Notesale: Turn your study into money

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2 The UK economy: performance and policies
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1 GDP as a measure of economic growth
→ Gross domestic product (GDP) is the measure of output of goods and services in a country in a year
→ It is given as a level of output, in the local currency
→ On its own it is almost meaningless; we need to know how many people there are, what the
currency is worth in terms of its spending power in the local economy and what the changes have
been since the previous measure
→ There are two meanings of the term economic growth:
▪ Actual economic growth refers to an increase in real incomes or GDP
▪ Potential economic growth is an increase in the productive capacity of an economy
→ Potential economic growth may be caused by an increase in the labour supply, or increased
investment or productivity – the difference between actual and potential economic growth is known
as an output gap
→ Although it is a useful measure, potential economic growth is hard to record and calculate
→ GDP is the sum of all goods and services produced in a country in a year
→ It is also the sum of all incomes earned in a country in a year, and the sum of all expenditure in a
year
→ GDP does not include earnings by its residents while they are abroad, i
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the earnings of a British
engineer who is working and being paid in Russia do not count toward British GDP
→ A country’s GDP can be considered as a circular flow of income where for everything that is earned,
something must be produced and something must be spent
→ The government measures all three flows: goods, income and expenditure – in theory these should
be equal, all at around £1
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2 Distinction between various terms
→ If economic growth is measured using national income, the value is meaningless unless the figures
and given in real values rather than nominal values, i
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adjusted for inflation

→ Another important distinction that needs to be made is to look at values rather than volumes – it is
meaningless to talk about the number of shoes being made in a country without considering the
price at which those shoes are sold for
→ For example, in terms of volume of exports, China far eclipses Germany, yet because German
exports are in high-value goods and services, Germany has the highest value of exports in the world
– Germany, then, gets more benefit from their exports, despite actuallt exporting less than China in
terms of volume
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4 Comparison of rates of growth between countries and over time
→ An increase in GDP of 10% in one country does not mean that country is doing better than a country
with 5% GDP growth
→ Equally, a comparison of growth rates over time must bear this is mind – Japan saw annual growth
rates of 10% in the 1960s compared to just 4% in the 1980s, but the 1980s figure is based on a much
larger economy
→ An evaluation of growth figures depends on:
▪ How well-off the country is in the first place
▪ How much of the output is self-consumed, so does not appear as GDP
▪ Methods of calculation and reliability of data
▪ Relative exchange rates – do they represent the purchasing power of the local currency?
▪ Type of spending by government – is money spent on warfare or quality of life issues such as
education and health?
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6 Limitations of using GDP to compare living standards between countries and over time
→ There are a number of limitations of using GDP to compare living standard, both between countries
and over time:
▪ Subsistence, barter and the hidden economy – if farmers consume their own output, if
goods are traded without the price system or if goods are paid for without being declared
for tax purposes, they will not be included in GDP; the size of the hidden economy is
estimated at 7% of GDP in the UK, 30% in Italy, 50% in Russia and up to 60% in sub-Saharan
Africa
▪ The informal economy – wagwan, capitalism? Some output is not recorded because it is not
bought or sold, but is still output, like volunteering at a charity shop or growing potatoes in
your garden and then giving them to your neighbours for free
▪ Currency values – when trying to compare countries, there is a difficulty in knowing whether
to use the official value of a currency (the exchange rate) or the purchasing power of that
currency
▪ Income distribution – when comparing countries’ income per head, some sense of the
income distribution should also be taken into account; if a large proportion of income is
earned by very few people, then the general standard of living in a country can seem higher
than it is due to a skewed mean
▪ Size of the public sector – if much of the spending in the economy is by government, it may
have positive effects (guaranteeing stability) or it may not (driving inefficiency)
▪ Consumer and capital spending – spending on investment goods might mean standard of
living increases in the future, at the expense of living standard today
▪ Quality issues – spending on schools might be high, for example, but how can we measure
the quality of education? Are improving results enough to show that the quality of the good
being purchased is actually better, or is the price simply becoming inflated?
→ These limitations mean that comparisons of living standards are likely to be inaccurate if they are
based solely on GDP
→ However, real income growth per head is a good guide to actual growth if these others factors are
taken into account
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1 Inflation, deflation and disinflation
→ Inflation is a sustained rise in the general price level
→ The general price level is measured using the consumer prices index (CPI) – the reason for using an
index is that percentage changes can be shown easily
→ Deflation is a fall in the general price level
→ It is problematic in a number of ways:
▪ It is a problem for people with debts, because the real value of money becomes higher, and
so the real size of any debt they face becomes larger – it is harder for them to pay back their
debts
▪ It also stops firms from wanting to invest in that country because the value of goods
produced by any investment is likely to reduce relative to the cost of the initial costs
▪ Deflation is also likely to reduce consumption, creating a shock to aggregate demand – why
buy an expensive consumer item when you know the prices are going to come down?
→ Disinflation occurs when prices rise more slowly than they have done in the past
→ For example, inflation might fall from 3% to 2%, meaning that prices are rising (there is inflation) but
it as at a slower rate than previously
→ Disinflation can be a sign that inflation is coming under control, but on the worrying side it can mean
that investment and confidence are low in the economy, and deflation might occur in the near term
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3 The government’s target for CPI inflation
→ The UK government has a symmetrical target for CPI inflation of 2% - the shorthand for this is CPI
inflation of 2% (±1%)
→ As a result, small price rises are acceptable to the UK government, but if prices rise by more than 3%
then they start to become a concern

→ Equally, if they start to rise by less than 1% then there is a risk of deflation and the Bank of England is
tasked with returning it to within the 1-3% acceptable range
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5 The RPI as an alternative measure
→ For many people, wage increases are linked to the rate of inflation, and, if the CPI measure is used,
wage increases will fail to account for one of the most significant elements of household costs
→ A more appropriate measure for wage determination is the retail prices index (RPI)
→ This is more inclusive that the CPI in that it includes housing costs, but it is not as reliable for
international comparisons because it is only used in the UK
→ Moreover, because RPI includes the costs of mortgage payments (which include interest payments),
any increase in interest rates will have the effect of increasing the value of mortgage payments,
increasing RPI
→ Changes to interest rates can therefore have a one-off sudden impact on the RPI
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7 The effects of inflation
→ The costs of inflation include problems for a number of groups:
▪ Consumers
▪ Firms
▪ The government
▪ Workers
→ There are also some benefits
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1 For consumers
→ The real value of savings falls as prices rise – people of working age are already significantly undersaving in the UK and inflation makes saving even less attractive
→ The purchasing power of those on fixed incomes falls as prices rise – for example, pensioners relying
on annuities for their main living expenditures will find their standards of living decline when there is
inflation
→ Those with high levels of debt benefit from inflation, as the real value of their debt falls – the value
of a mortgage loan relative to income is likely to fall when the general price level falls
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2 For firms
→ Loss of international competitiveness – exports become relatively expensive and imports relatively
cheap; the balance of payments is likely to worsen
→ Increased uncertainty – if firms think that costs are rising and fear increases in interest rates, they
may curb investment
→ Investment from abroad might decrease – inflation erodes the value of money, so why buy into a
currency that is falling in value?
→ Increased prices might be a sign that firms can make more profit – if inflation is demand-pull then
costs remain the same while revenue increase, and profits rise, perhaps increasing incentives to
invest
→ A little inflation means that real wage differentials can be changed without actually cutting wages in
nominal terms – the argument is that people will accept wage rises below the rate of inflation but
will never accept wage cuts
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3 For the government
→ Redistribution of income – those on fixed incomes will see incomes fall in real incomes; those with
index-linked incomes will not lose out unless they are linked to a fairly unrepresentative measures
such as the CPI; pensions and benefits are index-linked so the lowest earners in the economy see a
real-terms rise in incomes
→ Inflation reduces the real interest rate, so the cost of borrowing falls – the UK government has public
debt approaching £1
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& Schwartz, A
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4 For workers
→ Inflation might mean that some workers expect high wages but firms do not feel confident about
paying higher costs – this is particularly true if firms cannot pass on the higher costs in terms of
higher prices, so some workers find it hard to get work, especially if there is uncertainty and fears
that the interest rate may be raised
→ According to some economists, there is a trade-off between inflation and unemployment (the shortrun Phillips curve) – if unemployment is high then workers have to compete for jobs and wages fall,
reducing cost-push inflation, and the inverse is true [THIS IS NOT BORNE OUT BY ANY DATA]

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3 Employment and unemployment
→ The level of employment is the number of people in work
→ The rate of employment is the proportion of people in work relative to the size of the workforce –
the workforce consists of those people who are at work or those of working age who are willing and
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the employed and the unemployed)
→ The unemployed are people who are willing and able to work, but are not currently employed
→ The level of unemployed is the number if people who are unemployed, whereas the rate of
unemployment is this figure as a proportion of the workforce
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2 The distinction between unemployment and underemployment
→ Many people have some work but not enough hours to give them the pay they would like, or are in
jobs that do not pay as much as they would expect to be paid given their skills, training or education
→ For example, a classically trained musician may get some concert work at the weekends, but during
the week he may have to do lower-paid cleaning work in order to make up his income
→ The idea of underemployment became particularly important after the 2008 GFC, where the number
of underemployed people was fairly stable over the period before the onset of the crisis, but
between 2008 and 2012 it increased by up to 50%
→ This means that figures for unemployment may be misleading – it looks as though unemployment
did not rise as much following 2008 as it did in previous recessions, but this may be due to the rise in
underemployment
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4 The causes of unemployment
→ There are two different views on the causes of unemployment
→ On one side, there is the Classical view, where unemployment is a result of wages being too high –
as the wage rate falls, the market will clear and unemployment will fall away
→ Unemployment is a short-term problem that is fixed by a laissez-faire approach
→ Unemployment therefore arises when people are unwilling to accept the wage provided by the
market mechanism, and as a result it is known as real wage unemployment
→ On the other hand, the opposing Keynesian view argues that people can be employed even in the
long-run because wages are ‘downward sticky’ – they do not fall, because workers do not accept
wage cuts

→ Unemployment is a result of insufficient demand in the economy, as so it is referred to as demanddeficient unemployment
→ Keynes said that if people do not spend enough or save too much, there will be resulting multiplier
effects across the economy, and this will result in decreased employment
→ If people are losing jobs, there will be even less spending and subsequent effects upon
unemployment – the vicious circle continues
→ Even if wages are cut, there will not be more people employed – in fact, lower wages mean there
will be lower spending, so even fewer people are needed in employment
→ Apart from saving too much, other reasons for demand-deficient unemployment include:
▪ A lack of business confidence
▪ An increase in the value of a country
▪ Slow rates of productivity growth relative to other countries
▪ External shocks such as oil price rises (oil is imported and demand is price inelastic, so if
prices rise there will be less spending in the UK)
▪ Increased use of imports from low wage countries
→ Keynesians believe that demand-deficient unemployment can at certain times be a main cause of
unemployment, and a fiscal or monetary stimulus may be needed to reduce this
→ The Classical model fails to account for structural unemployment, because this is a case not where
an individual is unwilling to work for the market rate but rather where no such market rate exists,
because there is no market for some goods and services anymore, i
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typeset printing
→ Seasonal unemployment is also not addressed by the Classical model; this problem could be
resolved by improving the labour mobility of the workforce
→ Furthermore, frictional unemployment – people moving from one job to another – is not accounted
for by either model
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6 The effects of unemployment
→ The effects of unemployment to the economy include the following:

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The cost to consumers – people will have lower incomes and living standards will fall;
however, there is a wider unseen cost as people out of work lose morale and there are
repercussions for family members
The cost to firms – firms will find that people spend less, so they will have to lower prices
and make less profit; however, it may mean that people are more willing to stay in their jobs
owing to fear of unemployment, so they may be willing to work harder
The cost to workers – workers without work might find their skills become obsolete or at
least out of date, e
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an office worker who has had some years out might be surprised to go
back to work and find there are no faxes or scanners and technology has a whole new
interface
The cost to government – as unemployment rises, the government has to pay more in
jobseekers’ benefits and will receive less in tax
The cost to society as a whole – unemployed resources represent an opportunity cost, so the
economy could produce more without anything being given up and we could all have better
standards of living; there are also people who think that unemployment causes crime, civil
unrest and other social problems, although this may not always be the case

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4 Balance of payments
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1 Trade in goods and services
→ Trade in goods measures the movement of tangible products across international borders
→ The UK is a large exporter of pharmaceuticals and cars, but a major importer of foodstuffs, and,
since 2005, a net importer of oil and gas
→ Trade in services is a movement of intangible output
→ The UK is a major exporter of banking and insurance services, but an importer of foreign holidays
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3 Current account deficits and surpluses
→ A country such as Germany, which exports a large number of high-value goods, has a current
account surplus
→ This means that more money flows into the country than flows out for imports

→ On the other hand, a country that enjoys a high living standard and a high level of confidence, and
which is not as successful in export markets, is likely to be running a current account surplus, where
outflows are greater than inflows, e
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the USA, Spain and the UK
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2 Financial and capital accounts
→ The main elements of the balance of payments is the current account, but there are two other
components to be aware of
→ The first of these is the financial account which records money flows for investment purposes, i
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foreign direct investment and hot money flows
→ The other account is the capital account, which puts the other two accounts in balance by recording
the changes in net assets in each country, as well as errors and omissions
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3 The interconnectedness of economies through international trade
→ International trade means that countries become interdependent, relying on each other both for
income (through exports) and for resources, goods and services (through imports)
→ This reliance means that the economies are increasingly connected and if one country or area suffers
with weak demand this has a direct effect on other countries
→ For example, in recent times China has suffered slower growth as the recession in southern
European states continued
→ Interconnectedness becomes a problem when deficits or surpluses on the current account become
persistent – this is called a current account imbalance
→ The cause of a current account imbalance may be that a country is spending too much or that it is
not producing anything that potential customers abroad want to buy
→ It may be because of the stage in the business cycle, which clearly may be different for different
countries at different times
→ It may also be a result of the strength of the currency – if sterling is strong against the dollar then the
UK is likely to export less and import more because the price of UK exports rises relative to other
products on the world market, and imports become relatively cheap in the UK
→ Perhaps the most significant factor in the UK is the loss of the competitiveness in the manufacturing
sector owing to higher costs of factors of production in the UK relative to the Far East – it takes time
for economies to adjust to changing comparative costs and during the adjustment process the UK is
likely to face an ongoing threat
→ The costs of a current account imbalance become significant only when the deficit becomes
unsustainable

→ Sustainability means that the needs of the present are met without comprising the ability to meet
the needs of the future
→ Persistent deficits can make the value of a currency fall, so in some economies the government may
try to buy up surplus currency in order to maintain its value (although this does not happen in the
UK)
→ A fall in the value of the currency may restore competitiveness, as it makes imports seem more
expensive and exports relatively cheap on international markets
→ Persistent deficits see net incomes leave the country, which might mean demand in the domestic
country is subdued
→ If you are a worker you might lose your job, but from the perspective of the Monetary Policy
Committee (MPC) of the Bank of England subdued domestic demand might be a welcome
development, preventing the onset of inflation

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1 The characteristics of AD
→ Aggregate demand comprises consumption (𝐶), investment (𝐼), government expenditure (𝐺), and
exports (𝑋) minus imports (𝑀)
→ The formula is the following: 𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀)
→ When price levels falls, the level of 𝐴𝐷 expands along the 𝐴𝐷 curve; when price levels rise,
aggregate demand contracts
→ The 𝐴𝐷 curve is downward-sloping, not because ‘people buy more things when things are cheaper’;
there are three main reasons for the downward-sloping nature of the 𝐴𝐷 curve:
▪ Lower prices in an economy means increased international competitiveness, so there are
more exports and fewer imports; net exports are higher at lower prices
▪ The total amount of spending is approximately equal whether prices are high or low because
people have approximately the same amount of money to spend, so the area under the
curve is fairly constant – this is known as the real balance effect
▪ At higher price levels, interest rates are likely to be raised by the monetary authorities,
meaning that investment falls and savings increase
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3 Investment (I)
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1 Gross and net investment
→ Investment is an increase in the capital stock – it means creating assets that will generate income in
the future rather than in the immediate term
→ Investment forms around 10-15% of 𝐴𝐷, but the figure depends on whether gross or net investment
is being considered
→ Gross investment is the total amount of investment before any account is taken of depreciation of
assets
→ However, capital loses value over time – machinery wears out or becomes less efficient, and some
technology becomes entirely obsolete
→ Net investment takes account in the fall in value of capital assets
→ This a more useful measure if you want to look at the productivity of an economy and its productive
potential
→ However, it may not always possible to measure depreciation, and the way that it is measured varies
from country to country, so as a comparative measure it is less helpful
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2 Influences on investment
→ Investors are driven by factors that are likely to determine future sales – anything that improves
confidence in future sales is likely to increase investment and vice versa
→ There are a number of such factors:
▪ Changes in the rate of economic growth
▪ Business expectations and confidence (measured by surveys)
▪ What their main competitors are doing
▪ Government incentives and regulations
→ There is an inverse relationship between interest rates and investment – increases in capital stock
have to be financed, and this is usually through borrow; the lower interest rates are, the cheaper
borrowing is, and so investment increases
→ However, investment is not solely based on interest rates, and some have pointed out that the
interest elasticity of demand for investment is very low – it takes firms a long time to respond to
changes in interest rates by altering their investment
→ Furthermore, investment may be based more on the expectations of future interest rates, rather
than the current rate
→ Other main factors include demand for exports (a low exchange rate or surging demand in a country
to which a firm is trying to export) or access to credit (how keen banks are to lend, what conditions
they apply to loans and how much of the risk is channelled into the rate of interest)

→ However, much can be explained by a kind of irrational behaviour described by John Maynard
Keynes as animal spirits2
→ Keynes was an influential commentator throughout and between the world wars, particularly at the
time of the Wall Street Crash of 1929 and the subsequent Great Depression
→ His ideas opposed the Classical school’s insistence on the rationality of human behaviour, instead
suggesting that people are inspired by animal or herd instinct when buying stocks or investing
→ This means that when we see share prices rising, we are likely to buy in the hope of further gains,
and if prices fall then we will sell to avoid further losses – even though the rational choice would be
to buy when prices are low and sell when they are high
→ This creates extreme peaks and troughs in the business cycle, creating bubbles which – of course –
burst, meaning that governments would do well to intervene to prevent market volatility
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5 Net trade (X-M)
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1 Main influences on the (net) trade balance
→ Exports represent an injection into the circular flow of income, in that money paid for goods and
services sold abroad enter the domestic flow of income
→ Imports represent a withdrawal, since money flows out of the country
→ Exports minus imports (𝑋 − 𝑀) gives the total movement of funds, known as net exports – if there
are more imports than exports, this number will be negative
→ There are several reasons why the value of net exports may change:
▪ The main driver for net exports is the level of real income

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Consider a change in the exchange rate – if this increases in value against other currencies,
imports become cheaper and exports more expensive in real terms; over time consumers
respond to these relative prices and demand for imports rise while demand for exports falls
– whether this worsens the trade balance depends on if Marshall-Lerner conditions are met
▪ Changes in the global economy – if there is growth in a foreign country then demand for the
domestic country’s exports will increase
▪ The degree of protectionism
▪ Non-price factors – quality and after-sales service are major determinants net exports
→ When any one of the components of 𝐴𝐷 rises, the curve shifts to the right; the same happens if
imports fall
→ As a useful evaluation point, the above analysis involves changes in levels rather than rates, and so
even if incomes are rising, if they are rising more slowly than expected then the UK may experience
growth at a slower rate than they expected

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2 Aggregate supply (AS)
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