CT7 Part 4

• high but sustainable rate of economic growth
• low level of unemployment
• low and stable rate of inflation
• favourable (and sustainable) balance of payments position

• fiscal policy
• monetary policy
• other - eg competition policy, import controls, exchange rate controls

• savings minus borrowings minus drawing on past savings
• part of withdrawals

taxes less transfer payments - money taken from one group to another without production

Savings + Taxes + iMports

• 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

• total spending on G&S made within the country
• AD = Cd + I + G+ X = Cd + J

• 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)

• 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)

sum of all values added by all industries in economy over a year (Basic Prices)

• GDP = GVA + taxes on products - subsidies on products
• value of output produced domestically
• main measure of country's output

• or Gross National Product
• value of income earned by nation's resources
• GNY = GDP + net income from abroad

• allows for depreciation of capital equipment
• NNY = GNY less depreciation

• income available for households to spend
• GDI = GNY - taxes paid by firms + subsidies received by firms - depreciation - undistributed profit (RE) - personal taxes + benefits

• add up "value added" of each industry to get GVA, then add taxes less subsidies
• avoids double counting of intermediate products by using VA

add up incomes earned before taxes, not including transfer payments, to yield GVA

• all expenditure on domestically produced output
• = C + I + G + X - M
• do not include government spending on benefits (transfer payments)

• 1. when planned injections equals planned withdrawals
• 2. when aggregate demand = income

• 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

• 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

• 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

• percentage annual increase in economy's potential output, i.e. productive capacity
• two main determinants are 1) quantity of resources, 2) productivity of resources

output produced when economy operating at its normal level of capacity utilisation

absolute max that could be produced

actual output less potential output

• 1. upturn
• 2. rapid expansion
• 3. peaking out
• 4. recession / slump

• k = change capital stock / change income
• lower k means higher productivity of capital
• if know investment rate i, growth rate = i / k

those of working age without jobs who are available for work at current wage rates

unemployed + employed

# unemployed / labour force

figure compiled from national labour force survey in which people are asked if they are actively seeking work

# people in receipt of unemployment - related benefits

• 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

• shows total demand for labour at different real wage rates
• higher wages means employers employ less

shows number of people willing and able to accept jobs at each wage rate

• 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

• 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

• demand side or supply side policies both work
• eg demand: fiscal / monetary policy to increase AD
• eg supply: increase flexibility / training of labour market

percentage increase in prices over 12 month period

• 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

• 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

• 1. demand pull inflation
• 2. cost push 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

• 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

• 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

• medium of exchange
• means of evaluation
• means of storing wealth

branch, postal, telephone and internet banking for individuals & businesses at published rates of interest and charges

involving large loans to and deposits from companies, other banks & financial institutions at negotiable rates of interest and charges

• eg current accounts, deposits that can be withdrawn on demand without penalty
• form of customer deposit - liability for banks

• eg savings accounts, need notice of withdrawal
• form of customer deposit - liability for banks

• deposits / loans from another bank in exchange for some financial assets as security
• form of customer deposit - liability of bank

• tradable certificates issued by banks for fixed term
• form of customer deposit - liability of bank

• Assets of banks
• Bank bill: loan to industry, bought at discount redeemed at face
• T-bill: loan to government, as above

• assets held as security in repo
• asset of bank

• difference in average maturity of loans and deposits
• larger = greater profitability
• banks want to borrow short term and lend long term

ease of which an asset can be converted to cash without loss

proportion of bank's assets held in liquid form

process of pooling assets into marketable securities, such as bonds, backed by those assets

intermediate that financial institution (originator) sells assets to for conducting financial functions - in this case to bundle assets into CDOs

• bonds that SPV sells
• fixed income bonds backed by assets

function of Bank of England, requiring all recognized banks to maintain adequate liquidity

• gold and foreign currency reserves
• Bank of England uses this to influence exchange rate

• market for short term loans and deposits
• divided into discount and repo markets and parallel money markets

Bank of England buying back T-bills before maturity

• 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

• customer deposits, made up of
• sight deposits
• time deposits
• sake and repurchase agreements (repos)
• certificate of deposits (CDs)

• +: 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

• 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)

• consists of cash (notes and coins) in circulation outside the central bank
• aka cash in circulation

• consists of cash in circulation plus retail, wholesale and building society deposits
• made mostly of bank deposits

• = 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

• 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

• 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

• 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

• does not depend on interest rates
• assumed to be determined by authorities

• in part depends on interest rates
• increase in int rates will encourage banks to lend more

• transactions motive (buying G&S)
• precautionary motive (in case of extraordinary events)
• asset or speculative motive (ie form of saving)

• 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)

• 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

• 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)

• 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"

• level of GDP at which there is no deficiency of AD (E)
• where Ye = YF

• 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

• 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

• shows inverse relationship between unemployment and wage inflation
• also could show price inflation versus unemployment

• 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)

• pi = f (1/U) + pie
• where pi is actual inflation, U is unemployment, and pie is expected 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

• 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

equilibirium rate of unemployment, where ADL = ASL

• 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

• 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

• 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

• 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

• 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

• time lags - time to react and time for multiplier effect to work
• bandwagon effects - waves of optimism / pessimism

• ceilings and floors
• echo effects (necessity of replacement)
• accelerator
• random shocks
• government policy

• 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

• eventually supply shock will work its way through economy
• shock in other direction (reverse shock) will lead to turning point in cycle

• use of government spending and / or taxation to affect level of AD in economy
• can be expansionary/reflationary or contractionary/deflationary

how expansionary/contractionary entire public sector is

• one way to split total spending
• current: recurrent spending on goods and factor payments
• capital: investment expenditure

• one way to split total spending
• final: expenditure on G&S
• transfers: from taxpayers to recipients of benefits/subsidies

annual deficit of entire public sector, amount public sector must borrow

• 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

i.e. demand management, smoothing cyclical fluctuations

no corresponding increase in money supply when there is expansionary fiscal policy

where increases in government spending diverts money / resources away from private sector

• 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

• 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

• 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)

• 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

• reducing money supply
• increasing interest rates
• rationing credit offered by financial institutions (not used today)

involves central bank sell/buy government securities in open market to reduce/increase money supply

involves central bank purchasing large quantities of existing securities to increase money supply

• 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

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

• 1. control liquidity of banks (set minimum reserve ratio - no longer used)
• 2. public sector deficits (government borrow to increase money supply)

• Open Market Operations
• Central bank can raise/reduce amount willing to lend to banks
• Funding
• Increase/decrease minimum reserve ratio

• 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

• allows government to respond appropriately to unpredictable shocks
• without so, uncertainty would be damaging to investment and growth

• demand management policies unpredictable in magnitude and timing
• time lags may make policies destabilizing
• governments may attempt to manipulate economy to achieve political aims

• 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

attempts to control symptom or part of problem may not control the entire system as the symptom or part becomes poor indicator

• 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

• 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

• set of rules or principles within which economic policy operates
• these can be informal or enshrined in law

• 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

• increase quantity of factors of production
• increase productivity of factors of production

can reduce y making workers more responsive to job opportunities, or making employers more adaptable

• by encourage more competition in supply of labour and goods (reduce cost push inflation)
• by encourage improvements in productivity (reduce cost push inflation)

can improve trade performance of economy by improving the competitiveness of its G&S