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ECONOMICS
Unit 4: The National and International Economy
Chapter 14: Economic growth, development and standards of living
Meaning of Economic Growth
Economic Growth describes an increase in the potential output an economy can produce
...

Short-run economic growth is an increase in the output that results from making use of spare capacity
and unemployed labour; also known as economic recovery
...
The concept can be shown on a
PPF diagram, an AS/AD diagram, or an economic cycle diagram
...
Cyclical unemployment is
also evident due to a lack of demand
...
To improve the long-run trend rate of growth, we can increase the quantity and
quality of the factors of production
...

Economic development
Economic growth is not always the best indicator of welfare or wellbeing
...
In some countries the rich-poor divide is incredibly wide, where
the rich enjoy vast amounts of wealth, whilst the vast majority of the country lives in poverty
...

Resource depletion occurs when finite resources such as oil are used up
...
In the long-run, economic growth should be sustainable, using
renewable resources
...
g
...
As taught in unit
3, adding labour in the short-run, when the other factors of production are fixed, brings about the law of
diminishing returns
...
This measures the change in total output
when all the factors of production are changed in the economic long-run
...
It results from increased productivity, often as a result of technological progress, but
not always
...
Most
economists agree that technical progress is the main cause of economic growth, but disputes over what
causes technical progress itself
...
There are two main types of fluctuations: seasonal, and cyclical
...
Cyclical variations can
be divided into short-run fluctuations (economic/business cycle), or longer cycles (long-run trend rate of
growth)
...

The economy’s trend rate of growth is the
rate at which output can grow, on a
sustained basis, without putting upward or
downward pressure on inflation
...
25%
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However a recession can occur within a positive output gap – if economic growth falls for two consecutive
quarters, yet it is still above the trend rate of growth
...
In a positive gap, it is referred to
as the ‘boom’ stage, whilst in a negative gap, it is referred to as the ‘recovery’ stage
...
g
...
E
...
El Nino
– atmospheric and oceanic disturbance in the Pacific Ocean and surrounding countries occurring
every 7-14 years
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 Speculative bubbles
...
When people realise that house prices have risen far above the assets’ real values, asset
selling replaces asset buying causing the bubble to burst, destroying consumer and business
confidence
...

 Political business cycle theory which suggests that as an election approaches, Governments may
‘buy votes’ by encouraging a pre-election boost to the economy enhancing their chances of being
re-elected
...
E
...
the Great Recession (see
below), and the 1973 oil crisis, in which OPEC was formed to control oil (cartel)
...

Cause(s) of the Great Recession:
 Deregulation of financial industry
 US banks’ lending recklessly to sub-prime NINJAs (people with No Income No Jobs or Assets)
 People paying back high-risk, sub-prime mortgages could only just about pay it off, but the US
increased interest rates meaning they could no longer afford to pay off the mortgage or loan
 They defaulted, and the banks lost money
 Banks from all over the world (primarily Europe and the US, alongside Canada, Australia and a few
others) had all engaged in a complex system of mortgage and debt buying and selling – mortgages
and debts were sold to other banks and there was huge confusion over which loans were owned to
which bank
...
However some argue this has destabilised the economy because:
o Government timing may have been off because many of them reacted due to unemployment
and employment levels (which often occur several months after the change in output)
...
Its formula includes consumer spending, business spending, government
spending and the current account
...
e
...

Nominal GDP measures C+I+G+(X-M)
...

Nominal/Real GDP/Capita measures nominal or real GDP taking into account the population size
...

However both measures do not include a number of different aspects of social and economic wellbeing,
and do not account for the distribution of income (which is often much worse in developing countries):
 It does not take into account non-monetary work (e
...
housework and raising children at home and
home improvement jobs)
...
An example of this is the prostitution
industry which in the UK is estimated to be around £5
...
This includes tax evasion, which
does not contribute to GDP
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 LSEW (Friends of the Earth)
...

 National Wellbeing Index (ONS), measures how happy people are by giving people questionnaires
on education, relationships and heath
...
(It is subjective)
...
However most economists disagree claiming free-market
mechanisms would increase the price of renewable resources prompting consumers to purchase less of
the good, whilst producers look for other alternatives for that good to replace it as a factor of production
...
It differs from national expenditure, which measures realised or actual spending
...

AD Curve
With the AD and SRAS curve, the economy produces an equilibrium at which output and the price level is
determined
...
Any changes
to these result in a shift in the AD curve
...
This is due to
three main reasons:
 Wealth effect/real balance effect is the concept that as price levels fall, or increases at a slower
rate than wages, people effectively have more money to spend and disposable income increases,
leading to greater spending (consumption)
 As a result of increases in real money balances, the supply of money within the economy increases
...
Low interest rates encourage greater spending
and lending, leading to greater consumption and investment levels
 As the domestic price level falls relative to prices of international countries, or grows at a slower rate
than other countries, demand for domestic goods (exports) increase, causing the current account to
increase
SRAS Curve
The SRAS curve is determined by the factors below
...
Since all firms are profit-maximising, increases in price of their
produce indicate higher profits can be earnt, which gives firms an incentive to expand production, creating
growth
...

LRAS Curve
Generally, economists believe that the LRAS curve is vertical, with the exception of the Keynesian LRAS
curve (see below)
...
This is because it

occurs when the factors of production within the economy are being utilised – with full employment
...
The long-run equilibrium level of potential output can also be referred to as the natural level
of output
...
This can only be sustained temporarily because it produces beyond
the economy’s natural capacity of output
...
This is when the economy ‘overheats’
...
He
claimed without purposeful Government intervention, an economy could display permanent demanddeficiency
...

What is the purpose of learning this? Will we need it in the exam? Can we use it in evaluation?
Vertical LRAS
Because it is vertical, an increase in AD, when the equilibrium is at YFE will increase the price level, but not
output in the long-run
...
In the short-run it may work, but output and
employment will fall back to its natural rates
...

This can be used for evaluation
...

The multiplier exists whenever a change in one AD component causes multiple and successive stages of
change in output
...
g
...
This causes businesses to
earn more profits, causing them to be able to spend more, which they could spend on more labour causing
consumption to increase further
...

There are different types of multipliers corresponding to each component: Consumption multiplier,
investment multiplier etc
...

During the Keynesian era from the 1950s to 1979, Governments fine-tuned AD in the economy, using
contractionary fiscal policy to reduce demand-pull inflation when AD was too high, and expansionary fiscal
policy to increase output when AD was too low, or the economy was in a recession
...

The effect of the multiplier depends upon the marginal propensity to consume
...
If it was 0
...
This is opposite to the marginal propensity to
save
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The effect also depends upon other leakages such as imports and taxes
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5 during the
NICE decade era
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9-1
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This means spending cuts has a much
stronger reduction effect on the economy than it would have before the recession
...

Keynesian economics would be much more efficient and effective in countries with a large multiplier, than
countries like the UK where the multiplier is small
...
To achieve full employment, Governments
deliberately ran budget deficits
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Nominal national income can increase in 2 ways: through reflation of real output or through inflation of the
price level (the latter of which will not increase real national income)
...
They also claimed Government spending crowded out private sector investment (chapter
19)
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To portray the multiplier effect on a diagram, draw the initial shift in AD with a new AD curve labelled both
AD1 and (triangle (change in)) G (Government Spending)
...
The multiplier effect would have a purely inflationary affect if the LRAS curve is
used, or a purely output-rising effect if the Keynesian curve is used and the economy is operating within its
production possibility frontier
...
UK unemployment:
 During the 1950s and 1960s, unemployment was always below 3%
 During and after crisis of Keynesian economics in the 1970s, unemployment peaked at 11
...
9% in 1993
 Between 1997-2009 unemployment was between 3-5% - low, but not full employment
Free-market economists define unemployment as the market-clearing price for labour (where S=D)
...
This is equilibrium unemployment
...
However, FE does not consider frictional
unemployment as people move between jobs
...
Therefore in an economy, equilibrium unemployment equates to
frictional and structural unemployment
...
As the wage rate falls, it is more
profitable to purchase labour rather than capital to produce output, creating capital-intensive
methods of production increasing employment
Aggregate supply for labour (ASL) curves downwards (as wage rates rise, supply rises) because:
 As wage rates increase, workers with jobs will work longer hours, as they demand more time to earn
more money
 Higher wages attract people to enter the labour market
Figure 16
...
Full employment occurs at EFE, whilst the distance between EFE and E1 refers to
the natural rate of unemployment, or equilibrium unemployment, or structural and frictional unemployment
...
Employment usually lags a few months behind the business cycle because:
 Employers hang on to best employers for several months before they are certain demand for their
products are falling
 Employers are usually cautious when employment more workers full-time during a recovery period,
often offering overtime to current employees before deciding to recruit more workers
...
This measures the number of people claiming
unemployment related benefits (the main benefit of which is Job-Seekers Allowance)
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Both measures discount discouraged workers, and roughly half a million who are classified as economically
inactive
...
Causes of frictional
unemployment include the geographical immobility of labour, where family ties prevent people from moving
to another location in order to get a job, as does lack of knowledge about vacancies elsewhere and the cost
of moving and obtaining housing; and the occupational immobility of labour, where a certain skillset and
potential training may prevent someone from applying for a job, as do restrictive practices and
discrimination in the labour force
...
Temporarily, he will choose to be
unemployed as he looks for jobs set at or around his aspirational wage
...
(Figure
16
...
People claim the higher the unemployment benefits are, the longer period of time people are willing
to remain frictionally unemployed
...
This ratio is different depending on the worker
and the wage he receives in work
...
This destroys the incentive to work and creates an unemployment
trap where not working is more attractive than working
...

Seasonal unemployment is a type of casual unemployment caused by the weather and the seasons (e
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tourism and selling ice cream)
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Technological unemployment is a specific type of structural unemployment and occurs when one
industry experiences technological progress towards labour-saving technology, shifting the market towards
capital-intensive production methods
...
However, automation has taken its place, where
machines operate other machines, or itself, reducing demand for labour
...
These were called sunset industries
...
In the severe recessions of the early 1980s and 1990s, structural unemployment
affected almost all regions in the UK due to the widespread decline of deindustrialisation
...
g
...

Disequilibrium unemployment
Disequilibrium unemployment occurs when:
 ASL exceeds ADL
 Wage stickiness (the real wage rate fails to restore to a market equilibrium due to external factors)
The two types of disequilibrium unemployment is:
 Classical unemployment (or real-wage unemployment)
 Keynesian unemployment (or cyclical, or demand-deficient unemployment)
Classical unemployment:
Classical unemployment occurs when real wage rates are kept higher than the equilibrium wage rate,
causing a shortage of demand for labour
...
6
...

Keynesian unemployment:
Jean-Baptiste created Say’s law
...
As supply increases,
output is produced, alongside factor incomes such as wages and profits
...
Free-market
economists uphold this law, however Keynesians argue not all income is spent, some is saved, and
therefore the law fails, creating demand-deficient unemployment
...
7 (a) and (b): AD falls rapidly, due to recession
...
If free-market economists are right, wage rates will fall due to the
falling demand for labour, from W FE to W 1
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Costs and consequences of unemployment
Free-market economists believe some unemployment is necessary to provide downward pressures on
wage-rates, reducing inflationary pressures
...
In the late
1990s and early 2000s it was generally agreed that the dominant cause of unemployment in the UK was
due to supply-side problems rather than demand-side problems
...
They believe the state’s role
should be reduced to cut frictional, structural and classical (real-wage) unemployment
...
Keynesians disagree claiming unemployment is a result of large-scale labour market failure and
Government intervention is needed to prevent this
...
From 1993-2007, the rate of inflation remained 1% either side of the Government target of 2%,
except for one quarter where it nudged above 3%
...

Deflation is a continuous and persistent fall in the price level and increase in the value of money
...

Measuring Inflation
Retails prices index measures the headline rate of inflation and is used in the UK for setting welfare
benefit increases
...

CPI and RPI are both measured by collating a large number of typical items the public purchase regularly
...
The frequencies that certain goods/services are bought determine its
weighting in the basket of goods
...

The CPI basket of goods is very similar to that of the RPI however it excludes housing costs and mortgage
payments among other retail-based costs
...
5% prompting the
introduction of inflation targets and inflation becoming key to macroeconomic policy
 1992-1994: Rapid fall to about 2%
 1994-2006: NICE period (non-inflationary consistently expansionary) where inflation was almost
always close to 2%
 2007-mid-2008: UK suffered severe cost-push inflation due to rising oil, gas and food imports,
pushing inflation to 5
...
1% due to the house price bubble bursting (RPI was at 1
...
2%, its lowest point for 5 years since the house price bubble burst



2015: Deflation has become a worrying issue for the Eurozone
...


Inflation theories
 1700s-1930s: Old Quantity Theory of Money (Monetarist)
 1930s-1940s: Keynes’ General Theory (Demand-pull) (Keynesian)
 1950s: Modern Quantity Theory of Money (Monetarism - Milton Friedman)
 1950s-1960s: Keynes’ Cost-push explanation (Keynesian)
 1960s: Phillips curve (Keynesian)
 1968: Role of expectations is introduced into Milton Friedman’s Long-Run Phillips Curve
 1970s: Short-run Phillips curve argument breaks down
 1980s onwards: New Keynesians vs
...
Monetarist
Quantity theory of money (Monetarist):
The quantity theory of money suggests that inflation is caused by a prior increase in the money supply
...

It derived from an equation (the Fisher equation of exchange):
𝑀𝑜𝑛𝑒𝑦 𝑠𝑢𝑝𝑝𝑙𝑦 𝑋 𝑉𝑒𝑙𝑜𝑐𝑖𝑡𝑦 𝑜𝑓 𝑐𝑖𝑟𝑐𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑚𝑜𝑛𝑒𝑦 = 𝑃𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 𝑋 𝑡𝑜𝑡𝑎𝑙 𝑇𝑟𝑎𝑛𝑠𝑎𝑐𝑡𝑖𝑜𝑛𝑠
𝑀𝑉 = 𝑃𝑇
Where V is how often money is spent and where T is usually substituted for real national output (Y)
...
As a result, firms and households hold excess money balances which, when spent,
contributes to demand-pull inflation
...
This theory also assumes that money is quickly spent, and not saved
...

 Keynesians also argue that if there is spare capacity (unemployment) in the economy, an increase
in the money supply may increase output rather than the price level
...

The Quantity Theory of Money argues that the Government’s budget deficit and borrowing requirement
causes monetary expansion which triggers and sustains demand-pull inflation; while the Keynesian
Demand-Pull Theory argues that a budget deficit leads to an injection of spending into the circular flow of
income that, (only) with full or near-full capacity, results in excess demand and demand-pull inflation
...
There are many variants of this,
including:
 Wage-push – where increasing wages increase the costs of production for businesses which will
lead them to raising their prices
...

This happened in the UK in 2007 and the first half of 2008 due to rising oil, gas, food and other
commodity prices
...
This is accelerated by strong trade unions and monopoly powers
...
This is illustrated on a diagram via a
shift to the left of SRAS, against AD (no need for LRAS)
...
In the cost-push theory,
falling unemployment means the power of trade unions increase
and they can push for higher wages
...
Increasing
aggregate demand would shift an economy from point A to point
B on the diagram on the left
...
From this, the
development of the expectations-augmented Phillips curve and the theory of rational expectations came
about
...

The natural rate of unemployment is located
where the LRPC intersects the unemployment
axis on a Phillips curve diagram
...


Deflation
Deflation (falling prices) is currently strife across the eurozone
...
It is a problem because consumers often postpone big ticket
consumption decisions such as buying a new car
...
Japan has had
decades of deflation and a struggling economy
...
This is portrayed in an AS/AD diagram with an increase in SRAS, leading to
economic growth; as opposed to a fall in AD which leading to a shrinking economy occurring as part of bad
deflation
...
Additionally, low so-called creeping inflation can be indicative of a
health, growing economy and a general climate of business optimism
...

 Real interest rates, taking into account inflation, may be negative meaning lenders are really paying
borrowers for lending money from them, harming lenders who keep money in banks
...






Also, firms may divert profits from productive investment projects, towards unproductive commodity
hoarding and speculation
...

Less efficient bartering may take place making trade harder
...

Exports are uncompetitive and fall, leading to falling AD and possibly leading to recession
...


Chapter 18: Money, Banks and Monetary Policy
Money is both a medium of exchange and a store of value in the sense that it can be used to purchase
other goods/services, or it can be stored as a wealth asset
...
g
...
g
...

Representative money refers to receipts of bank notes which, historically, used to represent gold or another
commodity people traded in
...
Most modern money today is token money in the form of cash and
bank deposits
...

Commercial banks are divided into two types: retail banks, who largely deal with lending and borrowing to
and from the general public; and wholesale banks (investment banks) which deal with other financial
institutions
...

Bank of England
The Bank of England is the UK’s central bank
...
The main
function of the bank is to implement monetary policy on behalf of the UK
...

The BoE can control how much credit banks can supply (and thus the money supply) in two/three ways:
 Required Reserve Ratios refer to the proportion of money banks must keep as a reserve of assets
...

 Direct Controls:
o Quantitative Controls refer to maximum limits on the amount of money banks can lend or
the rate at which banks can increase total deposits
...

In the 1980s however, Thatcher abolished these policy instruments
...

Interest Rates
Now, interest rates are the major instrument used
...
If commercial bank rates change (let’s say, it decreases):
 Consumption increases
o The reward for saving falls; saving falls; disposable income increases
...

o Demand for assets such as housing and shares increases because people have more
disposable income and the cost of borrowing falls
...

 Investment increases
o The cost of lending falls; businesses bring forward investment projects as more projects are
profitable with a lower cost of borrowing the money
...

Transfer of payments increases
o The reward for saving falls; wealthy owners of international capital take money out of UK
accounts and into other accounts; the demand for the pound falls; strength of the pound
(exchange rate) falls; increases price competitiveness of UK exports; while prices of imports
rise and become less competitive in the UK market; causing net transfer of payments to
increase; boosting AD
...

In the past, the majority of banks’ sources of liquidity came from household savings
...
The rate of which banks led to each other is called the LIBOR (London interbank offered rate of
interest)
...

Transmission mechanism of monetary policy:

Quantitative Easing
Quantitative easing (QE) is a policy used to increase the money supply and is often used when interest
rates are too low to lower further and thus another policy must be used to prop up inflation
...
The BoE purchased £200 billion worth of bonds from March to November 2009 – economic
growth during this time was between 1
...

History of Monetary Policy
Since 1992, the BoE has estimated what inflation would be in 2 years’ time and aimed to implement policy
prior to this point in order to ensure inflation stays within 1% either side of the 2% target
...

In 2007-early 2008 rising prices of commodities led to inflation of 5
...
Once this passed through the
system by the end of 2008, another problem occurred: the credit crunch
...
There were fears
inflation would fall to 0% or even turn into deflation
...

In light of Keynesian Economics since Keynes wrote his General Theory in 1936, fiscal policy was used in
order to manage the level of aggregate demand in the economy
...

Under Thatcherism in the 1980s, demand management was rejected and there was a return to sound
finance economics and balanced budgets; alongside monetarism
...
e
...

In the 1990s, and when New Labour took power, fiscal policy returned, but the Government still believed
that monetary policy should be used to control demand and inflation in an economy, with fiscal policy
largely centred around supply-side policy
...

Taxation and Public Spending
Taxation basics:
 Taxation is a compulsory levy charged by the Government to raise revenue, primarily to finance
Government spending
...

 Progressive taxes are taxes for which the proportion of a person’s income paid in tax rises as
income increases
...

 Proportionate taxes (or flat-rate taxes) are taxes for which the proportion of a person’s income in
tax stays the same as income increases
...

 The average tax rate refers to total tax paid divided by total income earnt
...

 The marginal tax rate refers to the change in tax paid divided by change in income earnt in
response to a change in income
...

Principles of taxation:
A tax, according to Adam Smith, must abide by four principles
...
However, many believe this
is a justification for progressive taxation and fair means it should be based on ability to pay
...

 Convenient, meaning it should be done at a time that is practically viable (i
...
not mid-harvest when
output is yet to be realised
...

Another principle:
 Flexible (another common principle), meaning if the tax is a means of economic management, it
should be easy to change and alter to changing economic conditions
...

Generally, throughout the first half of the 20th century (with the exception of post-war spending), the UK saw
a gradual and steady rise in its public expenditure to national income ratio from 10% to 40%, reaching
47% in 1982/83
...
The primary determinant in the public expenditure to national
income ratio is the stage at which an economy is within the economic cycle
...
And vice versa in an economic boom
...
This refers to spending to produce hospitals, roads (not private
sector and welfare spending)
...
This figure is based on the stock of
national debt a Government has, and interest rates at the time
...
They can also be repealed on merit goods such as museums
...


Fiscal Policy
Fiscal Policy is the use of Government Spending, taxation and the Government’s budgetary position to
achieve the Government’s policy objectives
...
Its ideology was as follows:
 Economic growth could be higher and full employment could be achieved because if left alone,
businesses will often save too much and invest too little
...
They often justified this with the belief of
the multiplier effect (an initial investment into the economy would bring about a larger than initial
increase on the economy itself)
...

Generally, supply-side fiscal policy was treated as subordinate to demand-side fiscal policy; while it was
largely interventionist policy
...
It dominated economic policy under Thatcherism during
the 1980s
...

Any growth in output and employment resulting from it is short-lived and in the long-term the
ultimate effect is inflation
...

 Public spending should be kept controlled in order to avoid the crowding out of the private sector
...
e
...

 Fiscal policy became subordinate to monetary policy (i
...
interest rates and monetary controls to
control inflation and the money supply)
...

The Lawson Boom refers to a period
of time from 1983-1989 characterised
with economic growth and a shift from a budget deficit into a budget surplus
...
g
...

A collapse of confidence causes AD to fall, causing output to fall
...
This increased spending inject
demand back into the economy thereby stabilising and dampening the impact of the initial fall in AD,
reducing the size of the Contractionary multiplier effect which occurs as AD falls
...
As AD increases, unemployment falls and less people receive means-tested benefits such as
unemployment benefits taking demand out of the economy reducing the possibility of the UK overheating
during a boom phase
...

Budget deficit and borrowing
Generally, in a recession, spending on benefits increase will tax revenue from income falls, leading to a
budget deficit and increased borrowing, and vice versa
...
This is when factors regarding the changing structure of the
UK economy such as deindustrialisation and globalisation, can have an impact on the country’s finances
...

Diagram
Expansionary fiscal policy is aimed at increasing aggregate demand and causes AD to shift to the right
(either due to greater government spending, or greater consumer spending as a result of tax cuts)
...

On the diagram, the nearer he economy gets to full employment, the more inflationary the effect of an
increase in AD becomes, until full employment is reached and the economy is operating at full capacity
...

The effect of supply-side fiscal policy is largely the shifting of the LRAS curve to the right
...
This process is split into two forms:
 Resource crowding out – There is an opportunity cost with employing resources to the public
sector, because these resources won’t be available to the private sector
...
If unemployment exists, public spending would simply use idle
resources, taking up the slack in the economy and leading to a boosted economic recovery
...
The multiplier effect generates further
business for the private sector
...
Such taxes reduce the spending power of private individuals and firms paying
the taxes
...

PPF diagram:
Contrasting views can be portrayed on a PPF DIAGRAM
...
Some extreme free-market economists argue that the government spending multiplier would be
negative and the PPF would decrease because public sector spending is unproductive and displaces
wealth-creating private sector investment
...
Keynesians argue that producing at a point
within the PPF, would require public spending which would initially lead to a movement upwards, towards
the public sector spending area of the economy, but would be kinked towards the right towards private
sector investment due to the multiplier effect (look at the textbook pg
...

Additionally, while Keynesian economists believe that the level of employment is a good indicator of the
amount of slack within an economy, free-market economists argue that such an indicator is misleading and
thus crowding out can still occur when unemployment is high if there is not enough capital for example
...
They can do this by issuing
governments’ securities which are ‘IOUs’ issues by the Government in exchange for a loan given to them
by an institution, business, individual etc
...
They can be in the
form of bonds, treasury bills or gilt-edged securities (gilts) (basically all the same)
...
A government with a large amount of debt, and a poor, small
economy may have a much larger risk than a debt-less superpower
...

UKs government’s fiscal rules, 1998-2008
Throughout this period, monetary policy was used to manage AD rather than fiscal policy
...
The Code for Fiscal Stability
outlined a framework for implementing fiscal policy
...

 Sustainable Investment Rule: Debt should be held at a ‘stable level’ of less than 40% of GDP
Current spending does not create assets for future generations to use (i
...
public sector wages, salaries
and welfare payments)
...

Capital spending provides social capital for which future generations will benefit from such as roads,
hospitals, schools etc
...

Therefore, Labour believed the budget should be balanced between income and current spending, but a
budget deficit for capital spending is justified
...
The golden rule ensures this does not happen
...
E
...
Labour diverted funding away from the National Lottery to pay for public
spending
...

The Laffer curve
Supply-side economists believe that if taxes are put too high, the
disincentives to work, and recent globalisation allowing highincome individuals to leave the country, could result in falling
national output, and thus falling tax revenue
...
Beyond the peak tax rate of the curve (which isn’t
necessarily 50%), increasing the tax rate becomes counterproductive causing tax revenue to fall
...

Supply-side policy
Supply-side policies aim to make markets more competitive and efficient, increase the productive
potential of the economy, and shift the LRAS curve to the right
...


In the Keynesian era of the 1960s and 1970s, microeconomic policy in the UK was largely interventionist
and was labelled as industrial policy
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Supply-side
microeconomic policy is anti-interventionist aiming to roll back government interference in markets
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Broadly speaking, they want to create an enterprise
economy
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The EU does have some restriction over a country’s fiscal policy however via:
 Tax harmonisation: The EU requires VAT to be issued in all countries, but the rates vary widely
from one country to another
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 The Stability and Growth Pact: This is an agreement to limit budget deficits in order to promote
economic convergence between member states
...
The pact requires countries to
stay within a limit of a 3% budget deficit as % of GDP and if it breaks this limit 3 years in a row, it is
liable for large fines
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The fact that both Germany and France broke this agreement during the recession as well
angered many southern European nations, reducing the fines given for breaking the rule
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Also, imports of raw materials can boost
the choice of goods/services that producers can make as many goods/services cannot be produced
in certain economies
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This is called the principle of comparative advantage, as a result of the international division of
labour
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By producing only what a country is most technically
efficient at producing, overall output can increase across more than one country for a number of
different goods
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 Comparative advantage: This is measured in terms of opportunity cost
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For example, two countries (A and B) and producing two different types of good (Beans and Egg)
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Country A has an absolute advantage in
producing both goods
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A country that is absolutely worst at both activities possesses a comparative advantage in the
industry in which its absolute disadvantage is least
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However, there are several assumptions these arguments above make:
o Each country’s factors of production are assumed to be fixed and immobile; when in
reality there is a movement of labour and capital (particularly across economic unions
such as the EU)
...
E
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over-specialisation within agriculture such as monoculture can lead
to soil erosion and increasing vulnerability to pests increasing the likelihood of a
reduction in output
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In contrast, if a
country is self-sufficient, it has very little danger of suffering an imported recession
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Strategic trade theory: Similar to the above theory, justifies the protection of growing industries as
they gain a competitive advantage in the world over other competing industries
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 Agricultural efficiency: As stated before, in some industries such as agriculture, decreasing
returns to scale may harm efficiency e
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monocultures in agriculture
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 Sunset industries: Developed economies justify protectionism to protect older industries from the
competition of infant industries in developing countries
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 Anti-dumping: Protectionism is sometimes used to prevent the process of ‘dumping’, whereby
excessive surplus from overseas markets may be dumped into another market elsewhere at very
low costs, undercutting domestic competition
...
g
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 Demerit goods and ‘bads’: An output gain of demerit goods and bads do not necessarily lead to a
welfare game
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 Self-sufficiency: Sometimes it is argued that being self-sufficient is very important, particularly in
times of war or political conflict
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 Employment: Some argue that free trade leads to many TNCs from moving capital from developed
countries into countries with low labour costs
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They argue,
employing resources inefficiently is better than not employing resources at all
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In this situation, domestic demand
increases to Q2, while domestic supply falls to Q1 with the

quantity in between filled with imports
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In addition to this, the triangle created, signifying imports,
is added to the consumer surplus as well, creating a net welfare gain, equal to the area of imports
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However, a smaller tariff may
raise Pworld to P+Tariff
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In this situation, all areas
between P and P+tariff is removed from consumer surplus
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Patterns of Trade
Traditionally, world trade was primarily North-South trade, with the north exporting most manufactured
goods to the south, which exports primary production such as raw materials and foodstuffs back to the
north
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Much of this trade is within
Newly Industrialising Countries (NICs) such as India, China and South Korea; in addition to the BRIC
countries of Brazil, Russia, India and China
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This shift
represents the changing competitive and comparative advantage – the manufacturing and industrial sectors
of NICs are more competitive, arguably due to lower labour costs, sparking the deindustrialisation which
has occurred in developed countries
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Globalisation
Globalisation is the process of growing economic integration of the world’s economies
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Critics of
globalisation argue that it exploits poorer, developing countries, while there is a loss of culture
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They also claim that an
increased prominence of US goods such as Coca-Cola and McDonalds has destroyed local and national
products in other countries, harming economic growth there
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However, they argue that their wages encourage local wage growth as it is still far
higher than indigenous firms are willing to pay labour; they also argue their working conditions are much
better than indigenous firms
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Service sector:
The service sector has become increasingly mobile, with the example of call centres, which were
traditionally based in the UK, but now have been relocated overseas to countries such as India, which is
now more viable as it is easier to travel and transfer capital overseas, and it is easier to communicate
internationally
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Labour and capital mobility:

Labour mobility has led to the increased immigration of people from poorer, developing economies, into
more developed ones – although this has been offset in some countries by stricter immigration policies e
...

the points system in Australia
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Power of national governments:
Governments find it much harder to control MNCs operating within their economies – they are bound by
several jurisdictions, and can often threaten the government by leaving the economy altogether
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They are also heavily criticised when introducing trade barriers and protectionism
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Originally being the General Agreement on Tariffs and Trade it was replaced in the 1990s with the WTO
...
The meetings aim to end in agreement on reducing trade restrictions
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Supporters of the dependency trade theory argue that globalisation benefits the rich at
the expense of the poor
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This theory has grown in support among developing
countries, which have led to unsuccessful recent negotiations at WTO meetings
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This is split into two categories:
 Current Account (measures income currency flows including payments for exports and imports)
 Capital Account
Current account:
 The differences in the balance of trade in goods (sometimes called balance of visible trade), and the
balance of trade in services (sometimes called balance of invisible trade)
 Net income flows (below)
 Net current transfers
Since the 1990s, the UK’s trade in goods (which has been negative for a long time) has increased at a
faster rate than the UKs trade of services (which has been positive for a long time)
...

Net income flows are mainly investment income flows from profit and interest payments between
countries e
...
when companies in the UK invest in capital projects in other countries, which then pay back
money in terms of interest payments on the loan; or alternatively UK interest payments paid to MNCs
owning subsidiary companies in the UK
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Net current transfers measures the differences in transfer payments flowing between countries in the form
of foreign aid, grants and gifts etc
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A positive flow for a
long period of time would mean a country acquires a greater value in capital assets in other countries, than
other countries do in its own assets
...
This means that the UK became a large owner of overseas capital assets
...
This may be via a UK-based MNC starting a subsidiary company in another countries, or
via a merger/takeover of an overseas-based company
...

Portfolio overseas investment – the purchase of financial assets, usually done via shares and
governments bonds issued in foreign countries
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Owners of money may move money into a currency which is
expected to rise, and out of currencies whose exchange rates are expected to fall Funds flow into
currencies with high interest rates (to make more profit) and out of countries with lower interest rates
...

Because there is so much ‘hot money’ moving from country to country, it can affect the exchange rate itself
by altering the supply and demand for a currency
...

Such hot money can often destabilise exchange rates, as happened following the Great Recession in 2008:
 International credit ratings of many financial institutions and governments in many countries fell
 To tackle the recession, many governments racked up huge budget deficits, funded by overseas
borrowing, but due to lower credit ratings, there is less money available to borrow as people are
less willing to lend to countries with low credit ratings
 Many countries may resort to quantitative easing to spend money
 The creates a fear of uncontrollable inflation, which in turn leads to mass selling of the country’s
currency in fear of such an event
 This leads to a collapse in a country’s exchange rate
Balance of payments equilibrium
Balance of payments equilibrium occurs when the current account balances over a period of time
(usually several years)
...

However in the long-run, a persistent deficit could be indicative of an uncompetitive economy which failed
to produce enough goods/services to export
...

It is more of a problem in a country with a fixed exchange rate, than a floating one
...
Under a floating
regime, the exchange rate responds to market forces, and falls, thereby restoring export competitiveness
...
If it is
overvalued, the current account widens
...
This is when reserves of gold and hard currencies are
used to purchase its own currency on the exchange market
...
It is only a
temporary solution
...
By contrast, expenditure-switching
policies aim to switch expenditure from imports to domestic goods/services:
1
...
Therefore, consumers spend less in the
economy
...
If the
propensity if 0
...
Additionally,
deflation also has an expenditure-switching element, in that it reduces the price of domestic goods,
increasing the price competitiveness of the country’s exports, increasing the deficit
...

2
...

However, this does not solve the underlying cause of disequilibrium, most likely an inefficient
economy
...

3
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The effectiveness of this depends heavily on the price elasticities of demand for exports and
imports
...

This is more complicated if the price elasticity for imports is elastic, while the price elasticity of
exports is inelastic
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If the combined result is less than unity, a devaluation could worsen a deficit
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In the short-run, the MarshallLerner condition may not hold because elasticities of demand
are lower in the short-run than in the long-run
...
This initial
increase in the current account deficit may prompt a decline in
confidence, causing capital outflows which destabilise both
the balance of payments and the exchange rate
...


Is a current account surplus problematic?
A large surplus may be undesirable:
 It is impossible for all countries to have a surplus at the same time because one country’s surplus is
another country’s deficit
...

 A balance of payments surplus is an injection of AD into the circular flow of income which, due to
the multiplier effect, increases spending further
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Policies to cure/reduce a balance of payments surplus
This is essentially the opposite of the ‘three Ds’:
 Reflation (via expansionary monetary of fiscal policy, increasing a country’s demand for imports)
 Removal of import controls (to liberalise trade)
 Revaluation/appreciation – requires the Marshall-Lerner condition to be met, while a reverse J-curve
may also occur, meaning the surplus could increase before it starts to fall
Current account on AS/AD diagram
If the current account increases/moves into a surplus, AD shifts to the right
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Although further growth can cause very
inflationary effects if the economy is producing on its production possibility frontier, export-led growth may
occur
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Germany and Japan
achieved this throughout the 1960s – 1980s
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Chapter 22: Exchange Rates (including the pound, dollar and euro)
An exchange rate is the external price of a currency, usually measured in terms of another currency
...
The sterling index (or the effective exchange rate
index) measures the strength of the pound sterling against a number of leading currencies, each weighted
based on their importance to the UK in terms of international trade
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Determinants of the exchange rate:
 Trade flows (exports increases strength as other countries purchase pounds to buy British exports;
and vice versa)
 Investment flows (inward income flows increases demand for pound sterling)
 Interest rates and hot money flows (wealthy individuals move money to UK to gain interest)
 Expectations (Of future interest rates; of future exchange rates; to make profit)Fb
The real exchange rate measures the rate at which domestic goods are exchanged for imports, as
opposed to the rate of currencies themselves
...

Types of exchange rate system
Governments can either manage an exchange rate (managed systems) or let the market decide its price
(freely-floating systems, sometimes cleanly floating systems)
...
Alternatively adjustable peg systems
and dirty floating systems can be used (each more moderate than the last)
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When the exchange rate of the pound falls, exports become more competitive overseas because exports
appear cheaper
...
Similarly, as the exchange rate
of the pound increases, importers can purchase a higher volume of imports with the same amount of
pounds
...
As a result, a larger
quantity of pounds are placed onto the foreign exchange market to pay for these imports, pushing the value
of the currency down
...

Changes/shocks to the foreign exchange market:
An example of a shock is an improvement in the quality of foreign-produced goods causing UK residents to
demand more imports
...
This shifts supply to the
right
...

Advantages of a free-floating system:
 The market mechanism should always create a balance of payments equilibrium
...

 For efficient resource allocation, market prices must accurately reflect changes in demand and
competitive and comparative advantage resulting from technological progress – something that is
hindered by fixing and exchange rate
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


It insulates an economy against importing inflation
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Monetary policy can be used solely to achieve domestic policy objectives
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Disadvantages of a free-floating system:
 The assumption that freely-floating exchange rates are never undervalued or overvalued for too
long assumed the impact speculation and capital flows have on the currency value are negligible
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 International trade is hindered by volatility and uncertainty
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 Cost-push inflation: If inflation is high, trading competitiveness is low and the currency depreciates
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This prompts workers to demand
pay rises
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 Demand-pull inflation: If many countries with floating exchange rates use expansionary economic
policy to increase aggregate demand, worldwide demand would increase prompting demand-pull
inflation
...

Fixed exchange rates
A fixed exchange rate is one which is fixed at a certain level by a country’s central bank and maintained at
this level by intervention on the country’s foreign exchange market
...

Advantages:
 Certainty and stability for the economy
Disadvantages:
 Continued overvaluation or undervaluation of a currency; leading to current account surplus/deficit
 Inefficient resource allocation
 Possible importation of inflation
Other managed exchange rate systems
Managing exchange rates can be done when the central bank intervenes in the foreign exchange market
by selling/purchasing reserves of their currency onto/from the market
...
Some argue that instead of creating more confidence and stability than a freely-floating system,
and a lower likelihood of overvaluation and undervaluation than fixed exchange rates do, this often does
the opposite, bringing together the disadvantages of both
...
Assuming
a central peg is at a specific rate, if the rate falls below the peg floor, or above the peg ceiling, the central
bank intervenes in the foreign exchange rate market by selling/buying its own currency to artificially alter
demand to fix the exchange rate to the central peg rate it has chosen
...
However, if this system becomes too expensive, if, for example, the central peg
rate is too much higher/lower than the actual value, the central bank can change the peg rate
...
(On a diagram, supply/demand would change, then demand would
change it back due to intervention from the central bank)
...
The authorities claim the currency is officially floating, however they unofficially intervene
...
E
...

China often intervenes in the foreign exchange market
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The Euro
In 1999, the exchange rates of the 12 countries which first became members of the Eurozone were fixed to
each other
...
Eurozone countries are members of a
monetary union, within which monetary policy is controlled by the European Central Bank (ECB)
...

Impact of the Euro on Eurozone economies:
 Economic integration: Enables countries to benefit from increased specialisation, a larger market,
faster growth and higher living standards
...

 Speculation: The strength of eurozone economies (and its role as a world reserve currency) would
deter speculative selling/buying of the currency, brining stability to the exchange rate
...
The ECB monetary policy has often been criticised for
primarily catering to the needs of the major economies of France and Greece rather than those of
peripheral economies
...
This
deteriorated when France and Germany themselves broke the pacts
...


Other
‘Saltwater economists’ is a modern phrase used to describe Keynesian economists such as Krugman;
while ‘Freshwater economists’ is used to describe the more free-market economists

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