Chapter 6 Macroeconomic Problems.docx

1、Chapter 6 Macroeconomic ProblemsChapter 6 Macroeconomic ProblemsInflationWhat is inflation? Definition a persistent (sustained) increase in the price levels in an economy A complex macro-economic principle! Inflation has been the major (or one of them) priority for most governments economic policy N

2、eo-Classical and Monetarist economic policy focuses on the control of inflation Keynesian prioritise unemployment A change in price for a few goods is not inflation The rate is recorded on an annual basis Slow and steady inflation is not bad! Why? Competitive Confidence in Macroeconomy Predictable I

3、nflation in UK. Bank of England Separate entity to the government Monetary Policy Committee 2% Target Inflation Have to write to the prime minister/Chancellor of the Exchequer to explain and differences of /- 0.5% A trade off between inflation, unemployment! How is Inflation calculated? CPI Consumer

4、 Price Index (current index since 2003) Internationally known as HICP- covers entire population RPI Retail price index Headline inflation Includes mortgage payments no basis for international use Used by government to calculate pensions and benefits. Private contracts for calculating household rent

5、and wage bargaining RPIX excludes mortgage payments Underlying rate of inflation RPIY Excludes mortgage payments indirect taxes the Core rate of inflationThe causes of inflation 1. Monetary Inflation2. Cost-push inflation3. Demand Pull1. Monetary InflationMoney Supply increase Rate of Inflation incr

6、ease Important Only if the money supply is growing quicker than the output in the economy! Demand for money- when the value of money falls people need more to buy the same amount of goods and services The supply curve is vertical perfectly inelastic why? Quantity supplied fixed by central bank Print

7、ing more money effectively shifts the supply curve Value of money reduced price level increased Quantitative easing increasing the supply of money through the issuance of govt bonds via the central bank Quantity Theory of Money Theory developed by Friedman and Monetarist school of economics MV = PT

8、(Fisher equation) Where M is money supply, V is the number of times money changes hands, P is the price level and T is output or transactions in the economy Both sides of the equation is equal to expenditure in the economy By holding V and T constant (unaffected by changes in money supply) it follow

9、s that a change in money supply causes an equal % change in the price level (self study- research fisher equation relationship between Interest rate and inflation) 2. Cost-push inflation Definition A situation for inflation is caused by an increase in particular prices or wages It is independent of

10、aggregate demand Higher prices of raw materials such as metal/oil etc. Commodities Increased demand for higher wages to cover the increased cost of living Higher wages through trade union pressure Depreciation on the exchange rate raise cost for imported goods High inflation in trading partners econ

11、omy if demand for their goods is inelastic Increased corporate tax Supply shocks war, famine etc Tariffs? Quotas?3. Demand Pull Inflation Definition Where inflation in an economy is caused by an increase in aggregate demand such as an increase in government spending or a reduction in the overall lev

12、el of taxation in the economy Pulls prices up if the economy has no spare capacity Increased consumer spending Low unemployment Low interest rates Confidence in economyConsequences of Inflation It depends on: Rate Accelerating or stable Anticipated or shock How it compares to other economies Shoe Le

13、ather Costs Shoes worn out! Looking for the best interest rates to off set inflation (Firms and individuals) Walking from bank to bank etc. Before Internet/Telephone Consumers and firms looking for the lowest prices Looking for jobs! Menu Costs The costs involved in changing prices Printing new menu

14、s Labour costs of changing 1000s of prices New brochures/advertising etc. Changing web sites Wage Price Spirals A macroeconomic situation in which rising prices push wages higher; the rising wages then increase production costs that lead to further price increases a continuous spiral The outcome rec

15、ession- unemployment etcThe Inflation Rate Low stable inflation rates caused by a rise in AD will boost firms confidence Inflation may stimulate consumption Nominal interest rates may be low or even negative Leads to debt burdens falling i.e mortgage rates in REAL terms decreasing Rises in house pri

16、ces will create more WEALTH High inflation rates make it difficult to assess what is happening to the price of goods and services Confuse price signals Inflationary noise! Producers may see the rise in price of a good as increased demand when it may just be the result of inflation Leads to a misallo

17、cation of resourcesAccelerating VS Stable Inflation Makes planning difficult Would discourage investment May make wrong decisions based on expectations i.e. agree wage rises based on current inflation rate Anticipated Inflation when the general price level rises as expected Firms, workers, consumers

18、 and government can make necessary adjustments to maintain a level playing field. What adjustments can they make? Nominal Interest rates can be adjusted to maintain real interest rates Consumers can identify real and relative price changes Producers can see price signaling Governments can adjust tax

19、 thresholds, pensions, benefits and public sector pay Uncertainty about future inflation causes fall in consumption and investment Borrowers gain/ savers lose as inflation erodes the relative interest rate Income transferred from old to young (Old people save more) International Price competitivenes

20、s Inflation will make an economys exports more expensive (if higher than the trading partners) May discourage capital and financial investment In a floating exchange rate the exchange rate will devalue the currency can be a vicious circleBalance of payments A balance of payments means that revenue f

21、rom selling goods and services abroad equals expenditure on imports of goods and services. The balance of payments is an official record account - of these payments. Statistics on imports and exports have been gathered in the UK since 1687. As an official record, the balance of payments is broken do

22、wn into two accounts - the current account and the capital and financial account. The current account The current account is made up of the following payments:1. Trade in goods (visibles) - which includes the import and export of: balance of trade Finished goods, such as cars, computers. Semi-finish

23、ed , such as parts for assembly. Commodities, such as oil, tea and coffee. 2. Trade in services, such as financial services, tourism and consultancy - balance of invisibles/invisible balance 3. Investment income, which includes: Overseas profits, such as those from business activities of subsidiarie

24、s located abroad. Interest received from UK financial investment and loans abroad. Dividends from owning shares in overseas firms.4. Financial transfers, such as gifts, payments home from immigrant workers,donations to charity and overseas aid. E.g payment from UK to EU Current account (2009) The Cu

25、rrent Account for 2009 showed that the UK had a deficit of 18b.The capital and financial account This account measures the flows of capital and finance, including: Real foreign direct investment (FDI) - such as a UK firm setting up a manufacturing plant in South Africa. Portfolio investment - such a

26、s UK citizens buying shares in an overseas firm in anticipation of a long term return. Short-term speculative flows, called hot money - where speculators invest abroad to seek out the highest short-term return. Official financing - which occurs when a central bank buys or sells currencies, securitie

27、s and other assets to create an inflow or outflow in the accounts. In an accounting sense the Bank of England must ensure that the account balances. Official financing The balancing item Gathering accurate data is a huge challenge, and is impossible without a device called the balancing item. There

28、are inevitable errors in data collection as well as omissions. To allow for these, government statisticians employ the balancing item, which can be defined as the device used to compensate for errors and omissions in the balance of payments data, and which brings the final balance of payments accoun

29、t to zero.Current account deficits A deficit is a problem if:1. It is persistent.2. It forms a large share of GDP.3. There are no compensating inflows. 4. The economy has low reserves.5. The economy has a poor record of repaying debt. UK current account history There is a strong connection between a

30、 growing economy and trade deficits. As the economy came out of recession and into a period of strong growth from 1993 the current account deficit began to widen rapidly. The current account deficit fell quickly from 2008, when the economy entered a deep recession. Economic growth and trade performa

31、nce The strong inverse connection between a growing economy and trade deficits can be seen in the graph. Economic growth above trend rate accelerates the worsening of the trade balance. Causes of current account deficits There are a number of possible causes of a persistent current account deficit, including the following:1. Excessive growth If the economy grows too quickly, and rises above the trend rate for an economy , which in th