Economics help blog – Page 75

What happens in a recession?

10 March 202018 August 2019 by Tejvan Pettinger

A recession is a period of negative economic growth. In a recession, we see falling real GDP, falling average incomes and rising unemployment. This graph shows US economic growth 2001-2016. The period 2008-09 shows the deep recession, where real GDP fell sharply. Other things we are likely to see in a recession 1. Unemployment The …

Letter of 365 economists – did they really get it wrong?

13 August 2019 by Tejvan Pettinger

The March 1981 UK budget was controversial. In a period of rising unemployment, recession and high inflation. The government pursued deflationary fiscal policy trying to reduce inflation. The chancellor increased taxes by a total of £4 billion, with the aim of reducing inflation and reducing the budget deficit. Tax measures included A new 20% tax …

Horizontal and Vertical Equity Definition

7 April 202112 August 2019 by Tejvan Pettinger

An explanation of the difference between horizontal and vertical equity. Horizontal equity implies that we give the same treatment to people in an identical situation. E.g. if two people earn £15,000 they should both pay the same amount of income tax (e.g. £2,500). Horizontal equity makes sure we don’t have discrimination on the grounds such …

Harrod-Domar Model of Growth and its Limitations

7 December 20197 August 2019 by Tejvan Pettinger

The Harrod Domar Model suggests that the rate of economic growth depends on two things:

Level of Savings (higher savings enable higher investment)
Capital-Output Ratio. A lower capital-output ratio means investment is more efficient and the growth rate will be higher.

A simplified model of Harrod-Domar:

Harrod-Domar in more detail

Level of savings (s) = Average propensity to save (APS) – which is the ratio of national savings to national income.
The capital-output ratio = 1/marginal product of capital.
- The capital-output ratio is the amount of capital needed to increase output.
- A high capital-output ratio means investment is inefficient.
- The capital-output ratio also needs to take into account the depreciation of existing capital

Main factors affecting economic growth

Level of savings. Higher savings enable greater investment in capital stock
The marginal efficiency of capital. This refers to the productivity of investment, e.g. if machines costing £30 million increase output by £10 million. The capital-output ratio is 3
Depreciation – old capital wearing out.

Warranted Growth Rate

Roy Harrod introduced a concept known as the warranted growth rate.

This is the growth rate at which all saving is absorbed into investment. (e.g. £80bn of saving = £80bn of investment.
Let us assume, the saving rate is 10% and the capital-output ratio is 4. In other words, £10bn of investment increases output by £2.5bn.
In this case, the economy’s warranted growth rate is 2.5 percent (ten divided by four).
This is the growth rate at which the ratio of capital to output would stay constant at four.

The Natural Growth Rate

The natural growth rate is the rate of economic growth required to maintain full employment.
If the labour force grows at 3 percent per year, then to maintain full employment, the economy’s annual growth rate must be 3 percent.
This assumes no change in labour productivity which is unrealistic.

Importance of Harrod-Domar

It is argued that in developing countries low rates of economic growth and development are linked to low saving rates.

This creates a vicious cycle of low investment, low output and low savings. To boost economic growth rates, it is necessary to increase savings either domestically or from abroad. Higher savings create a virtuous circle of self-sustaining economic growth.

Impact of increasing capital

The transfer of capital to developing economies should enable higher growth, which in turn will lead to higher savings and growth will become more self-sustaining.

Structural unemployment

9 December 20197 August 2019 by Tejvan Pettinger

Definition: Structural unemployment is caused by a mismatch of skills between the unemployed and available jobs. Structural unemployed is caused by changes in the economy, such as deindustrialisation, which leaves some unemployed workers unable to find work in new industries with different skill requirements. Structural unemployment occurs even during periods of strong economic growth. It …

Effect of lower interest rates

2 December 20193 August 2019 by Tejvan Pettinger

A look at the economic effects of a cut in interest rates.

Summary

Lower interest rates make it cheaper to borrow. This tends to encourage spending and investment. This leads to higher aggregate demand (AD) and economic growth. This increase in AD may also cause inflationary pressures.

In theory, lower interest rates will:

Reduce the incentive to save. Lower interest rates give a smaller return from saving. This lower incentive to save will encourage consumers to spend rather than hold onto money.
Cheaper borrowing costs. Lower interest rates make the cost of borrowing cheaper. It will encourage consumers and firms to take out loans to finance greater spending and investment.
Lower mortgage interest payments. A fall in interest rates will reduce the monthly cost of mortgage repayments. This will leave householders with more disposable income and should cause a rise in consumer spending.
Rising asset prices. Lower interest rates make it more attractive to buy assets such as housing. This will cause a rise in house prices and therefore rise in wealth. Increased wealth will also encourage consumer spending as confidence will be higher. (wealth effect)
Depreciation in the exchange rate. If the UK reduce interest rates, it makes it relatively less attractive to save money in the UK (you would get a better rate of return in another country). Therefore there will be less demand for the Pound Sterling causing a fall in its value. A fall in the exchange rate makes UK exports more competitive and imports more expensive. This also helps to increase aggregate demand.

Overall, lower interest rates should cause a rise in Aggregate Demand (AD) = C + I + G + X – M. Lower interest rates help increase (C), (I) and (X-M)

UK interest rates

inflation-interest-rates

UK interest rates were cut in 2009 to try and increase economic growth after the recession of 2008/09, but the effect was limited by the difficult economic circumstances and the after-effects of the global credit crunch.

AD/AS diagram showing effect of a cut in interest rates

ad increase - inflation

If lower interest rates cause a rise in AD, then it will lead to an increase in real GDP (higher rate of economic growth) and an increase in the inflation rate.

What are the economic functions of a government?

22 December 20193 August 2019 by Tejvan Pettinger

Readers question: What are the functions of government in a capitalist economy? In summary, the economic functions of a government include: Protection of private property and maintaining law and order / national defence. Raising taxes. Providing public services not provided in a free market (e.g. health care, education, street lighting) Limit market failure through the …

NHS spending cuts

10 December 20191 August 2019 by Tejvan Pettinger

To what extent has the UK seen cuts in spending to the NHS and health care spending in recent years? In short: Actual spending on the NHS has increased. Real spending per capita has been broadly flat in recent years. As a share of the nations wealth, it is falling and it is true to …