Harry Sedgwick 13/3/08 MODULE 2 – the national economy Indicators of national economic performance Creation of wealth is a key fact and

we must be able to measure this national income of wealth. Income is a flow, wealth is what you have, your stock… so therefore if you have wealth you can change it in to income by selling these stocks. Creation of wealth is a key factor and we must be able to measure the income and wealth. Income = flow Wealth = is a stock. Static. If you have wealth, you can use the wealth to create income. If you have a high income you can accumulate wealth. National income is usually measured on an annual basis. There are three ways of measuring a national income: - 1. The output measure – the value of goods and services produced in the UK E.g. Company A (seed merchant) supplies seeds to farmer £100 Company B (farmer) sells wheat to mill £300 Company C (mill) sells flour to a baker £600 Company D (baker) sells bread to customers £1000 We must calculate Outputs minus Inputs (i.e. value added) So A- £100 B- £200 C- £300 D- £400 NO PRICE GOODS – value at factor cost -2. Expenditure method - care must be taken not to double count – purchases included are for final consumption. Taxes deducted. Subsidies added. -3. Income measure – The value of all incomes are added together to include wages from employment, Profits and rents. Transfer payments not counted. Welfare benefits. EQAULISING the three methods – all three methods should give the same calculation. We assume for instance that all goods and services created will be sold. Every time a good is sold this will create income for all those involved in making the good. So NATIONAL OUTPUT = NATIONAL EXPENDITURE = NATIONAL INCOME GDP – Gross Domestic Product (what is produced in the UK, never mind who owns the businesses, and makes no allowance for replacement) GNP – Gross National Product (value of UK output factors owned in UK) NDP - Net domestic product (GDP – replacement goods) Money (nominal) and real national income It is only possible to measure national income in money terms. Index numbers – valuable at a glance e.g. price rises from £403.57 to £432.41 Index is 100% - 107.04%

National income (NY) and living standards – The income of India is greater than the national income of Norway. Physical living standards = national income per head And national income per head = national income / population. For many people it’s not just about material possessions. These are about living standards: The air we breathe, crime rate, landscape, cultural factors, life expectancy, leisure time. Comparing living standards between countries – The simple way of comparing living standards is to compared national income per head e.g. UK $30,000 per head, Zimbabwe $1,000 per head. So UK 30x better off. However there are problems 1. Distribution of income – e.g. income per head in France is very similar to income per head in Germany. However income in France is distributed more unevenly which means that most Germans are better off than the French. 2. Social and geographical patterns - e.g. warmth, self sufficiency and leisure etc 3. PPP purchasing power parity – it does not always give an accurate idea of living standards by simply comparing exchange rates. E.g. £1 = $2 but for 2 dollars in America one can buy more goods than Brittan. PPP makes adjustments to solve this problem. Balance of Payments Britain is a great trading nation. We import and export about a third of our GDP. In America it is only about 14% instead of 33%. ACCOUNTS – Money coming in - exports Money going out – imports and foreign investments. E.g. Tesco setting up supermarkets in Greece etc. Visible Trade Account – Money flows in as we export GOODS and money flows out as we pay for the GOODS we import. More money is flowing out of the country faster that it is flowing in because we tend to import more goods that we export, in money terms. Invisible Account – Out flow and inflow of trades and services. This includes Banking, insurance. The invisible account records the payment for imports and exports of countries services. If an American account employs a British firm for insurance we bring in money. If a British firm employs an American insurance company then the money flows out. Also recorded on this accounts are INTEREST, DIVIDENDS and PROFITS. On balance we are on surplus on this account. In other words we receive more money than we spend out.

Current Account (Balance of Payments on Current Account) - The Economics Glossary defines the Current Account as the difference between a country's savings and its investment. "If the current account balance is positive, it measures the portion of a country's saving invested abroad; if negative, the portion of domestic investment financed by foreigners' savings." Visible account + Invisible Account Capital Account - Inflows and outflows of money capital. E.g. if Ibought French government bonds in 2002 this is an OUTFLOW on the UK capital account. Every year from 2002 to 2008 when the French government pays interest this is an INFLOW of funds into the UK invisible account. On the 26th February 2008 I sell these bonds to a non-British citizen and the money will flow in on the capital account. The capital Account also records money transfers. E.g. if a British person of Jamaican origin sends money to relative in the West Indies this will be an outflow on the capital account. The balance of payments will always balance. This is because it is designed to do so. Remember our 20 million pound deficit. This means there must be a CORESSPONDING INFLOW of 20 million on the capital account. If this does not occur automatically then the money will be borrowed from the board. Balance of payments deficits DO NOT confuse balance of payments debts with the British government’s budget deficit. The government’s budget deficit is now called the Public Sector Net Cash Requirement (PSNCR). If the UK is importing more than it is exporting then in a sense British consumers and firms are leaving beyond they’re needs. Sometimes deficits seem huge amounts but they are often for a rich country only a very small percentage of GDP and quite manageable. Of course eventually like a person a country cannot live beyond its means forever deficits today must mean surpluses tomorrow. The Government Economic Objectives Summary 1. Low Inflation 2. Full Employment 3. Economic Growth 4. Satisfactory Balance of Payment Through demand these four can conflict. If there is a high level of demand economic growth will be high and there will be full employment. However inflation will rise and there will be too many imports which will upset the balance of payments. If there is low demand there will be good inflation and

there will be less need for imports but it will cut employment and slow down economic growth. SUSTANIED NON INFLATIONARY GROWTH That is steady growth without inflation. This is what we want. Stagflation is what we do not want. This is a stop in economic growth but a rise in inflation.

Employment and Unemployment – Measuring Unemployment It used to be done by the claimant count, i.e. the number drawing unemployment benefit now called job seekers allowance. However many people might have been looking for a job but were not included in the figures because they were not entitled to benefit. The favoured measure now is the Labour Force survey which is now better for international Types of Unemployment 1. Cyclical Unemployment – due to deficiency of demand, not buying or spending enough. We associate this with a recession. 2. Structural Unemployment – more likely due to change in demand. E.g. people that had jobs in summer activities, selling deck chairs or ice creams etc. 3. Technological – the miracle of the word processor, a person on a word processor is at least 3 times more productive than one amazing secretary on a type writer. With the introduction of word processors a lot of secretaries lost their jobs as there was no need for 3 secretaries when just one person could do the work. It is one of the major reasons for the distribution of wealth. 4. Regional – people are geographically immobile. 5. Casual and seasonal – Seasonal – depends on the season as whether you get a job, summer jobs. Casual – where you never know whether you have a job. You could have a job-for-a-day then not have a job for a month. 6. Frictional / Transitional = people between jobs. The well qualified might stay unemployed until a better job comes into the market. 7. Other types – a. Low incentives, disposable income out of work / disposable income in work. b. Hysteresis - Where capacity is permanently lost e.g. deindustrialisation. Workers who lost their jobs in such industries are likely to stay long-term unemployed. c. Insider/Outsider theory – force up wages for members (Insiders) d. Queuing – this is the theory that people will not take the low paid jobs and wait for a better job to come along. Employment UK rise in the number of jobs available over the last few years. There has been a bit of controversy over immigrants taking jobs. It is the quality of the jobs. Many of the jobs immigrants take are not requiring as much skill. Incapacity benefit.

Costs of Unemployment Economic Costs - Wastes of resources Social Costs - is the standard of living.

BBC Radio 4 Programme Examining the effects of the financial crisis on the economy as a whole – - Credit Crunch = lack of money - Turning point of the last 10 or 20 years in finance - Commercial banks won’t lend so private backs have to fork out - Bundles of American mortgages = CDO - CDO’s are rubbish presented in a fancy wrapping - London taking over as worlds financial capital from new York - Christmas finally over Deflation - Opposite to inflation – in general terms this means that prices of goods are falling. Firms don’t favour deflation because they don’t like selling goods for low prices BUT - Deflation is nearly always accompanied by a RECCESSION. Why? This is because High level of AMD you don’t have a high employment. - The real aim is sustained non-inflationary growth. General (ECONOMIC) Objectives of Government Policies Main 4 • Economic Growth, • Rising Employment, • Control Inflation, • Satisfactory Balance of Payments. Achieving these objectives can cause conflict. Fiscal Policy – Government revenue and expenditure. US tax cuts are temporary. George Bush has sent out cheques to try and combat there recession. Monetary Policy C (MPC) – decides the interest rates, which is run by the bank of England.

Monetary policy is used to slow down or re-inflate the economy. Nationallythere are 0.8 million people claiming job seekers allowance. 2.5 million are claiming incapacity benefit. • Environment • Redistribution Economic Growth Increase in productive capacity and rise in GDP. This means there is an increase in output therefore creating an increase of capital. PPC is moved to the right. The output gap – in the short term NY may increase without real economic growth simply byemploying idle resources thus closing this negative output gap. In a boom resources may be over employed (e.g. excessive over-time that cannot be sustained) meaning the economy is operating beyond is potential output (positive output gap). True economic growth requires an increase in productive capacity. Causes of Economic Growth – factors of production 1. LAND – North Sea oil, wind, tidal power, nuclear power. 2. LABOUR – changes in demography, a country with an older population, participation rate women coming into the workforce helped this growth of the British economy. Also the amount of old people staying in the workforce. Immigration, young migrants take the jobs that we do not want so much. Education and training productivity is output per head, the better trained your workforce the better productivity. If someone’s well educated it’s so much easier for them to adapt. Many people think this is the most important factor in economic growth. Flexibility of workforce, if you are a flexible workforce you have willingness to change. Your workforce is multi-skilled. 3. CAPITAL – To increase productive capacity, to create real growth, you will need more and better capital (tools of production). Infra structure and social capital. It’s not just the amount but the quality of investment.Investment in the new industries, in companies that people will want to buy. This increases output of existing goods, reducing costs, boosting products. New products Government action on unemployment 1 - Cyclical unemployment – stimulate demand by lowering interest rates 2 - Structural unemployment – education and training. If they are educated then they can quickly change what they do. Flexible workforce.

3 - Others – a. See supply side economics. b. Improved employment service. Job centres are much more efficient. c. Welfare reforms. N.E.E.T.S = Not in Employment, Education or Training. A lot of people drawing incapacity benefits. Money (nominal) And Real National Income It is only possible or realistic to measure national income in money terms Inflation – general rise in the price level. National Income DEFLATOR. Country X Date National Income Inflation Rise 2006 2000 billion 5% 2007 2200 billion 10% Questions 1. List the government’s targets in respect of reducing incapacity benefit and lone parent benefits. a. The government hopes to lure 1,000,000 of the 2.6 million claiming incapacity benefit and 300,000 of the 760,000 people claiming lone parent benefit back to work. 2. What actions is the government considering? a. They will impose skill checks, training and subsidised apprenticeships. 3. What is considered to be the main cause of so many on benefits? a. Poor skills, laziness, hopelessness, low expectations and benefit traps. 4. What actions might the opposition take if given the opportunity? a. They propose sanctions for claimants who refuse job opportunities, extra screening for people claiming incapacity benefits and compulsory community work for the long term unemployed. 5. How has the makeup of in capacity benefit claimants changed over recent years? a. ?? 6. How does America Works encourage rehabilitation? a. ?? 7. Why might British employers fail to respond to inflation? a. ??

The Trade Cycle The UK has experience over 15 years of continuous economic growth which is unprecedented since the Second World War. This does not mean however that future growth is guaranteed. Stop and Go Economy Three to five years of growth then a big slow down which leads into a recession. As our economy has had growth for 16 years then we can expect an enormous slow down.

Slump– Loss of confidence, falling prices (property crash), negative equity, firms are finding it difficult to sell their products, high and rising unemployment. Reducing stocks. Negative Equity can form into the upturn. Recovery – rising demand, rising employment. Boom – lots of demand and high employment The old stop go recoveries means that boom should only last 3 or 4 years but we have been in a record 16 year BOOM.

Wage Price Spiral Rising rate of inflation = LEAPFROG effect. - When the inflation rises, big wage demands flood in. - To some extent inflation is a self fulfilling prophecy. If enough people think inflation will go up then it will most certainly rise. - It is the rate of inflation that matters. There is a huge difference between 2% and 20%. - Expectations: 4% expected to rise is a completely different problem to a 4% expected to fall (In inflation) Comparisons Problems with Inflation Problems likely to be greater when the rate is higher – 1. Shoe leather costs – time wasted from shopping around (opportunity cost)looking for the lowest price. 2. Menu costs 3. Psychological and political – even though peoples wages are rising with inflation they still don’t like prices going up. They don’t think they are. They think that the prices are higher than their wage. 4. Redistributional costs – some members of the community are able to increase their incomes at a greater rate than inflation rate, whereas others find their incomes lag behind inflation. 5. Unemployment and growth – uncertainty when inflation is rising higher than competitors then you can use business. Also with slow growth in inflation can result in a loss of jobs. 6. Hyper inflation – DISASTER, this is when moderate inflation gets out of control which then leads to a wage price spiral. How can a modern business function if confidence is lost the money that they earn?

Aggregate (total spending) demand and supply – - Real output = real income = real expenditure. - Real output is on the horizontal axis. Price level is on the vertical axis, It is the average levels of prices (e.g. RPI (retail price index) and CPI (consumer price index)). At price level P1. National income (NY) is at Y1 and at price level P2, National income is at Y2. -Total demand within the economy at any given price levels: 1. Consumption(c) 2.Investment (I) 3.Government spending (G) 4.exportsimports (x-m) equation = C + I + G + (X - M) The shape of the Ag Demand slope – The reason the curve slope downwards is because we expect National income to rise as the price level falls and vice versa. For example – if a household is on a reasonably fixed income (most are), then a rise in prices means that fewer goods and services can be brought than before. The higher the price level the less can be afforded.

All the individual expenditure is equal to the national expenditure therefore if everyone spends less the national income is reduced. Perhaps a more sophisticated explanation could be – a) Consumption – this is influenced by the rate of interest. When prices increase more money is required by consumers (and firms) to buy goods. Most money however is borrowed money (credit) and if borrowing increase the rate of interest rises. This rise in the rate of interest leads subsequently to a fall in consumption particularly for durable goods that are so often bought on credit

b) Investment – a rise in price leads to a rise in interest rates. (See a.) This

leads to a fall in demand on investment spending (marginal efficiency of capital). As rates of interest increase the fewer firms will invest and vice versa. c) Government spending – it is presumed that government spending is exogenous, i.e. determined by other variables outside the model, e.g. political decisions. d) Exports and Imports – if the price level rises in the UK, exports will become less price competitive and a fall in earning (NY) will ensure.

Keynesian economists argue for a steep curve, i.e. changes in the price level have only a slight effect on National Income. Classical economists argue the opposite. Another argument is the way in which a rise in the price level affects the consumption through the wealth effect e.g. people have savings. If the price rises you won’t get as much for your money. To restore the value of your money you have to save more and spend less. If you now save 20% of your income instead of 10% you will have 10% less to spend – CONSUMPTION FALLS. Shifts in the AD – Shifts in the AD curve will occur if there is a change in any relevant variables other than the price level. There are a number of such variables for example any of the following might shift the curve to the right – from AD to AD1

1. Consumption a) A fall in unemployment. b) MPC – monetary policies committee reduces interest rates- note this is a fall in interest rates NOT as a result of lower prices which concerns movement along the curve. c) A rise in the value of the stock market increasing consumer wealth. d) A change in the age distribution. e) New technology with wonderful must buy products.

f) A fall in income tax increasing disposable income. Of course the above in reverse would shift the AD curve to the left. Making AD2. 2. Investment – a) Lower interest rates b) Increase in business confidence c) Cut in consumption tax 3. Government spending – a) E.g. taking children out of poverty 4. Exports – a) An increase in revenue b) Fall in the £ The Multiplier – the idea of the multiplier is that any injection in to the economy will lead to a greater increase in national income/national output. e.g. firms make an investment if £10M for making a new road. Then from the £10M, £2M will be saved and £8M will be spent by builders etc. This process continues to happen as around 1/5 is saved and 4/5 is spent on other firms e.g. Cadburys. Aggregate supply – The aggregate supply curve shows the level of output in the whole economy at any given level of average prices. We will consider both the shirt run and the long run aggregate supply curves. Short run aggregate supply curve – (SRAS) – The short run is defined as the period when money wage rates and other factor inputs in are fixed in the economy. Thus if we assume that if firms wish to increase output they are unlikely to take in extra workers because of all the admin costs (e.g. regulations) But will respond to the extra orders in the short run by giving their workers overtime and working their resources harder. e.g. 100 blodgets a week 110 blodgets a week This may however add to costs since overtime rate have to be payed and tired workers may be less productive. To meet these higher costs firms will raise prices. Such price rises are likely to be modest so the SRAS curve tends to be

relatively price elastic. On the other side of the coin if demand falls in the short run firms fall react by cutting prices but the opportunities to cut prices are limited. Overtime

payments may disappear but firms will be reluctant to cut costs by sacking workers, price cuts therefore are likely to be modest. Shifts in the SRAS - a reminder that the SRAS curve shows the relationship between aggregate output and the average price level assuming that money wages and other factor inputs remain constant. If however wage rates do change then the aggregate supply curve will shift.

Factors causing shifts in SRAS – a) Wage rates – if there is a rise in wage rates(supply side shocks) the SRAS curve will shift from SRAS1 to SRAS2 and lead to a rise in the average price level from P1 to P2. This is the same the other way round P1 to P3. b) Raw material costs – A fall in such prices will lead to a reduction in costs and such firms to reduce the price of their products. In such cases the SRAS curve will shift from SRAS1 to SRAS3 with a fall in the average price level from P1 to P3. c) Taxation – If for example the tax burden or regulation on industry increased costs would increase and the SRAS curve would shift from SRAS1 to SRAS2 with a corresponding increase in the price level from 0P1 to 0P2. Long run aggregate supply curve – (LRAS) – For AS, we assume the theory’s of the classical economist namely that the LRAS is vertical:

The LRAS curve shows what the economy can produce with all factors fully employed. The LRAS curve may shift to the right under the following circumstances – 1) More and better capital equipment – infrastructure, technology. 2) Better education and training this raises productivity. 3) Incentives to work harder (financial awards), to investments, to be mobile etc. Most governments try to encourage increase productivity, which will enable an increase in output and therefore living:

Equilibrium output – The economy is in equilibrium when aggregate demand equals aggregate supply:

1. The level of natural income we predict will settle at Y1 at price level 0P given the situation above (SRAS and SRAD cross at same point). However this may be a level of national income with unemployment and other resources idle.

2. If in the short run there are idle resources real national output might be increased with an increase with a level of aggregate demand. (see later notes on fiscal and monetary policy). This may lead to some increase in the price level.

3. If all resources are fully employed (full employment level of national income illustrated by vertical LRAS curve) then any increases in aggregate demand will only lead to an increase of price level.

4. National income can be increased in real terms if the productive capacity of the economy can be increased, i.e. if the LRAS curve can be shifted to the right. What I need to knowAD and AS – - What determines the slope of AD curve. - What causes a shift of AD curve - what determines slope of SRAS curve - What causes a shift in SRAS curve Equilibrium output – - acceptable that when all resources are fully employed - Factors that cause a shift in the LRAS - Equilibrium real output will be where the AD cuts the AS curve. Main instruments of government macroeconomic policy – Fiscal policy – is about the government’s own revenue AND expenditure. e.g. the government are spending £618billion – governments spend more than they save negative PSNCR (budget defecate). This is balanced over the trade cycle. Regulating the economy AD – An increase in government expenditure halts the falling unemployment numbers but makes inflation rise. Governments need to spend less and tax more to reduce the number of imports. A) Lowertaxes on incomes (more disposable). B) Lower taxes on goods. C) Lower business taxes (disinflationary/Contractionary)

Relationary expansion – increase in public expenditure, subsidies. Recap multiplier – the multiplier suggests that any increase in national income will have a multiplying effect e.g. government spending £10M on a new hospital may lead to the creation of £20M addition income. To get the economy moving: Reflationary/Expansionary – Lower taxes on incomes – more disposable Lower taxes on goods – makes the good cheaper Lowering taxes on businesses – lower profit tax will give the firm more of their profits to put back into the business or to the shareholders Increase public expenditure – build more roads, give more subsidies. Disinflationary/Contractionary – is the opposite of the above. And is done if there is too much demand. Monetary Policy This is concerned with controlling the supply of money in an economy with particular concern about its effect on AD and AS. It is the Monetary Policy Committee (Bank of England) that operates and controls the supply of the UK’s money. A rise in interest rates for example increases the price of money and thus reduces demand for borrowing by households, and businesses. At the same time of course and increase in interest rates encourages saving (bigger rewards). Thus a rise in interest rates will be disinflationary and will cut the level of imports, helping the balance of payments deficit. UK has high MPM (Marginal Propensity to Import). If the problem appears to be rising unemployment, a slowdown in growth, then providing inflation is under control, one would expect the MPC to cut interest rates. Note of course the economy can only grow in real terms if there are idle resources. The weapons of Monetary Policy Over recent times and up until very recently interest rate in the UK has been the only weapon of monetary policy (HP and other credit controls disappeared years ago). All borrowing rates seemed to follow the bank rate. But now the link is not quite so clear, despite two ¼% cuts i the bank rates since last November. Borrowing costs seem to be rising because of the fear triggered by the credit crunch. Interesting times, the story continues to as witnessed by our superb diary contributions. To control inflation (excessive imports) – RAISE interest rates To stimulate growth and jobs – LOWER interest rates.

Supply Side Economics Increasing the productive capacity of the economy.

Clearly if the above can be achieved, the UK economy will produce more goods and services (economic growth), become more competitive (reduce B of P deficit), create more jobs (lower unemployment) and allow AD to expand without inflation. In other words achieve that supreme goal of sustained noninflationary growth.

Supply Side Measures 1. LABOUR SUPPLY – reduce power of TRADE UNIONS as they interfered with productivity by making excessive wage demands, demarcation, picketing, secret ballots, notice of strikes. 2. ENCOURAGE ENTERPRISE – trickle down 3. MAKE BUSINESSES MORE EFFICIENT – a. Privatisation – Gas companies, railway, buses, water, electricity, iron and steel, coal, shipbuilding, car firms, airlines, communications – most of these were monopolies. b. De regulation – Financial sefvices act. c. Less stringent planning - enterprise zones, don’t need to wait months for permission. 4. TAX CHANGES – Hard work and enterprise,

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