Economic Terms

Where resources in the economy are not distributed optimally and therefore consumers cannot purchase the quantity of goods that they desire. This occurs when the price is not equal to the marginal cost for firms and also the economy is operating on a point that does not lie on the PPF.

The diagrams below illustrate how graphically allocative inefficiency can be illustrated for firms and the economy as a whole. For firms, if they are producing at the point where price is not equal to the marginal cost, they are producing a sub-optimal amount of resources for consumers, the market shown below is a monopoly market, as this is a market with a high level of inefficiencies due to monopoly power.

The diagram on the right illustrates that when an economy is not producing on its PPF it is not using all the resources in the economy to produce a share of goods for economic agents to consume. Any point not on the PPF corresponds to an allocatively inefficient point.

The disinterested and selfless concern for the well-being of others.

Is a cognitive bias that describes the common human tendency to rely too heavily on the first piece of information offered (the "anchor") when making decisions. During decision making, anchoring occurs when individuals use an initial piece of information to make subsequent judgments.

For instance if individuals were asked whether the tallest building in the world was more or less than X amounts of ft, the mean answer given would be influenced by the x value given to them. As individuals use that information to sway their guess.

A rise in the value of a currency due to excess demand for the currency. This will result in higher export prices and lower import prices.

In this example an increase in exports has increased the demand for the currency from D to D1. Without any change in supply to accommodate this demand this means the excess demand increases the exchange rate (the price of the currency) fro P to P1. At a price of P1 the exchange rate has appreciated and the movement up the supply curve means that the equilibrium is re-established as D1 = S.

Foreign currency is possibly the best example of how the forces of demand and supply operate, as vast amounts of currnecy are traded around the clock. Market makers will continuously adjust currency rates (the price of a currency) to clear the market by balancing prospective buyers and sellers. If there are more prospective buyers than sellers this means the price is too low and market makers will respond by gradually raising the price. The respective laws of demand and supply means that this price rise will disincentivise demand and incentivise supply until the market finally clears when the price reaches the point where demand equals supply. This is how exchange rates appreciate. 

An appreciation in exchange rate can be caused by:

• An increase in demand - because foreign countries require sterling because they wish to acquire UK goods and services or they wish to move their savings to the UK.
• A reduction in supply - because UK firms and individuals supply sterling to acquire foreign currency so they can purchase imports or to move their savings to other countries. 

 

Making a profit by identifying opportunities to buy an asset in one market and to sell it on in another market at a higher price. The flowchart below illustrates the process of arbitrage for an investor to make an instant risk-less profit. Profit can be achieved without risk because the price differences occur at the same point in time which means that the respective trades can occur at the same time to exploit the price differential and make a profit.

The price differentials normally occur due to technical reasons e.g. a financial asset is traded in two locations (e.g. London and New York) and a temporary and unintended price differential emerges. These differentials are usually correctly quickly and so arbitrage opportunities must be identified and exploited quickly. Various software applications support this process. Although the price differentials are small and apparently trivia, large levels of profit can be made by applying large sums of money to exploit a small price differential.

The process in which banks convert large quantities of short-term, low risk, small and liquid deposits into a small number of much larger, long-term, riskier and illiquid advances (loans). This is how individual banks make majority of their profits by transforming assets to meet the incompatible needs and wants of borrowers and lenders simultaneously. 

The main risk with this type of approach for banks, is if a large long term loan is funded by a large number of small short term deposits, the bank may experience problems meeting the demands of depositors if large numbers decide to withdraw their deposit. In this situation the mismatch between the terms of depositors and borrowers is problematic as the loans may not be redeemable in the short term and this creates liquidity issues i.e. there may not be enough cash immediately available to allow depositors to withdraw their savings.

The diagram below illustrates how banks take cash from savers (surplus units - total income exceeds total expenditure) and the bank issues it off to borrowers (deficit units - total income exceeded by total expenditure) through loans in exchange for their debt (to be paid back at a later date).

An asset represents a valued economic resource belonging to an economic agent - in either tangible or intangible form - that adds to the wealth of an individual. 

Most commonly assets are a term commonly used when referring to financial institutions, as it appears on the balance sheets of these institutions.

For instance, the claims that banks have against economic agents represents what the bank owns on its balance sheet and therefore are marked down as part of their assets. For example a loan (advance) is an example of an asset that would appear on a bank's balance sheet as it is money that they have lent out to other parties but are expecting back into the bank in the future.

When the rights under a contract (e.g. property deeds) are transferred to another party. Commonly used to provide security for a large loan or mortgage.

Economic policy decisions that aim to restructure the economy so that is is possible to achieve economic growth as well as reduce the budget deficit and ultimately create a budget surplus so that national debts can be repaid. In order to achieve this the policies will involve increasing taxes (increased leakage) or reducing government spending (reduced injection).  The net result of this will be an inward shift in AD (AD1 to AD2 )and downward pressure on real national output (Y to Y1) and the price level (P to P1). 

If these policies contribute to a loss in confidence then it is likely that there will be a further fall in AD (AD2 to AD3). if the downturn is sustained in the long run some economists have argued that if the downturn is sustained over a long period tit will also lead to a damaging contraction in AS. 

 

It is important to understand that contraction is only part of the Austerity story. The point of experiencing the resulting contractionary effects of Austerity policies is that the negative short term impacts will be offset by a recovery in the medium and long term. This is expected to arise from avoiding any credit rating downgrades by being seen to proactively manage national debts, pursuing expansionary monetary policy and structuring the changes in taxes and spending to rebalance the economy so that the public sector contraction is covered by an expansion fo the private sector. 

Managing the cost of debt is critical in the UK due to the high levels of government, personal and corporate debt. Any reduction in the UK's credit rating will feed into financial markets and drive up the cost of borrowing.   

Needless to say this debate is heavily politicised and it is important that students are able to present a balanced view of this policy.

Automatic fiscal effects which help influence the path of economic growth due to cyclical changes in tax revenue and welfare costs. Often the presence of fiscal stabilisers reduces the effectiveness of a fiscal policy. 

For instance, if the government runs an expansionary fiscal policy, this should theoretically increase aggregate demand quite significantly as a result of the government spending component of AD increasing or higher consumption brought on by higher disposable income (Y-T). But taking into account the role of automatic fiscal stabilisers, the expansion in AD (upside in growth of output, employment and the price level) from this type of fiscal policy will be constrained and the aggregate demand curve shift may not be as significant i.e. shifts to AD₃ rather than AD₂.

This happens because if real output increases, then this will lead to more people in employment and the individuals who were already in employment might secure higher wages. As a result the level of tax revenue the government now receives will be higher. At the same time the spending on welfare benefits will fall as more people enter employment. On a positive note this improves the financial position of the government (budget deficit could improve) but it also acts as a limit on the upturn seen in the economy.

It is also important to note that this significantly impacts the multiplier effect as well.  As the impact of a positive multiplier, in reaction to an expansionary fiscal policy, may well become diluted by the operation of automatic stabilisers. The greater the multiplier effect, the greater the restraint automatic stabilisers place on the upturn in the economy. 

On the other hand, if the government runs a contractionary fiscal policy, this should theoretically decrease aggregate demand quite significantly as a result of the government spending component of AD decreasing or lower consumption brought on by lower disposable income (Y-T). But taking into account the role of automatic fiscal stabilisers, the contraction in AD (downside in reduction of output, employment and the price level) from this type of fiscal policy will be constrained and the aggregate demand curve shift may not be as significant i.e. shifts to AD3 rather than AD2.

This happens because if real output decreases, then this will lead to fewer people in employment and the individuals who remain employed in employment might be on lower wages or have a general insecurity about their job safety. As a result the level of tax revenue the government now receives will be lower. At the same time the spending on welfare benefits will rise as more people become unemployed. From the government's perspective, this has a negative impact on their fiscal finances (the reduction n the budget deficit may not be as large as anticipated.) but it does act as a limit on the downturn seen in the economy.

It is also important to note that this significantly impacts the multiplier effect as well.  As the impact of a negative multiplier, in reaction to a contractionary fiscal policy, may well become diluted by the operation of automatic stabilisers. The greater the multiplier effect, the greater the restraint automatic stabilisers place on the downturn in the economy.