The Short-run Macroeconomic Equilibrium

A very simplified Keynesian model is used to show the short-run macroeconomic equilibrium. For example, the rate of interest is fixed to simplify the model by keeping constant money in the economy. It is also assumed that production and employment depend on the amount of spending. In that we mean that if people buy more then firms will produce more, providing that they have the spare capacity available. The basic formula we use is that the level of National Income is equal to the domestic consumption plus the three withdrawals from the circular flow of income. Or, in shortened terms: Y = Cd + W. In this model, aggregate demand is actually known as aggregate expenditure (E) and relies on the amount of domestic consumption and the injections into the circular flow of income (J). Also written as AD = E = Cd + J. We reach a point of equilibrium when withdrawals equal injections and at this same point National Income will equal aggregate expenditure. If injections were to be higher than withdrawals then National Income would rise and the withdrawals would rise until withdrawals is once again equal to injections. Now enter the 45 degree line.

The 45 degree line shows the relationship between National Income and consumption, withdrawals and injections. Consumption and withdrawals are endogenous - their value is determined by the model. However injections are exogenous, meaning their value is determined independently of the model.

At ever point on the 45 degree line (Y), the items on each axis equal each other. The C line is consumption. It differs from Cd because it doesn't contain taxes and export spending. Consumption is a function of National Income: C = f(Y). As National Income rises, so does consumption - hence the upwards slope. It crosses the 45 degree line because poorer people may be required to spending above their earnings to survive where as richer people spend less than they earn, therefore at the end of the line it is below the Y line. The slope is given by the marginal propensity to consume - the proportion of any increase in National Income that goes on consumption. It is the change in consumption divided by the change in National Income. 

Consumption is determined by a whole bunch of different things: 

• Taxes
• Expected future incomes
• Expected future prices
• Consumer confidence
• Household wealth 
• Attitudes of the lenders
• Age of 'durables'
• Distribution of income

Any changes in these cause a shift in the consumption function whereas a change in National Income causes a movement along the consumption function. 

Now onto the withdrawals. The amount saved depends on the marginal propensity to save (mps). The proportion of an increase in National Income that is saved. Mps = Change in savings / Change in N.I. Taxes is pretty much the same - it depends on the marginal propensity to tax (mpt), or changes in tax / changes in N.I. It tends to rise as National Income rises because income tax is progressive. Finally imports - depending on the marginal propensity to import. Or, mpm = change in imports / change in National Income. 

Total withdrawals will look something like this: 

Injections now and we'll start with investment. It is determined by the following things: Consumer demand, expectations, interest rate, availability of finance and cost/efficiency of capital equipment. Replacing new equipment will rely on National Income. Government spending is independent of National Income in the short term, Exports is also classed as independent on National Income to keep the model simpler.  

That's it for the background on the theory. Next we'll be moving on to how National Income is determined from all of this. Stay tuned.

Sam. 

The Circular Flow Of Income

*I'd like to start by wishing everyone a happy new year! I hope you all had a good time over the festive period and are getting back into the swing of things as life returns to normal. I've had a great 4 week break and am now back studying, which mean the blog will be starting again on a consistent basis until Easter!*

Today's focus will be on the circular flow of income. I'm aware this has already been discussed but like I mentioned in a previous post I do plan on going over things again in a little more depth. The best way to learn about the circular flow of income is to actually see the flow graphically:

I'll now break the flow down into it's different sections, starting with the inner flow. The inner flow consists of the factors payments going from the firm to the households and payments for goods (consumption) flowing in the opposite direction. Firms pay money to households in the form of wages, interest and rent in return for the services of these factors of production. On the other side, households pay money to firms when they consume the firms goods and services. Note we're talking only about domestic firms and domestic households here.

In a scenario where all money was spent then that would complete the flow. However, in reality, not all money is spent. This is where the concepts of injections and withdrawals from the flow come in. Withdrawals are exactly what they sound like: money being taken out of the flow. It comes in three main forms. Firstly, savings. When money is deposited in banks or other financial institutions for the future that money has been withdrawn from the flow. Taxation is another withdrawal. Income tax and national insurance comes out of a households income whereas VAT comes out of a households consumption. Receiving benefits from the government is essentially a 'negative tax'. It's a tax that is flowing in the opposite direction. Therefore the total withdrawal in the form of net taxes is total taxation minus benefit payments. The final withdrawal is import spending. This is money that has left the flow of income because it is spent on goods and services abroad.

Injections, defined as additional money flowing into the economy, also comes in three forms. Firstly: investment. Investment is money that firms spend after gaining it through financial institutions. Secondly there is government spending. This includes such things as spending on roads, hospitals, schools and the like. It does not include state benefits, that is important to note! Finally, the other injection is export spending. Money that has come from people abroad buying our domestic goods and services.

There is a slight relationship between the withdrawals and injections into the circular flow of income. For example, suppose more money is saved (withdrawal) then more money will be available for banks to lend out to firms for investment (injection). The higher taxation is (withdrawal), the more like the government are to increase spending (injection). However, we must remember that these choices are made by different people. The choice to save and the choice to invest are made by two completely different, independent parties and therefore each will have their own agenda. Due to this we can say that injections may not equal withdrawals, however they could.

The final point I'd like to discuss here is equilibrium in the circular flow if income. Like most things in economics, market forces are able to bring the circular flow to equilibrium. I'll give an example. Suppose that injections exceed withdrawals. This may be because investment has rise, but irrespective of the reason due to  this national income will rise (because of more money circulating). A higher national income means that people can consume more, but as well as this people can also save more, pay more taxes and buy more imports. Therefore withdrawals will rise, and continue to rise up to a point where it is equal to injections. This is when equilibrium has been reached and national income will remain constant until another change occurs.

Thank you for reading guys and girls. Contact me if you have any questions or feedback, have a good day/night! Sam.

The Transformation of Policy Between the Wars

Immediately after the First World War, the government's aim for policy was to get the economy back to the 'normality' experienced prior to 1914. This sort of thing included the government playing a limited role in the economy, more integration with the world economy and restoration of the gold standard, free trade and a balance budget.

Initially these three final points are achieved. The budget is eventually balanced, albeit a higher budget than previous years due to the increase social spending and maintenance of the national debt. During the 1920's the policy of free trade is also pretty much restored. Britain gets back on the gold standard in 1925 at the rate of £1 = $4.86. Germany and France both rejoin the gold standard at a similar time, along with most other leading economies. Why did we return to the gold standard you may ask? Well, firstly it helped achieve the restoration of pre-war 'normality'. Also, it aimed to try and stabilise the currency which would in turn help out trade. Another feature of the gold standard was to allow the monetary system to function on its own. What I mean by this, is that if the country runs a payments surplus then gold will flow into the country, interest rates will be decreased so wages and prices will fall. This will in turn cure the surplus. It also works the opposite way for a payments deficit. A final point is that the gold standard was a means of stopping politicians from meddling with the money supply!

However, pre 1914 the gold standard worked but after the war and during the 1920's it just didn't. There is a list of potential reasons for this:

• Why the gold standard worked pre-1914:
• It was developed gradually over time.
• Capital and labour was freely moving.
• The central bank could use interest rates to protect the currency, independent of the government. 
• London was still a financial centre.

• What changed in the 20's?
• There was a rush to return to the gold standard.
• More protectionism and less migration due to barriers.
• Central banks were under pressure from politicians.
• Paris and New York now competing against London as financial centres. 

Mr. Keynes pops up again in this debate. He pointed out that British prices had risen faster than the US', so starting at the same £1 = $4.86 rate would be an overvaluation of the pound. Although this shouldn't have matter because the gold standard should re-adjust prices, Keynes doubted it would work. He thought it would have bad domestic effects including interest rates needing to be kept at 4.5-4.5% and due to this borrowing would become expensive and investment would suffer.

The world slump is the next chronological step in the economic history of Britain. The recession of 1929 - 1931 started because of the Wall Street Crash in the US. This meant massive balance of payments problems. In 1931 came the European Banking Crisis and so in Autumn of that year Britain was forced off of the gold standard. This was first portrayed as a temporary change, but gradually the realisation came about that it was for good. Interest rates were cut to 2% to encourage borrowing and investment which would boost the economy again! Amazingly, there was a recovery. GDP rose as investment rose and Britain actually now compared well with other global economies. It would be easy to say all of this was because of the gold standard, but it isn't true as many other factors were also contributing to the recovery of the British economy. What the slump did cause, however, is the abandonment of free trade between 1931 and 1932. 

Keynes had the idea that investment from the government was something that was necessary for the economy. But, the treasury wasn't in agreement with this theory. They believed it would unsettle foreign investors and worsen the national debt. Keynes thought that there was no point in cutting wages because demand and consumption would suffer. What was needed was public investment which would boost the economy via the multiplier effect. The treasury argued it would be inflationary and any more borrowing would get out of control. The only time borrowing was allowed was in a one-off circumstance for rearmament!

Thanks for reading again guys, that'll be it for economic history for a while... I promise! Haha.

Sam. 

Principles of Economics: The Budget Line (Microeconomics)

This post will make the next logical step on from indifference analysis by introducing the concept of the budget line. The budget line shows us the combinations of two goods that can be purchased with a given income to spend on them at their set prices. You guessed it, a graph is coming! The easiest way to show a budget line is for me to construct a diagram. Here is it, this is a budget line for good X and good Y assuming good X costs £2 and good Y costs £1 and the budget available is £30.

The area above the line isn't feasible to achieve given the prices of the two goods and the budget available. If incomes were to increase, say to £40 or the prices of both goods were to fall by the same percentage we would see the budget line shift as is shown in this next diagram. The rule is, changes in income or equal changes in price will cause the budget line to shift parallel to the original curve. Here's the new curve with an increased budget of £40:

The slope of the line here represents the relative price of the two goods. So in the example above it was 30/15 = 2 for the first line and 40/20 = 2 for the second line. The rule of thumb for that is Price of Y / Price of X. Prices can also change independently of each other, as we well know. If one price changes and the other doesn't, this causes a pivot on the diagram. If good X changed from £2 to £1 we'd see a pivot around the initial point on the Y axis. This next diagram will show that:

The pivot here is quite clear, as the price of good X decreases it means more can be consumed while the consumption of good Y remains constant. 

Next, we'll move on to a more complex concept - the optimum consumption point! This is where we combine the budget line from above and the indifference curves from the blog post I did a few days back. By definition, the optimum consumption point will be where the budget line touches the highest indifference curve on an indifference map. As with most concepts, this is also much easier to understand when represented on a diagram:

Here you can see that the budget line touches, or is tangential, to the indifference curve L2, which is the highest one it touches. Therefore we can say that the optimum consumption point for these two goods would be X1 of good X and Y1 of good Y. We know the slope of the budget line is Px / Py and we know from the previous blog post that the indifference curve slope at any point is MuX / MuY. Therefore, the optimum consumption point is the point where (Px / Py) = (MuX / MuY)!

A change in income will cause a change to the diagram. The budget line will either shift out or in depending on whether incomes rose or incomes fell. This new budget line would cross and indifference curve at a different point, if you joined the new optimum consumption point and the old one you'd have created a new line that we call the income-consumption curve in economics. As with a change in price of one of the goods, the budget line will pivot and a new optimum consumption point will be formed. Connect the original point and the new point and this line you've created is called the price-consumption curve. 

Now for the exciting bit! Actually deriving a consumers demand curve for a good!  

Ok, there is a demand curve derived for good X using the indifference curves and budget lines. Look at it, take it in, see if you can see what's going on. It's difficult, I know. Here's my explanation attempt: On the top diagram we have used good X along the bottom and money for all other purposes on the Y axis. We have a set budget and at varying prices of X this budget line is pivoting. Each of these new pivoted budget lines crosses indifference curves at different points to form a price-consumption curve. The points of intersection of each budget line translate down to as the quantities demanded of good X. Now, to work out the prices for the second diagram. Lets look at the first budget line for this. It crosses L1, we can see that. At that point it has translated down to the bottom diagram as Q1. The price here is the same as the slope of the curve.. so assuming we have a budget of £30 I'd say the budget line hits the X axis at roughly 17. So, 30/17 = 1.76, which is the roughly where the point is on the second diagram. If we did the same for the other two budget lines we'd receive prices of 1.2 and 0.94. These are those two other price points you can see on the diagram. Then as with any other demand curve, join the dots to actually complete the demand curve for good X. PHEW!

That's it, finally. It may be difficult to grasp in parts, if it is then comment with where you are finding it difficult and I'll give you a helping hand. I'll get back to you within a few hours normally, so keep checking back! Thanks for reading again guys, have a good day.

Sam. 

Preferential Trading Arrangements

Preferential trading arrangements refer to such things as trade blocs. Trade restrictions are held with the rest of the world but lower restrictions or none with member states. There are three types of preferential trading arrangement:

• Free Trade Area - This is when member states remove tariffs and quotas with one another. However, restrictions on trade with non-member states are kept individual to each nation.
• Customs Union - This is the same as above, but in addition there are common external restrictions on trade with non-member states. 
• Common Markets - This takes it one step further and the members operate as a single market. This means as well as the features of the above arrangements there is also a common taxation system, common laws regarding production, employment and trade, free movement of labour and capital and no special treatment by governments to their own domestic industries. Additionally to this, we sometimes see fixed exchange rates between members and common macroeconomic policies. 

Next we move on to trade creation and trade diversion, which come as a result of preferential trading arrangements. First, trade creation. This is when consumption shifts from a high-cost producer to a low-cost producer as a result of of joining the customs union. Normally this is due to obtaining the goods cheaper from other members of the union. As with most things, this can be modeled on a diagram! 

Trade Creation Diagram

This is it, the trade creation diagram. Let's explain it a bit. SDom and DDom are the domestic supply and demand of a good. Before the EU, the country had to pay at the 'PEU + tariff' price so domestic production was at Q2 and domestic demand was at Q1. The imports here were the difference between Q1 and Q2. With the joining of the EU, the price was now the PEU price, lower than before. This meant domestic supply had fallen to Q4 and domestic demand had risen to Q3. So the new imports level is the difference between Q3 and Q4, which is higher than before. Thus, trade has been created. 

Trade diversion works in very much the opposite way. This is when consumption shifts from a lower cost producer outside the customs union to a higher cost producer inside it. There is a net loss in world efficiency now the higher cost producer is being used. 

Trade Diversion Diagram

This is the trade diversion diagram. The country was initially paying price P1 for the good, meaning they consumed at Q1 and produced at Q2. Price falls to P2 because of the joining of the EU. We can see here, that consumer surplus has improved. The original consumer surplus at price P1 has now increased to include the areas 1, 2, 3 and 4 on the diagram. We also notice a loss of producer surplus by area 1 which will be the fall in profits. No tariffs are paid out anymore, so the areas 3 and 5 are lost to the government in terms of revenue. This leaves an overall net gain of areas 1 + 2 + 3 + 4 - 1 - 3 - 5 = 2 + 4 - 5. Here we can decide whether the trade diversion has been beneficial or detrimental. If the size of area 5 which we have lost is greater than the size of areas 2 plus 4 which we've gained then there is a net loss, otherwise we've achieved a net gain. 

If there are high external tariffs or a small cost difference between goods produced inside and outside of the union then a customs union is likely to lead to trade diversion.

In the long term, a customs union could have advantages and disadvantages, I'll name a few of both:

• Advantages:
• Increased market size - allows firms to potentially exploit economies of scale to lower costs.
• Better terms of trade with world markets because of the power of the customs union.
• Increased competition which will stimulate efficiency and bring costs down.
• Disadvantages:
• Resources may flow to the geographical centre for the lower transport costs leaving depressed regions on the edge of the union.
• Mergers will be encouraged which will boost monopoly powers.
• Diseconomies of scale.
• The administration costs of maintaining the union.

The basics of preferential trading arrangements in one blog post, tadaaa! Thank you for reading, keep sharing and following the blog! Thanks guys, have a good day.

Sam.

Principles of Economics: Demand (Microeconomics)

*Disclaimer: I'm fully aware of the fact that I've already written a post on demand. However, I've decided to cover it again now I know more on the subject and can give a better coverage.*

Basically, I'm back to cover a very basic principle of microeconomics: Demand. Demand refers to the amount consumers can and are able to purchase of a good or service, 'can and able' being a very important part. Note that a consumers want for a good should not be included in demand. I'm sure everyone wants a flashy sports car on their drive yet the true demand of that good will be very small. Glad we got that out of the way. The demand of a good in a market plays a pivotal role in determining the price. For this, demand must interact with supply and the point at which they meet can be called the 'market output' or the 'equilibrium output'. This is displayed on a graph which I'll do a post about in a few days. The price at this 'equilibrium output' is called the 'market price' or the 'equilibrium price' which is essentially the price consumers have to pay for the good and the price suppliers are selling at.

It's important for me to point out here also that when looking at demand we assume that we're operating in a market of perfect competition. This basically means that in the market there are an abundance of consumers and producers and therefore they have no control over prices. We call them price takers. The size of each producer is too small and there is too much competition from other firms that it would be impossible for them to raise prices and still make sales. Perfect competition is the closest theoretical example to most real-world markets and therefore we use it in our examples.

Let's now look at the relationship between the demand and the price of a good or service. The law of demand is as such: 'When the price of a good rises, the quantity demanded will fall'. This occurs for two reasons:

1. The good/service will cost more than substitute goods. Other similar products will be comparatively cheaper and therefore demand for the good will fall as consumers start to purchase the substitute. For example, a Playstation 3 could be said to be a substitute good for an Xbox 360. Therefore, if the price of the Xbox 360 were to rise then the demand for it would fall as consumers move over to purchase the comparatively cheaper Playstation 3. This is called the 'substitution effect' of a rise in price.
2. People will feel poorer. A rise in the price of a good means people will effectively be able to afford less of the good which makes them seem less well-off, or poorer. This is known as the 'income effect' of a price rise. 

Obviously it occurs the other way also; if the price of a good falls then the quantity demanded will rise. We'll consider the following example, theoretical figures for the monthly coffee demand:

Now, if we were to plot the demand curve for this data it would look something like this:

A typical demand curve would look like this, if real data is being used. The curve you can see slopes downwards from left to right, also called a negative slope, as when the price falls the quantity demanded rises. In most cases, however, real figures aren't used, it's just theoretical. In these cases the demand curve will just be a straight line sloping down from left to right. Remember that we still use the term 'curve' when the line is straight. 

Apart from the price of a good, the demand for a product is also determined by other factors. These are as follows:

• Tastes - The more desirable a good the more it will be demanded and vice versa. This is often affected by advertisements, fashions and what other consumers are purchasing. 
• Quantity and Price of Substitute Goods - If a substitute good has a higher price then demand for the good in question will be higher. If the substitute good has a lower price then the demand will be lower for the initial good.
• Quantity and Price of Complimentary Goods - This works in the opposite way to above. Complimentary goods are products that are consumed together, examples would be cars and petrol or DVD players and the actual DVDs. If the complimentary good's price rises you can expect the demand for the good in question to fall and vice versa. 
• Income - This one is fairly obvious. As people's incomes rise, so does their spending power and therefore demand for 'normal' goods will rise. With this, demand for 'inferior' goods will fall. When we say 'inferior' goods we are talking about things such as supermarket own brand foods. 
• Distribution of Incomes - This determinant is a little more ambiguous. If wealth was re-distributed from the rich to the poor, then demand for luxury items would rise as the poorer people would be able to buy these goods for the first times. It works in the opposite way too, if the poor in society get poorer then the demand for 'normal' goods will fall as the demand for 'inferior' goods should rise. 
• Expectations - Last but not least, people's expectations. Everyone speculates, and if the speculation is that the price of a good is set to rise in the near future then we can expect demand to rise in the short term. If the price is expected to fall we'd expect demand to fall as people hold out until the lower price arrives. 

When we put together a demand curve, we do it assuming that all other things are remaining equal and this is known as ceteris paribus. Nothing but the price changes and when the price changes it results in a movement along the curve. A movement along the curve is different to a shift of the curve, which is very important to remember. When any other determinant of demand changes the curves will shift. A movement along means the demand curve remains the same but the demand just moves to a different point on that curve. A shift means a new demand curve, where at each price a different amount is demanded. 

This is the same demand curve we used earlier, but here we can see that the demand curve has shifted. At each price a different amount of coffee is being demanded. This occurs when a non-price determinant of demand changes. That's probably the hardest basic principle of demand to grasp, but here it is summed up:

• A change in price results in a movement along the demand curve.
• A change in a non-price determinant results in a shift  of the demand curve.

If the change in the determinant of demand causes a rise in demand then the demand curve will shift to the right. If the change in the determinant causes a fall in demand then the demand curve will shift to the left.
The proper names for these two principles are as follows:

• A shift in the demand curve is called a change in demand.
• A movement along  the demand curve is called a change in the quantity demanded.

And that is pretty much that, the principles of demand. The hardest part here is probably differentiating between a movement a long and a shift in the demand curve, however you can pick it up rather quickly. Feel free to comment if you feel i missed something out or something is incorrect. Thanks for reading!

Sam.

What Is Economics?

Since I'm reviving this blog, I thought I'd start a fresh in some ways. I therefore have decided to open up this new era of the blog with the simple, yet very difficult to answer question of what economics actually is.  It's a very ambiguous subject in regards to how you'd define it, the study of what exactly? I've encountered a good example of just how difficult it is to define the subject recently during my search for a university. The fact that different universities place the subject in different areas is the said example. The University of Birmingham, for example, place the study of economics within the business school - giving the subject a more monetary focus. However, this contrasts from the University of Warwick whom place economics within the faculty of social sciences - looking more at wants and scarce resources. This differentiation from the universities suggests that Economics is a broader subject than some may have first imagined.

Let's look at a few potential ways of defining economics. One definition could well be 'the human science which studies the relationship between scarce resources and the various uses which compete for these resources'. If we analyse this definition somewhat we could agree that this definition holds true. Economics could most definitely be classed as a human science. It's not an art and studying it will almost always involve looking at the action of humans. The relationship between scarce resources and the uses of resources is also looked at in the study of Economics. One of the first things you learn about as a beginner economist is the basic economic problem of scarce resources and unlimited wants. So, you wouldn't be wrong to define economics in this particular way.

Another definition I've come across is that 'economics is the science of production and consumption, or the use of goods and services'. Production and consumption are definitely involved in the study of economics, these link back to the scarce resources problem that occurs due to consumption being higher than production. However, I feel using 'the use of goods and services' in a definition for the subject is a bit lacklustre and doesn't quite do it justice. But that isn't to say this definition is wrong, as it most certainly isn't. Along with the likes of 'economics is the study of how to improve society'. Economics does look at how best to allocate scarce resources to improve society partly, but not all for that reason. These two definitions aren't incorrect, I just think they don't get the whole point of the subject across.

This debate wouldn't be complete without a token definition relating somehow to money! 'Economics is the study of wealth'. Well, there it is, the study of wealth. Somewhat true of course, the economy is measured in terms of money, goods and services are normally purchased using money and a lot of people evaluate their position in life by how much wealth they have. But what actually is money? It's a medium for exchange when buying goods, a unit of account for placing a value on things and a store of value when saving. So technically, anything could have ended up being money instead of coins and notes as long as it was in scarce and controlled supply, stable and able to keep its value, divisible without loss of value and portable.  Money does play a big part in the economy, some would even say the economy revolves around money with the flow of income and what not, but I'm still not entirely convinced the subject can be classed as the study of wealth.

I could go on and on, reeling off lists of different definitions of 'Economics', but I won't of course, you have better things to do than read that. I'll leave it there and hope I've successfully got the point across that I was trying to make -Economics is a very broad subject and therefore very difficult to define whilst accurately including everything the subject covers. If i was being asked, I'd class it as the study of scarce resources. I question you to have a think about how you'd define the subject!

That's all from me for now, thank you for reading!