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MacroEconomics
Revision Workshop
Student Name
Session 1
Dissecting the Recession
Question 1 In economics, investment is best defined as Your Actual
answer answer
1
2
3
4
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The rise of household saving
One key change in the UK economy has been a sharp rise in the household saving ratio
– rising from 0% of disposable income to over 8% in less than two years – what has
caused this and what are the benefits and risks for the UK economy?
1 1
2 2
3 3
4 4
Inflationary pressures
Unemployment
Price Level
LRAS
AD
Real Output
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Business investment spending (I)
Key evaluation point: A cycle in one country can affect economic activity in others – the
UK economy is vulnerable to external shocks affecting aggregate demand and aggregate supply
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Consequences of the recession
Price Level
AD1
AD2 LRAS
SRAS
Y2 Y1 National Output
1 Business profits
2 Labour productivity
3 Unemployment
Trend
Time
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Describing the Accelerator Process
Question 5 Which one of the following is most likely to occur Your Actual
in the boom phase of an economic cycle? answer answer
Question 6 The ‘multiplier’ usually refers to the final effect Your Actual
of a change in the level of? answer answer
A Interest rates
B Government spending
C Tax rates
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Supply-side policies in action
We will go through some examples of supply-side policies from the UK and other countries –
this is an area where good examples can really help your answer.
1 Unemployment
4 Controlling inflation
Supply-side policies and the trend growth rate – a good diagram to use
National
Output
Trend
Time
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Supply-side policies - using AD/AS diagrams to show a rise
in productive potential
Price Level
LRAS
Level of demand is
important in making
investment and innovation
viable
Most supply-side
improvements come from
the private sector
Sustainability issues if
policies raise a country’s
long term growth rate
When writing about supply-side policies in the UK remember to focus on the global nature
of the economy and the importance of the economy remaining competitive in domestic and
overseas markets. The challenges from emerging market countries are especially important.
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Question 5 The diagram below shows two long run aggregate supply curves for at
equilibrium at Y1. In order to move the economy to Y2, a government might
Output
0 Y1 Y2
D Reduce the level of tax on profits that flow from new patents
Question 5 The diagram below the AD and SRAS curves for an economy that is
initially in equilibrium at W. Following a 20% rise in imported raw material
prices and a fall in export sales due to a recession in a major trading-
partner economy, equilibrium is likely to
Price Level
SRAS2
X
Y SRAS1
W
Z
AD1
AD2
Output
A Stay at W
B Move to Z
C Move to Y
D Move to X
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Session 3 Study Notes
Monetary Policy
• Changes in policy interest rates
• Quantitative easing (QE)
• Changes in the exchange rate
Fiscal Policy
• Automatic stabilisers
• Changes in government spending
• Changes to direct and indirect taxes
• Changes to the level of government borrowing
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Monetary Policy
Monetary policy involves changes in
• Policy interest rates (and other interest rates in the economy)
• The exchange rate
• The availability of credit
To influence
• The level and growth of aggregate demand and output
• Control inflationary and deflationary pressures
• Meet an inflation target and achieve price stability
2 Risks of deflation
3 To prevent a depression
Freezing of Higher
credit supply Interest rates
Hits
personal
sector wealth
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How rates affect the economy – analysis and evaluation
A change in interest rates affects AD, output and inflationary pressure in several ways.
Consumer
and Business
Confidence
Effects on
the housing
market
The incentive
to save
The cost of
borrowing
and the cost
of servicing
existing debts
The value of
the exchange
rate
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Quantitative Easing
The Bank of England introduced a policy of quantitative easing in March 2009. The Bank of
England has bought up to £200 billion of assets - mainly government bonds financed by the
issuance of new central bank reserves.
Advantages of a lower £ against the Euro Disadvantages of a cheaper pound v the Euro
Overseas demand for UK exports Costs of imported components & raw materials
LRAS
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Fiscal policy – aggregate demand and supply effects
Our focus here is mainly on how fiscal policy has been used to manage the economy during the
financial crisis and recession. But it is important to understand that fiscal policy decisions affect
both aggregate demand and aggregate supply. Indeed many of the fiscal stimulus policies of the
last few years might also have significant effects on aggregate supply.
Taxes Subsidies
Budget Govt
deficit spending
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Test your understanding of fiscal policy
A Frictional
B Structural
C Cyclical
D Technological
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Tips for scoring high marks on evaluation questions
Evaluation questions carry the highest marks and the quality of you answer will make a huge
difference to your final grade. We will offer our suggestions for doing well on evaluation.
Some recent evaluation questions on Unit 2 papers:
• Using the data and your own knowledge, assess the importance of higher labour
productivity in bringing about improvements in UK macroeconomic performances
• Assess the view that a fall in the exchange rate of the pound will help improve the
performance of the UK economy
• Assess the view that inflation is always caused by an increase in aggregate demand
• Assess the view that rising consumer spending is always good for the UK economy
• Evaluate alternative measures that can be used to reduce unemploymenty
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UK Economy at a Glance
Recession Recovery
2009 2010 Comment
Manufacturing output -10.4 3.2 Collapse in industrial output in 2009 but more
signs as industry benefits from weak pound
Unemployment LFS) 7.6 7.7 Unemployment to stay lower than in the
measure (%) last recession - fewer hours and wage cuts
have helped
Unemployment CC 4.9 6.1 Claimant count also likely to peak below
measure (%) 2 million - but long term unemployment is a
worry
Labour force (million) 31.4 31.2 Small shrinkage in size of labour force - partly
reverse migration and discouraged worker
effect
Average earnings -0.1 3.4 Negative earnings growth for millions in
(inc. Bonuses 2009 - pay cuts and pay freezes (but CEO
pay remained strong)
RPI Inflation -0.5 3.8 Some deflation in 2009 (mainly due to big
cuts in mortgage interest rates) - RPI spikes
higher in 2010
US Dollar /Sterling $1.57 $1.61 Relative exchange rate stability against the
dollar? Hard to forecast - many UK imports
priced in Ss
Sterling / Euro Euro 1.11 Euro 1.09 Euro set to gradually strengthen against
sterling despite woes of the PIGS
Base (policy) 0.5 0.5 Policy interest rates set to remain
interest rate (%) below 1% for at least the rest of the year -
MPC in wait and see mode
10-year government 4.1 3.4 Where next for bond yields? Much depends
bond yield (%) on election result and credibility of new govt
fiscal plans
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AS MACRO Key Term Glossary
Accelerator effect Where planned capital investment is linked positively to the past
and expected growth of consumer demand.
Animal spirits The state of confidence or pessimism held by consumers and
businesses.
Appreciation A rise in the market value of one exchange rate against another
Automatic stabilisers Automatic fiscal changes arising automatically as the economy moves
through different stages of the business cycle - for example a fall tax
that the government takes out of the circular flow in a recession.
Bank run When a substantial number of depositors suspect that a bank may
go bankrupt and withdraw their deposits. Bank runs are rare but one
happened with the Northern Rock in the autumn of 2007.
Bond Both companies and governments can issue bonds when they need to
borrow money. The issue of new government debt is done by the central
bank and involves selling debt to capital markets.
Budget deficit Occurs when government spending is greater than tax revenues. The
UK budget deficit in 2009-10 is forecast to be more than 12% of GDP.
Business confidence Expectations about the future of the economy – vital in business
decisions about how much to spend on new capital goods.
Capacity utilisation Measures how much of the productive potential of the economy is
being used. Utilisation falls during a recession.
Capital stock The value of the total stock of capital inputs in the economy
Capital-labour Replacing workers with machines in a bid to increase productivity.
substitution This can lead to structural unemployment.
Catch-up effect This occurs when countries that start off poor tend to grow more rapidly
than countries that start off rich. The result is some convergence in the
standard of living as measured by per capita GDP.
Claimant Count The number of people claiming unemployment-related benefits. Since
October 1996 this has been defined as the number of people claiming
Jobseeker's Allowance.
Classical LRAS The classical LRAS curve is drawn as vertical because classical
economists argue that a country’s productive capacity is determined by
factors other than price and demand such as investment and innovation.
Comparative advantage Comparative advantage refers to the relative advantage that one country
or producer has over another. Countries can benefit from specializing in
and exporting the product(s) for which it has the lowest opportunity cost
of supply.
Corporation Tax A tax on the profits made by companies.
Constant prices Constant prices tells us that the data has been inflation adjusted.
Consumer confidence Expectations about the future including interest rates, incomes and jobs.
Consumer durables Products such as washing machines that are not used up immediately
when consumed and which provide a flow of services over time.
Credit crunch Situation where banks across the economy reduce lending to each
other due to falling confidence that loans will be repaid. This restricts
the flow of money around the economy and can result in less credit
being available for consumers and businesses, resulting in an increase
in the cost of obtaining credit.
Current account of the The overall balance of credits minus debits for trade in goods, trade
Balance of Payments in services, investment income and transfers.
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Hot Money Money that flows freely and quickly around the world economy looking
to earn the best available rate of return. It might be invested in any asset
whose value is expected to rise (e.g. property or shares) or simply be
placed in an account offering the best real rate of interest.
Household wealth The value of assets owned by households – including property, shares,
savings and pension fund assets.
Immobility of labour Barriers to the movement of people between areas and between jobs.
Income elasticity Responsiveness of demand to a change in the real income of consumers.
of demand
Inflation target The Government sets the Bank of England a CPI inflation target, which
is currently 2 per cent. When inflation rises or falls more than 1% above
or below the target, the Governor of the Bank of England must write an
open letter to the Chancellor of the Exchequer to explain why.
Inflationary pressures Occurrences likely to lead to price rises. These can come from both the
demand and the supply-side.
Innovation Changes to products or production processes – innovation is important
in delivering improvements in dynamic efficiency.
Interest elasticity The responsiveness of demand to a change in interest rates. This is
of demand relevant in discussing the effects of changes in monetary policy.
International Monetary The International Monetary Fund (IMF) is an organisation of 186
Fund (IMF) countries, promoting global monetary cooperation, financial stability,
international trade, employment and sustainable economic growth.
It has provided help for several nations in the wake of the 2007-09
financial crises.
Inventories These consist of materials and supplies which are stored for use in
production, work-in progress, finished goods and goods for re-sale.
Investment Spending on capital goods including plant & machinery and infrastructure.
Investment income Interest, profits and dividends from assets owned and located overseas.
J Curve Effect The effect of currency depreciation on the trade deficit depends on
price elasticity of demand for exports and imports. In the short term,
demand is often inelastic and the J Curve effect says a trade deficit can
actually worsen after depreciation, but get better in the medium term.
Job search The process by which workers find appropriate jobs given their tastes
and skills.
Keynesian Unemployment caused by a lack of aggregate demand in the economy.
unemployment
Keynesian economics The economics of John Maynard Keynes. The belief that the state can
directly stimulate demand in a stagnating economy. For instance, by
borrowing money to spend on public works projects like roads, schools
and hospitals.
Labour shedding Cut backs in employment often seen in a slowdown or a recession.
Labour shortages When businesses find it difficult to recruit the workers they need.
Labour supply The number of people able, available and willing to work at prevailing
wage rates.
Lagging indicators Indicators which tend to follow economic cycles e.g. unemployment.
Leading indicators Indicators which predict future economic trends e.g. consumer
confidence.
Leveraging The use of borrowed funds to increase your capacity to spend or invest.
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Precautionary saving Saving because of fears of a loss of real income or employment.
Price stability Price stability occurs when there is low inflation and the price changes
that do occur have little impact on day-to-day decisions of people.
Productive potential The productive capacity of the economy – boosted by high quality
investment.
Productivity A measure of efficiency e.g. measured by output per person employed
or output per person-hour.
Propensity to import The proportion of any change in income that is spent on overseas
products.
Propensity to save The proportion of any change in income that is saved rather than spent.
Protectionism Restricting trade through tariffs and other forms of import controls.
Quantitative easing Central banks flood the economy with money by printing new notes,
in order to increase the supply of money. The idea is to add more money
into the system to avert deflation and encourage banks/people to
borrow and spend.
Quota A quota imposes a physical limit on the quantity of a good that can
be imported into a country in a given period of time.
Real disposable Income after taxes and benefits, adjusted for the effects of inflation.
income
Real income Nominal income adjusted for the effects of price changes (inflation)
and expressed at constant prices.
Real interest rate The nominal rate of interest adjusted for inflation.
Real wage The nominal wage adjusted for the effects of inflation.
Recession A period of at least six months when an economy suffers a fall in output.
Redundancy Making someone redundant is to end their employment due to a lack of
work available for them.
Remittances Sending of money to people in another country.
Repo Rate (policy rate) The official 'base' rate of interest that is set by the Monetary Policy
Committee and which, when changed, sends a signal to the rest of the
financial markets about a desired change in the direction of other
borrowing and savings interest rates. Repo is the rate of interest at
which the Bank of England is prepared to lend to banks.
Retail Price Index (RPI) The RPI is broadly similar to the CPI but includes mortgage repayments
and some taxes, and excludes the top 4 per cent of earners. It is used to
calculate increases in wages, state benefits and pensions.
Risk averse Exhibiting a dislike of uncertainty, often seen in a recession.
Saving ratio The percentage of disposable income that is saved rather than spent.
Slowdown A fall in the rate of growth of an economy but not a full-scale recession.
Slump A sustained decrease in real GDP and a persistent rise in unemployment.
Soft landing A slowdown in economic activity but which does not result in a recession.
Spare capacity When a business is not making full use of its available capacity – there
are spare factors of production including land, labour and capital. When
an economy has plenty of spare capacity, short run aggregate supply
tends to be elastic.
Stagflation A combination of slow economic growth and rising inflation, can lead
to stagflation. The most notable recent period of stagflation occurred
during the 1970s, when world oil prices rose dramatically, and UK
inflation rose at one point to nearly 30 per cent.
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Notes
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