Entries Tagged 'readers questions' ↓

Readers Question: the way in which fiscal spending inflates prices and crowds out private spending.

Government spending is a component of AD. Therefore, if we have an increase in G, we would get an increase in AD (AD=C+I+G+X-M)

If AD increased faster than Aggregate Supply, we are likely to get an increase in inflation. We can show this with a simple AD / AS diagram.

Diagram Showing Inflation 

 Note, if AS increased at same rate as AD, then prices may not rise. But, if the fiscal spending causes growth to be above the long run trend rate inflation is very likely.

There is a more complicated reason for fiscal spending causing inflation. I haven’t time to elucidate at moment. But, if government finance debt by selling gilts to the banking sector, this can cause an increase in the money supply and inflation.

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You are welcome to ask questions on Economics.

I will post the answer on this blog, for everyone to benefit from.

I shall try to answer the economics question and / or point to other resources but please bear in mind.

1. The replies will be guidance and not for duplication. Your essays should always be your own work.
2. My speciality is economics for British A Level standard. My university economics is rusty in parts, because generally I don’t use it in teaching A level economics.
3. I can’t guarantee to always give full answers it also depends on my time schedule.
4. The answers will not necessarily be complete. I know several of my essays on this site could be improved.
5. I will answer as a new post. Check home page of blog for new post. With question and answers
6. If you leave your email in the comments, I can try and let you know (email will not be published)

I studied PPE at Lady Margaret Hall college, Oxford University, and currently work as an Economics A Level teacher. I have also examined several different economic units for Edexcel AS and A2.

If you find the information useful, you are welcome to buy me a coffee

The first Readers Questions has had 100 comments.

Readers Question: what does AD stand for in economic terms??

AD = Aggregate Demand.

Aggregate Demand is composed of various factors C, I, G, X – M

C= Consumer spending

I = Investment (Gross fixed Capital Formation)

G= Government Spending

X= Exports

M= Imports

AD places a crucial role in determining the level of national output in an economy. Although Monetarists will argue it is AS which will determine the long run trend rate of growth.

Readers Question: What are the effects of a decrease in foreign incomes on UK exports, how will this effect the equilibrium level of income and the balance of trade?

Quite a few readers have asked this question. Unfortunately, A Level economics no longer uses the Keynesian 45 degree line approach to solving problems such as this. The last time I used this Keynesian model was quite a long time ago, so I am a bit reluctant to answer this kind of question. Nevertheless I will try offer some ideas.

Firstly, it is useful to understand what is happening from a simple perspective, then we can try to use the Keynesian model.

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Readers Question: What will happened to the income of business sector if there is an economic decline in America?

An economic decline in the United States, is pretty much guaranteed to reduce the income of the business sector. The recent falls in the US stock markets are largely due to  expectations of a future downturn in the economy. Lower growth leads to lower profits, therefore dividends decline and shares become less attractive. If the US enters into recession, firms will experience a decline in profitability. This is because:

1. Tendency for price wars to develop in a recession. Low sales encourage firms to cut prices
2. Falling sales will lead to lower revenues.

Some firms will be affected more by the downturn. Firms producing luxury goods (Income elasticity of demand >1) will experience the biggest % fall in demand. This is likely to include manufacturers of luxury cars, 5 star hotels. Firms producing basic necessities will be more insulated from the effects of a recession.

1. How can you show an AD shift left or right, using the circular flow? The conflict in my understanding is W MUST equal J because of identities etc. Yet AD can only move if W>J or J>W. I thought that if that happened, that is macroeconomic disequilibrium. Not a shift. is it disequilibrium (excess supply or demand), that leads to a shift? (like market forces and ordinary D&S diagrams?)

AD = C + I + G + X – M (total demand in the economy)

Keynesian Model

In the Keynesian model we refer to Aggregate Expenditure (E) A different term to the AD / AS model

AD = E = Cd + J

Here J(injections) equals investment (I), Government Spending (G) and Exports (X)

It is true that in Equilibrium J = W injections equal withdrawals.

If there is an increase in injections into the economy. There will be a rise in E (Total Expenditure = AD) causing a rise in National Income.

This means that there will be disequilibrium because J is now greater than W. However, as National Income rises there will also be a rise in withdrawals (W) people save more, pay more tax and spend more on imports

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Readers Question: Critically evaluate the argument for and against the likelihood of an imminent house price correction in UK ?

House prices in the UK have risen much faster than inflation; in the past 6 years average house prices in the UK have more than doubled. This has caused many to speculate that house prices are overvalued and are likely to fall, in the near future, to more realistic levels.

These are the arguments in favour of house prices falls.

House prices have risen faster than average incomes.

This has made it more difficult for first time buyers, especially the younger generation to get on the property ladder. With falling demand for new houses, it is only a matter of time before this is reflected in lower prices.

Rising Interest Rates.

Interest rates have increased 5 times in the past 18 months. This rise in interest rates increases the cost of mortgage payments. Therefore, more people will struggle to make mortgage payments and therefore make renting more attracting than buying. It is also worth noting interest rates have a delayed effect; this means it takes upto 18 months for interest rate increases to have an effect on the economy. Therefore, even if interest rates don’t increase anymore, there will be more people affected by interest rate rises (e.g. those negotiating new fixed rate deals, will see a big increase in cost)

Speculation.

If house price rises have been caused by the fundamentals of supply and demand, there is unlikely to be any correction. However, some experts believe the booming housing market has created a ‘bubble effect’; this means that speculators and foreign investors have been buying houses to try and make capital gains. If the market turns, then these speculators will seek to leave the market and cash in their capital gains. This could make a small correction much bigger. – Falling house prices lead to a fall in confidence and discourage many others from buying.

UK investors may also be alarmed by the experience of the US housing market which has already gone from boom to bust.

Prices overvalued

Evidence suggests that house prices are already starting to fall in some parts of the country. Demand is falling from many areas of the economy. Bovis, the new house builder predicted prices would fall by 3% this year. link – Times

A study by PwC suggested house prices are overvalued by 10% - link BBC. This follows reports from the International monetary Fund IMF, which also states UK house prices are fundamentally overvalued.

However, it is notoriously difficult to decide whether house prices are overvalued or not. For example, back in 2003, many commentators argued house prices were already overvalued. The UK housing market has often defied Market predictions

Credit Crisis

The run on Northern Rock, was due to problems in global credit markets. These problems will have an increasing effect on the UK Housing Market. Basically, US mortgage lenders were too willing to lend risky amounts to sub prime lenders. When the housing market faltered there was a rise in mortgage defaults as people couldn’t pay back their repayments. Therefore, many US mortgage companies went bankrupt. This has made other financial institutions much more wary of offering support for mortgage lending. To summarise it is increasingly difficult to get mortgages, especially risky unconventional mortgages. Therefore, this will make it more difficult for first time buyers to get a mortgage; demand will fall further.

However, UK mortgage lending is generally much stricter than US. At the moment, there is not a significant problem of mortgage defaults. With interest rates unlikely to rise in 2008, affordability is unlikely to deteriorate.

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Q. Is A Strong Canadian Dollar A Good Thing?

This is an interesting question. The effects of an appreciation are good for some aspects of the Canadian economy, but, create problems for Canadian exporters.

• The real winners are Canadian consumers who are able to buy US goods at a much cheaper price. US border towns are reporting booming trade as Canadians make the short trip across the border to buy more goods.
• example: Disney World trip: Oct 2006 cost C$3,839. In Oct 2007, the same holiday would cost C$3,428
• Steak dinner in Detroit : Oct 2006 cost C$129. In Oct 2007 C$107
• The real losers are Canadian exporters and the Canadian tourism industry. The appreciation makes Canadian goods and services appear more expensive to US consumers.
• Exporters are seeing their profit margins squeezed as the US price of their exports increase. There is only so much that profit margins can be reduced and so most exporters have been forced to raise their price.

However, it is worth noting not everything is doom and gloom.

• Exporting to non US countries is mainly unaffected. The strength of the loonie is mainly against the US dollar and not the EURO and Yen. Unfortunately, most of the Canadian trade is with the US.
• The effect of a strong loonie, depends on the price elasticity of demand. If demand is inelastic then a strong dollar will only cause a small % fall in demand. It is worth remembering that part of the loonie’s strength is due to the strong demand for Raw materials. Demand for these exports is very inelastic