Gross Domestic Product (GDP)Using the Expenditure Approach The Expenditures Approach measures the market value of allthe ...
Gross Domestic Product (GDP)Using the Income Approach The Income Approach measures the aggregate income earnedby all hous...
Methods of Calculating GDP: Value-of-Final-Output Under the Value of Final Output, only the value of the lastproduct is c...
Methods of Calculating GDP: Sum-of-Value-Output The Sum of Value Added approach finds the sum of valueaddition during the...
Nominal GDP Nominal GDP measures the value of goods and services atcurrent price levels. It is calculated as:GDPt = Pt *...
Real GDP Real GDP is adjusted for inflation/deflation. Real GDP can be calculated as:GDPt = Pb * Qt where Pb is price i...
GDP Deflator The GDP Deflator is used to calculate Real GDP, given NominalGDP. GDP Deflator = (value of current year out...
National Income National Income is the compensation paid to all factors ofproduction. National Income comprises of: Emp...
Personal Income Personal Income is a broad measure of household income. It is a gauge for changes in the ability of cons...
Personal Disposable Income Disposable Income is calculated as personal income lesspersonal taxes. Disposable Income meas...
Saving and Investment There is a positive relationship between saving andinvestment. The higher the savings rate, the mo...
Fiscal Balance Fiscal Balance is a measure of Fiscal Policy. It measuresGovernment outflows and inflows. It measures the...
Trade Balance Trade Balance is a measure of an economy’s transactions withother economies. The Trade Balance measures th...
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 d...
Aggregate Demand Curve The aggregate demand curve represents the total quantity ofall goods and services demanded by the ...
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 t...
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,...
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 wi...
Shifts in the Aggregate SupplyCurveStudy Session 5, Reading 17
Economic Growth Sources Labour supply Human capital Physical capital Technology Natural resources (renewable and non...
Economic Growth Measures The Growth Accounting Equation measures the growth inpotential GDP. It is calculated as:Growth ...
Production Functions The Production Function specifies the output of an economyfor all combinations of inputs. A product...
Input Growth and Total FactorProductivity Increases in the quantity of inputs lead to increases ineconomic activity. In ...
The Business Cycle and Its Phases The Business Cycle is a series of fluctuations in the level ofgrowth in economic activi...
The Business Cycle and Its PhasesStudy Session 5, Reading 18
Business Cycle: Impact onInventories As the Business Cycle enters the contraction stage, AggregateDemand shifts to left r...
Business Cycle: Impact on Labour The Business Cycle has a significant impact on employmentmarkets. As economic condition...
Business Cycle: Impact on LabourStudy Session 5, Reading 18
Impact on Physical CapitalUtilization Capacity utilisation fluctuates with different stages of thebusiness cycle. As eco...
Impact on Physical CapitalUtilizationStudy Session 5, Reading 18
Theories of the Business CycleNeoclassical and Austrian Schools Markets will reach equilibrium because of the invisible h...
Theories of the Business CycleNeoclassical and Austrian Schools Markets will reach equilibrium because of the invisible h...
Theories of the Business CycleKeynesian and Monetarist Schools Generalized price and wage reduction is hard to attain. T...
Theories of the Business CycleNew Classical Schools The New Classic School suggests that actions of economicagents should...
Theories of the Business CycleModels without Money - RealBusiness Cycle Theory Cycles have real causes. Monetary variabl...
Theories of the Business CycleModels with Money Inflation often a cause of business cycle. Central bank intervention to ...
Types of Unemployment Structural unemployment arises due to an absence ofdemand for the workers that are available. Fric...
Measures of Unemployment The Unemployment Rate is the most commonly used measureof labour market conditions. The Partici...
Inflation Inflation is a sustained rise in price levels. It causes a fall in purchasing power, because one unit ofcurren...
Disinflation Disinflation is a decline in the inflation rate. Disinflation is different from deflation. After the perio...
Deflation Deflation is a sustained decline in price levels. Deflation is often caused by a decrease in money supply orcr...
Construction of Indices to MeasureInflationLaspeyres Index Under a Paspeyres Index, the composition of the consumptionbas...
Construction of Indices to MeasureInflationPaasche’s Index Paasche’s Index is a ratio of the total purchase cost of aspec...
Construction of Indices to MeasureInflationFisher’s Index Fisher’s Index is the geometric mean of a Laspeyre’s andPaasche...
Comparison of Inflation Measures The Consumer Price Index (CPI) is a commonly used measureof inflation. However, when co...
Uses and Limitations Weight differences may cause an understatement of prices in aWholesale Price Index. Laspeyres Index...
Factors That Affect Price LevelsCost Push Inflation Cost Push Inflation occurs when prices rises due to an increasein cos...
Factors That Affect Price LevelsDemand Pull Inflation Demand Pull Inflation refers to the increase in prices due to aninc...
Factors That Affect Price LevelsInflation Expectations Inflationary expectations can become self fulfilling. Therefore, ...
Types of Economic IndicatorsThere are 3 broad classes of economic indicators: Leading economic indicators have turning po...
Aggregate Indicators Economists often consider aggregate leading, lagging andcoincident indicators when getting a feel fo...
Monetary Policy Monetary Policy is uses changes in the money supply andcredit in the economy to control economic growth....
Fiscal Policy Fiscal Policy involves government decisions about taxation andspending. It can be used to redistribute wea...
Money Money is any object or record that is generally acceptedas payment for goods and services and repayment of debts. ...
Characteristics of Money Is easily divisible Is difficult to be counterfeit Has a known value Is readily acceptable H...
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 principa...
Demand and Supply for Money The Quantity Theory of Money suggests that total spending isproportional to the money supply,...
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 ...
Roles of Central Banks Supplies currency in an economy. Banker to the government. Lender of last resort. Banker’s bank...
Objectives of Central Banks Regulate the financial system. Stimulate economic growth. Implement monetary policy. Manag...
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 abil...
Relationships between MonetaryPolicy and EconomicGrowth, Inflation, InterestRates, and Exchange Rates Inflation - control...
Expansionary Monetary Policy An increase in the money supply will result in a decrease ininterest rates which encourages ...
Contractionary Monetary Policy A central bank will control monetary policy by selling securitieson the open market. Addi...
Limitations of Monetary Policy Interest rate adjustments may not be seen by the market as acentral bank intends. Rate ri...
Roles and Objectives of FiscalPolicy Changing Fiscal Policy involves managing the economy throughchanges in aggregate dem...
Tools of Fiscal Policy The level of transfer payments can be adjusted through thesocial security system. For example, the...
Fiscal Deficit A budget deficit is an indicator of the fiscal stance. It occurswhen government expenditure exceeds govern...
Should We Be Concerned With aBudget Deficit – Arguments For andAgainst The quality of growth in an economy is important....
Difficulties in Implementation Aggregate demand cannot be controlled completely by fiscalpolicy. The effectiveness of Fi...
Expansionary Fiscal Policy Expansionary fiscal policy is used to stimulate economicgrowth. Results in aggregate expendit...
Contractionary Fiscal Policy Contractionary fiscal policy is used to restrain the economyduring or in anticipation of an ...
Interaction of Monetary and FiscalPolicy Both monetary and fiscal policies can be used to influence theeconomy. Easy mon...
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L1 flash cards economics (ss5)

  1. 1. 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
  2. 2. 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
  3. 3. 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
  4. 4. 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
  5. 5. 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
  6. 6. 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
  7. 7. 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
  8. 8. 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
  9. 9. 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
  10. 10. 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
  11. 11. 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
  12. 12. 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
  13. 13. 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
  14. 14. Aggregate Demand Four Sources Consumption Investment Government spending Net exportsStudy Session 5, Reading 17
  15. 15. 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
  16. 16. 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
  17. 17. Aggregate Demand CurveStudy Session 5, Reading 17
  18. 18. 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
  19. 19. Aggregate Supply Curve in theShort and Long RunStudy Session 5, Reading 17
  20. 20. Shifts in the Aggregate DemandCurveStudy Session 5, Reading 17
  21. 21. 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.
  22. 22. Shifts in the Aggregate SupplyCurveStudy Session 5, Reading 17
  23. 23. 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.
  24. 24. Shifts in the Aggregate SupplyCurveStudy Session 5, Reading 17
  25. 25. Economic Growth Sources Labour supply Human capital Physical capital Technology Natural resources (renewable and non-renewable)Study Session 5, Reading 17
  26. 26. 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
  27. 27. 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
  28. 28. 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
  29. 29. 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
  30. 30. The Business Cycle and Its PhasesStudy Session 5, Reading 18
  31. 31. 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
  32. 32. 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
  33. 33. Business Cycle: Impact on LabourStudy Session 5, Reading 18
  34. 34. 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
  35. 35. Impact on Physical CapitalUtilizationStudy Session 5, Reading 18
  36. 36. 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
  37. 37. 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
  38. 38. 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
  39. 39. 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
  40. 40. 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
  41. 41. 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
  42. 42. 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
  43. 43. 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
  44. 44. 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
  45. 45. 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
  46. 46. 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
  47. 47. 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
  48. 48. 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
  49. 49. 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
  50. 50. 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
  51. 51. 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
  52. 52. 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
  53. 53. 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
  54. 54. 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
  55. 55. 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
  56. 56. 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
  57. 57. 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
  58. 58. 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
  59. 59. 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
  60. 60. 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
  61. 61. Functions of Money Medium of exchange Store of value Unit of accountStudy Session 5, Reading 19
  62. 62. 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
  63. 63. 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
  64. 64. Demand and Supply for MoneyStudy Session 5, Reading 10
  65. 65. 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
  66. 66. 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
  67. 67. 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
  68. 68. Implementation of Monetary Policy Open Market Operations Policy Rate Reserves RequirementStudy Session 5, Reading 19
  69. 69. 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
  70. 70. 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
  71. 71. 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
  72. 72. 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
  73. 73. 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
  74. 74. 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
  75. 75. 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
  76. 76. 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
  77. 77. 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
  78. 78. 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
  79. 79. 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
  80. 80. 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
  81. 81. 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

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