CT7 Part 4

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  1. Four Macroeconomic Objectives
    • high but sustainable rate of economic growth
    • low level of unemployment
    • low and stable rate of inflation
    • favourable (and sustainable) balance of payments position
  2. Macroeconomic Policy Instruments
    • fiscal policy
    • monetary policy
    • other - eg competition policy, import controls, exchange rate controls
  3. Net Savings (S)
    • savings minus borrowings minus drawing on past savings
    • part of withdrawals
  4. Net Taxes (T)
    taxes less transfer payments - money taken from one group to another without production
  5. Withdrawals (W)
    Savings + Taxes + iMports
  6. Injections (J)
    • I + G + X
    • I = expenditure on capital goods
    • G = gvt expenditure not incl spending on transfer payments
    • X = expenditure by foreigners on domestic G&S
  7. Aggregate Demand (AD) - Macroeconomic Environment
    • total spending on G&S made within the country
    • AD = Cd + I + G+ X = Cd + J
  8. Effect on increasing Injections on Macroeconomic Objectives
    • output increases (economic growth)
    • employment increases
    • inflation increases (tends to, as prices rise)
    • BoP deteriorates (increases demand for imports, exports less competitive due to inflation)
  9. Value Added
    • firm's total revenue less purchases from other firms
    • equal to incomes earned by factors used in production process (i.e. wages / interest / rent / profit)
  10. Gross Value Added (GVA) at Basic Prices
    sum of all values added by all industries in economy over a year (Basic Prices)
  11. Gross Domestic Product (GDP) at Market Prices
    • GDP = GVA + taxes on products - subsidies on products
    • value of output produced domestically
    • main measure of country's output
  12. Gross National Income (GNY) at Market Prices
    • or Gross National Product
    • value of income earned by nation's resources
    • GNY = GDP + net income from abroad
  13. Net National Income (NNY)
    • allows for depreciation of capital equipment
    • NNY = GNY less depreciation
  14. Households' Disposable Income
    • income available for households to spend
    • GDI = GNY - taxes paid by firms + subsidies received by firms - depreciation - undistributed profit (RE) - personal taxes + benefits
  15. Product Method
    • add up "value added" of each industry to get GVA, then add taxes less subsidies
    • avoids double counting of intermediate products by using VA
  16. Income Method
    add up incomes earned before taxes, not including transfer payments, to yield GVA
  17. Expenditure Method
    • all expenditure on domestically produced output
    • = C + I + G + X - M
    • do not include government spending on benefits (transfer payments)
  18. Conditions for Equilibrium National Income
    • 1. when planned injections equals planned withdrawals
    • 2. when aggregate demand = income
  19. The Multiplier
    • changes in injections have a multiplier effect on income
    • principle of cumulative causation states that an initial change can cause a much larger ultimate change
    • multiplier = k = change GDP / change E = change Y / change J
    • k = 1 / (1 - mpcd) 
    • mpcd = marginal propensity to consume domestic G&S
  20. Marginal Propensity to Consume Domestic G&S (mpcd)
    • defined as change Cd / change GDP = change Cd / change income
    • slope of the E (planned expenditure) line
    • increasing mpcd leads to decreased proportion withdrawn, thus increasing multiplier
  21. Actual Growth Rate
    • percentage increase in output over 12-month period
    • i.e. rate of growth of actual output
    • main determinant is growth of aggregate demand (in SR) - i.e. in line with business cycle
  22. Potential Growth Rate
    • percentage annual increase in economy's potential output, i.e. productive capacity
    • two main determinants are 1) quantity of resources, 2) productivity of resources
  23. Potential Output
    output produced when economy operating at its normal level of capacity utilisation
  24. Full-Capacity Output
    absolute max that could be produced
  25. Output Gap
    actual output less potential output
  26. Four Phases of Business / Trade Cycle
    • 1. upturn
    • 2. rapid expansion
    • 3. peaking out
    • 4. recession / slump
  27. Capital - Output Ratio
    • k = change capital stock / change income
    • lower k means higher productivity of capital
    • if know investment rate i, growth rate = i / k
  28. Unemployed
    those of working age without jobs who are available for work at current wage rates
  29. Labour Force
    unemployed + employed
  30. Unemployment Rate
    # unemployed / labour force
  31. Standardised Unemployment Rate
    figure compiled from national labour force survey in which people are asked if they are actively seeking work
  32. Claimant Count
    # people in receipt of unemployment - related benefits
  33. Main Costs of Unemployment
    • financial cost to unemployed
    • personal cost to unemployed
    • personal cost to family / friends of unemployed
    • worsening of government's budgetary / fiscal position
    • lost services / investment government could have provided
    • under utilization of nation's resources
    • LT effect of unemployed resources on productive capacity of nation
  34. Aggregate Demand for Labour (ADL)
    • shows total demand for labour at different real wage rates
    • higher wages means employers employ less
  35. Aggregate Supply of Labour (ASL)
    shows number of people willing and able to accept jobs at each wage rate
  36. Equilibrium Unemployment Causes
    • frictional (search) unemployment - time taken to find "right" job / empe, due to imperfect info
    • structural unemployment - caused by changes in industry structure
    • technological unemployment - resulting from labour saving tech
    • regional unemployment 
    • seasonal unemployment
  37. Disequilibrium Unemployment Causes
    • demand-deficient (cyclical) unemployment: unemployment caused by fall in AD (no corresponding fall in real wage) usually due to recession
    • real-wage unemployment: unemployment caused by inflexible wages (eg held above market by legislation or unions)
    • growth in labour supply
  38. Unemployment Policies
    • demand side or supply side policies both work
    • eg demand: fiscal / monetary policy to increase AD
    • eg supply: increase flexibility / training of labour market
  39. Rate of Inflation
    percentage increase in prices over 12 month period
  40. Costs and Benefits of Inflation
    • C: Menu Cost
    • C: mental arithmetic
    • C: redistributional effects -> from those with fixed incomes to those with more bargaining power
    • C: Uncertainty
    • C: balance of payments worsens as exports less competitive
    • C: resources
    • C: hyperinflation
    • B: since wages usually "sticky" downwards, inflation can have advantage of allowing real wages to fall
  41. Deflation Problems
    • companies unable to increase prices following any increase in costs
    • consumers delay purchases hoping prices fall
    • value of debt increases in real terms, thus consumption and investment decreases
  42. Causes of Inflation
    • 1. demand pull inflation
    • 2. cost push inflation
  43. Policies for Inflation
    • fiscal and monetary demand side policies can reduce AD
    • supply side policies can reduce cost push pressures and increase productivity
    • inflation targeting can reduce expectations
  44. Demand Pull Inflation
    • caused by persistent increase in level of AD
    • firms respond to increase in AD by increasing prices and output
    • pulls closer to full capacity
    • associated with boom in industry
  45. Cost Push Inflation
    • caused by persistent increase in costs, independent of level of AD
    • firms respond to increased costs by increasing prices
    • causes reduction in AD so firms reduce output
    • associated with slump in economy
  46. Functions of Money
    • medium of exchange
    • means of evaluation
    • means of storing wealth
  47. Retail Banking
    branch, postal, telephone and internet banking for individuals & businesses at published rates of interest and charges
  48. Wholesale Banking
    involving large loans to and deposits from companies, other banks & financial institutions at negotiable rates of interest and charges
  49. Sight Deposits
    • eg current accounts, deposits that can be withdrawn on demand without penalty
    • form of customer deposit - liability for banks
  50. Time Deposits
    • eg savings accounts, need notice of withdrawal
    • form of customer deposit - liability for banks
  51. Sale and Repurchase Agreements (Repos)
    • deposits / loans from another bank in exchange for some financial assets as security
    • form of customer deposit - liability of bank
  52. Certificate of Deposit (CD)
    • tradable certificates issued by banks for fixed term
    • form of customer deposit - liability of bank
  53. Bills of Exchange
    • Assets of banks
    • Bank bill: loan to industry, bought at discount redeemed at face
    • T-bill: loan to government, as above
  54. Reverse Repos
    • assets held as security in repo
    • asset of bank
  55. Maturity Gap
    • difference in average maturity of loans and deposits
    • larger = greater profitability
    • banks want to borrow short term and lend long term
  56. Liquidity
    ease of which an asset can be converted to cash without loss
  57. Liquidity Ratio
    proportion of bank's assets held in liquid form
  58. Securitisation
    process of pooling assets into marketable securities, such as bonds, backed by those assets
  59. Special Purpose Vehicle (SPV)
    intermediate that financial institution (originator) sells assets to for conducting financial functions - in this case to bundle assets into CDOs
  60. Collateralised Debt Obligations (CDOs)
    • bonds that SPV sells
    • fixed income bonds backed by assets
  61. Prudential Control
    function of Bank of England, requiring all recognized banks to maintain adequate liquidity
  62. Exchange Equalisation Account
    • gold and foreign currency reserves
    • Bank of England uses this to influence exchange rate
  63. Money Market
    • market for short term loans and deposits
    • divided into discount and repo markets and parallel money markets
  64. Rediscounting
    Bank of England buying back T-bills before maturity
  65. Assets of Retail Banks
    • cash
    • balances held at central bank (reserve balances or cash ratio deposits)
    • short term loans (market loans, bank bills, T-bills, reverse repos)
    • longer term loans (fixed term loans, overdrafts, balances on credit cards or mortgages)
    • investments
  66. Liabilities of Retail Banks
    • customer deposits, made up of
    • sight deposits
    • time deposits
    • sake and repurchase agreements (repos)
    • certificate of deposits (CDs)
  67. Effects of Securitisation
    • +: reduces risks for banks
    • +: allows banks to grow
    • +: may be cheap way of borrowing for banks
    • +: pooling of assets reduces CF risk for investors
    • -: lower national liquidity ratio may lead to excessive expansion of credit
    • -: moral hazard of banks tempted to make greater risk lendings
    • -: increased systemic risk to banking collapse as banks more entertwined
  68. Functions of Central Bank
    • issuer of notes
    • banker to the government, banks, and overseas central banks
    • provider of liquidity to banks (lender of last resort)
    • oversees activities of banks and other fin insts (prudential control)
    • operator of country's monetary policy
    • operator of country's exchange rate policy (using exchange equalisation account)
  69. Monetary Base (Narrow Money)
    • consists of cash (notes and coins) in circulation outside the central bank
    • aka cash in circulation
  70. Broad Money
    • consists of cash in circulation plus retail, wholesale and building society deposits
    • made mostly of bank deposits
  71. Bank Multiplier (b)
    • = 1 / L, where L is the liquidity ratio
    • number of times greater the expansion of bank deposits is than the additional liquidity in banks that caused it
  72. Main Credit Creation Complications
    • banks' liquidity ratios may vary
    • banks may not operate a simple liquidity ratio
    • some of the extra cash may be withdrawn from the banking system
  73. Money Multiplier (m)
    • number times greater the expansion of money supply is than the expansion of the monetary base that caused it
    • m = change broad money / change monetary base
  74. Four Main Ways Money Supply can Change
    • change in bank's liquidity ratio
    • change in non bank private sector's holdings of cash
    • flow of funds to / from abroad
    • public sector deficit
  75. Exogenous Money Supply
    • does not depend on interest rates
    • assumed to be determined by authorities
  76. Endogenous Money Supply
    • in part depends on interest rates
    • increase in int rates will encourage banks to lend more
  77. Three Motives for Holding Money
    • transactions motive (buying G&S)
    • precautionary motive (in case of extraordinary events)
    • asset or speculative motive (ie form of saving)
  78. Factors Affecting Demand for Money
    • money national income
    • frequency with which people are paid
    • financial innovations
    • speculation regarding expected returns on financial assets
    • rate of interest (opp cost of holding money)
  79. Effect of Change in Money Supply on Exchange Rate / Balance of Payments
    • increase in MS causes reduction in domestic exchange rate as:
    • part of excess money balances will be spent on foreign assets
    • domestic int rates will fall below those of foreign assets
    • speculators expected domestic currency to fall
  80. Equation of Exchange
    • MV = PY
    • M = Money supply
    • V = Velocity of circulation, average # times money is spent on G&S each year
    • P = price level expressed as index
    • Y = real national income (real GDP)
  81. Quantity Theory of Money
    • V (due to theory of portfolio balance) and Y (assumed perfectly inelastic in LR and unaffected by AD) fixed in LR, thus direct relationship exists between Money Supply and Prices
    • supported by "monetarists"
  82. Full Employment Level of GDP (YF)
    • level of GDP at which there is no deficiency of AD (E)
    • where Ye = YF
  83. Recessionary / Deflationary Gap
    • shows by how much AD (E) is deficient at tbe full-employment level of income
    • occurs when Ye < YF, i.e. when there is demand deficient unemployment
  84. Inflationary Gap
    • shows by how much AD (E) is excessive at full employment level of income
    • occurs if Ye > YF, i.e. when there is excess demand and demand-pull inflationary pressure
  85. Phillips Curve
    • shows inverse relationship between unemployment and wage inflation
    • also could show price inflation versus unemployment
  86. Three Main Explanations of Phillips Curve Disappearance
    • Inflation and unemployment resulting from non-demand factors (PC shift right)
    • Expectations (increased rate of expected inflation shifts outward)
    • Inflation Targeting (if successful, reduces expected inflation to target rate at all levels of unemployment - PC horizontal)
  87. Rate of Inflation Formula (re unemployment and expected inflation)
    • pi = f (1/U) + pie
    • where pi is actual inflation, U is unemployment, and pie is expected inflation
  88. Accelerationist Theory of Inflation
    • Policy implication: unless employment kept at "natural rate" inflation will accelerate each year
    • when reduce unemployment below U* (NAIRU) then leads to demand pull inflation, more output and unemployment, thus higher expected inflation
    • PC shifts up next year (expected inflation same), and if nominal AD continues same rate, REAL AD decreases, unemployment returns to U*
    • further attempts to reduce U restarts this cycle
  89. Rational Expectations
    • assumes expectations of inflation are based off current situation
    • assumes prices and wages flexible so markets clear quickly
    • theory states that SRPC is vertical too, so economy always operates at NAIRU
    • if gvt increases AD to reduce U, firms expect increase in AD to reflect quickly in higher wages / prices, thus will not increase output or employment
  90. Natural / Non Accelerating Inflation Rate of Unemployment (NAIRU)
    equilibirium rate of unemployment, where ADL = ASL
  91. Hysteresis
    • inability of employment to recover from recession, even when no longer a deficiency in demand
    • when recovered, firms lack capacity/skilled workforce to expand output
    • PC shifts right and NAIRU increases
  92. Inflation Targeting Effect on Phillips Curve
    • Bank of England has successfully met inflation target by maintaining level of AD (through interest rates) and by reducing expectations of inflation
    • This is possible as int rates removed from gvt control and thus less politics in int rate policy
    • PC now horizontal line at target rate of inflation
  93. Accelerator Theory of Investment
    • level of investment depends on rate of change of national income and can greatly fluctuate as a consequence
    • new investment is required to provide additional capacity
    • since investment is injection, any increase has multiplier effect on national income
  94. Fluctuations in Investment over Business Cycle
    • Recession: no need new investment
    • Upturn: rapid investment needed to cope with increased demand
    • Expansion: leveling out of investment
    • Peak: decrease in investment as growth of income decreases
  95. Fluctuations in Stock (Inventory) over Business Cycle
    • Upturn: stocks fall as firms cautious about incr output/unemployment
    • Expansion: build up stock levels as output grows faster than demand, once stocks recovered levels output slows
    • Peak: stocks may increase as firms produce more than required
    • Recession: to reduce stock levels ouput falls faster than fall in demand
  96. Two Demand Side Reasons for Persistence of Booms and Slumps
    • time lags - time to react and time for multiplier effect to work
    • bandwagon effects - waves of optimism / pessimism
  97. Five Demand Side Reasons for Turning Points in Business Cycle
    • ceilings and floors
    • echo effects (necessity of replacement)
    • accelerator
    • random shocks
    • government policy
  98. Real Business Cycle Theory
    • explains cyclical fluctuations in terms of aggregate supply shocks (cf AD shocks)
    • these shocks may come in many forms, eg changes in structural unemployment or changes in tech / availability of raw materials
  99. Supply Side Reasons for Booms / Slumps / Turning Points
    • eventually supply shock will work its way through economy
    • shock in other direction (reverse shock) will lead to turning point in cycle
  100. Fiscal Policy
    • use of government spending and / or taxation to affect level of AD in economy
    • can be expansionary/reflationary or contractionary/deflationary
  101. Fiscal Stance
    how expansionary/contractionary entire public sector is
  102. Current and Capital Expenditure
    • one way to split total spending
    • current: recurrent spending on goods and factor payments
    • capital: investment expenditure
  103. Final Expenditure and Transfers
    • one way to split total spending
    • final: expenditure on G&S
    • transfers: from taxpayers to recipients of benefits/subsidies
  104. Public Sector Deficit / Puiblic Sector Net Cash Requirement (PSNCR)
    annual deficit of entire public sector, amount public sector must borrow
  105. Discretionary Fiscal Policy
    • deliberate use of government spending and/or taxation to change level of AD
    • can be undertaken as part of fine-tuning policy or to remove sever inflationary/deflationary gaps
  106. Fine-Tuning Policy
    i.e. demand management, smoothing cyclical fluctuations
  107. Pure-Fiscal Expansion
    no corresponding increase in money supply when there is expansionary fiscal policy
  108. Crowding Out
    where increases in government spending diverts money / resources away from private sector
  109. Magnitude Problems of Fiscal Policy
    • rise of government spending may simply replace private sector expenditure
    • pure fiscal expansion may cause crowding out
    • cut in tax may not increase spending much
    • multiplier effect depends on mpcd
    • accelerator and pump-priming effects depend on B and consumer confidence
    • economy subject ot unpredictable random shocks
  110. Timing Problems of Fiscal Policy
    • takes time to recognize problem
    • takes time to consider appropriate changes
    • takes time to implement changes
    • takes time for changes to work way through economy via multiplier and accelerator effects
  111. Use of Fiscal Policy
    • automatic fiscal stabilisers (no intervention, taxes and spending automatically stabilise income)
    • directionary fiscal policy
    • fiscal rules (rules on operation for government finance, eg deficit caps)
  112. Monetary Policy
    • Refers to control of interest rates and / or money supply to affect level of AD in economy
    • primarily used to control inflation, but also influences output, unemployment, and/or exchange rate
  113. Short Term Monetary Measure Categories
    • reducing money supply
    • increasing interest rates
    • rationing credit offered by financial institutions (not used today)
  114. Open Market Operations
    involves central bank sell/buy government securities in open market to reduce/increase money supply
  115. Quantitative Easing
    involves central bank purchasing large quantities of existing securities to increase money supply
  116. Funding
    • where monetary authorities alter the balance between long term government bonds and short term t-bills for a given level of government borrowing
    • alters level of liquid assets held by banks, thus their ability to lend
  117. Liquidity Trap
    where int rates cannot be further lowered, and any further increase to money supply not spent, but held in asset balances as people wait for economy to recover
  118. Medium / Long Term Ways to Control Money Supply
    • 1. control liquidity of banks (set minimum reserve ratio - no longer used)
    • 2. public sector deficits (government borrow to increase money supply)
  119. Techniques to Control Money Supply
    • Open Market Operations
    • Central bank can raise/reduce amount willing to lend to banks
    • Funding
    • Increase/decrease minimum reserve ratio
  120. How Central Bank Controls Interest Rates
    • CB needs announce increase in interest rates then create a shortage of banking liquidity (eg through OMO)
    • then will raise rate at which it lends to banks
    • however, may not be effective if borrowing is insensitive to int rates, or is unstable
  121. Case FOR discretionary demand-management policy
    • allows government to respond appropriately to unpredictable shocks
    • without so, uncertainty would be damaging to investment and growth
  122. Case AGAINST discretionary demand-management policy
    • demand management policies unpredictable in magnitude and timing
    • time lags may make policies destabilizing
    • governments may attempt to manipulate economy to achieve political aims
  123. Case FOR rules-based approach to FP and MP
    • setting and sticking to rules allows influence people's expectations (more stable)
    • having stable monetary and fiscal framework makes easier for firms to do long term planning
    • if firms know no discretionary backup in adverse market conditions, will need to be more efficient
  124. Goodhart's Law
    attempts to control symptom or part of problem may not control the entire system as the symptom or part becomes poor indicator
  125. Taylor Rule
    • rule adopted by CV for setting rate of interest
    • states int rate will be raised (and by how much) if: inflation is above target, or if economic growth is above sustainable level
    • relative importance of 2 can be decided by government or CB
  126. Difficulties with rules based approach to FP and MP
    • need first decide what to target, and how rigidly to stick to target
    • may have Goodhart's Law problem
    • thus why Taylor Rule applied, cf simple inflation target
  127. Constrained Discretion
    • set of rules or principles within which economic policy operates
    • these can be informal or enshrined in law
  128. Why Bank of England made Independent
    • to remove blame for higher int rates from government
    • make int rate setting more consistent and objective
    • make int rate decision making process more transparent
  129. Supply Side Policies Influencing Economic Growth
    • increase quantity of factors of production
    • increase productivity of factors of production
  130. Supply Side Policies Influencing Unemployment
    can reduce y making workers more responsive to job opportunities, or making employers more adaptable
  131. Supply Side Policies Influencing Inflation
    • by encourage more competition in supply of labour and goods (reduce cost push inflation)
    • by encourage improvements in productivity (reduce cost push inflation)
  132. Supply Side Policies Influencing Balance of Payments
    can improve trade performance of economy by improving the competitiveness of its G&S
Card Set:
CT7 Part 4
2013-09-10 09:18:33
actuarial ct7

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