Contemporary Economic Policy Revision sheet

Annotations:

• His logic, following the multiplier model was that the government should not be like a household, saving money when income is low, instead he recommended increasing the deficit in order to dampen the recession

1. Keynesian Cross Diagram
   1. Assumptions
      1. Firms have spare capacity

         Annotations:

         • Firms have enough surplus resources/profits to actually change their modes of production by investing more or hiring more staff
      2. Firms respond to changes in aggregate demand

         Annotations:

         • As the aggregate demand increases, or decreases, firms respond by changing the modes of production, to meet the demand. This occurs until AD = Y
   2. Multiplier effect

      Annotations:

      • INCREASE IN AGGREGATE DEMAND
      1. What can increase the multiplier effect?

         Annotations:

         • When income drops, people start saving more, meaning that autonomous spending drops C drops People create additional savings but it is savings of money, not put into the bank Income then goes down with a rise of unemployment 
      2. Paradox of thrift
      3. Fallacy of composition
   3. understanding consumption
2. Risk of trying to clear the deficit
   1. Austerity

      Annotations:

      • Can have a negative effect on aggregate demand 
   2. Conditions matter

      Annotations:

      • Austerity is an okay policy in a boom, however, not recomended in a recession
3. Why is a high Debt-GDP ratio bad

   Annotations:

   • If debt reaches really high debt-GDP ratio, then the amount GDP can increase by is reduced by how much debt has to be payed off.  For example, if debt to GDP ratio is 77% then each additional percentage of debt costs 0.017 of real growth investors also request higher interest rates for the higher risk if government keeps spending, it's bonds will be lower rated, meaning it is more likely to default its debt Meaning aggregate demand is reduced   
   1. Sovereign debt crisis

      Annotations:

      • Describes the way in which lenders require higher and higher yields for lending to the government, so they have to cut spending, in order to not be reliant on these funds 

1. Aggregate Demand

   Annotations:

   • (GDP) A reflection of what is produced in a country, calculating using the purchases of all goods and services at home take away all the goods and services imported Equally can be described as a reflection of total income# Aggregate supply - total supply of the goods produced  (equal to aggregate output The aggregate supply curve in the AS-Ad model reflects the total production that firms are willing to produce  (
2. Deficit
   1. /austerity
      1. Fiscal policy tightening
   2. National Debt

1. Positive aggregate demand shock

   Annotations:

   • In general as GDP decreases as prices are higher because investment decreases at a higher price  This is because there is a increase in interest rates in banks because less people are saving, and bank wants more people to save --> meaning firms borrowing have to pay higher interest rates, reduces investment demand Alternatively, less consumption as prices increase because people have less buying power Most important to note is that the aggregate demand shock (i.e the shock to GDP is independent of PRICE LEVEL)  What happens according to the AS-AD model if there is a positive aggregate demand shock, independent of price level, (there is a higher income) on the economy? In the short term, this shock may mean that the firms are increasing investment due to positive beliefs, meaning that there is more production. Because of this, and the fact that people must be employed,  GDP is increased as well as aggregate supply at all price levels  for a short while (as aggregate demand and aggregate supply are effectively the same, can't have AD increase without AS increase) (short term equilibrium on the right of the long run AS curve) However, this decrease in unemployment means that wages go up, it is more expensive for firms to produce more, therefore aggregate supply shifts the left, meaning there is an long run equilibrium at a higher price level and the same GDP level --
2. Negative aggregate demand shock

   Annotations:

   • If there is a negative aggregate demand shock, independent of price, what happens? In short term, if the shock is uncertainty, and people stop consuming or even further,  the firms postpone investment and reduce staff, then aggregate demand will fall, as less consumption as well as investment.  Supply is by definition adjusted to the aggregate demand drop in the short term because less investment means less production (This is described by the AD curve shifting left) - meaning that at any given price level, the GDP is lower However, the rise in unemployment pushes wages down after awhile (When sticky wages change) It then becomes much cheaper for firms to produce more, so supply increase This means that the Aggregate supply curve shifts to the right.
3. Assumptions

   Annotations:

   • 1.Suggests that wage changes, due to changes in employment lead to changes in supply  2. Consumption is effected negatively by an increase in price level 3. Investment decreases at a higher price level because less people can save, meaning that banks have to increase their interest rates to persuade people to save and don't want to loan too much 4. Government spending is independent of price level 5. Aggregate supply curve reflects how much firms would be willing to supply at any given point IT is because of these assumptions that there is a downwards sloping aggregate demand curve, and an upwards sloping supply curve When there are good expectations of the economy, firms will increase investment, hire more people, pushing wages upwards Whereas, if there are bad expectations for instance, firms will reduce investment, unemployment will rise, pushing wages downwards 
4. How the graph is drawn

   Annotations:

   • X axis is full capacity output (Real gdp) (how much firms can produce, assuming that they are fully employed based on what spare capacity they had) Y axis is price level
5. Relationships

   Annotations:

   • Price levels adjust to achieve equilibrium
6. Assumptions 2

   Annotations:

   • 1. if there is an aggregate demand increase, wages rise with the raisin g of price levels.  goods and services raise prices based on expectations as we shall find out
7. Supply shocks
   1. Positive supply shock
   2. Negative supply shock
      1. Oil or electricity price increase

         Annotations:

         • If there is a rise in the price of electricity and oil, then costs of production for factories etc will go up -- meaning that they will supply less, meaning price level goes up because of the rarity oft he goods produced. Output level goes down at the same time because firms have to make cuts to investment and cuts to staff, meaning consumption and investment go down. (AD basically going down) Firms contracting therefore puts down pressure on wages THUS, STAGFLATION 
8. List of different shocks

   Annotations:

   • 1. (supply) oil and electricity price increases 2. (AD shocks) government spending, pessimism about future, optimism about future, increasing GDP of other countries - they will import more, meaning we export more 

Annotations:

• Sometimes it is difficult for the governments to get through the fiscal policy they want, therefore, they willl rely on monetary policy to stabilise the economy

1. Effects of different policies on Keynesian Cross
2. Effect of different banking policies on AS-AD model
3. Methods to change interest rates
   1. Changing the required reserve ratio
   2. Open market operations
      1. Central bank sells bonds
      2. Central bank buys bonds
   3. Interest rates on reserves
      1. Increase interest rate
         1. Lowers aggregate demand
         2. Reduces inflation
      2. Decrease interest rate/Monetary loosening
         1. Raises aggregate demand by increasing investment

            Annotations:

            • Higher money supply because it is less beneficial for the commercial banks to have a high reserve ratio More consumption because people prefer to have money than save More investment 
         2. pushes up inflation
         3. Could be used in conjunction with high government spending to increase AD without a crowding out effect
         4. Why might this policy not work?
            1. Liquidity trap

               Annotations:

               • When the interest rate is already so low that reducing it is inaffective at changing money supply in the economy
               1. Solutions to liquidity trap
                  1. Quantitative easing

                     Annotations:

                     • This is a solution for when the interest rate is already very low, and does not affect money demand.  By buying assets such as bonds, the central bank can actively raise money demand as these assets cannot be purchased by citizens  If the government interest rates have already been lowered by the central banks purchase of bonds, then the central bank will buy other assets such as within the commercial banks in order to encourage lending
                     1. Central bank purchases private sector assets, such as bonds and funds. This raises the price of the assets, meaning that they have a lower yield. This lower yield pushes the asset sellers to move into other areas of the economy, purchasing assets with high yields. This generally increases demand, pushing up the prices of these bonds and making them have a lower yield. These lower yields mean that companies can borrow easier. Those profiting then have more money to put into the bank, increasing investment and borrowing among firms and consumers
               2. 'effective lower bound'
            2. All dependent on conditions
4. Aims of monetary policy
   1. Influence aggregate demand

      Annotations:

      • Lower interest rates encourages firms to invest more, increasing aggregate demand
5. Types of bank money
6. Types of interest rates

1. Effects on AS-AD model
   1. Fiscal tightening
   2. Fiscal loosening

      Annotations:

      • Increasing aggregate demand by doing government spending merely increases the debt unnecessarily and leads to higher prices This could potentially lead to a debt crisis Government has to pay the debt back some time, and there is a high risk that people may just stop buying bonds, will need to increase interest rates even further to encourage people to buy bonds, leading to later crisis Whole point of fiscal loosening, lower taxes higher spending and the increased deficit will be to make sure that households consume during a recession to reduce the multiplier effect  Increase in G is usually lower than the increase in the output because the sudden AD shock, acts via the multiplier model as consumption is increased
2. Effects on Keynesian Cross

   Annotations:

   • It was originally suggested by keynes that an increase in government spending and higher taxes was beneficial because it would dampen fluctuations in aggregate demand and dampen the multiplier
   1. Tightening

      Annotations:

      • Austerity, spending less
   2. Loosening

      Annotations:

      • When the government increases spending, there is an increase in aggregate demand briefly, but the multiplier model is cancelled out because of changes in interest rates Based on Keynes Liquidity Preference theory and money demand theory 
      1. Government increases interest rates on bonds because of debt

         Annotations:

         • Since government wants to spend more they may need to borrow more, meaning that they will encourage people to purchase more bonds by increasing interest rates. This means that consumption goes down and AD shifts back
      2. Banks increase interest rates

         Annotations:

         • As aggregate demand is increased due to government spending, income goes up, but so does money demand because people want to spend more. This urges the banks to increase interest rates, to get people to save more, but this then reduces investment, meaning multiplier effect is cancelled out 
      3. Crowding out effect
      4. Crowding in effect (pro spending)

         Annotations:

         • Positivity encouraged within the country, investment increases (surely depends on what kind of  spending) Only really works when the firms are not near their full capacity 
3. Types of policies

   Annotations:

   • Automatic stabilisers: Unemployment benefits Active stabilisers: Increasing employment benefits to help smooth consumption Fiscal loosening - increasing government spending pump priming - reducing taxation to increase consumption and reduce unemployment Fiscal tightening - when in boom, the government may reduce spending and increase taxes, ready for a time when this spending will be needed
4. Classical Monetarists vs Keynes
5. Does being in a recession have a long term effect?
   1. Yes -- Pro counter cyclical policies
      1. Fiscal policy to reduce fluctuations
      2. supply side policies to affect economy in long run

         Annotations:

         • In the long run, an increase in aggregate demand through increasing government spending does not affect the GDP in the long run, but increases the price level
   2. No -- Monetarist school of thought -- the adjustments are very quick

1. 2008 global crisis
2. Exchange rates

Annotations:

• Wage changes are caused by demand and supply shocks, which cause the economy to change  Keynesian cross only accounts for changes in aggregate demand IN AS-AD -- Recessions are short term, and only result in price changes due to Stagflation occurs when there are supply shocks

1. crowding out effect

   Annotations:

   • 1. increased income 2. increased money demand 3. higher interest rates 4. aggregate demand reduced
2. crowding in effect

   Annotations:

   • 1. aggregate demand increase 2. positivity in firms increases investment 3. aggregate demand increases further

Annotations:

• This is a model which works hand in hand with the AS-AD model, except that instead of output being on the X axis, unemployment is there instead, since increasing aggregate demand comes with high inflation but low unemployment  

1. trade off between employment and inflation
2. As AD is increased, unemployment is lower, with the trade off that prices become higher to pay for the employment
   1. Later found that there was not a trade off, and that in the long run, the economy could stay at the same rate of unemployment but have greater inflation
      1. Long run philips curve developed at the natural rate of unemployment
         1. In short run, economy would move up the short run philips curve, when there would be higher inflation but less unemployment. However, expecting the wage increase, firms raise prises, cancelling out any household gains from wage rises
            1. In long run, unemployment would stay the same, but the prices would be higher, since there is merely more money paying for the same amount of goods, as output is independent of money supply (MORE EFFICIENT FOR FIRMS TO WORK THIS WAY)
         2. Explained using the quantity theory of money and the theory of money demand
            1. Price level adjusts to make sure that money supply is in equilibrium with money demanded
               1. MD=PY / V MS = PY / V
                  1. Assumptions: velocity does not change, and output is independent of money supply. Therefore, as money supply increases because of an increase in aggregate demand, so must the price because there is the same amount of money hunting for the same amount of products. Therefore, when money supply is increased through aggregate demand increases, and the prices go up, people demand more money from firms
                  2. V= velocity, PY = nominal income, M = money supply, so if money supply is higher, price by definition must increase since output and velocity stay the same
                     1. Supply side policies try to change the output so that inflation does not have to change. This would suggest that the long run aggregate supply curve has moved to the right in the AS-AD model, since there is a higher output, even at a higher aggregate demand (because of increased money supply)
               2. V = PY / M
            2. Milton Friedman's helicopter drop analogy is a good way to describe how money supply changes merely increase inflation

1. Types of unemployment
   1. Structural
      1. Simiilar to frictional unemployment, except this takes longer because there is a mismatch between characteristics of the vacancies and the skills that the population have
         1. Can be caused by technological advances, in which few are able to use the new technology as well as rapid relocation
   2. Frictional
      1. Intevitable unemployment that occurs when firms are looking for staff and people are looking for jobs due to changes in the market
   3. Natural
      1. This is a measure of unemployment which is independent of the status of the economy -- particularly both structural and frictional unemployments
   4. Classical
      1. This occurs when labor demanded by firms is less than labour supply meaning wages are too high
   5. Cyclical
   6. Surplus unemployment - When wage controls are put in place meaning that the firms cut their workforce to stay within budget constraints