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Economic Terms

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Terms of Trade

The relative price of a country's exports in terms of imports and is defined as the ratio of export prices to import prices. It can be interpreted as the amount of goods a country can import per good that is exported i.e. how much the revenue received from each exported good can buy in terms of imports.

For instance if the average price of exports rise relative to import prices there has been an improvement in the terms of trade - a unit of export buys relatively more imports. Likewise if import prices fall relative to export prices. Therefore if a country's terms of trade improve it is either because the average price of their exports have increased or the average price of their imports have fallen as the diagram below shows.

Tertiary sector

This sector distributes primary and secondary products and provides services.

The Chancellor of the Exchequer

Is a UK government cabinet position with responsibility for financial and economic matters. The post is currently occupied by George Osborne.

The Economic Problem

Is one of the fundamental economic theoretical principles in the operation of any economy. It asserts that any economy has a limited amount of economic resources (factors of production) at its disposal and therefore producers need to identify the best way of allocating these scarce resources to best satisfy the infinite needs and wants of consumers across the economy. This all runs on the basis that consumers tastes and preferences are ever-changing and producers need to find the best way of diverting a finite amount of resources to the goods and services which hold the greatest value and importance to consumers. Therefore, the economic problem is driven by two concepts; choice, and scarcity. Producers have to make tough choices by prioritising the human wants that can be fulfilled alongside what is feasible for them to produce given those scarce resources. Each choice represents an opportunity cost for producers due to the scarcity of these resources. The ability of producers to achieve the optimal allocation of resources can be best represented by looking at the PPF of any economy.


The General Theory of Employment, Interest and Money

Was written by John Maynard Keynes. Its main idea was that markets will not deliver efficient outcomes if there is minimal intervention. His view was that without proactive demand side fiscal policy, markets will deliver under employment and investment.

The Quantity Theory of Money

Is a classic monetarist inflation theory established over 500 years ago, that states increases in the price level are solely determined by increases in the money supply. This theory is the core of monetarism.

The theory's prediction can be best shown via the Fisher Equation. This equation is an adaption of the equation of exchange and is named after the American economist Irving Fisher.

Now there are a few assumptions that monetarists impose on the equation in order for the theory and the subsequent results to hold. The most important of these assumptions is that T and V are always assumed to be constant values in the short-run at least. Monetarists particularly stress V is held constant because the demand for money is a function of income and this does not immediately change in the short-run from a change in M. Based on this assumption the equation cancels down to:

However, this assumption of a constant velocity of circulation in particular is often a sticking point for opposing Keynesian economists. This is because they argue that V must change even in the short-run because it is determined by human spending impulses from consumers and firms, which to assume is constant is illogical in their eyes. For instance, if the money supply is increased then the base rate must be changed and by doing so this affects economic agents demand for money (liquidity preferences).

If we take the monetarist assumptions as given and we get the simplified equation of M=P, any permanent change in the money supply creates an equal permanent change in the price level i.e. if the money supply doubles then the price level will double.

The mechanism of this inflation theory can be represented with the following graphs below:

At period t1 the initial increase in the money supply causes the amount of money circulating in the economy to permanently increase from M1 to M2. This immediately causes the velocity of circulation to fall by an equal factor (V1 to V2) temporarily as each unit of currency does not change hands as many times within a year now there is more money circulating around. However, as the extra money begins to be spent by consumers the number of transactions (T) in the economy starts to gradually rise over time and this creates pressure for price level to rise over time (P) as a result of demand-pull inflation. As a result of more transactions being conducted in the economy, this starts to cause the velocity of circulation to rise over time as consumers make more transactions. But, as the price level rises this causes the number of transactions to fall back to its original level, which also means V also falls back to its original level, as consumer real incomes start to fall back to their original levels. So at the final equilibrium there is a higher price level with the same values for V and T.

The results of this theory can be represented in an AD/AS framework:


Assuming no accompanying LRAS curve shift is created this creates demand pull inflation and this can lead to an inflationary spiral, which is not always a problem for the economy, as this type of inflation arises from higher consumption, economic activity and results in growth. But, it is important to note that if the inflation rate becomes too high and volatile it becomes unhelpful as it undermines confidence and competitiveness in the long-run.

When evaluating the Quantity Theory of Money it is important to consider the following points:

  • Accompanying Productivity Changes e.g. An outwards LRAS curve shift will create dis inflationary growth and will cause the predictions of the model to break down.
  • Confidence Levels e.g. The theory assumes that consumers will always spend idle cash balances but they may prefer to hold onto cash balances.
  • Level of Spare Capacity e.g. AD expansion may be absorbed and not create inflation if the economy is operating below the full employment level.
  • Reverse Causation e.g. Money supply may accompany inflation rather than cause it. 


The Ultimatum Game

Is a game in economic experiments to provide key insights into the pshycological behaviour of an individual.

It works by one player being offered a sum of money. Immediately afterwards they are required to make a second player an offer and if that player accepts the offer he must hand over the amount prescribed in the offer, leaving the original player with the left-overs. However, if the second player rejected the offer because it was too low then both players walk away with nothing. So the first player needs to offer the second player an offer that he will not be able to refuse. However, economic theory suggests that the game should be played by the first player offering the second player $1 and he should then accept it. As it would be the lowest amount the first person can give away and the second player will not turn any offer of money down, making it a mutually beneficial offer. But often a perception of fairness evolves and takes over and the first player offers the second player a much fairer allocation of the sum of money. This is shown in the logical sequence below.


Third Degree Price Discrimination

Is when firms charge a different price to different consumer groups. This is a very common form of price discrimination. For example this is done when cinema tickets are sold in which adults have to pay more compared to children.

Below is a table to show a firm that engages in this form of price discrimination in which those who value the good highly i.e. those that are paying £40 or more are charged £40. Whilst those that value it less i.e. those who value it below £40 get charged £20. Therefore in this case the firm has segregated the market into two different markets - high and low valuation.

Here is a graphical representation of the firm splitting the market into two different forms and therefore they face a kinked demand curve. Inelastic demand curve for high prices in market A and and elastic demand curve for low prices in market B.

Third parties

A person or individual not directly involved in an action, transaction or agreement.

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