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    Oxford Economics - Study Guide

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    emaadyesyes

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    IB STUDY GUIDES Aad area att te Pe adh Pls PCr Economics — FOR THE IB DIPLOMA 2nd edition 1 Microeconomics ‘Atypical demand cure can bo darn as astra ine using mr ar cam sightly cured andi aye ay at ‘ouch the ames, What matters When drawing a tical demo curve is that is negstely sloped, Other factors affecting demand ('shift’ factors) f= Changes in consuaners' income may affect demand, Far example, if income increases then demand For most goods is expected to inciease, so the demand curve is ‘expected to shift to the right. This isthe case of "normal goods Fos some gacds typically lawerqulity goods, an increase in income will lead ta a decrease in demand and a shift of the and eurveto the left This i the ease ef inferior’ gods, The same good may behave 25 a normal good in one society or ‘market and as an inferior good in ancthée For example in courtry-with a generally loxsncome poplacion, an increase in Income may lead to an increase in dhe demand for used ca, whereas in anode country where people have higher incomes, further incase im incon levels may lead to a decrease in the demand for used cars ‘an increase income Feast an increase in fedemand or more emraty, ifinaome and demane: change in tho same dean an increasein come eads wan decrease in is demand av, more generat ifincorse and demand change imopposie directions ‘= Changes in the price of ather related goods will have an Impact on demand. Fist lets consider a change bn tye pice cf complements. Twa gouds are considered complements if they ave alter consumed together For example, For many people coffee and sugar ave camplaments because they e+ i Nod gd i ieecleets : ‘Stincere eran thio ese font l wot \ ° (quantity domandes pee pend (GH ‘agure 1.12 The fect ofan incease in insame on a seal goad and on an info god drink their coffe with sugar We expect that if the price aF coffee increases thon the demand for sugar may Gocrease, Mote genevally, if gaodsX and Yare considered as strong, camplements then an increase in the price of good ¥ will lead ta a decrease in the demand for good X. Demand fat X. wil shift to the Ft et 2) be he ina dara fr spur Asume a th pice ct aff, a zamelaren, inten: Prise peru (F) fbesand for sugar is exacted lel sie the a foes prespz ‘Quantity demanded per pevod (4) ‘iguee 1a Thostfict oF ae incease inthe plat aca “Thete may aio be changes in the price of substitutes. Two ‘goods are considered subsituies Hey are in competitive ‘consumption and consumers typically buy aewe ar the other as ‘the goods satisy the same need or want. Examples are coffeo and tea ws Pepsi Cala and Coca Cola, Ifa supermarket inconases ‘the price of Pepsi Cola then itis expected that the damand far ‘Coca Cola will increase, Mote generally, if good x snd good ¥ af considered lose substitutes then an intreaze in the price of ‘good Y wil ead to an ineeate in the demand for X. Demand or K will shift ta te ght fence good (An incre ince wi decrave cement sent to hele fam 01 D2 rice peru dP s (Quantity demanded pe pried (Qt) 2 Macroeconomics. i ovialinczme (cumulative) WO To Population (cumulatively ranked) poe » rikest Figure 23.15 Te Loren crv sea the Gini content The Gini coeficent messures the degree of income inequalty in ‘3 population, tcis the vari ofthe araa botwean the Lorena curve ang thediagonal over the atea ofthe half square on whith the cure les. The Gini coefcient the ratio af the area between the Loren: carve and the diagonal aver the aes af the hallsquare o, facusing on Figura 2.3.15, area (A) divided by area (f+ 8 area (8) ini coofcient = Ses Gc Bp The Gini coefficient can-vary from 0 denoting perfect equality: ach person gets the same incorne) to ¥ (denoting perfect inequality all income gaes to the share of the population with the highest income) Range of values of Ci a) Tpically, highly unequal income dstbutions are distrbutinns With a Gini coefficient between 0 50 and 0.70. Some repeesentathe values ofthis coetfisent ere: Bri 0.57; Zimbabwe 0.50, Auentina 0.69, Uganda 0.48, the USA 0.48, the UK 0.34, ‘Australia 0.30, Austia 0.27, and Dermatk and Sweden at 0.23. The Organisation for Economic Cooperation and Development (OECD) average in-the mid: 2600s was around 0.31 Keep i mind that often what mattrs most isnot the leva of Income distribution but the direction of change (hat i, Whether income distinution # becoming more er less unequal). Poverty Absolute poverty is defined by the minimum income necessary to Salsy Basic pyc neds, the 2008 Weld Bank international poverty line is set $1.25 (purchasing power parity - PP) per day. Relative poverty measumes the extent to wisich @ heusehold's income falls below the national average, Causes and consaauences of poverty Poverty locks individuals inta a viclous perenty eye er trop Low income is bath a cause and a consequence of poveny. As a result of thet lew incame, these individuals human capital very low. They cannot afford the opsorunity cost af schealing, Theie savings are nanceistent, 0 they are notin a position te invest in physical capital and fin developing countries) they are farced in their effort te survere te deplete or destroy any natuts capital they may have access to, Low human, ply sical and rratural capital implies low pracuctivty, which in tur leads to Jom income, clasing the eycle Possible benefits and costs of a mare equitable income distribution ‘A more equitable distrebution may help accelerate growth and promote human and economic development in many ways. ‘= Tho vary poor wll be able to afosd access tn enucial rescurees, such as education and medical cate, so the amount and quality of productive resources availabe to 4 country increases Better education and health improves labour as productorty wil be highes (= The propensity ofthe poot to consume is higher than that Af the sich so redistribution will increase AD, especi basic goods and services, = Social tensions wil be lower, sa governments ear! more easily unger important economic vefarms requiring @ high degree of consensus within the population. If poeple feel that they enjay the flulsf econantic growth then they wl be willing to wor harder and sacriice move nw in onder For theen ot thei childrento enjoy mare ata later date, They will tewiling and able to save more, allowing higher rates oF investment and so growth. Fewer social tensions decrease uncerainey and sks for comesti and foreign investors ‘= Trust increases amang the population so the cost of seamomic transactions desreases. Mee eeamemie activity ‘wil take place sa growth wil accaterate (On tie ather hand, consider the following. = An exossively oqual incame distribution could lewer ecanomic efficiency. Itould lewer the incentives for people to work hard and for risk taking, In this way, grawch may be under ined The role of taxation in promoting equity Direct and indirect taxes Ditec tana: are taxes on income, on profits andl on wealth, “The charactwisti aa direct tax istat its burden cant be shifted onto another entity Indiec taxes incude taxes on goods and on expenditures and they have heen discussed ‘een The butden of an inde tay can be sifted ence 2 siforent ent Progressive, propottianal and regressive taxation ‘Teexplain the difference between these types of taxes itis important ta define the marginal tox tate (RATA ad the average tax rate (ATR) “The RATA i the percentage taken by the government on the last ‘dollar eamed, or te extra tax paid as a result of petra income -eamed “The ATW i the rate ofthe tax ealerted aver income eamed on, more generally the ratio ofthe taxcollected over the tax base. “The tnx base refers to whatever i taxed, for example income, spending, plomts and wealth. ‘A progressive f2x system is one in which individuals with higher incomes pay prapertionately mote $0 the ATR rises at 2 Macroeconomics income sses. ina progressive income tax system the MTR is sreater than the ATA. (Resmem ter that ifthe average increases it fellows that the marginal is greater than the average} [A proportional tax systern is one in which all individuals pay the same proponion af ther income independently af the Invl af ‘hes income. In proportional tax system the ATR remains constant as incame rises so the MIR is equal te the ATR, A Rat tate (propostional income tax exsts in several caunbies, suchas Latvia, Russia, and Estonia, and ic being considered by mary thers. It presents many advantages tx the progressive income tan systems that most countries have. Bsincentives are lower, administrative costs ae lowar, the systems simple and more transparent and its potentially von far, as loepholes do not exist which usually higherincome households take advantage a ‘A repressive tax system is one in which poorer individuals pay 4 greater proportion of thei income, ln.a regressive tax system the ATR decreases as income rises s0 the MTR is [ess than the ATR, Indect taxes ate propartienal with respect to expenditure but regressive with respect te income, This is wy indirect taxation on foed and basic gaods is lower than in other systems, or sot at rem, ln Figure 2.16 tho horizontal avis measutes the tax base (<3 income} and the verical tre amaunt cf tax paid, A proportional tax system illustrated by any straight Bae through the rig, kn a progiessive tax spite the slope of the line is increasing while ina vagiessive tax cystam the dopa ofthe line is dereasng, i Tax have fncome Figare 2.3.16 sree, proportional and regress tation Measures to promote equity Shortrun solutions Usually goveraments resort toa mixture of progeessve income aves coupled witha system of transfer payments, Tansier Dajeents include pensions, unemployment benefits, disability benefits, child allowances and scbsiiex By taxing households ‘wit higher incomes moze heauily than those with lower micemes and spending more on trensfer payments, rational come nay be redisbibuted in an ateinpt to satty the equity goal, Social health insurance anda system of sublic education susualy par ofa package thet aims at effectively increasing the income of the lowerincame strata Long-un solutions in the long mun, the most effertve route t= a more equitable inceme éisriewtion is by improsing the quality and axcess to education and healthcare services for the most deprived income groups. Schools, healthcare centres, im praved infrastructure that incledes attr roads, as wall 3s sanitation ad clean water supties wil all contnbute to an incebase in human capital. heather population with etter education, training snd skills will nctease labour praductivty ad lead to Fighor incomes. The importance of fair judicial system, better natitutions ia general and lower corruption should nat be underestimated. Atarispmgessive: | Ala spoporiank | A tins raessive iteamt | WibexTRcorsiont | ¥ tno aTR + ati MIR> AIR | thats, MIR-= ATR | thats MIR = aT which means | wich msancthat | which means that hat higherineame | —higherincome | higher income indhidvals pay | individuals pay | individuals pay proportionately | pmportonately | proportionately loss, mor, the same, mare genera, | or rure generaliy | amore genera thactax paid ies | thattaxpald rises | atta pale toes fastortman ine | asfastastve | slowerthan the tee basa, tan base. taxbase, Fiscal policy Fiscal policy fs # demand-side policy Demandside polices aternpt ta increase or decrease |AD (ot, mote precisely to slow dey the increase of AD) in over to affect real eutput {otowth), employment ahd the inflation, Later we will Se thal these same paliies are also used to correct a trade imbalance and are refered to as expenditure ing policies Fiscal policy refers to the manipulation of the level of goverment expenditures (C) and/or gawernment rwrerues (T} in arder to influwnce AD and, through this, econamic variables such as weal output ang growth, employment and inflation. The government budget Sources of revenue and types of expenditures Governments typically earn most resenues from direct and taxation. They may era also revenues from the cale of (goods and services (for example, revenues from the sale and export of oil ate a major source of government revenues for countries predusing and exporting oi), The proceeds fram the sale of govemmentowned assets, sich as state owned jonterprises that aro then privatized or goverment lane, ane alo one-off revenues, Spending is cased into-carent spending, capital enpendituces and capsfer payments. Curant expenditure include wages and salaries of publi sertor employees as well as spending en consumables {day today items} such as stationery. Capital cexpendiaues refer ta publi investment spending, These expenditures include all spending on iniastructare, for example sparing on the construeton of roads, harbours hospitals ana schools, ensfer payments repmesent transfers of maney From ‘one group to anather and 1s sch are not included in the calculation of GDP ut are part of income redismibutin policies. Transler payments ineude sacial seeunty welfaro) expences, for example pensions, unemployment benefits, disability payments and schalarshia grants The budget outcome The sitions lesen the sie af government expenitures and govemmert ince (eax rerenuos) desenrines whether there 3 bucget dofet, a bucget saps ora balances budget. Het ae specie defitions ss Abudget deficit exists ifgoverament expenditures (6) acead goverment revenues oF income (Th. Te ‘a budget defies record 1 bode cups le wont the budget ia blancs = A budget surplus exists if government avenues ex income (M) exceed government expenditures (G} = Abalanced budget exists ff gavernet expenditures (6) are equal to gavernment ceverutes or income (7. “The public faationsl or government) debt Assume the Formation of a new country in, say, 2008, Assume thatits government in 2005 had spent 150 rife of its own dolla curency and Mad collected 120 millon dollars. It ineured a budget deficit equal t0 30 milan dollars Assume rrowethat in 2007 it had spent 180 millon dollars and had collected in tzx and other revenues 170 milioa dollars. 1a 2007 it recorded a budget defieit equal to 10 million goliars. ts fublicdbt is at 40 milion dollars. IF en 2008 itspest 110 millon dollars ane caliected in tax and other revenues 215 millan Golaes, ec nsconded in 2008 a budger surplus 95 milion dallas. ts public debt will now stand at 35 million dallets. The public debt is defined a5 the the cumulative tata ofall gowemment borrowings lest repayments’ or the suru ofall money owed by-a government ata point in time. Budget defets orsumpluses and the pubite debt are therefore not the sasne but they ate linked, 35 the aublic debt grows when the government runs a buelget deficit ad shrinks wher budget surplus. “The publi nallonal or goveraent ded should nat be confused with 3 county extema| cet. The external deot eters ta what a eounoy (pubic wn private sector) owes a foreigners ad is denormatnd in frien eachango. the nallonal debt, ows. ‘he rational debt shine ‘he nator dab unenangeat 2 Macroeconomics Expansionary and contractionary fiscal policy Expansionary (or reflationary) fiscal policy Keynes introduced the idea thatthe (equilibrtm level of jutgut was demand-iriven, The level of AD (effective demand) determines the love! of overall economic act There was no guarantee, according to this schoo! of thought, that equilibrium output and full employment outpat will ‘oineide, There could very well be a deflationary (oF recessionary] gap. AO saukd be insufficient it For whatever reason, the private secto: (households and fms} decided to hold back on their spending. A recession could resalt $2, though this, Keynes intraduced the idea of exeansionary fiscal policy, Expansionary (ox, reflationany fiscal policy aims at increasing [AD in onder to increase national iene (eal output) and ‘employment and so close a deflationary dap. Wt requires am increase in government spending {G) and/or 3 decrease in taxation {f}.Since government spending is-2 component of AD, a ise in G mill directly increase AD, it tothe right. im other words, if private spending (C+ i}is nat sufhcient te generate full employment, then the government shauld increase its spending (61 by bosrewing from the private sector (deficit spending: G >T) A decrease in taxation (7) wil indirectly also inetease AO as ct wil increase disposable income that people have (defined as inzame minus direct taxes} and wil induce more spending. IF thraugh an increase in government expenditures and/or a decrease in taxes, AD increases (that fs, shifts tothe ight) then @ deflationary (or secesvonatyl dap can be died, a Figure 2.4.1 illustrates Avrage pe loa (F) ww W eal tceme/iacome tH) Figure 2.8.1 tspursionay cal pliey ‘Assume an economy in equilibrium at teal output level ¥. Given that the full employment (or potential} level ef output is at YE. there is a deflationary (or recessiona‘y} gap equal ta distance YIVE Let's say the government decides to employ expansionary fiscal policy in an attempt to clase this gap The inereass in gavaenment expend decrease in taxes (T) wil increase AD (as explained above), in this ease, say, rom ADT to AD? The new equilibrium level af teal output is at ¥2, which is closer to the full omploymant level VE It should be realized though that the opportunity cast af such a policy is the risk of accelerating Inflation, In Figure 24.2 vhs ris is shown te dagend crucially on the shape of the AS curve and, move precisely fon haw close or far from full employment the economy ‘operating. Real autcome/income {4} Figure 2.4.2 The shape of 8 andthe effets of exparcimary fal palicy ‘Assuring that the economy was ia equilibsiam 3t 1, the Snerease im AD fromm ADT 12 AD? leads to an inctease in ees ‘output without the average price evel being acwersely atferted If though, the dellationary gap was smaller and the econoomp ‘as im equilibrium at ¥3, then the increase in AD from AD3 to ‘ADA would lead not only te an increase in real output But alse to same increase in prices (that i,t would be respansibe for some inflation} Ifthe ecanamy sat fall employment ane government expenditures increase and/or taxes decrease, the resulting increuse in AD well rave only inflationary, ‘Fwe employs monetarst or new classical AD and AS framework then the effects are similar as shawn i Figure 2.43. nas srs ‘mvorage price ews (P) WN Real eateome/‘ncame (0) Figure 24.3 Ext feel polky im a mecetanst on naw sca Ramewonk 2 Macroeconomics. tf theve i a deflationary gap then expansionary fiscal policy will Increase AD from ADT te ADZ. The result es niahet real output but alse inflationary pressures. I though, the econamyis at its patential output and AD increases asa racult of celationary fiscal policy from AD3 to ADS, then no lasting increase in veal ‘output wil result, Any increase in real output will be temporary, nthe long run, real output will etum at its patential rate at the cost of higher inflation. Expansionary fiscal pabcy will not have succeeded in increasing real output Contractionary (deflationary) fiscal policy Or the ether hand, an overheating economy, defined as an concmy where AD is apy erasing reting inflationary "orf a fling econ ory increasing wal outa and seerasing unerkyenent {to help cose a defationary gap) Goal pressures, requires eontractionary fiscal policy The government must decrease government expenditures and inetease taxes sa that AD decreases ‘The deviease in government expenditures (6) will directly decrease AD for slaw down its increase) while an incase in dec taxes wll decrease disposable incomes, lowering ‘consumption {C} and 59 AD. lea diagram, AD will shift left, alleviating inflationary pressures (shown as a decrease in the average price level) but tise risking a contraction of the exonamy (that i, a Lower level ‘af output and a higher rate of unemployment) The tisk of 1 Microeconomics (aca Cala, Azur thatthe prea of Pepa ola a submits, ieee rice per wit Demand for Coca Colas expected vwinewara rei shit fom a1 row, © (Quantity domanded per peed (C3) Figure Lid The ote anbesease io the pe a a sine Be careful though, when anabsing demand in this way. To take anther example let's assume shat salmonellacaintad chicken is faund inte siepermartes of a particalarcoomsry Cermand for chick wil collapse and wi ts price. What do-you expect te happen to the demand for fish fish is consider a safe substitute? f= Changes in tastes affect demand, The more desivable people find a good, the move they wil demand i, Tastes ane affected by advertising, by fashion, by observing other consumers, by consideration of health, ete, 1 Changes in the sice ofthe market (the rumiter oF consumers) wll have an effect. As the size of « market increases, demand Far most products wll tend 19 rst and wie versa, ‘= Changes inthe age distibution of the population affect the pattem of demand, A welbknown exarmple refers to an ageing Population [where the average age i rising) wheve demand for fase testh rises and demand for chewing gum drops ‘= Expectations of changes in market prices or in income wil have an effect, For example, people expect that the price ‘of 3 good wil ise in the future, they are lkely we buy more ‘of itor befare prices go up (shifting the curent demand ‘curve to the igh) Shifts of demand versus movements along a demand curve Many students make mistakes over this because they do not gat into the habit of distinguishing berwaen demand and quantisy demanded, Demand changes (and on a dhagram the demand curve shifts) when any determinant ather than the prve of the (good changes, For example, a change in incorne will change demand and shift te demand curve to the ght arto the et Quantity demanded changes when the price af the good changes and resls in a movement along the demand curve, Far example, ifthe price of gaod increases itis quantity demanded that decreases, Demand and ts gaghical representation ate not alfected, Tere isanlya movement along the deimared cure, saps crweang tate demand cure sts ‘up Using tee ters vry ate lead tb mistakes. ees st the cexession the demand cure sist her if you re cestsbag an increase ger! and Te osm cree ss ‘a thee yeu we seewime.a creme in demand, Trevenrent eee teemand curve shih of the demand curve > Supply: the behaviour of producers | anya the other tacts ffcting demon changes AVP Pe. Thiwhere denotes income. Festands lor ace ofsubstlutes Pe stands farpice anoT stands lor asies) itt prow of tha ga changes gh) The supply of a good summarizes the behaviour af producers (or fis} in a masko. tis the relationship betwoen various possible prices and the enresparding quantities that rms are-wiling to offer per period, cetes paribus Ceters parbus means that all ther Factors affecting supply are assumed constant, The relationship between price per unit and quantity supplied per period is direct [postive mearing that at higher peas producers will be willing to offer more per period This posite lationship between pice ex unit and quay supplied per period of time is often refered to as the lw of supply. The law of supply states that if the pie of praduct increases then quantity supped per penod expected te increase A sugplycutve shows the direct relationship between the price per unit oFa gacd and the quantity supplied per period. Ws typicaliy Upwaed sloping, Price per unt srmeasured on the vertical axis ang quantity applied per pried on ths harzontal ais A supply curve may fer to an individual frm or to the make, The market supply cure is the harigontal summation af the supply cures of an individual firm. This means that at each price we add the quartibes supplied ty each frm. So, a market consists of 100 identical firms and each i willing to offer 200 units per month at the price af $5.09, then the macket sugply wil be 20,000 units por month pricad at $5.00 pat unit. @ Qeanticy supplied ep 2s) igus TALS styl maint supply cans 2 Macroeconomics. hold mongy at each lvel of invarest rates will increase, shifting the demand for money ta Pe night Ioeorest eate ( ote tha ners rates rope on, money demand ay become nity lat fe Kepesin SMe Feuity tap) — = . sn wat ss tener feta iovT) . Money a Figure 2.8.1 Demand ot mane quit pefenees) ‘Money supply Money supply isconsicnod at his lee to be ‘exogenaus, meaning that tis not affected by the level of AD and interest rates but that i fine at sore level by the centzal bark The rmongy supply inchades cash (cans and notes) aswell ascurent acenunt deposits (alo known as sight account Gepasts). The dehnibon may be expandad to vacude rove assets Figure 252 illustrates the typical shape ofthe money supply prided by the central bank nao ata | oe gore 2.5.2 Te money sip fsegnous a nd ye col Nar The central bank can affect the ste ofthe money supply as Fallows. 1» Iean change the required reserve ratio. Commercial banks need to keep only 2 fraction ofthe money depasited in their vaults and can lend our the rest. They need to do that to ensure that they are suificiently quid to meet their obligations to depositors. the central bank increases the requiced reserve rato tien they wil be able to lend aut less s0 the money supply will derreate, shifting the cure in Figute 25.2 to the left = Thecentral bank can change the discount rate. There are ety mary interest rats ina economy. Ove suck rates che discount rata which is the interes rate at which commercial banks can borrow if they need to ftom the central bank IF the central han wants to decrease the money supply and shift the cunce to the left ther it could incense this discount rae, making 7 more costly for commercial Banks ta get hold ef-extr cash ta lend out to their customers. ‘= The contral bank can conduct open market enerations IF it decides to buy orange juice om the epen market costing 100 million euros then its vaults wil ll up with orange ice and the ‘market will have an extra 190 milion fresh euros. The money supply will have increased and shifted to the night If che centzal bank decides to sell some of the ‘range ice for 80 milion euros then the maskes will have mare otange juice BuTBO mallion fess euros, that, the money supply wil have decreased. The central bank does not buy and sell orange juice because, frst, this would significantly disrupt the price of 4 bassc goed that many of usbuy aa alio the goad would be costly to stare, Instegd it buys and sells (outstanding) bonds in the open market. If it buys bonds ican increase the money supaly and sells onds it can decrease it Interest rate determination by the central bank ‘The interaction ofthe supply and the demand for money will determine, at in any market Ue interest ate which influences. all other masket interest rates. igure 2.5.3 illstrates the point Money (Mh intire 25.3 lest rate deri by the cert bak Given a money demand Md and maney supply at MST the market interest rate will be determined at rtf the cental ‘bank wishes for sare reas ts lower interest rates team inerease the money supply to M2. can do this by decreasing the teguired reserve ratio, lowering its discount rate or ‘canducting open matket purchases of fowtstanding) bands “The interes rate in the money marker will decrease te £2. On ‘the other hand, if farsome reason the central Nani wishes to increase interest res itcan decease the money supply to hs. This can be dane by increasing the required reserve ratio, rating is diseaunt rate or conducting apen matket sales of outstanding} bonds. The interest rate in the money matket wll increase ta 13 Monetary policy 2 Macroeconomics Monetary policy's, tagether with ical policy a demande paligg I aims to affect ecanomic vanishes such as eal output and growth, employment ard ination Ifthe goal iste increase AAD then the consral bar willadopt easy r loose (axpansionary} monetary policy, inceaasing the money supply and, uhrough ths, lowering interes rates. Thes would typically be the plicy choice far an economysnracesion or bout ta enter ane (that, when 2 deflationary or recessionary gap is present). the goal isto decease AD (orto slow dow A incase) ten the Cental Bark vill adopt tight oF contractionary monetary policy. decteasing the money supply and, though this increasing incest ates This ‘auld typically be the polic

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