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ECON 4

Revision Notes 2015/2016

AQA Unit 4 – ECON 4 Economics: The National and International Economy Revision Notes
3
...
1 – Macroeconomic Indicators:
The Economic Cycle and Economic Growth: Economic Growth is an increase in the productive
capacity of an economy, which is measured by GDP
...


The Two Short-Run Economic Growth Diagrams
 Long-term economic growth rate is the average rate of economic growth sustained over a
period of time through an increase in the productive potential of an economy
...
In the PPF
diagram, this is shown by the outward shift from PPF1 to PPF2 whereas in the LRAS curve, it is shown
by the rightward shift from LRAS1 to LRAS2
...

This all leads to numerous advantages related to economic growth, such as:
 Increases the living standards and purchasing power, as well as economic welfare of all
involved in the economy
 There are more jobs available in the economy
 There is an accelerator effect involved with a growth in investment
 Greater business confidence
 Provides more green and environmentally friendly technologies through innovation
 Provides a fiscal dividend for the government tax revenue which can then be reinvested to
correct market failures or to provide important public & merit goods as well as solid
infrastructure
...


II
...


Resource Exhaustion – Finite resources are being used up really quickly due to the
expanding world population
...

Environmental damage – There are large industrial emissions which huge piles of waste
causing a huge destruction of animal habits
...

Global warming – Greenhouse gas emissions are being thrown into the atmosphere due to a
rapid increase in industrialisation in countries such as India and China
...
The solution to this, would be an increase in pollution permits which
would mean that firms are only permitted to emit pollutions based on the number of
permits they hold, which can actually be resold/purchased
...


The Economic Cycle is the cyclical pattern of short-term fluctuations in GDP from year to year, over a
period of time
...

Boom – This is the phase of the economic cycle where economic activity has reached its peak and
thus unemployment is low and spending is high
...

Recession – This is where the output in the economy is negative for two successive quarters, i
...
two
quarters
...

Once the value has gone well beyond its true value, people will start to sell these assets to
ensure a maximisation of profit
...

 Inventory changes is quite simply, the supply side version of the speculative bubble
...

 Political cycles come of particular importance in the months leading up to a general
election
...

 Shocks are unexpected changes in either AD or AS
...

Uses of National Income Data: There are 3 main ways in which the size of an economy is measured,
and they are:
I
...

III
...

If to GDP, we add interests, profits & dividends which flow into the country & take away those
flowing out, we get the GNP
...

However, with GDP there are a number of difficulties when using it as a measure of living standards,
such as:
 GDP does not really measure output completely in the sense that it can only measure the
value of goods and services that have been recorded as traded in markets
...
It also does not account for the ‘black market economy’ which makes up 10-15% of the
UK economy
...
Prices of goods/services such as
computers will have fallen, however, their capabilities will have increased greatly
...

 GDP also ignores the amount and value of leisure time taken by those working
...
)
 GDP figures also do not take into consideration what is actually being produced
...

 The Human Poverty Index is a measure which emphasises on longevity, knowledge,
economic provision and social inclusion to measure development
...

 The Misery Index simply adds the unemployment rate to the inflation rate, based on the
assumption that a combination of higher unemployment and higher inflation, means a
higher level of economic and social costs for a country
...
The levels of unemployment can
be measured by:
I
...


Claimant Count – This includes the people who are eligible to claim Jobseeker’s Allowance
(JSA), which they are able to do for up to six months, however does not include those who
are not eligible to claim JSA, such as over 60-s, or those on government training schemes
...
This is used
for international comparison and is most frequently used in the UK
...


Frictional unemployment is a form of voluntary unemployment and can also be referred to
as transitional unemployment
...
This could be due to a range of reasons, such as not accepting the
going wage rate
...
Or, they are unaware of the different range
of jobs which are available for them
...

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Ilford County High School

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II
...

IV
...


VI
...
0 would
mean that an employee would receive the same amount of income as they would if they
were unemployed and lived of benefits
...

Seasonal unemployment is a form of casual unemployment resulting from fluctuations in
demand throughout the year (based on seasons), because of a sudden increase/decrease in
demand at certain times of the year
...

Structural unemployment is when there is a long-run decline in demand for labour due to its
relative supply falling too
...
This all means that there is now a gap of
skills which cannot be filled by the skills held by labour workers of the primary & secondary
sectors and thus there is huge structural unemployment
...

A form of structural unemployment is technological unemployment which arises as groups
of workers in particular industries are substituted by labour-saving technology
...
This deficiency will lead to rising unemployment and subsequent
negative output gaps
...


VIII
...
Involuntary
unemployment occurs when a worker would be willing to accept the going wage rate,
however, cannot get a job offer
...


The Real Wage Unemployment diagram
Unemployment has a whole has a number of detrimental consequences, such as:
I
...
This means
that the economy is under producing and there is an opportunity cost at the potential
output
...
This also decreases the standard of living for the families as
well as causing problems in terms of self-confidence and motivation
...
This is the hysteresis effect where short-term unemployment can become the cause
for long-term unemployment
...

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II
...
There can be large
differences in standards of living of people who are employed and those unemployed, which
can lead to mental and physical health, leading some to even attempt suicide
...


There are however potential benefits which can be linked with unemployment, especially the idea
that rising unemployment can lead to firms keeping their costs low due to the reduced power of
employees forcing higher wages and salaries
...
because the economy is only producing between its PPF
...
These are
different for the type of unemployment faced in the economy, between:
 Demand-side policies – These are used to counter cyclical/demand-deficient unemployment
in the economy, where there is an attempt to stimulate AD
...

Offers could also be made to firms, such as subsidies or reduced taxes, to employ labour in
areas where unemployment is particularly low
...
There is an attempt
to provide the skills and the incentives for workers to find work, through training and
vocational courses, which increase the skills of the unemployed
...

The Phillips Curve illustrates a trade-off between inflation and unemployment in the economy
...
) If there is an
increase in AD (with AS remaining constant), inflation accelerates as the labour market tightens and
wages as well as prices build up as trade unions feel their power by becoming over-confident about
their jobs and thus push for higher wages
...
The Philips curve is different for each economy and so each individual government
can study its Phillips curve to determine when and how they should intervene
...
This can influence the tightness of fiscal
policy, for example, with a high NRU there’s lower capacity for growth, so fiscal policy should be
loosened to accommodate
...
It is very much like equilibrium unemployment
...
And if it goes above this point,
then of course inflation will increase again
...
Additionally, Supply-side economists would say that the
NRU allows a government to see the value of the NRU, which can be used to determine policy
responses such as cut income tax, reduce/abolish NMW, reduce state benefits, to prevent effects of
things like outsourcing which increases the NRU
...
This is calculated through the Consumer Price Index (CPI) which indicates
the rate of inflation through the % increase of it
...
The rate
of inflation in December 2015, however, was merely 0
...

The CPI is simply a weighted price index used to measure the changes in price of a typical basket of
goods and services, which are determined by the Family Expenditure Survey which is a monthly
survey of what this typical basked is actually made up of and how spending changes in UK
households
...

The CPI has a few limitations when used as a measure of inflation, and these are:
 Different groups in society all experience different rates of inflation, as different groups in
society have different goods and services in their typical basked of goods
...
, and thus
does not truly reflect for all
...

Cost-push inflation occurs when businesses are faced with an increasing cost of production and to
counter this, raise their prices in order to maintain profit margins
...

 Rising Labour costs can again increase the costs of production for a firm
 Higher indirect taxes such as excise duties or VAT means that the suppliers tend to pass the
burden of these taxes onto their consumers, thus we pay more for products
 Wage-price spirals are when employees are unwilling to accept a pay rise unless it is greater
than the rate of inflation, especially if inflation is continuing to increase
...


Cost-Push Inflation Diagram

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Demand-pull inflation occurs when there is little spare capacity in the economy, because AD
exceeds AS and thus any subsequent increase after AS is exceeded, will lead to an increase in the
price, as there is now the whole Demand/Supply concept
...


Demand-Pull Inflation Diagram
Quantity Theory of Money can also be referred to as monetary inflation, derived by Fisher in the
20th century, explains that an increase in the money supply of the economy, will in turn increase the
price levels within it too
...

Here, there is an assumption that V & T stay relatively constant/stable, and thus it could be deemed
that any change in M would lead to a change in P which makes this known as the Quantitative
Theory of Money
...
With higher
prices, exporting firms will lose customers abroad which could mean a rise in unemployment
due to falls in revenue, worsening balance of payments, due to exports falling which is a

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








Revision Notes 2015/2016
component of AD which will slow down the growth in the economy and thus the creation of
an output gap - ceteris paribus
...
This will again damage growth, employment
and the balance of payments
...
Their consequent time shopping around to
do this & gather information, is known as shoe-leather costs
...

The idea of a fiscal drag is that people will pay a higher proportion of their income in tax due
to inflation, as tax thresholds to not move in line with inflation
...
This is because psychologically, one feels better when
they are mentally getting more money
...
Here, there are two main types, which are:
 Good deflation – This is when the prices of goods and services falls due to technological
advancements and efficiencies across the economy and AS increases in both the short &
long runs
...

The problems associated with deflation, can be:
 Those who could be economically active, such as consumers, investors, choose to delay their
spending, in hope/anticipation that the prices will continue to fall – this is particularly the
case with big items, such as TV, Washing Machines etc
...
This means that the circulation of money decreases greatly and could
also lead to more inflation
...
4
...
However, it could also be used to influence the supply-side of the economy
such as incentives for employers/employees to work/invest in work
...


Direct Taxes – These are those taxes which are levied on income, wealth, property such as
Income Tax, Mansion Tax, Corporation Tax, Inheritance Tax and even Council Tax
...


II
...
Adam
Smith defined 6 main points which make a tax system a good one, and they are:
I
...

III
...


V
...


A tax system has to be easy and cheap to collect for the government and should thus be
economical such that revenue is maximised
...

Taxpayers and those regulating it should have a whole idea of how the tax system works and
know exactly what they need to pay, how they need to pay & how much they’re paying and
thus be certain
...


So which is better – Direct vs Indirect Taxes? The arguments that indirect taxes should be used, are:
 It efficiently influences spending patterns where arguably indirect taxes are much more
effective in changing the overall pattern of demand for goods and services
...

 Also, indirect taxes don’t really provide disincentives on individuals in the same way that
direct taxes have in the sense, that a rise in VAT won’t be treated in the same way as a rise
in Income Tax
...
Most goods and services
are susceptible to being paid VAT, however most food and children’s clothes are actually
exempt from VAT as well as leisure gambling activities too
...

 There is also an element of flexibility involved with indirect taxes, in yhe sense that they can
be changed more easily and with less ‘hooha’ than direct taxes, which are also limited to
change once a year in the budget (usually done so in April)
 You could argue that people have a choice as to whether or not they purchase goods which
are due for indirect taxation, however, as the majority of necessary goods are taxed
indirectly, due to its inelastic demand, this can be near enough impossible to do
...
Those on lower incomes and
those who are poorer, are more likely to feel the impacts of a rise in indirect taxes, as
opposed to those who are wealthier
...

 High levels of indirect taxation can force individuals to do everything in their capacity to
avoid them – this is a very weak point and is more a case with direct taxes
...

A progressive tax system means that the proportion of their incomes a person pays in tax, rises as
the amount of income they have increases such as Income Tax
...

A proportional tax system or a flat-rate of tax system, means that the proportion of tax one pays on
their income stays exactly the same as their income increases
...
There are 3 main types/forms of government expenditure in an economy, and they are:
I
...


III
...

Current expenditure is spending on the day-to-day expenses of running public services,
including paying teachers, running the NHS be it staff, medicine, paying for electricity &
heating in schools etc
...


Governments can pursue two different fiscal stances, which can be either expansionary fiscal
policies or a contractionary/deflationary fiscal policies
...
They may choose to do this through increasing government spending and cut taxes
...
Here, it is worth noting that this could lead to a rise in the levels
of inflation and subsequent conflict in macro-economic objectives in the economy
...
This is done as an attempt to create a
greater stability in the economy by smoothing out fluctuations in the economic cycle, as well as
influencing the levels of demand in the private and public sectors as it sees necessary
...
This is simply any change in injections or withdrawals in
the economy which then lead to a greater change in the national income
...

The formula to work out the value of the multiplier effect, is

1

...

There are arguments both for and against a budget deficit
...
With this, there is a theory known as the loanable
funds theory
...


The Loanable Funds Theory Diagram
A larger government deficit in turn increases the interest rates in the economy as they are pushed
up for everyone in the economy which thus increases the competition for available funds in the
economy
...

This can be coincided with a growing national debt which over time, as government borrowing
increases more and more, the national debt increases too
...

The Crowding-in theory however, argues that government spending and deficits may have beneficial
positive multiplier effects such that with spending on education, infrastructure and health care
boosts both AD and LRAS
...

An increase in public sector spending will to increase private sector spending as contracts are
awarded to private sector firms for construction payments
...
Active intervention by the government could include
changes in the levels of government spending, or even changes in tax rates be it old ones, or
introducing new tax rates too
...
For instance, in a recession, welfare
benefits help to protect incomes and allow continued spending by those who are unemployed,
supporting them to maintain a good standard of living
...
This
stabilises the economy in both regards and are known as automatic stabilisers
...
This means that when prices rise, people
lose real spending power, since they’re losing money in tax which should have been under an
adjusted threshold
...
Supply side policies can increase production and competition in markets
whilst in the labour market, it attempts to make markets much more flexible through reducing
unemployment which should in turn increase the productive capacity of the economy too
...


Lower rates of income tax are charged in an attempt to create incentives to work, or tax
thresholds/personal tax allowances can be raised too, to make working more of an
incentive
...
This is demonstrated
in the Laffer curve below
...


III
...


Revision Notes 2015/2016
Reducing state welfare benefits and ‘welfare to work’ is an attempt to create an incentive
to choose low-paid employment rather than claiming benefits related to unemployment by
making them more difficult to claim
...
Other incentives to work include the introduction of
the national minimum wage and the Working Families Tax Credit (WFTC)
Education and training is the Governments attempt to provide the relevant skills to labour
through training to boost the productive capacity of the labour in the economy which should
increase the output of each member of the labour force and thus increase international
competitiveness
...
This was done in the 1980’s by the Conservative
government
...

What is money? And what are the functions of money? There are 4 main functions of money, which
are:
I
...


III
...
It is an asset which is accepted in exchange for
goods and services which is what we use for trade in today’s day and age
...

Money is also used as a store of value or wealth which can be stored such that if we choose
to not use it today, we can choose to store it (usually in a bank, or if you’re an Asian, under
the bed) and use it in the future
...


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IV
...


Money comes in two different types, Narrow Money & Broad Money
...

Broad Money (M4) is money which is held in the banking system, including sight and time deposits,
which is used for saving and for spending, based on the needs/wishes of the consumer in relation to
how & what they want to spend
...


II
...


By controlling the supply of money, governments used monetary base control to reserve
asset ratios on banks meaning that they are obliged to hold a certain proportion of their
assets in reserve at all times in an attempt to also control inflation
...
This in turn
reduces money supply because any money which is stored with the Bank of England is not
usually counted as part of the money supply
...
So money supply can increase or decrease
...


When setting interests rates, the Monetary Policy committee take into consideration a number of
factors, which include:
I
...


III
...


V
...


They will look at financial markets including share prices, which indicates investor
confidence in the economy
...

The levels of consumer spending and credit figures in terms of the Money and credit levels
in the economy which will cover both broad and narrow money in the economy
...

Figures for employment and unemployment are presented as the Labour Market can be a
key indicator of demand-pull and cost-push inflationary pressure
...


However, there are periods when it is necessary for the BoE to adopt a loose monetary policy to
actually stimulate aggregate demand to create an upwards pressure on inflation at a time when
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interest rates are actually very low, or even negative
...

This is done through the BoE creating new money and using it to buy assets owned by financial
institutions and other firms
...
This ensures that AD is stimulated even when interest rates are really low
...

However, a danger of using QE is that financial institutions may initially use this ‘new money’ to
increase their reserves, and only lend it out when the economy improves
...


The official interest rate decisions affect the market rates such as mortgage and bank deposits rates
set by commercial banks and financial institutions
...

These all affect AD in the economy which results from domestic and external demand
...
Lower market interest rates increase the domestic demand by
encouraging consumption rather than saving by households and investment by firms
...

These changes in AD affect the inflationary pressures in the economy, both through cost-push and
demand-pull inflation
...


Exchange Rate Policy: Changes in the exchange rate can have powerful effects on the macroeconomy, affecting variables such as the demand for exports, imports, real GDP growth, inflation,
business profits and of course, employment
...
The scale of the change in the exchange rate and how big of a change the fluctuation is
II
...
What is the price elasticities of the goods/services affected by the changes in the exchange
rate, which thus influences the behaviour of businesses and consumers in response to it
IV
...


Inflation is affected because changes in the price of imports due to an appreciation in the
exchange rate usually reduces the price of imported consumer goods, materials and capital
goods, reducing inflation in the economy, as prices are in fact lower as more goods are
imported
II
...
A strong dollar makes it more
expensive for Britain to import these items
...
Higher exchange rates make it harder to sell to overseas firms because of the relative UK
price
...

Though these changes in the exchange rate can have a powerful effect on the economy, we tend to
assume that all other factors will remain constant, which of course is very rarely the case, because:
I
...
There is always a time lag in the time it takes for the demand for exports and imports to
change due to a change in a currency level
...
The effects of exchange rates on export and import demands actually tends to be pretty low,
because of the low price elasticity of demand
IV
...
They use methods such as:
a
...
Firms tend to out-source components from overseas in order to keep their
production costs down
c
...
4
...
Globalisation can be said to be the
increased interdependence of countries across the globe due to advancements in technology and
communication
...
MCN’s as a whole have been able to influence
globalisation, because of the following specific actions:
I
...


III
...
Local employees can learn these
processes and techniques, and the local economy can benefit from this new expertise
thereby which was the whole thought process behind the Chinese Open Door Policy
...
A classic
example is oil-drilling in the Middle East, for which the majority of local workers are
unsuitably qualified, and expat workers are brought in from India and the Philippines simply
because the native Arabs can’t (and won’t!) do the dirty work
...

Capital flows (for a variety of reasons) – setting up a production plant in a foreign,
developing economy will inevitably require capital transfers to and from the economy in
question
...
g
...


There are a number of factors which have influenced the speed at which globalisation has been able
to spread, such as:
I
...


III
...


There has been a mass technological change in relation to communication, which has
enabled easy, secure and quite cheap transfer of information for MNC’s between sites
across the globe
...

Transportation has improved significantly
...
Plane travel has also become much easier
and more common, allowing for air deliveries for goods which are required urgently
...

Thanks to organisations such as the WTO or the GATT agreement as well as the whole being
of the EU, trade between countries is much cheaper, as there are less tariffs which have to
be dealt with/overcome
...

II
...

IV
...


VI
...


VIII
...


X
...

Shift in the structure of the economy away from the secondary sector and more so into the
tertiary sector, especially in MEDC’s
...
However,
many smaller firms can’t cope with the mass economies of scale which are enjoyed by
MNC’s and their minimalistic costs of production, and thus they go bust, forcing them to
close down
...

Increased integration of and mixing between cultures
...

Foreign Development Investment provides new skills and jobs for local workers, providing
them skills which they would previously have had no chance of developing, which increases
the productive capacity of the economy greatly
...

Absence of laws in some LEDCs mean companies may exploit workers particularly in China
and India, where cheap labour is common
...

I
...


III
...
But the focus has again shifted because
developing countries industrialise and exploit their comparative advantage of cheap labour,
allowing developed countries to have cheap production and lower interest rates due to
reduced inflationary pressures
...

Developed countries are able to experience cleaner environments as their
primary/secondary sector work has been shifted to developing countries
...


V
...

However, for developing countries, the increasing levels of trade are assisting their
development to become more integrated into the world economy leading to their own
domestic firms being able to establish contracts with international markets and subsequent
multiplier effects, reducing the levels of unemployment and poverty
...
It exists simply because firms and governments realise the
benefit which can be brought about by it, is much greater than the costs of it & thus are advocates
of it, because:
I
...


III
...
Again, like
mentioned above, some of these firms won’t be able to cope with the mass economies of
scale and will be forced to cease trade
...

International trade is essential to achieve full employment and the exploitation of
economies of scale, especially in the UK where we’re too small by ourselves
...
The theory of
comparative advantage illustrates the gains from trade and is often used to justify why countries
should remove trade barriers and begin to accept free trade because global resources together, can
be used much more efficiently when countries specialise in producing goods and services in which
they have a comparative advantage
...

There are of course, with any theory, a bunch of assumptions which are made for this theory too,
which include:
I
...

III
...

V
...
g
...

Constant returns to scale (i
...
there are no economies or diseconomies of scale)
...

Transportation costs are ignored
...
e
...


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The Theory of Comparative graph
Absolute advantage is where a country, given a fixed amount of resources is able to produce more
than other countries who are given the exact same amount of fixed resources
...


The Theory of Absolute Advantage
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There are however, a number of criticisms and limitations surrounding the unrealistic nature of the
theory of comparative advantage, such as:
I
...

III
...


V
...


VII
...


Transport costs and other negative externalities may outweigh any comparative advantage
and thus to not consider them ruins the whole purpose of it
...

Governments may restrict trade due to embargos or to promote domestic firms
...

The principle of comparative advantage is derived from a highly simplistic two good/two
country model
...

Influential US economist Paul Krugman proposes that the continual achievement of
Economies of Scale by global produces using new technology means that many countries,
including China can produce very cheaply and export surplus goods
...

The Theory of Comparative Advantage measures static advantage (i
...
cost advantage) but
not any dynamic advantage (i
...
possible innovation advantages)
...


The Effect of a Tariff on Economic Welfare – Diagram plus Explanation
The main arguments which are used to defend the ideas of free trade, alongside the welfare gains
diagram above, are:
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I
...


III
...


V
...

VII
...


Revision Notes 2015/2016
Free trade should promote specialisation, which should lead to an efficient allocation of
resources with countries producing goods and services at a lower cost
...

Lower costs for firms who are producing for a wider international market, they can increase
output and achieve lower costs per unit, meaning they will achieve Economies of scale
...

Wider choice for consumers gain from a wider choice of goods and services to choose from
...
But, they risk not being able to cope with the Economies of Scale
enjoyed by the international producers
...

More trade and economic links between nations should also enhance political ties and
prevent conflict, which was the purpose behind the foundation of the EU, post-World War II
...

Trade wars may occur as one country may find another’s restrictions unfair and retaliate,
causing a trade war
...
It’s unfair to punish the whole economy with a restriction on the basis of one
industry
...


The alternative to free trade, is protectionism
...

Tariffs – These are taxes which are placed on imported, but not domestic goods
...
This is done to increase the domestic price of
imported goods, which instantly makes domestic goods much more attractive to consumers
...

II
...
They can take form in cheap finance, tax breaks or non-market rent, or regional
aid which is given to reduce the costs of exports for exporters
...

III
...

IV
...
This is done to increase the price of
imported goods and contrary to common belief, a government gains no sort of income from
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quotas, unlike tariffs
...


The arguments for protectionism and anti-free-trade are:
I
...


II
...

IV
...

The whole idea of protectionism policies leads to inefficient and monopoly producers, who
quite simply do not face enough efficient competition
...


The Balance of Payments: This is the balance of payments records of the financial transactions
between businesses and the government in the United Kingdom and the rest of the world
...


The Current account considers the trade in goods and services section which makes up the
balance of payments
...


III
...
Current transfers
consist mainly of government transfers to and from overseas organisations including the EU,
UN, and NATO etc
...
The fact that the UK’s net income flows
are usually positive, suggests that we tend to own more profitable assets across the globe
compared to the assets held by foreign multinationals in the UK
...
It consists of three main components,
which are:
a
...
The net portfolio level of investment which simply involves the purchase of financial
assets such shares
c
...

Insignificant Capital Account of the Balance of Payments is the part of the Balance of
Payments that shows either how the current account deficit is financed how the current
account surplus is used but is largely irrelevant and unimportant
...
Examples of entries on the capital account include inter-government loans, privatesector loans as well as certain types of foreign aid
...
And on the other hand, a deficit is where the value of imports, exceeds the value of
imports
...

Long-term capital flows can be simply split up into direct investment and portfolio investment,
which means that the investment is made up for a period much longer than a year
...

The benefits of a rapid growth in the levels of international capital flows due to globalisation,
include:
I
...

Muhammad Gangat
Ilford County High School

ECON 4
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It generates a source of finance firms that would otherwise be unable to obtain a source of
finance from within their own country, due to limitations in the development of their
country, which is particularly the case in LEDC’s
...


However, there are also a range of disadvantages which come about as a result of this mass growth
in levels of international capital flows, including:
I
...


III
...

Foreign Direct Investment can actually lead to an increasing global dominance of
multinational firms, who will easily be able to just buy-out companies across the globe and
thus lead to an exploitation of a country’s consumers and resources
...


The Balance of Payments Equilibrium occurs when imports are equal to exports over a number of
years
...

In order to control and reduce a balance of payments deficit, governments tend to isolate the supply
and demand side causes of the problem
...
However, with supply-side
problems, governments tend to use two main policies to equal out the deficits and maintain
international competitiveness
...


II
...
It is a deflationary policies by
using:
a
...
Monetary policy by increasing interest rates to depress spending through making
borrowing more expensive and saving more attractive
...

Expenditure switching policies: These are policies which are used to correct the current
account imbalances by encouraging consumers to buy domestic goods, rather than imported
ones, by either raising the prices of imported goods, or lowering the prices of our domestic
goods
...
Direct Controls – These are controls on imports, such as tariffs and quotas
(described above
...

Organisations such as the WTO work to stop this happening, as these controls
reduce global welfare
...
Devaluation is where there is a reduction in the value of a currency in a fixed or
even semi-fixed exchange rate system
...
The effectiveness of such measures,
rests wholly on the levels of price elasticities of demand for exports and imports,
which is considered by the Marshall-Lerner condition, which states that when the
sum of the elasticities of demand for both exports and imports is greater than one, a
fall in the exchange rate will lead to an improvement in the current account
...
Initially, the volume of imports will change
very little, however, depreciation raises the price and thus the value of imports also rise
...


The J-Curve Effect

Muhammad Gangat
Ilford County High School

ECON 4

Revision Notes 2015/2016

So is a current account deficit really that deep?
I
...

III
...

A long-run deficit suggests a high level of disequilibrium in a market which could be
caused by a lack of competition in industries of a country
A deficit becomes a big problem when the exchange rate of a currency is a fixed one,
which means that exports tend to be too expensive in overseas markets and imports are
much cheaper (considered in more detail below
...


So if that’s the case, does a current account surplus matter that much?
I
...


III
...
This means that if they choose
not to act, the countries with a deficit, will face even bigger deficits, leading to them
being forced to have import controls, which would force all countries, even those with
surpluses to suffer
...
This can easily lead to
demand-pull inflation
...


To ensure that a balance of payments surplus doesn’t get out of hand, or spiral out of control,
governments tend to implement policies which include:
I
...

III
...

Revaluation is where the value of a currency is increased wherein the Marshall-Lerner
criterion is upheld
...
There are a
number of factors which affect the demand for a currency, which includes:







Demand for its exports
Inflows of Foreign Direct Investment
Inflows of Portfolio Investment
The levels of speculative demand for the currency
Official buying of the currency by the Central Banks
A surplus of exports over imports will increase demands for a currency and thus lead to an
appreciation of its value, through trade flows
...

Muhammad Gangat
Ilford County High School

ECON 4

Revision Notes 2015/2016

 A fall in the interest rates of one currency coincided with a rise in another currency,
speculation will lead to a depreciation of one currency and thus the demand for it may
decrease significantly
 High levels of inflation in one economy will lead to a decrease in the demand for its currency

The effect of Inflation on exchange rates
There are additionally a number of factors which affect the supply of a currency, including:







Demand for its imports
Outflows of Foreign Direct Investment
Outflows of Portfolio Investment
The levels of speculative selling of the currency
Officially selling of the currency by the Central Banks
A deficit of imports over exports will increase the supply of a currency and thus lead to a
depreciation of its value, through trade deficits
...


There are two main types of exchange rate systems, and they are:
Floating exchange rates is determined solely by the market demand for and supply of a currency,
with no government intervention needed
...
This demand for each
other’s currency could exist for a number of reasons, including:
 To allow an easier purchase of each other’s goods or services
 To invest in each other’s firms
 To buy each other’s currencies in the hope and anticipation that they will over time, rise in
value
 To put funds into each other’s banks, when the rate of interest increases
...


There is a continuous and automatic adjustment of the exchange rates, as the Forex changes
its rates automatically in order to reflect the purchasing power of one currency against
another currency
...
There is a reduced level of speculation pressure, which would otherwise lead governments
to reduce the value of their currency in order to ensure that speculators achieve some sort
of gain, which can be rather destabilising on the country’s import and export prices
...
It reduces the need for governments to hold large exchange reserves, compared to in a fixed
rate system, wherein they would be required to hold these large reserves
...


There is no guarantee that there will be a resolve of the problems in the balance of
payments because the whole concept is dependent on the price elasticities of demand for
exports and imports
...
There is an effect on the levels of domestic inflation because when the currency depreciates,
the price of imports increase and thus necessary goods/services such as raw materials, food
and oil become more expensive, leading to firms having to increasing their prices, which will
raise the CPI and RPI, leading to increases in inflation, further leading to workers demanding
higher wages – the spiral continues!
III
...
Rapid increases in the
value of a currency can lead to an increasing level of unemployment because export prices
increase whilst import prices become cheaper
...
The government sets an exchange rate and are constantly trying to achieve this rate
...
This shortage will
naturally force the Exchange Rate to increase whilst an excess of supply of that exchange rate, will
force it to be pushed downwards
...


Muhammad Gangat
Ilford County High School

ECON 4

Revision Notes 2015/2016

Fixed Exchange Rates
There are a number of advantages of Fixed Exchange Rates, such as:
I
...
Certainty because with fixed rates, the business knows the price that
it’s likely to receive for the goods that it sells and what it’s going to pay for its raw materials
...

II
...

III
...

IV
...

V
...
Cost push inflationary pressures will also decline as
imports (including raw materials) become cheaper
...
A low fixed exchange rate can help boost price competitiveness and will raise AD
...
An increase in uncertainty if de/revaluation is expected in the economy of the exchange
rate
...
A fixed rate may make trade with other members of the system artificially cheap relative to
that with other trade partners, leading to trade diversion
...
If the economy is in recession, the fixed rate cannot fall to boost international
competitiveness
...
Possible Balance of Payment crisis in a country whose currency is overvalued
...
Need periodic revision regularly as a country grows at different rates, and differences in the
level of inflation mean that if rates remain the same, some countries have permanent
surpluses, while others have permanent deficits
...
In order to maintain a fixed exchange rate which actually favours an export led economy, the
government might need to run a perpetual deflationary policy, reducing the country’s
economic growth and its standard of living won’t grow as fast, which is a clear conflict in
macroeconomic objectives
...
Speculation will occur given the huge capital flows that take place, countries with consistent
Balance of Payment deficits which will see rises in speculative flows since speculators expect
the currency to devalue to improve the situation
...
Initially, the EEC was formed with the following objectives:
I
...

III
...


A creation of a common market and economic area within which there would be a free
movement of goods, services, persons/labour & capital
An emphasis on the progressive elimination of tariffs and quotas
There was a creation of a common external tariff of 25%
And the introduction of a Common Agricultural Policy

The European Commission is an institution which is responsible for the representation of the
interest of all EU member states especially in relation to its implementation of EU laws and policies
which are decided by the Council of Ministers along with the European Parliament but is also
responsible for proposing and starting new legislatures
...
Established in 1998, with its
headquarters in Frankfurt, it is responsible for maintaining the Euro’s purchasing power and
subsequent price stability by keeping inflation at 2% or thereabouts
...
Additionally, they authorise the issue of bank notes
which is a tool for ensuring that there is a smooth operation of the European banking system
...

The Single Market came about through the 1957 Treaty of Rome and actually came into
implementation in 1992 which subsequently created the European monetary Union which set out
four economic freedoms which it wanted to create in Europe and they were:
I
...

III
...


Free movement of goods
Free movement to provide services
Free movement of capital
Free movement of people

The single market has a range of advantages, which include:
I
...

Muhammad Gangat
Ilford County High School

ECON 4
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With such a large market, the competition would be fierce, leading to an increase in dynamic
efficiency and subsequent loss of monopoly power because companies which are inefficient
will lose their market share and will be forced to exit it
...

The single market has allowed for an increased liberalisation of cheap airlines and cheap
energy costs, which would otherwise have been impossible without the introduction of the
single market
Due to the freedom of movement for goods and open borders, businesses have benefitted
from a reduction in export bureaucracy which would initially reduce delivery times and
increase costs
...


There are also a number of possible disadvantages which could occur such as:
I
...

III
...


There may accidentally be a range of adverse impact on some sectors of a national economy
as the increased international competition may mean that domestic firms may not be able
to compete
...

There service sector has opened up more slowly than the goods sector which means that the
competition in the sector is not as fierce as was initially envisaged
...


Initially, this was all linked to a simple free trade union, allowing for countries to trade with one
another without tariffs or quotas limiting their level of trade
...
Some of these methods of integration
include:
I
...


III
...

V
...

There is still a free trade area, which eliminates barriers between countries in the EU but
each still continues to operate their own barriers with countries not in the EU like the USA or
China
...

A Common market is simply a customs union which provides a movement of labour and
capital across boundaries
...


Trade deflection is a problem which arises when traders will try to import goods to the member
state of the trade area with the lowest tariff who will then be responsible for exporting within the
Muhammad Gangat
Ilford County High School

ECON 4

Revision Notes 2015/2016

free trade area to all other member states
...

Trade creation is when an increase in trade and economic welfare results as a result of the reduction
and elimination of trade barriers like tariffs and quotas occurring as a result of the introduction of a
customs union which also allows countries to buy goods/services from a country within the union for
a cheaper price than what they would do so initially because capital can be transferred without any
restrictions
...


Trade Creation Diagram
Trade diversion occurs when as a result of joining the union, the country is forced to buy good s for
a higher cost because they are sellers within the union & occurs as a result of the common external
tariff
...
Now, it’s cheaper for the UK to purchase
from less efficient producers such as France & Spain
...
With a market of
over 500 million people living in the union, economies of scale can easily be exploited through the
intra-community trade
...
There is of course the
danger that oligopolistic markets could arise with the increased demand on competition, however,
the EU Competition Commissioner has ensured that there will be no infringement on ensuring a high
level of competition
...
From the point of view of
the UK, we see the new entrants as beneficial because:
I
...

III
...

II
...


With 100 million increased in population, these 10 countries have only added 5% to the GDP
of the EU – this is very small
Led to a fear of a huge influx of cheap labour and consequent withdrawals from the
economy due to these workers sending their money back home
Huge influx of migration from the East to the West of Europe due to the freedom of
movement causing tension in countries to whom migrants are migrating to

One of the final stages of the development of the EU would be the introduction and advancement of
a Monetary Union which would encompass common policies for economic growth, monetary and
fiscal policies and to do so, there was the creation of the single currency, the Euro which went ahead
on the 1st January 1999 and was regulated by the ECB described above
...


II
...
4% according to the European
Commission
...


IV
...

This has also removed the capacity for EMU member states to engage in the unethical
practice of devaluation of their currency (explained above) which can potentially lead to
increase inflationary pressures, just to increase their competitive position on the
international stage
...

Due to the political independence of the ECB who sets the interest rates, there is likely to be
a lower rate of interest throughout the union as this will meet the ECB’s commitment of low
inflation which all helps to increase economic growth
...


As the ECB controls the whole monetary policy of the Eurozone and EMU members, the UK
wold lose its independent monetary policy which has a number of different implications
such as:
a
...
The ECB is unlikely to act in the interests of one country, when it could be affected
by a demand-side economic shock which would in turn create structural
unemployment and because it doesn’t affect all countries, the ECB will not respond
...
If the ECB does take the initiative to adopt a single policy there is the chance that it
would affect some member countries more than others
...
, the U would be a lot more sensitive if there was a change in interest
rates and a change in AD could be immense for the UK
...
Some suggest that the ECB is too heavily focused and concerned about ensuring it
retains its non-inflationary credentials, which can occur at the expense of economic
growth because the inflation rate of 2% can lead to higher levels of unemployment
...
The reason for
Cameron arguing for the UK to stay out of the Euro is explained below:
I
...


Economic convergence is the most difficult problem for the UK joining the single
currency
...

To be able to deal with economic shocks, there is a requirement of labour flexibility,
which means that the labour market should be willing to accept lower levels of wages
...

Muhammad Gangat
Ilford County High School

ECON 4
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Revision Notes 2015/2016
The UK has had the greatest amount of investment into the EU over the past 2 decades
and there is now a fear that if the UK stays out of the Euro, firms in the UK may
potentially suffer from a fall in the value of the sterling and will go on to base
themselves in Europe instead
...
In the current UK situation, the MPC would be
able to adjust interest rates to compensate for any changes in AD but without such
abilities to do so, they would not be able to do so

---