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AS Economics- The National and International
Economy
Chapter 4: Aggregate demand and aggregate supply and their
interaction
Introduction to macroeconomics
Macroeconomics: the study of issues that affect economies as a whole
...

Price level: the average of the prices of all the products produced in an economy
...

AD=C+I+G+(X-M)
...

Investment: spending on capital goods, which are used to produce goods and
services
...

Exports: products sold abroad
...

-If a country has trade surplus, then aggregate demand will increase
...

-If a country has trade deficit, then aggregate demand will decrease
...

Net exports: the value of exports minus the value of imports
...

Factors of consumer expenditure:
1) Real disposable income:
Real disposable income: income after taxes on income have been deducted and state
benefits have been added and the result has been adjusted to take into account
changes in the price level
...

-The proportion of income that is spent may, however falls as disposable income
rises
...

2) Average propensity to consume (APC):
Average propensity to consume (APC): the proportion of disposable income spent
...

-This might mean that households will devote less to consumer expenditure
...
g
...

-Different to income in that it represents accumulated past saving and assets
...
g
...

4) Consumer confidence and expectations:
Consumer confidence: how optimistic consumers are about future economic
prospects
...

-This is why sometimes the proportion of income spent can rise as income rises
...

 It reduces the incentive to save because by spending now people are giving up
less interest
...

-Consumer spending might fall, because:
 People may think that the reduction is only temporary (net savers)
...

 They may be delaying changing their spending if they think that the rate will
fall further
6) The age structure of the population:
-It is generally thought that the young and elderly spend a relatively high proportion
of their disposable income (not always the case)
...

-Poor people spend a higher proportion of their income than do the rich people
...

8) Inflation:
Inflation: a sustained rise in the price level
...

-However, sometimes people increase their saving when prices rise because they
might try and maintain the real value of their saving
...

Saving: real disposable income minus spending
...

Average propensity to save (APS): the proportion of disposable income saved
...

2) The rate of interest:

-A rise in the rate of interest increases the reward for saving and so usually
encourages people to save more
...

Target savers: people who save with a target figure in mind
...
g
...

4) Saving schemes:
-Some saving is contractual when people agree to save a certain amount on a regular
basis in insurance and pension schemes
...

-In those countries, people will find it straightforward to save and will have the
confidence to place their savings with these institutions
...

-In contrast, a government decision to raise state pensions may reduce the incentive
for people to save for retirement
...

-Sometimes the elderly dissave, drawing on their savings to maintain their living
standards when they retire (decline in the national savings ratio)
...

Savings ratio: savings as a proportion of disposable income
...

 They have a desire to pass on something to their children
...

-Investing leads to an increase in productive capacity in an economy, by meaning
more capital is available for production
...

-In itself, however, a rise in disposable income may not be sufficient to encourage
firms to invest:
 Firms would also have to believe that the rise in demand will last and that their
existing capital goods are not sufficient to produce the extra output
...

3) Capacity utilisation:
Capacity utilisation: the extent to which firms are using their capital goods
...

-In contrast, if they have considerable spare capacity, they may be able to increase
output without having to buy new capital goods
...

 They are likely to contribute to firms‟ optimism about the future
...

-A cut on corporation tax (corporate tax) increases the amount of profit firms can
keep and so can result in an increase in investment
...

6) Rate of interest:
-A rise in the rate of interest would be likely to reduce investment for three main
reasons:
 It will increase opportunity cost of investment
...

 A higher rate of interest is likely to reduce investment, as firms will anticipate
that consumer spending will fall
...

Unit cost: average cost per unit of output
...

8) Price of capital equipment:
-A reduction in the price of capital equipment may also increase investment
...

10) Subsidising:
-Governments may offer money to businesses to reduce unemployment or to
encourage production of a good they want companies to produce:
 This means they have more money to invest
...

12) Location:
If in the EU, for example, businesses are more likely to invest in factories in the EU,
to reduce shipping costs
...


Government spending

-Does not count benefits, as they are a part of consumer expenditure
...

-If tax revenues are greater than expenditure a government is running a budget
surplus
...

Influential factors:
1) Government‟s view on the extent of market failure and its ability to correct it:
-In countries where here is a high level of state intervention, government spending
usually forms a higher proportion of aggregate demand than in those countries where
free market forces play a greater role
...

-If an economy is good more tax is paid, allowing for more government spending
...

3) A desire to please the electorate:
-Voters can put pressure on the government to spend money improving education,
health care and transport infrastructure
...
g
...

5) Interest rates:
-High interest rates on debts and loans limits spending in other areas (opportunity
cost)
...

Gross domestic product (GDP): the total output of goods and services produced in a
country
...


Net exports
Influences on export and import revenue:
1) Real disposable income abroad:
-A rise in income abroad is likely to result in more exports being sold
...

3) The domestic price level:
-The value of exports may fall and the value of imports rise if the domestic price level
rises relative to the price levels of country‟s trading partners:
 If domestically produced products become more expensive, firms and
households at home and abroad will switch from them to products in other
countries
...


-A fall in a countries exchange rate will reduce the price of exports and raise the price
of imports:
 This, in turn, is likely to result in a rise in export revenue and a fall in import
expenditure
...

5) Government restrictions on free trade:
-A countries‟ net exports may rise if other countries‟ governments remove trade
restrictions or tariffs
...

6) Others:
-Some countries may be unable to produce certain things due to factors such as
resources or climate and may therefore import
...

-This causes economic growth to go down
...

-Lack of efficiency (lack of competitiveness)
...


The relationship between aggregate demand and the price level
-Aggregate demand is inversely related to the price level:
 A rise in the price level causes a fall, or contraction, in aggregate demand
...

-In AD there is no relative price change among domestic producers
...

-A fall in price level increases the amount of goods and services that wealth, kept in
the form of money in bank accounts and other financial assets, can buy
...

2) The rate of interest effect:
-A rise in the price level means that some people will sell financial assets such as
government bonds, to obtain more money to pay the higher prices
...

-This means the government spends less and aggregate demand contracts
...

-This means households and firms would buy more from foreign producers and less
from domestic producers
...


Shifts in the aggregate demand curve
-A change in price level causes a movement along the AD curve
...
g
...


Aggregate Supply
-The shape of aggregate supply is influenced by the level of capacity existing in the
economy
...

Shifts in the aggregate supply curve:
-A decrease in aggregate supply is represented by a shift to the left of the AS curve
...

Causes of changes in AS:
a) Short run:
-Changes in the cost of production:
 If there is a fall in material costs or a fall in wages, the economy‟s cost of
production falls and aggregate supply increases
...

-Graph:

b) Longer run (alter productive capacity):
-Increase in quality and/or quantity of factors of production
...

 Build new factories
...

 Research and development
...
g
...

 Renting land in other countries e
...
China renting land in Ukraine
...

-Labour:
 Increase immigration
...

 Population growth
...


-Entrepreneurship:
 Government spending to help entrepreneurs
...

 Lower tax on business profits
...

 Therefore prices stay the same
...

b) Intermediate:
 Resources start to become scarce
...

c) Classical:
 All resources are used up
...

 This is called full capacity
...


Macroeconomic Equilibrium
-Macro economic equilibrium is where AS and AD cross
...

-However, if aggregate demand was higher than aggregate supply, there would be a
shortage of goods and services
...

Circular flow of income is a simplified model of the economy that shows the flow of
money through the economy
...

 Wages and salaries
 Labour
 Goods and services
-There are three leakages (or withdrawals):
Leakages: withdrawals of possible spending from the circular flow of income
...

 Investment (I)
 Government spending (G)
 Spending on exports (X)
-If the value of injection equals the value of leakages, output will not be changing and
there will be macroeconomic equilibrium
...

-When injections exceed leakages, aggregate demand will increase
...

-This multiplier effect occurs when people spend money, that expenditure becomes
the income of those who sell them the products
...

-So there is a knock-on effect, with AD rising by more than the initial amount
...

 Size of the multiplier
...

-Graph showing an increase in aggregate demand raising the country‟s output but
leaving the price level unchanged:

-Graph showing an increase in aggregate demand raising both the country‟s output
and its price level:

-Graph showing an increase in aggregate demand raising the price level but having no
effect on the country‟s output:

Aggregate supply depends on
-Three key influences on the effect of a change in AD on the output of an economy,
unemployment and inflation:
 Size of the change
...

-Graph showing an increase in aggregate supply increasing the country‟s output and
lowering the price level:

-Graph showing an increase in aggregate supply raising potential output but having no
effect on the country‟s output or price level:

Changes in AD and AS
-If AS can match increases in AD the economy can enjoy higher output without
encountering inflationary pressures
...

Overheating: the growth in aggregate demand outstripping the growth in aggregate
supply, resulting in inflation
...

Output gap: the difference between an economy‟s actual and potential real GDP
...

-Graph showing negative output gap:

-Graph showing positive output gap:

Trend growth: the expected increase in potential output over time
...


Chapter 5: Government economic policy objectives and
indicators of national economic performance
Key performance indicators
-Economic growth:
Economic growth: in the short run, an increase in real GDP, and in the long run, an
increase in productive capacity, that is, in the maximum output that the economy can
produce
...
For an economy to increase its output its cost of
production must go down
...
For the productive capacity of the
economy to increase the quantity or quality of factors of production must
increase
...

 It usually falls when a country‟s output increases
...

 This includes people who are willing and able to work and are out of jobs
(labour force)
...

 Some people aged between 16 and 65 are economically inactive because they
might be homemakers, disabled or have retired early
...

-Inflation:
Inflation: a sustained rise in the price level of goods and services in an economy
...
It causes
a fall in the value of money
...

 Deflation is the opposite
...

-Balance of payments:
Balance of payments: a record of money flows coming in and going out of a country
...

 It allows us to see what product the country buys and sells, which countries it
trades with and which countries it is investing in and receiving investment
from
...

-Economic fluctuations:
 The government wants to reduce economic fluctuations to increase an
economy‟s long-term growth potential
...


-There is a low unemployment rate:
 Lower than most EU countries
...

 Flexible labour market
...

 Success of government‟s monetary policy
...

 Advances in technology and the immigration of workers from the enlarged EU
have also helped to increase AD and AS
...

-This has led to economists to suggest that the shape of the UK‟s aggregate supply
curve may have changed, becoming more elastic up to full capacity level
...


Objectives of government economic policy
1
...

 Achieved when increases in aggregate supply match increases in aggregate
demand (actual economic growth matching trend growth)
...
It is a
measure of how fast the economy can grow without generating inflation
...

2
...

Unemployment: a situation where people are out of work but are willing and able to
work
...

Full employment: a situation where those wanting and able to work can find
employment at the going wage rate
...

-LRAS Curve:

-PPC curve:

3
...

-UK government has set the Bank of England a 2% inflation rate
...

4
...

-If import expenditure exceeds export revenue in the short term, the government does
not tend to worry if the deficit is self-correcting:
 This could happen for example when there is a deficit arising from the import
of raw materials that will be converted into finished products, some of which
can be exported
...

Current account deficit: when more money is leaving the country than
entering it, as a result of sales of its exports, income and current transfers
from abroad being less than imports, income and current transfers going
abroad
...

5
...

6
...

-This may be done in order to ensure everyone has access to basic necessities and/or
to correct what is seen as an inequitable distribution of income
...

 It will also not want to make state benefits so generous nor easy to obtain that
living off benefits is made more attractive than working
...
ECONOMIC GROWTH

Measuring economic growth
-Economists first calculate nominal GDP
...

-They then convert it into real GDP
...

-Economic growth is usually measured by the annual percentage change in real GDP
...

Production and productivity:
-Production is what is produced, so when real GDP increases it means that output has
risen
...

-It is possible for production and productivity to move in opposite directions:
 When an economy is expanding, production will rise
...

 This might indicate that, while an economy may appear to be doing well, its
ability to sustain rises in output may be in doubt
...

2) Existence of an informal economy:
Informal economy: economic activity that is not recorded or registered with the
authorities in order to avoid paying tax or complying with regulations, or because the
activity is illegal
...

-The rate of inflation in the informal economy is usually much lower than that in the
rest of the economy, meaning that the official measures overstate inflation
...

-Tax revenue is lower than would be possible if all economic activity were taxes,
which can have consequences for tax rates and government spending
...

Economy of Scale: the advantage of producing on large scale, in the form of lower
long-run average cost
...

-A rise in GDP may not benefit many of the population if income is unevenly
distributed, or if they are working longer hours, or working under worse conditions
...
g
...


The causes of economic growth
Short run economic growth:
-In the short run, an economy with spare capacity can experience economic growth as
a result of an increase in aggregate demand:
 Increase in Consumer expenditure
...

 Increase in Government spending
...

 Decrease in iMports
...

-Graph:

Long run economic growth:
-For an economy to experience economic growth in the long run, its productive
capacity has to increase
...

 Increase education
...

 Increased road/infrastructure spending
...

-Graph:

The cost of economic growth
-If an economy is currently using all of its resources, and thus producing on its
production possibility curve he only way it can increase its output is to switch
resources from making consumer goods to making capital goods:



In the short run there is an opportunity cost of not producing as many
consumer goods, however in the long run the extra capital goods will enable
more consumer goods to be demanded
...

-Economic growth may reduce the quality of some people‟s lives:
 A growing economy is one that requires some people to adopt new skills and
some to change jobs
...

 Some people may find these changes stressful
...

2) Enables poverty to be reduced without redistributing income:
-Higher output raises tax revenue without having to increase tax rates and some of
this can be used to finance schemes to help the poor
...

-Increases unemployment, which in turn may decrease poverty:
 Economic growth can help a government achieve its objective of full
employment
...

3) Helps increase a country‟s status and power:
-Actual economic growth raises the level of a country‟s real output and can thereby
increase it status and power in international organisations and international
negotiations
...

International Monetary Fund (IMF): an international organisation that helps coordinate the international monetary system
...


2
...

Unemployment rate: the percentage of the labour force who are out of work but are
willing and able to work
...

 This is based on the International Labour Organisation‟s definition of
unemployment („out of work, want a job, have actively sought work in the last
four weeks and are available to start work in the next two weeks or are out of
work, have found a job and are waiting to start it in the next two weeks‟)
...

 It uses a survey to collect information on the labour force, including type of
employment, earnings and educational qualifications of the labour force, as
well as unemployment
2) Claimant count:
Claimant count: a measure of unemployment that includes those receiving
unemployment-related benefits
...

Difficulties of measuring unemployment:
1) LFS measure:
-A relatively expensive method
...

2) Claimant Count:
-Is thought to capture less of those who are unemployed:
 Some people can be actively seeking work but not entitled to claim
unemployment-related benefits
...


Causes of unemployment
1) Demand side:
-Cyclical unemployment:
Cyclical unemployment: unemployment arising from a lack of aggregate demand
...

 Unemployment may be high
...
There is a
mismatch between skills and the jobs available in the economy
...

 Might be people unemployed on one side and job vacancies on another part
(regional unemployment)
...

-Frictional unemployment:
Frictional unemployment: short-term unemployment when workers are in-between
jobs
...

Some level of frictional unemployment is always likely to exist in an
economy
...

Some people‟s labour is only demanded at certain times of the year, e
...
ski
instructors (seasonal unemployment)
...

-Graph:

2) Lost tax revenue:
-Unemployment results in tax revenue being lower than possible:
 If more people were in work, incomes, spending and possibly profits would be
higher
...

 This higher tax revenue could be spent on education, health care and transport
...

-If a government wants to maintain a given level of spending in the face of rising
unemployment, it will have to either raise tax rates or borrow:
 Higher tax rates will reduce people‟s disposable income and their spending
power
...

3) Government spending on unemployment benefits:
-If unemployment rises, the government will have to spend more on unemployment
related benefits:
 This may mean that it will have to reduce its spending on other areas, such as
education, or it will have to raise its borrowing or tax rates (opportunity cost)
...

 Marital break-ups can increase the need for housing benefits and the provision
of social housing
...

5) Costs to the unemployed:
-The unemployed may suffer from poor health and family-break-ups
...

-Work provides some people with a sense of purpose and worth
...

-One of the costs or unemployment can be unemployment itself
...

-In terms of demand, employers may be reluctant to take on someone who has been
out of work for a long time because:
 The length of times that they have been out of a job may indicate that they are
not goods workers
...

-In terms of supply, the long-term unemployed may tend to seek work less actively
over time:
Long-term unemployment: unemployment lasting for more than a year
...

 They may become discouraged by rejection after rejection
...

-A country may experience immigration from countries with high rising
unemployment:
 This can be beneficial if the country has an ageing population and a shortage
of labour, but it may place a burden on the country‟s housing stock
...

2) Can reduce demand-pull or cost-push inflation
...


4) The existence of unemployment makes it easier for firms, wishing to expand, to
recruit workers
...

-A low rate of unemployment is not to be considered a problem, because there will
always be people in-between jobs:
 Frictional unemployment exists even in a booming economy
...

3) The type of unemployment:
-When there is cyclical unemployment, the costs of unemployment benefits and other
costs of unemployment will tend to be high:
 This is because such unemployment is widespread and can be on a significant
scale
...

-Structural unemployment is likely to cause problems in particular areas of the
country
...

-Young men tend to be more prone to unemployment
...


The overall effect
-It is generally agreed that the costs of unemployment above a certain level exceed
any benefits
...

Evaluation
Therefore, I believe that structural and cyclical unemployment are mainly harmful to
an economy as it causes a large opportunity cost to the government and it means that
not all the resources are use efficiently
...


3
...
Differs from the retail price index (RPI) in
methodology and coverage
...

-Another measure of inflation used in the UK is the retail prices index (RPI):

Retail prices index (RPI): measure of inflation that is used for adjusting pensions
and other benefits to take account of changes in inflation and frequently used in wage
negotiations
...

 It is used for adjusting pensions and other benefits to take account of changes
inflations
...

-Both measures are the average change from month to month in the prices of
consumer goods and services bought in the UK
...

-However CPI includes university accommodation fees, foreign students‟ university
tuition fees and stockbrokers
...

-Measures of inflation also tend to overstate inflation, as they measure the price of a
fixed basket of products (they do not take into account people‟s ability to alter what
they buy during the year)
...

-It arises from aggregate demand increasing at a faster rate then aggregate supply
...

-Where the economy is producing too close to the productive capacity, the shift to the
right of Aggregate Demand from AD3 to AD4 causes a larger increase in price level
from P3 to P4 (close to being purely inflationary)
...

AD=C+I+G+(X-M)
Higher consumption may be caused by:
 Higher disposable incomes
...

 Lower interest rates
...

 Increased wealth (e
...
house prices rising)
...
Caused by the SRAS curve shifting to the left
...
Therefore, to maintain profit the firm would want to pass on the
higher costs to consumers in terms of higher prices
...
This is called cost push
inflation
...

-This depend son whether the income rises by more than, less than or the same as
inflation (real income)
...

-Menu costs get their name from the need for restaurants to print new menus on a
frequent basis during times of high inflation
...

-It can also be expensive to print and distribute new catalogues
...


-During periods of inflation, households and firms cannot afford to have money lying
idle, not earning interest, as it will be losing value
...

4) Administrative cost:
-As well as shoe leather cost and menu cost, inflation can impose other administrative
costs on firms:
 Staff time may have to be devoted to adjusting accounts, assessing raw
material costs, negotiating with unions about wage rises and estimating
appropriate prices
...

-If there is inflation, market prices do not signal relative scarcity of products
efficiently
...

-This means the purchasing power of money falls
...

-Borrowers will gain and lenders will lose if inflation reduces the real interest rate
...

7) Fiscal drag:
Fiscal drag: people‟s income being dragged into higher tax bands as a result of tax
brackets not being adjusted in line with inflation
...

-If tax brackets are not adjusted in line with inflation, people‟s income will be pushed
into higher tax bands
...

-The government will receive more tax revenue
...

-Inflation also complicated household financial planning, making it difficult for
people to decide how much to save and where to place their savings
...

-If workers think that inflation will be a problem, they will ask for pay rises just to
protect their current real earnings
...

10) Loss of international competitiveness:
-If the country‟s inflation rate is above that of its main competitors, its goods and
services will become less price-competitive:
 This is likely to result in fewer exports being sold and more imports being
purchased
...

-Workers also like rises in their pay, even if these are matched by higher prices, with
their real pay remaining the same
...


Deflation
-Measures of inflation tend to overstate price rises and sometimes mask a fall in the
price level
...

-Deflation caused by a fall in aggregate demand may result in a harmful deflationary
spiral:
 Lower aggregate demand will cause firms to cut back production
...

 Households are likely to reduce spending, because of fear that they will expect
prices to be even lower in the future
...


The significance of inflation
1) Size of inflation:
-A high rate of inflation is likely to cause a number of problems for an economy:
 Hyperinflation leads to very significant menu, shoeleather and administrative
costs and considerable inflationary noise
...

 Firms will have to devote a large amount of time and effort to managing their
money
...

 There is a risk that people will stop being prepared to accept money un
payment and would resort to exchanging goods
...

-Cost-push inflation tends to be more harmful for an economy than demand-pull
inflation:
 This is because cost-push inflation is often accompanied by a fall in real GDP
and a rise in unemployment
...
BALANCE OF PAYMENTS
Structure
1) Current account:
-Includes trade in goods, trades in services, net income flows and current transfers
...


-If positive then there is a current account surplus
...

-Trade balance of goods:
 Also known as visible and tangible trade balance
...

-Trade balance of services:
 Also known as invisible and intangible trade balance
...

-Net income flows:
 Remittances of wages e
...
Philippine nurses working in the UK, but sending
her wages back to family in the Philippines
...
g
...

 Profits from foreign owned business
...
g
...

2) Financial account and capital account:
-Concerned in the ownership of foreign assets
...

-Portfolio investment:
 Buying shares in foreign companies
...


Causes
The causes of a deficit on the current account of the balance of payments:
-This occurs when the country‟s expenditure abroad exceeds its revenue from abroad
...

 Because there has been a net outflow of investment income
...

 A rise in incomes at homes would also contribute to this deficit, because the
country‟s inhabitants are likely to buy more products (some will be imports
and some may be domestically produced products originally intended for
exports market)
...

c) Structural problems:
 When the deficit is caused by the country‟s firms charging too much for their
products, producing poor quality products or not picking up on changes in

demand, then that is a structural problem (concerns government as the deficit
may persist compared to the others)
...

 This depends on the relative volume of investments made and the level of
profit earned
...

-Two main reasons why this might happen:
 Because the country‟s revenue from exports exceeds it expenditure on
imports
...

1) Causes of a surplus on the trade in goods and services:
a) Strength in an economy:
 The country is likely to have a surplus if its products are high quality, are
produced at a low cost and reflect what households and firms at home and
abroad want to buy
...

c) Weakness in an economy:
 When an economy is in a recession, a country‟s inhabitants may not be buying
many products, including imports, and its firms, finding it difficult to sell at
home, may be competing more vigorously in export markets
...

2) Time:
-A deficit that lasts a short time is unlikely to be very significant
...


Determination of exchange rates
-The Bank of England Monetary Policy Committee‟ main indicator of the pound‟s
value is he bank‟s trade-weighted index
...

-Most countries‟ exchange rates are determined by the market forces of demand and
supply
...


-If the demand for the currency rises, this will increase the exchange rate
...

-Graph showing the effect of an increase in demand for pounds:

-Graph showing the effect of an increase in supply of pounds:

Factors that influence demand and supply for currency:
a) Competitiveness:
-If UK products are internationally competitive, the demand for them will be high and
the supply will be low
...

-Key factors that influence competitiveness are labour productivity, investment and
relative inflation rates
...

This will increase demand for pounds and cause a rise in the value of the pound
...

d) Interest rates:
-A rise in UK interest rates, relative to other countries‟ interest rates, will be likely to
increase demand for pounds:
 Foreigners will want to buy pounds in order to open accounts in UK financial
institutions to benefit from the higher interest rates
...


-FDI in the UK will be attracted by a strong UK economic performance, a skilful
labour force and favourable government policies, including regional development
grants available to incoming firms
...

2) Lower costs for firms:
-Imports of raw materials are now cheaper than before, and this can be represented by
an outward shift of the AS curve
...

4) Lower interest rates:
-If inflation is lower then interest rates should also be lower
...

-Exports are also more expensive so exports will fall
...

-Some regions of the economy are affected by this more than othrs
...

4) Tourism:
-A stronger currency means tourists get fewer pounds when they visit the UK and so
visiting the UK becomes less attractive
...


The relationship between exchange rate and the interest rate
Effect of changes in exchange rates on interest rates:
-If the UK‟s exchange rate rises, export prices expressed in terms of foreign
currencies will rise
...

-Lower aggregate demand will reduce inflationary pressure
...

Effect of changes in interest rates on exchange rates:
-A reduction in the interest rate will reduce the return on money kept in UK financial
institutions
...

-This means that more of the currency is being sold
...


The effect of a change in the exchange rate on export- and import-prices
-A fall in the exchange rate (depreciation) if causes by market forces, will reduce the
price of exports in terms of foreign currencies:
 Most exporters would be likely to let their exports prices fall in line with a fall
in the exchange rate
...

-A fall in the exchange rate will increase the price of imports in terms of domestic
currency
...

 A rise in import prices will reduce expenditure on imports again if demand is
elastic
...

 More workers will be taken on in order to produce more products, both for
exports and for the home market
...

 In addition, domestic firms facing more expensive imported ribal products at
home, the prospect of their products being cheaper abroad and higher demand
in both markets will be under pressure to keep their costs and price low
...

Monetary policy: central bank and/or government decisions on the rate of interest,
the money supply and the exchange rate
...


Fiscal policy
Fiscal policy: the taxation and spending decisions of a government
...

-The key aim of fiscal policy is to influence aggregate demand (AD):
 They can raise AD by either increasing their own spending and/or by reducing
taxes
...

-Government spending:
 A component of AD, so if it is increased, this will directly increase AD
...

 Lower corporation tax (corporate tax) would tend to increase the ability and
willingness of firms to invest, thereby increasing another component of AD
...

Deflationary: policy measures designed to reduce aggregate demand
...

-Changes in government spending and taxation may be done for reasons other than
influencing the level of AD:
 Encourage consumption of merit goods
...

 Altering distribution of income
...

The nature of fiscal policy:
-A government may seek to influence aggregate demand to ensure that it matches
aggregate supply (AS) and so avoid both unemployment and inflation
...

 To achieve this the government uses discretionary fiscal policy or to allow
automatic stabilisers
...

Automatic stabilisers: forms of government spending and taxation that change
automatically to offset fluctuations in economic activity
...

Types of taxes:
-Different taxes are either implied in order to distribute wealth or pay for services
...

a) Income tax:
-Progressive tax
...

-As a person‟s income rises, both the amount and the percentage a person pays in a
tax rises
...

2) Indirect tax:
Indirect tax: a tax levied on goods and services
...

Regressive tax: a tax that takes a greater percentage from the
 income of the poor
...

b) Excise duty:
-Imposed on specific goods
...

d) Inheritance tax:
-A tax on transfers of wealth above a certain amount
...

1) Capital expenditure:
 E
...
hospitals, schools, roads
...
g
...

3) Transfer payments:
-Money transferred from taxpayers to recipients of benefits:
 E
...
pensioners and the unemployed
...
g
...

Ways of government spending:
1) Social protection:

-Amount of spending depends on benefit rates and by the level of economic activity
(unemployment levels)
...

3) Education:
-Amount of spending depends on age composition of population
...

5) Debt interest:
-Dependant on the level of government debt and the rate of interest
...

-May arise because of cyclical or structural factors:
 If there is a recession, tax revenue is likely to fall and government spending
on benefits is likely to rise, due to the operation of economic stabilisers
...

 Government may use expansionary fiscal policy in order to increase economic
activity
...

 The only way to resolve this would be to cut government spending and/or
raise tax revenue
...

-Government can pay off its debts
...

Difference between deficit and debt:
Debt is the total value of all your deficits over time
...

-Demand-side policy (seeks to influence AD)
...
5%
...

-A higher interest rate tends to reduce consumption and lower firms‟ investment
...

 A higher exchange rate will make exports more expensive and imports
cheaper
...


-So a rise in the interest rate is likely to decrease AD by reducing consumption,
investment and exports minus imports
...

 In this case foreigners may move their money to other countries and so
exchange rate may fall
...

 A rise in the money supply, by increasing the amount that banks have to lend,
reduces the interest rate
...

 A central bank may want to reduce exchange rate in order to improve the
current account position of the balance of payments and to stimulate economic
activity, by stimulation growth in AD
...

 This aims to reduce AD, usually in a bid to lower inflation
...


Supply-side policies
Supply-side policies: policies designed to increase aggregate supply by improving
the efficiency of labour and product markets
...

-Always designed to increase AS (never to reduce AS)
...

-Their aim is to lower costs of production and increase productive capacity by
increasing the efficiency of labour and product markets
...

 Used to enable markets to work more efficiently
...

-If output per worker per hour does increase, the potential output of the economy will
rise
...

-They may find it difficult to break into established markets
...

3) Reduction in direct taxes:
-Lowering taxation increases AS
...

-A cut in corporation tax will increase both the funds that firms have available to
invest and the return from any investment undertaken:
 If investment increase the productive capacity of a firm does increase
...

 This will be the case if it persuades more unemployed to accept employment
at the going wage rate, as their disposable income will now be higher
...

 It may also be the case that what is stopping the unemployed from gaining
employment is not a lack of willingness to work at the going wage rate but a
lack of jobs
...

5) Reduction in unemployment benefit:
-A reduction in unemployment benefit will widen the gap between income from
employment and the benefit
...

 This reduce the negative output gap and move output closer to full capacity
...

 Cutting their benefits will reduce consumption
...

 Cutting benefits is also likely to widen income inequality
...

-If however, these people are unable to seek work, then all such a measure will do is
to reduce the income of benefit recipients
...

 This will also reduce the cost of employing labour
...

8) Privatisation:
-This is the transfer of firms from the public to the private sector
...

-Other economists, however, argue that government ownership of firms is beneficial
in a number of cases where there there is a high risk of market failure
...


Policies to reduce unemployment
-The choice of measures will be influence by the cause of the unemployment, the rate
and duration of unemployment and the state of the other macroeconomic objectives
...

-In such cases expansionary fiscal policy and/or monetary policy can be used to create
jobs
...

-One consequence of a rise in AD may be a rise in the price level if the economy
moves close to full employment
...

-Graph:

Supply-side policies:
-Those people, who are out of work when the level of AD is high, and when there is
no shortage of job vacancies, are likely to be in between jobs, lacking appropriate
skills, geographically or occupationally immobile, have family circumstances that
restrict their ability to work or are lacking the incentives to move off benefits and find
employment
...

-Supply-side policies can be implemented to increase economic incentives and the
quality of labour services offered by the unemployed
...

 Improve education and training and the provision of work experience may rise
the skills of the unemployed
...

 Legislation and the subsidising of special equipment and adaptation of
buildings may facilitate employment of more disabled workers
...
g
...

 Cutting rules and regulations that firms have to follow in hiring, employing
and firing workers
...

-However, they might create inflexibility in labour markets:
 Firms wanting to expand will be limited in how much they can offer to attract
new workers
...

-A government may provide subsidies, so that firms can cover rising costs without
having to put up their prices:
 This measure may reduce costs in the long run if some of the subsidies are
spent on investment
...

Demand Pull Inflation:
-To reduce demand-pull inflation, a government may use deflationary fiscal and/or
monetary policy instruments:
 These are ones that seek to reduce inflation by decreasing aggregate demand,
or at least the growth of AD
...

-Increase interest rate, which is likely to reduce AD by reducing consumption,
investment and net exports
...

-If people are convinced that a central bank has a determination, experience and
ability to meet its target they will act in a way that does not cause inflation
...

-If the productive capacity of the economy grows in the line with AD, with rightward
shifts in the AD curve (from AD1 to AD2) being matched by rightward shifts in the
LRAS curve (from LRAS1 to LRAS2), the economy can grow (from Y1 to Y2)
without the price level changing (remains at P1):
 This means people will be able to enjoy more goods and services without the
economy experiencing inflation and balance of payments problems
...

-Graph:

Policies to promote economic growth
Short run:
-Increases in output in the short run can occur due to increase in AD in the economy if
the economy is initially producing below productive capacity
...

-Some fiscal and monetary policy instruments have the advantages that they have the
potential to increase both AD and AS:
 E
...
a lower rate of interest is likely to stimulate not only consumption but
also investment
...

-Graph:

Long run:
-In the long run, increases in the country‟s output can continue to be achieved only if
the productive capacity of an economy increases
...

-This is what supply-side policies seek to achieve:
 E
...
measures that raise investment will increase AS
...

-To use capital efficiently, it is important to have educated and healthy workers:
 Investment in human capital should increase the productive capacity of the
economy
...

The extent, to which this occurs, is influenced by the appropriateness and the
quality of the investment
...

-Governments try to avoid AD increasing faster than the trend growth rate permits,
since this can result in the economy over heating with inflation and balance of
payments problems arising
...

-In other words they seek to avoid economic cycles
...


Policies to improve the balance of payments
Short-run:
-There are 3 main ways a government may try to raise export revenue and/or reduce
import expenditure in order to correct a current account deficit
...

1) Exchange rate adjustment:
-A country may seek to reduce the exchange rate if it believes that its current level is
too high as a result it‟s causing its products to be uncompetitive against rival
countries‟ products
...

-A lower exchange rate will cause export prices to fall and import prices to rise:
 To succeed in increasing export revenue and reducing import expenditure, it is
important that demand for exports and imports is price elastic, so that a change
in price can cause a proportionally larger change in demand
...

2) Deflationary demand management:
-To discourage expenditure on imports, a government may adopt deflationary fiscal
and monetary policy instruments
...

-There is a risk, however, that the resulting reduction in spending may cause
aggregate output to fall and unemployment to rise
...

Tariff: a tax on imports
...


-These measures may however have inflationary side effects:
 Imposing tariffs will increase the price of some products bought in the
country, raise the cost of imported raw materials and reduce competitive
pressure on domestic firms to keep costs and prices low
...

Long-run:
-If a deficit arises from a lack of quality competitiveness, low labour productivity or
high inflation, then reducing the value of the currency, deflationary demand-side
policy instruments and import restrictions will not provide long-run solutions
...

 It may also increase funds for research and development at universities to
encourage invention and innovation
...

-Some supply-side policies can also take a relatively long time to have an effect and
can be very expensive for the government
...

-To reduce a surplus, a government may seek to raise the value of its currency,
introduce reflationary fiscal and monetary instruments and/or reduce import
restrictions
...

-Changes in government spending affect G component of AD while changes in
taxation affect C and I by altering the disposable income of households and the post
tax income of firms
...

Disadvantages:
1) Time lag:
-To recognise the need for a change in policy
...

-To draw up and implement new tax codes and government spending plans
...

2) Inflexibility of government spending:
-Difficult to cut spending on health care and pensions
...

3) Not always based on accurate information:

-If e
...
forecasts inaccurately predict a recession in the near future, a government may
do expansionary fiscal policy:
 If the economy is actually heading for an economic boom such as move will
add to inflationary pressure
...

4) Depends on households and firms consumer confidence:
-A cut in income and corporation tax may not lead to higher consumption and
investment, if households and firms lack consumer confidence
...

6) Rise in taxation and benefits disincentives:
-A rise in income tax rates or an increase in state benefits may discourage some
people from working
...

8) Depends on economic activity in other countries:
-Fiscal policy changes can also be offset by changes in economic activity in other
countries:
 E
...
if UK is pursuing an expansionary fiscal policy but its main trading
partners are experiencing a recession, AD may not rise much in the UK
...

-Central bank is independent from government and can make decisions free from
political interference
...

Disadvantages:
1) Not always based on accurate information:
-Business confidence may be misleading and forecasts of trends in unemployment
may be inaccurate
...

2) Difficult to control:
-In supply money, there is a strong profit motive that commercial banks have to
increase bank lending
...

-To gather the information on which to base the change
...

4) Depends on households and firms consumer confidence:
-If consumer confidence is high, a rise in the interest rate will not cause people to
reduce their spending and firms to alter their investment
...

6) Decreasing interest rate is ineffective if interest rate is low already:
-When the interest rate falls to very low levels, a further cut is likely to be ineffective
in stimulating economic activity, as it does not cause a large effect on the interest rate
...
g
...

8) Side effects on balance of payments:
-A rise in the exchange rate, may worsen the balance of payments position
9) Depends on elasticity:
-If the country is interest-rate elastic, a change in the interest rate will cause a
proportionally larger change in the demand
...

-A higher quality of resources should also make domestic firms more price and
quality competitive, and so improve the country‟s current account position
...

-This means the extra capacity would not be used
...
g
...

3) Expensive:
-Some supply-side policies can be expensive to work with and do not guarantee they
will work
...

-In contrast such measures may make it more difficult for a government to achieve
low inflation and a satisfactory balance of payments position
...

 Aerospace engines
 Telecommunications
 Financial services (London)
...

-London has a range of advantages over the rest of the world‟s financial markets:



Located half way between Asian and US markets (right place and right time
zone)
...

 Ready supply of skilled personnel
...

-Top 3 destinations of UK exports in 2006:
1
...
France
3
...
Germany
2
...
USA
...

-Lower prices and higher quality that results from the higher level of competition that
arises from countries trading internationally
...

-Firms have larger markets in which to sell their products and from which to buy raw
materials
...

-Increases world GDP, which leads to global growth
...

Disadvantages:
-Can create bigger inequality
-Can lead to structural unemployment:
 Due to e
...
occupational immobility of labour
...

-You depend on other countries
...

-Bad working conditions
...


Exchange Rate
Exchange rate: the price of one currency in terms of another currency or currencies
...

-If demand increases then this will lead to higher demand for the currency so the price
will go up and so the exchange rate will rise
...

Increase in the Exchange rate:
-Imports become cheaper and import quantity increases
...

-Net exports go down (more of a deficit or a smaller surplus)
...

Decrease in the Exchange rate:
-Imports become more expensive and import quantity decreases
...

-Net exports go up (less of a deficit or more of a surplus)
...

-Appreciate: value of a currency goes up compared to another currency
...

The demand for the UK £ will increase if:
 Export volumes increase due to increased popularity of goods
...

 Speculators think the value of the £ will increase in the future
...

The supply of the UK £ will increase if:
 Export volumes decrease due to decreased popularity of goods
...

 Speculators think the value of the £ will decrease in the future
...

Basic Diagram:

Higher exports:

-Higher exports means more demand for the pound to pay for these exports
...

Higher imports:

-Higher imports means more pounds have to be supplied in order to buy foreign
currency in order to pay for the imports
...

Higher interest rates:

-If interest rates increase in one country compared to another (assuming the risk is the
same), foreign investors will move their money into the country with the highest
interest rate
...

Speculation (down for UK pound):

-If speculators believe the pound is over valued compared to other currencies they
will want to sell pounds whilst the price is high and buy currencies, which are
relatively under valued
...


Protectionism
Protectionism: this is a policy protecting domestic industries from foreign
competition
...

-Restrictions on imports:
 Government may be concerned that, e
...
certain undesirable products may be
imported
...

-Protectionism results in the deliberate restriction of the free movement of goods and
services between counties and economic blocs
...

-They can be imposed with the intention of raising revenue and/or discouraging
domestic consumers from buying imported products
...

Opening to trade:
-Now there is a new line of World supply:
 This is perfectly elastic as there are many different substitutes that they could
import from (196 countries)
...

-This causes excess demand of Qd – Qs, which will then be imported (imports equal
Qd-Qs), and domestic suppliers suffer
...


-This means there is an increases the price from Wp to Wp + tariff
...

-This means the excess demand falls and the domestic suppliers supply more so they
suffer less
...

- The triangles on each side of the box are labeled A and B
...

-Area B is a consumption distortion as domestic demand falls
...

Winners of tariff:
-Government of the importing countries
...

Losers of tariff:
-Government of the exporting country
...

-Domestic consumers
...

-The products of services it affects
...

-The price elasticity of supply
...

Quotas
-Quotas can be imposed on imports to ban a certain amount by the quantity of by the
value of the exports
...

-This is likely to push up price
...

Voluntary Export Restraint (VER):
-A country may agree to restrict its exports in return for a similar limit being put on
the exports of the other country or to avoid damaging import restrictions being
imposed on its products
...

Foreign exchange restrictions:
-A government may seek to reduce imports by limiting the amount of foreign
exchange made available to those wishing to buy the imported goods and services or
to invest or to travel abroad
...
g
...

 E
...
the EU have an embargo on USA beef, which is hormone injected as it
has been linked to cancer
...

Quality standards:
-Quality standard may be set high and complex requirements may be put in place with
the intention of raising the costs of foreign firms seeking to export to the country
...

Why do governments use protectionist methods?
-Prevent imports of certain goods e
...
demerit goods
...

-Prevents domestic firms being outcompeted (maintain competitiveness)
...

-Government tax revenue:
 Especially with tariffs
...

-Costly to implement
...

-Price of imports increases, which increases cost-push inflation
...

-Risk of retaliation (trade war)

---