Virtual Economy Glossary (D-F)

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Deflate To deflate the economy means to set out to deliberately reduce the level of economic activity. This is most likely to be necessary because there is an excess level of demand and this is leading to demand-pull inflation. Deflating means using deflationary policies. These could include cutting government expenditure, increasing taxes or raising interest rates.
Deflationary fiscal policy Deflationary fiscal policy is using the level of government expenditure and taxation to reduce the level of aggregate demand in the economy. Deflationary fiscal policies could include:
  • Increasing the level of income tax
  • Reducing government expenditure
  • Increasing VAT and other indirect taxes
Deflationary gap A deflationary gap exists when there is insufficient demand available in the economy to generate a full-employment equilibrium. In other words there is not enough being bought to provide jobs for everyone who wants them.
Deflationary monetary policy Deflationary monetary policy is using interest rates and other monetary policies to reduce the level of aggregate demand in the economy. Deflationary monetary policies could include:
  • Increasing interest rates
  • Open market operations
Deflationary policies Deflationary policies are policies that are aimed to reduce the level of aggregate demand in the economy and therefore slow down the rate of growth of output. This may be necessary because of increasing inflation or a significant balance of payments deficit. The government could use either deflationary fiscal policies or deflationary monetary policies.
Demand-deficient unemployment Demand-deficient unemployment happens when there is not enough demand in the economy to employ everyone who wants a job. It will tend to happen mainly in recessions or downturns in the trade cycle. Keynesians argue that this shortage of demand is one of the key causes of unemployment. In other words unemployment is involuntary.
Demand management policies These are policies that Keynesians argued should be used to control the level of demand in the economy. If there was a shortage of demand governments should aim to boost demand (reflationary or expansionary policies), and when there was excess demand they should do the opposite (deflationary or contractionary policies). In other words the government should be aiming to do the opposite to the trade cycle. For this reason these policies were often called 'counter-cyclical demand management policies'.
Demand-pull inflation If there is an excess level of demand in the economy, this will tend to cause prices to rise. This type of inflation is called demand-pull inflation and is argued by Keynesians to be one of the main causes of inflation.

Demand-pull inflation

As demand increases from AD1 to AD4 there is increasing inflationary pressure on prices. This is demand-pull inflation - "too much money chasing too few goods."
Demand-side See Demand management policies
Demand-side policies See Demand management policies
Diminishing returns Diminishing returns refers to a situation where a firm is trying to expand by using more of its variable factors, but finds that the extra output they get each time they add one gets progressively less and less. This usually arises because their capacity is limited in the short-run and the combination of the fixed and variable factors becomes less than optimal.
Direct taxes Direct taxes are taxes on income. The main direct tax in the UK is income tax.
Disposable income Disposable income is the income people have left after they have paid their tax. It is the money that they can choose how they wish to spend.


Economic rent Economic rent is the difference between what a factor of production is earning (its return) and what it would need to be earning to keep it in its present use. It is in other words the amount a factor is earning over and above what it could be earning in its next best alternative use (its transfer earnings).
Economies of scale Economies of scale occur when larger firms are able to lower their unit costs. This may happen for a variety of reasons. A larger firm may be able to buy in bulk, it may be able to organise production more efficiently, it may be able to raise capital cheaper and more efficiently. All of these represent economies of scale.
Expansionary fiscal policy See fiscal policy.
Expansionary monetary policy See monetary policy.
Expectations-augmented Phillips Curve The expectations-augmented Phillips Curve was developed by Milton Friedman to try explain the breakdown of the Phillips Curve in the 1970s. He incorporated people's price expectations, and said that there would be a number of short-run Phillips Curves - one for each level of price-expectations. However, in the long-run there would be no trade-off between unemployment and inflation and any attempt to reduce unemployment to below its natural rate would simply be inflationary. For more detail on this see the Monetarist section of the Virtual Economy.
External benefits See Positive externalities
External costs See Negative externalities
Externalities - negative Externalities occur where the actions of firms and individuals have an effect on people other than themselves. In the case of negative externalities the external effects are costs on other people. These are known as external costs. There may be external costs from both production and consumption. If these are added to the private costs we get the total social costs. The most common example of external costs are things like pollution where people other than the firm may bear the health costs and other problems.
Externalities - positive Externalities occur where the actions of firms and individuals have an effect on people other than themselves. In the case of positive externalities the external effects are benefits on other people. These are known as external benefits. There may be external benefits from both production and consumption. If these are added to the private benefits we get the total social benefits.


Factors of production The factors of production are the resources that are necessary for production. They are usually classified into 4 different groups:
  1. Land - all natural resources (minerals and other raw materials)
  2. Labour - all human resources
  3. Capital - all man-made aids to production (machinery, equipment and so on)
  4. Enterprise - entrepreneurial ability
The rate of economic growth that an economy can manage will be affected by the quantity and the quality of the factors of production they have.
Fiscal drag Fiscal drag refers to the effect inflation has on average tax rates. If tax allowances are not increased in line with inflation, and people's incomes increase with inflation then they will be moved up into higher tax bands and so their tax bill will go up. However, they are actually worse off because inflation has cancelled out their pay rise and their tax bill is higher. The only person that is better off is the Chancellor as he is getting more tax and hasn't had to increase tax rates. Chancellors have been known to use this as a subtle means to raise more tax revenue. To maintain average tax rates, allowances should be increased by the amount of inflation each year.
Fiscal policy Fiscal policy is the use of government expenditure and taxation to try to influence the level of economic activity. An expansionary (or reflationary) fiscal policy could mean:
  • cutting levels of direct or indirect tax
  • increasing government expenditure
The effect of these policies would be to encourage more spending and boost the economy. A contractionary (or deflationary) fiscal policy could be:
  • increasing taxation - either direct or indirect
  • cutting government expenditure
These policies would reduce the level of demand in the economy and help to reduce inflation.
Fiscal year The fiscal year is the same as the tax year. It runs from April 6th of one year to April 5th of the next year. Any budget changes are always implemented for the next fiscal year. i.e. to start on April 6th.
Fisher equation of exchange The Fisher equation of exchange was developed, surprisingly, by Irving Fisher. The Fisher equation appears in various guises, but perhaps the most common is:

MV = PT where:
M is the amount of money in circulation
V is the velocity of circulation of that money
P is the average price level and
T is the number of transactions taking place

This equation is in fact an identity as it will always be true. At its simplest level you could imagine an economy that has a money supply of £5. If this £5 is on average used 20 times in a year, it will have generated £100 of spending. In the Fisher equation above M would be equal to £5, V equal to 20 and PT would be £100. This £100 could be made up of, say 100 transactions of £1 each. PT can therefore be thought of as equivalent to National Expenditure.

Frictional (search) unemployment When somebody loses their job (or chooses to leave it), they will have to look for another one. If they are lucky they find one quite quickly, but they may be unlucky and it may take some time. On average it will take everybody a reasonable period of time as they search for the right job. This creates unemployment while they look. The more efficiently the job market is matching people to jobs, the lower this form of unemployment will be. However, if there is imperfect information and people don't get to hear of jobs available that may suit them then frictional unemployment will be higher.
Full-employment equilibrium This is the level at National Income at which everyone who wants to work is able to. There is in other words sufficient demand to employ everyone. Classical economists argued that the economy would automatically tend to this equilibrium, whereas Keynesians said that it was the role of government, through their policy, to ensure we got there.
Funding Funding is a situation that arises when the government convert short-term securities into long-term ones. If the government sell more long-term securities then this will reduce the banks' liquidity. This in turn will reduce their ability to lend more. Funding therefore acts as a contractionary monetary policy. Over-funding is when the government sell more securities than necessary. This also is a contractionary monetary policy.