2015-6 Lecture 13 - James Eden, business economics module on Level 4 business management course. PDF

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James Eden, business economics module on Level 4 business management course....

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Money and Prices Monetarist economists and long pointed to a direct link from the money supply to inflation. If the money supply is rapidly expanded inflation will increase The starting point is the equation of exchange MV = PY M = Money Supply V = Velocity of circulation P = price level Y = real output This is an identity and true by definition however there is disagreement about V and Y and how changes in M affects these variables and hence P MV is another way of expressing aggregate demand whilst PY can be seen as the monetary value of aggregate supply

Money Supply and Aggregate Demand The way changes in the money supply will affect prices (P) and hence inflation depends on how V and Y react. Monetarist economists argue that changes in money supply will directly affect prices with little or no effect on output. Keynesians argue however that output will be affected and price changes will be limited. As is often the case the reality is often somewhere between the two viewpoints. Velocity of circulation (V) In the short run at least as the increased money supply lowers interest rates individuals may hold more money (i.e. they do not spend it) meaning that V will slow down. Increases in M for example, are largely offset by falls in V so there is no effect on MV i.e. aggregate demand

The reason for this is that the interest rate and exchange rate mechanisms discussed above may be weak in practice. For example investment may depend less on the rate of interest and more on business confidence and expectations. Whilst this may be disputed it is certainly true that in the short run at least the effect on V is highly unpredictable In the longer run, V is likely to be more stable so that changes in M will affect aggregate demand. Over time as the money supply increases individuals have more time to decide how much to invest in financial assets, banks and in consumer durables. Hence some of the extra money will be used in the purchase of cars, fridge-freezers, central heating etc so that aggregate demand (MV) rises. In summary, as the money supply increases, in the short run, V will probably fall but change is unpredictable. Increased M will not affect aggregate demand

This is very much the view of Keynesian economists who believe that monetary policy is therefore not effective. They favour fiscal policy in attempting to impact on aggregate demand. Classical/monetarist economists however believe that in the long run, V will be stable and constant. Therefore increased M will raise aggregate demand. They therefore believe monetary policy to be very effective in influencing demand and prices Output (Y) In the short run aggregate supply is likely to be fairly elastic (upward sloping) providing that there is capacity in the economy. Hence changes in aggregate demand (MV) will raise Y and P.

P

AS

P P1

AD1 AD

0 Y Y1 Along the upward sloping part of AS then an increase in aggregate demand will raise Y and P. Note AS gets steeper as Y increases. This is because the economy will be approaching full capacity so that further increases in Ad have a bigger effect on P than Y

In the longer run AS is likely to be vertical so that increases in AD will affect only P and Y will be unchanged.

P

AS

P1

P

AD1 AD

0

Y

How does the vertical AS curve come about? In the real world firms and markets are interconnected. Assume the economy is at point a below. As aggregate demand rises to AD1 then the economy moves to point b in the short run. Firms start to produce more and hire more raw materials etc. But this leads to rising raw materials prices, higher wages and costs for firms.

As this happens then the AS curve shifts to the left (recall in microeconomics we saw that higher costs caused a leftward shift in the supply curve). AS moves to AS1 AS1 P

AS

P2 P P1

c b a

AD1 AD

0 Y Y1 So the overall shift is from a to c along a vertical line between the two points. The long run AS curve will pass through these points. According to this theory, long term increases in Y will only occur if the AS schedule can be shifted to the right. This would require supply side measures to boost the economic potential for growth. Such measures might include; improved education and training, privatization of state

sector firms to encourage efficiency, reduced trade union power, improved labour mobility, cuts in welfare benefits Summary conclusions Keynesians: monetary policy is unpredictable and largely ineffective in affecting the economy. Fiscal policy (changes in taxation and demand) is the most effective way of achieving goals. Such policy is only likely to lead to price changes if the economy is at full capacity. Classical/Monetarist economists: No policy should be used in a discretionary way. Monetary policy will often affect prices so that government should set targets e.g. for changes in interest rates or the money supply and stick to them. Fiscal policy is ineffective and at best will only have temporary effects on output.

Unemployment

Unemployment tends to fluctuate inversely with economic growth. Not everyone without a job is unemployed. People below working age, pensioners or those not looking for work are excluded. The rate of unemployment is usually expressed as a % of the labour force (those in employment + the unemployed). According to the current data 5.1% of the UK labour force is unemployed which is just under 1.7 million people. http://www.bbc.co.uk/news/business35359689 this data above shows the claimant count which amounts to all people in receipt of unemployment benefit. This will exclude unemployed people who are not eligible for benefit. It also shows the standardised rate of unemployment which is used internationally

As benefit regulations get tougher then the claimant count is likely to fall but this will not affect the number of people actually unemployed Labour Market One definition of unemployment is disequilibrium unemployment this generally occurs when the real wage is above the level needed to achieve equilibrium in the labour market W

SL U

W1 W* DL 0

Q*

QL

At W1 the supply of labour exceeds the demand the demand for labour so there are unemployed workers shown by U.

This type of unemployment may arise for a number of reasons: 1.Trade union power forces wages upwards or the imposition of a national minimum wage above the equilibrium wage rate. Classical/Monetarist economists argue that this is a common cause of unemployment and can only be resolved by reducing the power of trade unions. Such economists also believe that welfare benefits are often too high in relation to wages so that there is a disincentive to take jobs. Minimum wages are one way of reducing this by but often it is argued that benefits should be reduced.

2.There is a lack of consumer demand (demand deficiency) this means firms will reduce demand for labour and the DL curve moves left. This would normally cause wage rates to fall however this tends not to happen as firms will often pay wages above the equilibrium rate to attract high quality labour, motivate workers and reduce labour turnover. Hence this type of unemployment persists. Keynesians argue that this is the most common cause of unemployment and can only be resolved by active government fiscal policy

W

SL

U W* DL1 0

Q*

DL QL

Even if wages did fall this would tend to reduce demand further as people have less income and make the problem of deficient demand even worse. 3.Increases in the supply of labour will tend to move the SL to the right and depress the wage rate. Again there will be resistance to this as above. This is a problem of demographics or mass immigration leading to changes in population size

W

SL SL1

U W* W1 0

DL Q* Q1

QL

There are also categories of unemployment that may be termed equilibrium unemployment. This is when the economy may be in equilibrium but unemployment will still exist as a result of a ‘mismatch’ between the demand and supply of labour. These include: 1.Frictional unemployment - Some people will be between jobs having been made redundant, finished a fixed term contract etc and will be searching for work. This can be minimised by providing more information about vacancies or encouraging people to be more geographically mobile.

2.Structural Unemployment – this arises as traditional industries disappear over time. This may be a result of changing tastes, technological change or overseas competition. This is often a problem for certain regions: Merseyside (docks, shipbuilding) Tyneside (coal mining, shipbuilding) West Midlands (vehicles) South Yorkshire (steel, coal mining) South Wales (coal mining)

Costs of Unemployment 1.The most obvious cost is to the unemployed themselves. These will be financial, and psychological. 2. Unemployment imposes financial costs on the taxpayer. It also costs the government in terms of lost tax revenue.

3.Unemployment is a waste of scarce resources. Skills are eroded over time which reduces the quality of those resources 4.There is a link between unemployment and crime/social unrest...