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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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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
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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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2 Short-run AS
→ Shifts in 𝐴𝑆 occur when factors change that affect most firms
→ In the short-run these changes simply affect firms’ costs of production and not the amount that they
are willing and able to produce
→ Short-run shifts are often called external shocks and cause 𝐴𝑆 to shift up or down rather than right
or left (which indicates a change in capacity)
→ These factors might relate specifically to the cost of workers (labour market) or the way in which
firms compete (product market)
→ Short-run shifts might include:
▪ Changes in costs of raw materials and energy – in a developed country like the UK, most raw
materials are imported and, if global competition increases, UK costs fall; the cost of these
imports depends on demand pressures from other parts of the world as well as supply, e
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a
global increase in demand for oil would cause UK production costs to rise
▪ Changes in exchange rates – if the euro falls in value relative to the pound, many costs
would fall in the UK, meaning that 𝐴𝑆 in the UK increases
▪ Changes in tax rates – if there is an increase in indirect taxes, there will be an increase in
costs for almost all firms in the UK, e
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a rise in VAT will make prices go up for all firms as
they try to pass on this extra cost
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1 Labour market
→ In the labour market, a rightward shift in the 𝐴𝑆 curve could occur in the following ways:
▪ Changes in relative productivity – productivity is output per unit of input and, if it increases
relative to a country’s main trading partners, the productivity gap is said to be closing, e
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the gap is currently closing between the UK and France, so although the UK has lower
nominal productivity than France, this gap is falling
Changes in education and skills – increased spending on education and training should mean
that a country’s workforce can produce more output per worker; education increases the
value of their potential output
Demographic changes and migration – a decreasing birth rate and increasing life expectancy
in the UK we can expect a decline in the size of the economically active work force
Increases in health spending – these mean that people are able to work for longer, and can
return to work sooner after a health crisis

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3 NATIONAL INCOME
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1 The circular flow of income
→ The economy can be imagined as a simple model where there are just households and firms
→ The households own all the factors of production – land, labour, capital and enterprise – and the
firms are all the producing units
→ Money moves from households to firms when they buy goods and services; money moves back from
firms to households as payment for the factors of production they use in the form of rent, wages,
interest and profit
→ This simple model is known as the circular flow of income, where the income and output of an
economy should always be the same, as they are both measured by GDP
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4 ECONOMIC GROWTH
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1 Causes of growth
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2 Factors which could cause economic growth
→ Actual economic growth can occur because there is an increase in one of the components of
aggregate demand (𝐴𝐷), the formula for which is as follows: 𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀)
→ Export-led growth is where specifically the export component (𝑋) of 𝐴𝐷 improves, which has the
additional benefit of improving the trade balance
→ Actual economic growth can also occur because of an increase in short-run aggregate supply (𝐴𝑆)
because costs of production fall, for example as a result of deregulation (removing constraints that
limit competition) or due to an increase in the size of the workforce reducing wage costs
→ A shift in the 𝐴𝐷 or 𝐴𝑆 curve to the right should cause an increase in actual growth
→ However, if 𝐴𝐷 increases and the 𝐴𝐷 curve is crossing the vertical part of the Keynesian 𝐴𝑆 curve,
the only effect will be increased price levels and the associated inflation, rather than higher GDP,
since the economy is already operating at maximum capacity (𝑌𝐹𝐸)
→ Similarly, if 𝐴𝑆 increases and the 𝐴𝐷 curve is crossing the 𝐴𝑆 curve on its horizontal part then there
will be no change in equilibrium and output remains unaffected
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4 The importance of international trade for (export-led) economic growth
→ Export-led growth – where the driver of growth is an increase in the export component of 𝐴𝐷 – is a
main driver of growth in many economies
→ For countries that have been rapidly emerging into industrialised states, such as China and India,
exports can often account for more than 50% of 𝐴𝐷, since consumers have relatively low incomes
and the government is not sufficiently developed to spend heavily on public services
→ The main benefit of export-led growth is that at the same time as improving economic growth, it
also improves the trade balance
→ The main problem with export-led growth is that it makes exporters vulnerable to changes in
demand in other economies, and they are often at the mercy of exchange rates
→ China’s growth slowed significantly as a result of the global financial crisis in 2008 and in order to
maintain its strong exports the government decided to intervene to devalue the renminbi to make
exports look relatively cheaper on the international market
→ While this dealt with China’s short-term problem with export demand rising more slowly than the
trend, it created its own long-term problem in the form of Donald Trump’s 25% steel tariffs, which
may damage the Chinese steel industry and lead to redundancy in that sector

2
...
2 Constraints on growth
→ There are several factors which constrain growth:
▪ Absence of efficient capital markets – one of the main reasons why Latin America grows
more slowly than the Asian subcontinent is that Asia has more credible and efficient capital

▪

▪

▪

markets; in many sub-Saharan African countries, the interest charged on credit is over 50%,
as a result of the asymmetric information in credit markets, where the lender knows very
little about the borrower and so charges enormous interest rates in order to cover the risk
Government instability – where governments are incompetent, or lack transparency or
strong political backing, the economy struggles to attract inward investment (𝐼); the
government may also be running a fiscal deficit, meaning their spending (𝐺) will be reduced
Labour market problems – a shortage of skilled labour is a major constraint on growth,
because as countries get richer, birth rates drop, and so the supply of labour falls in the longrun; in developed countries the best way to fix this problem is to operate relaxed
immigration policy, although this creates a ‘brain-drain’ in developing countries where
skilled labour leaves the country, exacerbating the shortage
External constraints – trade is a key driver to growth, and so if an economy faces
protectionism in trade then it is unlikely to success, while global recession, volatility in
exchange rates and terrorism can also slow down world trade; figures suggest that for every
3% growth in world trade there is a 1% increase in GDP, while the inverse of this is also true

2
...
3 Output gaps
2
...
3
...
4
...
2 Positive and negative output gaps and difficulties of measurement
→ If the economy is growing faster than the trend, pressures will grow in the economy, such as tight
labour markets, wage pressures and shortages of raw materials – this referred to as a positive output
gap
→ It may be a sign that the economy is overheating, and could lead to contractionary monetary policy
from the central bank (the Bank of England’s Monetary Policy Committee), or contractionary fiscal
policy from the government
→ However, if the economy is growing below the trend then it is likely that there is spare capacity in
the economy – this situation is known as a negative output gap
→ It means there is scope for a cut in interest rates, or expansionary fiscal policy, which is likely to
generate inflationary pressure
→ Estimates of the UK’s output gap (as of 2017) are as follows:
▪ The OECD estimates that the UK has a negative output gap of -0
...
27%
▪ The Office for Budget Responsibility estimates the positive output gap at 0
...
4
...
3 Use of AD/AS diagram to illustrate an output gap
→ The output gap is a measure of the difference between actual and potential growth in the economy,
based on estimates of what the production possibility of a country is relative to its actual GDP

→ One way in which Keynesians illustrate the output gap is by demonstrating the distance along the 𝑥axis between actual output (𝑌) and output with full and efficient allocation of all factors of
production (𝑌𝐹𝐸)
→ Keynesians believe that negative
output gaps can exist in the longrun, while Classical economists
deny this, drawing long-run
aggregate supply vertically at the
level of 𝑌𝐹𝐸

2
...
4 Trade (business) cycle
→ The trade cycle, also caused the
economic or business cycle,
demonstrates recurring trends in
economic growth rates
→ Booms tend to be followed by
economic slumps or slowdowns,
which tend to be followed by
recession, before the economy
moves into the recovery phase, and then back into a boom
→ This trend is explained in part by animal spirit – Keynes’ term for the speculative action that results
from any rise or fall in output or asset prices
→ However, other reasons can explain the trend such as the effects of changes in capital which
exacerbates changes in output and the role of expectations in the decision-making of businesses

2
...
5 The impact of economic growth
2
...
5
...
4
...
2 Costs
→ Despite the above benefits, growth can also incur the following costs:
▪ Income inequality – the unwaged and unskilled are less likely to benefit from increased
incomes; although money may eventually trickle down to lower income groups, at least in
the short term we may see a two-speed economy where some are accelerated towards
higher incomes while others see no such increase – there is also likely to be short-term
unemployment with those with labour market inflexibility
▪ Environmental problems – depletion of natural resources and external costs such as carbon
emissions and other forms of pollution are likely to increase with economic growth;
however, high-income governments can use their increased tax revenue to clean up the
environment, and enforce carbon control measures
▪ Balance of payment problems on the current account – with higher incomes, domestic
consumers suck in more imports and there is less incentive for firms to export; however, if
growth were export-led then the current account would improve
▪ Bottlenecks in the economy – when there is little spare capacity in the economy, factors of
production such as skilled labour and fuel rise in price; monopoly power may also develop,
which can be used as a barrier to the entry of new firms, shown by an increasingly inelastic
𝐴𝑆 curve
▪ Social dislocation and stress – higher incomes will be earned by some, but not all, and so the
improved living standards seen by those with high incomes can cause social dislocation
among those on lower incomes, who feel the need to meet these higher expectations, and
may take out unsustainable debt to do so
▪ Problems of rapid growth – this can cause short-term spikes in prices; if a country grows too
quickly then there may be bad planning, corner cutting and shoddy workmanship

2
...
5
...
5
...
5
...
1 Distinction between monetary and fiscal policies
→ A demand-side policy is a deliberate manipulation by the government of 𝐴𝐷 in order to achieve
macroeconomic objectives
→ There are two demand-side policies:
▪ Monetary policy – decision-making using monetary instruments such as the interest rate and
quantitative easing
▪ Fiscal policy – the government’s management of its spending and taxation with the aim of
changing the total level of spending in the economy
2
...
2
...
1%, but between 2008 and 20111 he had to write 10 of these letters; since then
inflation has been less problematic
→ There are two major tools that can be used by the MPC:
▪ Interest rates
▪ Quantitative easing (only used since 2009)
2
...
2
...
1 Interest rates
→ The MPC sets the Bank Rate each month, and the objective of their decision-making is to maintain
the government’s 2% inflation target
→ Changing the rate of interest sets of a number of processes, referred to as monetary transmissions
mechanisms, which affect aggregate demand (𝐴𝐷)
→ One such transmission mechanism is through consumption, where the interest rate affects mortgage
rates, which alter the amount of money available for spending once mortgages have been paid for
→ Furthermore, the cost of credit affects how easily consumers can borrow in order to buy big-ticket
items, and the interest rate affects how lucrative saving is compared to spending
→ Investment is sensitive to interest rates, since most investments involve borrowing to pay for
productive capital, and higher interest rates mean that fewer projects are deemed worthwhile
→ Net exports are also affected by the interest rate, because with a floating currency higher interest
rates attract hot money flows, increasing demand for the currency, so the exchange rate becomes

stronger, therefore making exports relatively more expensive on the international market, causing
the trade balance to worsen
2
...
2
...
2 Quantitative easing
→ The MPC announced in March 2009 that it would start to inject money directly into the economy to
boost spending – a policy known as quantitative easing (QE)
→ It began with the Bank of England purchasing illiquid financial assets (such as government bonds)
from commercial banks, replacing an asset that could not be lent out with liquid assets (i
...
cash)
that could be lent
→ QE was needed because spending in the economy slowed very sharply in the latter part of 2008 and
early 2009 as the global financial crisis gathered pace
→ This threatened a downward spiral through a combination of contracting real output and price
deflation
→ The MPC responded decisively, cutting the Bank Rate from 5% to 0
...
5
...
2
...
1 How does QE work?
→ Money is generated ex nihilo by the bank as is used to buy government bonds (gilts), causing the
value of these bonds to rise, which will eventually spread out among the economy, raising the prices
of other assets
→ Furthermore, because some of the gilts are purchased from commercial banks, the gilt (an illiquid
asset) will be replaced with cash (a liquid asset), increasing the credit that commercial banks have
available to loan
→ At the same time, the purchase of gilts by commercial banks from households and businesses leave
these households and businesses with more readily available (liquid) assets
→ As a result of QE, asset holders in general – including households and businesses – will have
portfolios with higher value and more liquidity
→ If they feel wealthier and have more money immediately available, it is more likely that they will
consume (in the case of households) and invest (in the case of businesses), thereby boosting 𝐴𝐷
→ Furthermore, lower yields for financial products – in other words, lower interest rates – will lead to a
reduction in the cost of borrowing
→ However, there are factors that may work to dampen the effects of QE; the banking sector became
risk averse after 2008, meaning that even with more funds available to loan, they may not be willing
to do so, creating a liquidity trap – nevertheless, because QE has multiple effects, its ineffectiveness
upon banks’ ability to loan does not make it altogether useless
→ A second round of assert purchases, known as QE2, was agreed by the MPC in October 2011, who
voted unanimously for another round of gilt purchases, bringing the total stock of purchases to £375
billion
2
...
2
...
2
...
5
...
3 Fiscal policy instruments
→ Fiscal policy is the manipulation of taxes and government spending to influence the overall level of
demand in an economy
→ Expansionary policy means cutting tax (𝑇), raising government spending (𝐺) or a combination of the
two, so that the net effect is that 𝐴𝐷 rises
→ Contractionary policy is where 𝑇 is greater than 𝐺
2
...
2
...
1 Distinction between government budget deficit and surplus
→ If government spending is greater than taxation, the government is operating a budget deficit, also
referred to as a fiscal deficit
→ The net effect is to pump spending power into the economy, which is amplified by the multiplier
effect
→ According to Keynesian thinking, this sort of policy should be pursued in a recession because any
money that is borrowed can be paid back once the economy returns to a boom
→ By contrast, if government spending is less than taxation, there is said to be a budget surplus where
spending power is taken out of the economy – this causes negative multiplier effects
→ The consensus among economists is that in times of boom or fast growth in the economy, the
government should rein in its spending to curb inflationary pressures
→ This is better known as contractionary fiscal policy and it helps to balance the government budget
2
...
2
...
2 Distinction between direct and indirect taxation
→ The government can change its fiscal policy by altering government spending or taxation; within
taxation it can use direct or indirect taxation
→ Direct taxation is targeted at incomes, e
...
income tax, corporation tax, etc
...
g
...
e
...
5
...
4 The role and operation of the Bank of England’s MPC
→ When interest rates are raised, the cost of borrowing rises
→ Consumers who borrow in order to finance their spending might be deterred from doing so and
savers will be less keen to spend their savings since there is a greater opportunity cost in doing so
→ People with mortgages – of whom there are 10 million in the UK – will find their mortgage interest
payments rise, and therefore will be discouraged from spending, although those with fixed-rate
mortgages will not feel this immediately
→ Hire purchase – the method of buying consumer durables on credit – will incur increasingly
expensive monthly repayment installations, discouraging consumption in this way
→ House prices may fall if mortgages become more expensive, since fewer people are willing and able
to demand a house, which may have negative wealth effects

→ Firms will find that investment is less attractive in many cases, and that fewer investments will result
in higher returns that the cost of borrowing
→ This reduces current 𝐴𝐷 and also reduces future productive potential, which can damage incomes
and therefore consumption in the future
→ The trade balance will worsen because of the effect of ‘hot money flows’ on the exchange rate, and
also because interest rates are essentially a cost of production for many firms, and so the price of
exports will rise relative to imports, so the value of total exports will fall and the value of total
imports will rise
→ All these changes shift the 𝐴𝐷 curve to the left with multiplier effects – depending on the shape of
the 𝐴𝑆 curve this may decrease both the price level and real output
2
...
2
...
5
...
6

Strengths and weaknesses of demand-side policies

2
...
2
...
1 How effective is monetary policy?
→ Monetary policy has a shorter time lag than fiscal policy, although the MPC estimates that interest
rate changes can take 18 months to 2 years to have their full impact
→ There are further delays because many mortgage holders have fixed-rate policies, which delay the
impact on their spending for a number of years
→ Furthermore, monetary policy is a blunt tool which hits the whole economy, affecting both small and
large firms, and rises in interest rates often worsen income distribution
→ However, perhaps the most significant criticism of monetary policy is that it raises the cost of
production for firms where there may already be cost-push inflation, creating a vicious cycle
→ Evidence shows that the first round of QE in 2009 raised the level of real GDP by 1-2% and increased
inflation by between 0
...
, 2002
...
1st ed
...


2
...
2
...
2 Does fiscal policy work?
→ In the UK fiscal policy can only be implemented in an annual budget, although there is room for
manoeuvre, creating a time lag in decision-making for fiscal policy, added to which there is an
implementation lag as many tax changes cannot be introduced until the start of the financial year in
April, sometimes 1 or 2 years ahead
→ Therefore, a fiscal stimulus may not actually come into effect until the economy has already
naturally started its recovery, potentially leading to an overheating of the economy
→ Furthermore, if a government deliberately tries to expand its spending, people may try to cash in by
increasing their pay demands, leading to no change in output but an increase in wage costs and
therefore cost-push inflation
→ Also, there are crowding-out effects of increased spending by governments:
▪ For example, the presence of a government-run hospital may make it impossible for a
private hospital to operate in the same area
▪ There is also financial crowding-out in the sense that the government borrows to fund its
projects and this may cause interest rates to rise as a result of the increased demand for
loanable funds, stifling private initiatives
→ However, it can be argued that expansionary fiscal policy is simply inflationary because the debt
issued to finance the expansion, often Treasury bills, is so liquid that it acts like printing money

2
...
3 Supply-side policies
→ Supply-side policies include any action by the government intended to increase the amount that
firms are willing to supply at any given price level
→ They involve improving the supply side of the economy, i
...
productivity, availability of resources, tax
or benefit incentives, removing regulations that add to costs or other cost reductions
→ In other words they seek to shift the 𝐴𝑆 curve to the right
2
...
3
...
5
...
1
...
e
...
5
...
1
...
5
...
2 Strengths and weaknesses of supply-side policies
→ Some supply-side policies are clearly very effective, e
...
deregulation in the phone industry has
resulted in lower price levels and better aftercare
→ However, there are some industries in which there is either no opportunity for increased
competition or where the benefits are outweighed by the increased costs, e
...
increased
competition in the NHS has merely resulted in increased management costs and not improved
efficiency
→ Another issue with supply-side policies is the time lag – some policies, such as education, can take
many years to have any effect on production costs; if anything, in the short run they increase costs
because prospective students become economically inactive and the workforce shrinks
→ One of the strongest arguments against supply-side policies is that if they are used in the face of
demand-deficient unemployment, they will have no effect at all
→ Japan is often used as an example, where for over 25 years there has been an increase in overall
productive capacity but a real deficiency in demand and no change in equilibrium unemployment
→ Supply-side policies can cause poverty and inequality, e
...
the policy to cut out-of-work benefits such
as JSA might indeed encourage some people to find a job, but if there are no jobs available or they
have insufficient human capital then there will be no effect upon the labour market and their living
standards will fall; the same is true of cutting the minimum wage and limiting the power of the trade
unions
→ Furthermore, supply-side policies have side effects on the demand side, e
...
cutting taxes has fiscal
policy implications
→ Market-based supply-side methods like cutting minimum real wages and reducing trade union
power affects lower income earners adversely and disproportionately
→ However, effective supply-side policies have the benign effect of both lower inflation and higher
rates of economic growth

2
...
4 Conflicts and trade-offs between objectives and policies
2
...
4
...
5
...
2 Economic growth and the balance of payments on the current account
→ As an economy grows and incomes rise, consumers are likely to demand more imports, and firm’s
incentives to export will diminish as it is easier to find eager customers in the domestic market
→ As a result, economic growth is likely to worsen the current account
→ The main exception to this is export-led growth
→ A second reason why growth may not necessarily worsen the balance of payments is if the growth is
caused by an increase in 𝐴𝑆, e
...
owing to decreases in costs or increases in investment, an economy
will become more internationally competitive, meaning that the economy can export more and
import less while growing
2
...
4
...
g
...
5
...
4 Economic growth and income redistribution
→ When an economy grows, incomes are most likely to rise at the top end of the income spectrum,
such as bonuses for sales executives
→ The effect is a widening of income inequality
→ However, over time, people at the high end of the income scale may employ people from the lower
end of the income scale, such as domestic staff, or contribute to increased demand for low-wage
workers, like baristas – increased demand for low-skilled labour should eventually lead to increased
wages
→ Nevertheless, many critics argue that although some of the benefits may indeed ‘trickle down’ over
time, there is a ‘two-track’ labour market where if low-skill wages rise, this acts as a signal and
causes low-skill immigration to fill the gaps, reducing low-skill wages, whereas this does not happen
with high-skill labour
→ Another counter-argument is that even if wages rise by a constant percentage for everybody,
income inequality still rises in real terms
2
...
4
...
5
...
6 million at the start of 2008 to around 2
...
5
...
5
...
1 Fiscal policy and supply-side policy
→ Increased government spending may be used as part of a fiscal policy to reduce 𝐴𝐷, and much of
this spending will be directed to the health and education sectors
→ In this case, fiscal and supply-side policies are working in tandem to improve growth prospects and
the supply-side effects may cancel out any ill effects on the price level from the expansion in
demand
→ By contrast, if a government is using contractionary fiscal policy as a means of trying to control the
price level, the impact of this may be a leftward shift in the 𝐴𝑆 curve, meaning that prices might rise
rather than fall, and output may contract even further than intended
2
...
6
...
5
...
3 Monetary policy and supply-side policy
→ A tight monetary policy means that interest rates are higher than they perhaps need to be, and
although this may control inflation, it increases costs for firms if they are borrowing money so it may
cause supply to shift inwards
→ However, raising interest rates tends to make exchange rates rise, and because UK firms import
nearly all their raw materials, this may reduce production costs, shifting 𝐴𝑆 outwards
→ In the case of cutting interest rates, as in loose monetary policy, this can reduce borrowing costs for
domestic firms, but may increase component costs – firms do, however, gain international
competitiveness



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