AGGREGATE DEMAND AND SUPPLY • Just as the intersection of demand and supply for a product determines price in a single market, the intersection of aggregate demand and aggregate supply determines the overall price level in the economy • The AD curve slopes down from left to right due to: - international substitution effect: if prices in economy fall people will be encouraged to buy more domestically produced goods (and less imports) - the inter-temporal substitution effect: if prices fall people will need less money leading to lower interest rates and higher levels of expenditure - the real balance effect: if prices fall people’s real savings will increase leading to further expenditure • The AS curve slopes up from left to right due to: - greater profits to be made at higher prices (while real wage rates remain the same; however the curve tend to eventually become inelastic due to diminishing returns and growing shortages (as economy nears full production) Aggregate demand and aggregate supply AS Price level If the price level is initially P2, the excess demand will cause price level to rise to Pe Pe b a P2 AD O National output ECONOMIC GROWTH AND THE BUSINESS CYCLE • Distinction between actual and potential growth - Actual growth is the percentage increase in national output: the rate of growth in actual output. - Potential growth is the rate at which an economy could grow if working at full capacity. An economy can easily under perform. Thus for example in a recession the actual rate of growth may be well below the potential level. Short-run concerns in economies often relate to the actual rate of growth (and the desire to maintain it at a high level). Long run concerns are more with factors of production in the economy that can potentially influence the rate of growth. Growth and the production possibility curve Good X b Growth in Growth in actual output potential output a I II O Good Y ECONOMIC GROWTH AND THE BUSINESS CYCLE • There are four phases that are identified in terms of the business cycle 1 The upturn 2. The expansion 3. the peaking out 4. The slowdown - In practice this are not fully regular as diagrams would suggest. For example sometimes the expansion phase (boom) might be very short. In other cases the slowdown (recession) might extend over a decade.. - Also a recession could vary significantly from mild to extremely severe. - Fluctuations in output are usually caused in the short-term by variations in the overall level of aggregate demand (i.e. the total expenditure in the economy). - In the long-run changes in the potential of the economy to produce output are more important. Real GDP in France and the UK 500 France 450 UK 400 Real GDP, 1960 = 100 .. 350 300 250 200 150 100 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Source: AMECO database (European Commission) and OECD Economic Outlook (OECD) Note: 2009 and 2010 figures based on forecasts Economic growth in the UK 400 6.0 Quarterly growth rate 350 GDP 5.0 4.0 £ billions (in 2005 prices) . 300 3.0 250 % change 2.0 200 1.0 150 0.0 100 -1.0 50 -2.0 0 -3.0 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Source: National Statistics times series data The business cycle Potential output National output 3 4 2 Actual 3 output 4 2 1 1 O Time POTENTIAL CONTRIBUTION TO GROWTH Increases in Quantity of Resources • Capital - Output depends on stock of capital invested in economy e.g. roads, factories, machinery, buildings etc. - A major factor in the growth of the Celtic Tiger (1994 - 2001) was a huge increase in multinational investment in Ireland (especially by US firms). - By contrast very poor nations (as in Africa) are unable to set aside sufficient resources for investment and therefore find it hard to achieve economic growth. - Investment needs to be financed out of savings (or borrowing) and understandably poor countries find it hard to save. POTENTIAL CONTRIBUTION TO GROWTH (con) • Labour - Clearly if the numbers working increases, the level of output should also increase. This was also a major factor in the boom in the Irish economies in the late 90's. the work force effectively doubled in 10 years enabling a very large increase in output. - However as well as the numbers working, the quality of labour employed (e.g. in terms of education and skills is very important). - Ireland can no longer compete with lower cost countries (such as in Eastern Europe) in terms of unskilled production. Thus it makes greater sense for us to concentrate on more skilled areas such as information technology. POTENTIAL CONTRIBUTION TO GROWTH (con) • Land and Raw Materials Ireland is well endowed with agricultural land (with agriculture and the food industry important sectors of the economy). Unfortunately we are not well endowed with important raw materials such as oil and gas. - However though helpful these are not vital for economic growth (as the success of Japan after the 2nd World War demonstrated). • Enterprise - This is the 4th factor of production. If an economy is to thrive, people must be willing to undertake the risks of setting up business. In the past there was a great lack of an enterprise culture in Ireland which inhibited growth. This is why we began to rely so much on importing enterprise from abroad by attracting multinational companies through tax breaks and grants. POTENTIAL CONTRIBUTION TO GROWTH (con) • Increases in Productivity - Changes in technology are very important to prevent the law of diminishing returns setting in with respect to investment. So for example the rise of computer and internet technology has greatly increased the possibilities for new types of investment thus enhancing growth prospects. • Policies to achieve Growth - The policies of the Government can greatly affect the capacity of an economy to grow. During the 1980's there was very little growth in the Irish economy largely because of the past effects of reckless Government borrowing. In recent years the determination of the Government to reduce income tax initially contributed considerably to our growth prospects. However subsequent reliance on a massive property bubble has created much of our present problems Explanations of Long-term Growth • Neoclassical or ‘Solow’ growth model – diminishing returns to capital – need for replacement investment – steady-state national income – effect of an increase in the saving rate – human capital and education – technological progress CAPITAL ACCUMULATION • The rate of growth of capital accumulation depends on two factors: 1. the marginal capital output ratio; this is the amount of extra capital ΔK divided by the extra amount of output that it produces divided ΔY So k = ΔK/ΔY The lower the value of k the higher is the productivity of capital 2. the proportion of national income that is invested (i) which assuming that all savings are invested is the proportion that is saved (s) The formula for growth becomes g = i/k (or g = s/k) Thus if 20% of national income went into new investment with the marginal capital output ratio k = 4, then the growth rate = 20/4 = 5 Output (Y), Investment (I), Depreciation (D) Steady-state output Output (Y) f Y1 a Depreciation (D) Y0 Investment (I) g I0 b c Equilibrium D0 at point g O K0 K1 Capital stock (K) Effect of an increase in the rate of saving and investment Output (Y), Investment (I), Depreciation (D) m Y Y2 f Y1 D n I2 h I1 g Initial equilibrium New equilibrium K1 K2 Capital stock (K) Output (Y), Investment (I), Depreciation (D) Effect of a technological advance p Y2 Y2 Y1 f Y1 D n I2 h I1 g K1 K2 Capital stock (K) Explanations of Long-term Growth (con) • Endogenous growth theory – when technological progress is not a ‘given’ – determinants of technological progress • importance of institutional factors & policies • research and development • training and education • incentives – impact on production function? • move upwards over time • become steeper REASONS FOR IRELAND’S BOOM • Continued investment in education since 1960’s with more emphasis in recent years on technical education • Considerable foreign direct investment (FDI) - especially from US - in Ireland due to following reasons - generous grant support and tax concessions by Government - Ireland a member of EU since 1973 - only English speaking country in Eurozone - availability of skilled labour - political stability • Generous structural funding by EU during late 80’s and 90’s providing funds for infrastructural development • Availability of labour supply both in quantitative and qualitative terms through - unemployed, significant increase in female participation, open approach to immigration etc. REASONS FOR IRELAND’S BOOM (con) • Government Policy - promotion of a more enterprise oriented approach - responsible management of fiscal policy - emphasis on continuing tax reductions as a way of stimulating incentives • Pay Constraints - in view of the high productivity levels attained, growth in incomes were very moderate during the 90’s - significant improvement in industrial relationships • International Conditions - as Ireland is a very open economy, favourable conditions in major markets are very important (with rapid increase in exports up till 2001) REASONS FOR IRELAND’S BOOM (con) • After temporary downturn in’01 and ’02 return to substantial economic growth (03 -07) though at a lower rate than in first phase • However a significant change in the reasons for growth was at work: - continued foreign investment in Ireland under threat from cheaper countries in Eastern Europe and elsewhere - exports which had grown very rapidly until 2001 had been stagnant since 2001 - later boom very much driven by massive growth in construction - demand for property largely dependent on the extension of increased credit So in a sense we were borrowing from future to pay for today’s activities - wage rates and other expenses had risen considerably making Ireland an increasingly expensive country within which to do business PRESENT SITUATION • A sharp downturn in Irish economy has taken place due to a number of reasons - substantial drop in activity in construction sector (which had been the recent engine of growth) - continuing fall in stock markets around the world (and especially in Ireland) further damaging business confidence - severe worldwide financial crisis directly impacting on construction activity and on economy in general - reckless lending by Irish banking sector has damaged our credit worthiness abroad - recession in US and other markets (of great importance to Irish economy) - despite recent fall in inflation, cost basis still very high in Ireland making us vulnerable to competition and movement of multinational firms elsewhere GROWTH IN CHINA • Capital - high savings rate is then efficiently channelled by government into key infrastructure projects - clever concentration on showcase investment in key areas which helps to attract foreign investment - creation of specific investment zones, free trade and tax incentives - quick approval of investment projects - strong industrial tradition with China now seen as the world’s leading manufacturing base • Labour - China benefits from a vast pool of potential cheap labour with many of the 40% of the population still working for very low returns in agriculture eager to move to other sectors - benefit from a vast diaspora abroad who increasingly are being encouraged home to aid the economic effort - increasing emphasis on educational and technical skills with many going abroad to achieve their objectives GROWTH IN CHINA (con) • Land and Raw Materials - China has an abundance of natural resources e.g. coal, iron ore, oil, natural gas and minerals (such as lead aluminium and zinc) - because of the demands of domestic growth, China has invested heavily in Africa and other countries with a view to exploiting its rich natural resources such as oil and copper • Enterprise - liberalisation measures by ruling party has greatly increased opportunities for domestic enterprise - multinational investment - which is at present welcomed – increases access to enterprise in the higher tech industries • Other - huge domestic market - strong business attitude - authoritarian government (preserving political and social cohesion) with a desire to promote growth COSTS OF ECONOMIC GROWTH • The benefits of economic growth are obvious. The standard of living increases with people in general having more money to spend on consumer goods and services. Also it enables the Government to improve services such as health and education and spend more on improving the infrastructure e.g. roads. However there are costs • Higher growth in the short run could require more investment thus lessening resources for consumption. This happened in a dramatic fashion in the Soviet Union under Stalin! • Growth can generate extra demands and social pressures to keep up so that people still feel that they have too little. • There may be adverse social effects as people become more materialistic and less caring in society. • There can also be environmental consequences e.g. terrible traffic congestion in major cities. • Non-renewable resources e.g. oil and gas can be run down and finally the benefits may not be distributed equally. UNEMPLOYMENT • Meaning of Unemployment - measurement by live register - QNHS measurement by ILO and PES methods • Standardised Unemployment - ILO measurement which requires that no payment for even I hrs work in previous week made, or that no search was made in previous four weeks or that person not available to take up employment in next two weeks • Labour force made up of those in employment or seeking employment; excludes many students still in full-time education and married women who opt to stay at home Unemployment rates in selected industrialised countries 14 UK France 12 USA Japan 10 % of workforce 8 6 4 2 0 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Source: AMECO database (European Commission) 2009 and 2010 based on forecast Standardised unemployment rates in different sections of the labour market: 2008 (Q2) Total under Women Men Total (all Women Men (all Country 25 years under 25 under 25 ages) (all ages) ages) old years old years old Belgium 6.6 7.2 6.1 15.7 17.2 14.5 Germany 7.5 7.4 7.5 10.3 9.5 11.0 France 7.2 7.6 6.8 16.7 16.0 17.3 Ireland 5.5 4.4 6.4 11.1 8.4 13.5 Japan 5.0 3.9 4.1 7.1 6.4 7.8 Netherlands 2.8 3.0 2.6 5.2 5.2 5.1 Spain 10.4 12.3 9.1 23.9 25.9 22.2 UK 5.1 4.7 5.5 13.3 10.8 15.4 USA 5.2 5.1 5.4 12.7 11.6 13.8 EU15 6.8 7.4 6.3 14.5 14.4 14.9 TYPES OF UNEMPLOYMENT • Classical - arises from artificial restrictions on market forces e.g. by trade unions • Involuntary (Keynesian) - due to business cycle e.g. a fall in aggregate demand leading to recession • Structural - applies to special groups of workers or regions of the economy; requires special measures • Frictional (short-term) - can reflect a healthy jobs market leading to considerable job mobility • Cyclical - due to variations in economic activity • Technological e.g. application of IT systems • Seasonal e.g. changing availability of work in tourist sector • Wholetime, part-time and temporary • Hidden • Discouraged and marginalised workers Classical unemployment ASL Average (real) wage rate B A W2 We ADL O Q Q 2 1 No. of workers Equilibrium and disequilibrium unemployment ASL Disequilibrium N Average (real) wage rate unemployment b a c W2 e We Equilibrium unemployment ADL O No. of workers COSTS OF UNEMPLOYMENT • Losses to unemployed themselves in terms of lower earnings than possible from social welfare payments • Losses to economy and economic growth through waste of valuable productive resource • Costs to government and tax payers (less tax raised and higher social spending required) • Workers who stay unemployed for long periods may lose valuable skills • Other costs - higher rates of crime and domestic problems • Can be very demoralising for those affected and community as a whole MEASURES TO DEAL WITH UNEMPLOYMENT • Achieving and maintaining higher levels of economic growth in economy • Adopting specific measures to deal with problem areas - e.g. retraining for workers made unemployed, special job schemes for young workers, infrastructural investment in disadvantaged regions etc. • Improving job information services • Matching educational programmes to future job needs in economy • Job sharing schemes • Incentives for those with enterprising ideas • Lower tax rates on employed INFLATION • Inflation refers to the general rise in prices in economy • Main measurement is Consumer Price Index (CPI) which is perhaps the best known of all indices. It is now measured on a monthly basis in Ireland • Level of inflation in Ireland had been higher than other EU countries prior to the recession but fell from 4.1% for 2008 to – 4.5% for 2009 • The degree of inflation can vary as between - mild - creeping - rampant - hyper • Fast rising inflation undermines the value of money CAUSES OF INFLATION • Demand pull - when overall demand exceeds supply (e.g. in a boom) • Cost push - when costs push up demand e.g. wages through trade union pressure, - profits of monopoly firms and imported inflation • Sectoral inflation - e.g. when excess demand in certain labour markets pushes up price • Monetarism - where inflation is due to excess money supply Demand-pull inflation AS Price level P2 P1 AD2 AD1 O Q1 Q2 National output Cost-push inflation AS2 AS1 Price level P2 P1 AD O Q2 Q1 National output EFFECTS OF INFLATION • Reduces the value of money creating a wage price spiral • Can redistribute money away from those on fixed incomes • Encourages speculation in the economy - property market in Ireland during Celtic Tiger - investments in stock market • Penalises savers and rewards borrowers - higher inflation in Ireland than EU contributed to credit boom • Causes uncertainty which is bad for planning • Can have damaging effect on international confidence affecting exchange rates, interest rates, foreign investment etc.
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