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When something unexpected happens that affects one economy (or
part of an economy) more than the rest. This can create big
problems for policymakers if they are trying to set a macroeconomic
policy that works for both the area affected by the shock and the
unaffected area. For instance, some economic areas may be oil
exporters and thus highly dependent on the price of oil, but other
areas are not. If the oil price plunges, the oil-dependent area would
benefit from policies designed to boost demand that might be
unsuited to the needs of the rest of the economy. This may be a
constant problem for those responsible for setting the interest rate
for the euro given the big differences--and different potential
exposures to shocks--among the economies within the euro zone.

Boom and bust. The long-run pattern of economic growth
and recession. According to the Centre for International
Business Cycle Research at Columbia University, between
1854 and 1945 the average expansion lasted 29 months
and the average contraction 21 months. Since the second
world war, however, expansions have lasted almost twice
as long, an average of 50 months, and contractions have
shortened to an average of only 11 months.


An economy that does not take part in

international trade; the opposite of an
OPEN ECONOMY. At the turn of the
century about the only notable
example left of a closed economy is
North Korea.


Deflation is a persistent fall in the

general price level of goods and
SERVICES. It is not to be confused with
a decline in prices in one economic
sector or with a fall in the INFLATION
rate (which is known as DISINFLATION).

People generally spend a smaller share of their BUDGET on
food as their INCOME rises. Ernst Engel, a Russian
statistician, first made this observation in 1857. The reason
is that food is a necessity, which poor people have to buy.
As people get richer they can afford better-quality food, so
their food spending may increase, but they can also afford
LUXURIES beyond the budgets of poor people. Hence the
share of food in total spending falls as incomes grow.

One of the two instruments of macroeconomic policy; monetary
policy's side-kick. It comprises public spending and taxation, and any
other government income or assistance to the private sector (such
as tax breaks). It can be used to influence the level of demand in the
economy, usually with the twin goals of getting unemployment as
low as possible without triggering excessive inflation. At times it has
been deployed to manage short-term demand through fine tuning,
although since the end of the keynesian era it has more often been
targeted on long-term goals, with monetary policy more often used
for shorter-term adjustments.


Short for gross national product, another

measure of a country's economic
performance. It is calculated by adding to
GDP the income earned by residents from
investments abroad, less the corresponding
income sent home by foreigners who are
living in the country.

Very, very bad. Although people debate when, precisely, very rapid INFLATION

Very, very bad. Although people debate when, precisely, very rapid INFLATION
turns into hyper-inflation (a 100% or more increase in PRICES a year, perhaps?)
nobody questions that it wreaks huge economic damage. After the first world war,
German prices at one point were rising at a rate of 23,000% a year before the
countrys economic system collapsed, creating a political opportunity grasped by
the Nazis. In former Yugoslavia in 1993, prices rose by around 20% a day. Typically,
hyper-inflation quickly leads to a complete loss of confidence in a countrys
currency, and causes people to search for other forms of MONEY that are a better
store of value. These may include physical ASSETS, GOLD and foreign currency.
Hyper-inflation might be easier to live with if it was stable, as people could plan on
the basis that prices would rise at a fast but predictable rate. However, there are
no examples of stable hyper-inflation, precisely because it occurs only when there
is a crisis of confidence across the economy, with all the behavioural
unpredictability this implies.


Investment from abroad; the


The shape of the trend of a countrys trade balance following a
DEVALUATION. A lower EXCHANGE RATE initially means cheaper
EXPORTS and more expensive IMPORTS, making the current account
worse (a bigger DEFICIT or smaller surplus). After a while, though,
the volume of exports will start to rise because of their lower PRICE
to foreign buyers, and domestic consumers will buy fewer of the
costlier imports. Eventually, the trade balance will improve on what
it was before the devaluation. If there is a currency APPRECIATION
there may be an inverted J-curve.

A branch of ECONOMICS, based, often loosely, on the ideas of KEYNES,

A branch of ECONOMICS, based, often loosely, on the ideas of KEYNES,

characterised by a belief in active GOVERNMENT and suspicion of market
outcomes. It was dominant in the 30 years following the second world war, and
especially during the 1960s, when FISCAL POLICY became bigger-spending and
looser in most developed countries as policymakers tried to kill off the BUSINESS
CYCLE. During the 1970s, widely blamed for the rise in INFLATION, Keynesian
policies gradually gave way to monetarism and microeconomic policies that owed
much to the NEO-CLASSICAL ECONOMICS that Keynes had at times opposed. Even
so, the idea that PUBLIC SPENDING and TAXATION have a crucial role to play in
managing DEMAND, in order to move towards FULL EMPLOYMENT, remained at the
heart of MACROECONOMIC POLICY in most countries, even after the monetarist
and supply-side revolution of the 1980s and 1990s. Recently, a school of new,
more pro-market Keynesian economists has emerged, believing that most markets
work, but sometimes only slowly.


Old news. Some economic statistics move

weeks or months after changes in the
not be a reliable guide to the current
state of an economy or its future path.

The big picture: analysing economy-wide phenomena such as
MICROECONOMICS, the study of the behaviour of individual markets,
workers, households and FIRMS. Although economists generally
separate themselves into distinct macro and micro camps,
macroeconomic phenomena are the product of all the
microeconomic activity in an economy. The precise relationship
between macro and micro is not particularly well understood, which
has often made it difficult for a GOVERNMENT to deliver well-run


The school of ECONOMICS that developed the free-market ideas of

CLASSICAL ECONOMICS into a full-scale model of how an economy
works. The best-known neo-classical economist was ALFRED
MARSHALL, the father of MARGINAL analysis. Neo-classical thinking,
which mostly assumes that markets tend towards EQUILIBRIUM, was
attacked by KEYNES and became unfashionable during the
Keynesian-dominated decades after the second world war. But,
thanks to economists such as
MILTON FRIEDMAN, many neo-classical ideas have since become
widely accepted and uncontroversial.

How far an economys current OUTPUT is below what it would be at
full CAPACITY. On average, INFLATION rises when output is above
potential and falls when output is below potential. However, in the
short run, the relationship between inflation and the output gap can
deviate from the longer-term pattern and can thus be misleading.
Alas for policymakers because nobody really knows what an
economys potential output is, the size and even the direction of the
output gap can easily be misdiagnosed, which can contribute to
serious errors in MACROECONOMIC POLICY.

A In 1958, an economist from New Zealand, A.W.H. Phillips (191475), proposed that there was a trade-off between INFLATION and
UNEMPLOYMENT: the lower the unemployment rate, the higher was
the rate of inflation. Governments simply had to choose the right
balance between the two evils. He drew this conclusion by studying
nominal wage rates and jobless rates in the UK between 1861 and
1957, which seemed to show the relationship of unemployment and
inflation as a smooth curve.
Economies did seem to work like this in the 1950s and 1960s, but
then the relationship broke down. Now economists prefer to talk
about the NAIRU, the lowest rate of unemployment at which inflation
does not accelerate.

The foundation stone of MONETARISM. The theory says that the quantity of MONEY
available in an economy determines the value of money. Increases in the MONEY
SUPPLY are the main cause of INFLATION. This is why Milton FRIEDMAN claimed
that 'inflation is always and everywhere a monetary phenomenon'.
The theory is built on the Fisher equation, MV = PT, named after Irving Fisher
(1867-1947). M is the stock of money, V is the VELOCITY OF CIRCULATION, P is the
average PRICE level and T is the number of transactions in the economy. The
equation says, simply and obviously, that the quantity of money spent equals the
quantity of money used. The quantity theory, in its purest form, assumes that V
and T are both constant, at least in the short-run. Thus any change in M leads
directly to a change in P. In other words, increase the money supply and you
simply cause inflation.


Policies to pump up DEMAND and

thus boost the level of economic
activity. Monetarists fear that such
policies may simply result in

GOVERNMENT policies intended to smooth the economic cycle,
expanding DEMAND when UNEMPLOYMENT is high and reducing it
when INFLATION threatens to increase. Doing this by FINE TUNING
has mostly proved harder than KEYNESIAN policymakers expected,
and it has become unfashionable. However, the use of automatic
stabilisers remains widespread. For instance, social handouts from
the state usually increase during tough times, and taxes increase
(FISCAL DRAG), boosting government revenue, when the economy is


Payments that are made without any good

or service being received in return. Much
PUBLIC SPENDING goes on transfers, such
as pensions and WELFARE benefits.
Private-sector transfers include charitable
donations and prizes to lottery winners.

If you pay your cleaner or builder in cash, or for some reason neglect
to tell the taxman that you were paid for a service rendered, you
participate in the underground or black economy. Such transactions
do not normally show up in the figures for GDP, so the black
economy may mean that a country is much richer than the official
data suggest. In the United States and the UK, the black economy
adds an estimated 5-10% to GDP; in Italy, it may add 30%. As for
Russia, in the late 1990s estimates of the black economy ranged as
high as 50% of GDP.

This usually refers to FIRMS, where it is defined as the value of the firm's OUTPUT
minus the value of all its inputs purchased from other firms. It is therefore a
measure of the PROFIT earned by a particular firm plus the wages it has paid. As a
rule, the more value a firm can add to a product, the more successful it will be. In
many countries, the main form of INDIRECT TAXATION is value-added tax, which is
levied on the value created at each stage of production. However, it is paid,
ultimately, by whoever consumes the finished product.
Another definition of value added refers to the change in the overall economic
value of a company. This takes into account changes in the combined value of its
SHARES, ASSETS, DEBT and other liabilities. Part of the pay of company bosses is
often linked to how much economic value is added to the company under their


The difference between basic pay and total

earnings. Wage drift consists of things such as
overtime payments, bonuses, PROFIT share
and performance-related pay. It usually
increases during periods of strong GROWTH
and declines during an economic downturn.

Producing OUTPUT at the minimum possible cost. This is
not enough to ensure the best sort of economic
EFFICIENCY, which maximises society's total CONSUMER
plus PRODUCER SURPLUS, because the quantity of output
produced may not be ideal. For instance, a MONOPOLY can
be an X-efficient producer, but in order to maximise its
PROFIT it may produce a different quantity of output than
there would be in a surplus-maximising market with


The annual income from a SECURITY,

expressed as a percentage of the current
market PRICE of the security. The yield on a
SHARE is its DIVIDEND divided by its price. A
BOND yield is also known as its INTEREST
RATE: the annual coupon divided by the
market price.

When the gains made by winners in an economic
transaction equal the losses suffered by the losers. It is
identified as a special case in GAME THEORY. Most
economic transactions are in some sense positive-sum
games. But in popular discussion of economic issues, there
are often examples of a mistaken zero-sum mentality, such
as PROFIT comes at the expense of WAGES, higher
PRODUCTIVITY means fewer jobs, and IMPORTS mean
fewer jobs here.