supply is not easy.Study Session 5, Reading 19
• Roles and Objectives of FiscalPolicy Changing Fiscal Policy involves managing the economy throughchanges in aggregate demand. Changes in Fiscal Policy can be used to encourage investment,or increase savings. Fiscal Policy can also impact the distribution of wealth,through the methods of taxation determination.Study Session 5, Reading 19
• Tools of Fiscal Policy The level of transfer payments can be adjusted through thesocial security system. For example, the amount of transferpayments could be increased if the government wanted toadopt of a more expansionary fiscal policy. Tax policy should have four attributes: Simplicity Efficiency Fairness Revenue efficiencyStudy Session 5, Reading 19
• Fiscal Deficit A budget deficit is an indicator of the fiscal stance. It occurswhen government expenditure exceeds government receipts. A budget deficit differs from a balanced budget and budgetsurplus. Budget deficits occur when tax collection is lower, andgovernment spending is high. A fiscal deficit can be financed by borrowing by thegovernment.Study Session 5, Reading 19
• Should We Be Concerned With aBudget Deficit – Arguments For andAgainst The quality of growth in an economy is important. In the case of good growth, a fiscal deficit is not necessarilybad. However, large and consistent fiscal deficits may not be goodfor an economy in the long run as they may result in significantfiscal debt balances.Study Session 5, Reading 19
• Difficulties in Implementation Aggregate demand cannot be controlled completely by fiscalpolicy. The effectiveness of Fiscal Policy can also be impacted bypolicymaker’s lack of complete information about theeconomy. Additionally, lags implementation may be due to: Recognition Lag - lags in data may cause a delay in action Action Lag - delay in taking action Impact Lag - late actions cause a late impactStudy Session 5, Reading 19
• Expansionary Fiscal Policy Expansionary fiscal policy is used to stimulate economicgrowth. Results in aggregate expenditure and hence, increasedaggregate demand. Government spending increased (G). Decrease in taxes may also lead to higher C or I. Leads to larger budget deficit or smaller budget surplus.Study Session 5, Reading 19
• Contractionary Fiscal Policy Contractionary fiscal policy is used to restrain the economyduring or in anticipation of an inflation-inducing business-cycle. Results in a decrease in aggregate demand and aggregateexpenditure. Results in a decrease in government spending. Increase in taxes may reduce C and I spending.Study Session 5, Reading 19
• Interaction of Monetary and FiscalPolicy Both monetary and fiscal policies can be used to influence theeconomy. Easy monetary policy/tight fiscal policy Easy monetary policy/easy fiscal policy Tight monetary policy/tight fiscal policy Tight monetary policy/easy fiscal policyStudy Session 5, Reading 19