Macroeconomics introduction & government objectives
Government Objectives and Targets
Four main targets:
1.
2.
3.
4.
Low unemployment – lots of people in work
Low and steady inflation – prices and wages fairly stable
Steady and sustainable economic growth (%change in GDP) – the economy to grow a little bit each year
A positive balance of payments – to export more than we import
Two other possible objectives:
- To reduce inequality in the country – to redistribute income and wealth in order to help the poor
- To protect the environment – to avoid pollution and congestion
Macroeconomics is the study of how a national economy works and the interaction between economic growth in output
and national income, employment and the general level of prices.
A macro-economy consists of all the different markets for goods and services, labour, finance, foreign exchange and other
traded items.
Changes in the behaviour of producers and consumers in individual markets will therefore have an effect on the macroeconomy and the rate of economic growth, inflation, employment and trade.
Most national governments share similar macro-economic objectives. These are:
• Low and stable price inflation
• A high and stable level of employment
• Economic growth and prosperity
• A favourable balance of international payment
Governments can use different policy instruments, including taxes and regulations, to help achieve their objectives
through their impact on the actions of producers and consumers.
Fiscal policy involves varying total public sector expenditure and/or the overall level of taxation to influence the level of
demand in an economy.
Expansionary fiscal policy may be used during an economic recession to boost demand for goods and services through
tax cuts or increased public sector spending. Firms may respond by hiring more labour and increasing output. However,
increasing demand can force up market prices and involve spending more on imported goods and services from overseas.
Increasing imports will have a negative impact on the balance of payments.
Contractionary fiscal policy may be used to reduce price inflation. It involves reducing demand in an economy through
tax increases or cuts in public sector spending. However, firms may respond to falling demand by cutting their output and
reducing employment. Increased taxes may also reduce work incentives and therefore productivity.
Fiscal policy instruments
Increased income taxes
Reduce income taxes
Increase taxes on profits
Cut taxes on profits
Increase indirect taxes on
goods and services
Cut indirect taxes on goods
and services
Impacts on consumers
Disposable income is reduced
and consumer spending falls
Disposable incomes and
consumer spending rise
Consumers are not directly
affected but may pay higher
prices if firms cut output
Consumers may benefit from
reduced prices as output rises
Consumers on low incomes
may be hit hardest by price
rises because they spend all
or most of their incomes
Consumers may expand their
demand for goods and
Impacts on producers
Market prices and profits fall as consumer demand
falls. Firms cut output and employment
Market prices and profits start to rise so firms
expand output and employ more labour
After-tax profits fall. Firms may increase their
prices and/or cut output in response
After-tax profits rise so firms may expand their
output and employment
Consumer demand may contract and profits fall.
Firms may cut output and reduce their demand for
labour
Expanding demand will boost profits which are an
incentive to firms to raise their output and demand
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Revision notes
Raise public expenditure
Cut public expenditure
services as after-tax prices fall
Public sector workers could be
paid more. Low income
families may receive more
benefits. More public services
could be provided for free
Public sector workers could
suffer pay cuts or be made
unemployed. Welfare benefits
may be reduced
more labour
Firms supplying goods and services to government
will enjoy increased revenues and profits, and may
expand their output and employment
A cut in public spending on capital projects, such
as road and school building, will cause cutbacks in
the construction industry. Subsidies paid to other
firms may be cut.
Monetary policy involves varying the interest rate charged by the central bank for lending money to the banking system
in an economy.
Contractionary monetary policy may be used to reduce price inflation by increasing the interest rate. Because banks
have to pay more to borrow from the central bank they will increase the interest rates they charge their own customers for
loans to recover the increased cost. Banks will also raise interest rates to encourage people to save more in bank deposit
accounts so they can reduce their own borrowing from the central bank.
As interest rates rise, consumers may save more and borrow less to spend on goods and services. Firms may also
reduce the amount of money they borrow to invest in new equipment. A reduction in capital investment by firms will
reduce their ability to increase output in the future. Higher interest rates may therefore reduce economic growth and
increase unemployment.
Expansionary monetary policy may be used during an economic recession to boost demand and employment by
cutting interest rates. However, increasing demand can push up prices and may increase consumer spending on imported
goods and services.
Monetary policy instrument
Raise interest rates
Cut interest rates
Impacts on consumers
Spending falls as consumers
save more and borrow less.
Impacts on producers
Firms cut output and employment in response to
falling demand.
The foreign exchange rate of
the national currency may rise.
This will reduce the prices of
imports
Firms borrow less to invest in new capital equipment,
which may harm economic growth.
Consumers may buy more
imports instead of homeproduced goods and services
Spending rises as saving
becomes less attractive and
borrowing less expensive
Prices of exports sold overseas will rise if the
exchange rate increases. Exporting firms may suffer
falling demand and profits.
Firms increase output and demand more labour as
demand rises.
Firms may increase investment
The exchange rate may fall
causing imported inflation
Prices of exports sold overseas may fall if the
exchange rate rises. Demand for exports may rise.
Supply-side policies aim to increase economic growth by raising the productive potential of the economy. An increase in
the total supply of goods and services will require more labour and other resources to be employed, will reduce market
prices, and provide more goods and services for export. Supply-side policy instruments aim to encourage firms and
employees to become more productive, and to remove any barriers that may prevent this.
Supply-side policy instruments
Tax incentives
Subsidies or grants
Education and training
Labour market regulations
Reducing taxes of profits and small firms can encourage enterprise. Tax allowances
can also be used to encourage investments in new capital equipment and R & D
These reduce production costs and also help firms to fund the research and
development (R&D) of new technologies.
Teaching new and existing workers new skills to make them more productive at
work.
Including minimum wage laws to encourage more people into work, and legislation to
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Revision notes
Competitive policy
Free trade agreements
Deregulation
Privatization
restrict the power of trade unions
Regulations that outlaw unfair and anti-competitive trading practices by monopolies
and other large powerful firms
Removing barriers to international trade to allow countries to trade their goods and
services more freely and cheaply
Removing old, unnecessary and costly rules and regulations on business activities.
The transfer of public sector activities, such as refuse collection, to private firms to
provide them more efficiently.
Check I’ve got this
a.
b.
c.
Explain the four main macroeconomic objectives and why they may be in conflict with each other.
Explain how taxation and government spending intend to change an economy.
Explain how interest rates and the supply of money may alter an economy.
And if I’ve really got it…
d
Discuss whether governments should use spending, taxation, interest rates or supply side policies to rebalance an
economy in recession or boom. [This is a common 10 mark question.]
Taxation
A public sector is a major employer, producer and consumer in many modern economies. For example, the public sector
in France employs 22% of the workforce.
Public sector organizations include:
• National, regional and local government authorities and their administrative departments and offices
• Government agencies that run services such as the Child Support Agency and Prisons Service in the UK
• Public corporations
To pay the running costs of government organizations and for the goods and services they consume or provide the public
sector must raise revenue. Tax revenue is the main source of public sector finance in most countries.
Public expenditures are financed by taxes and other revenues. Most revenue is raised from taxation. Taxes are used by
governments to help them achieve a number of objectives:
• To finance public expenditure
• To reduce inequalities in income and wealth through a progressive tax system.
• To discourage the consumption of harmful products, such as cigarettes, by raising their prices
• To protect the environment by discouraging damaging and polluting activities, for example, by taking gasoline,
carbon emissions and landfill waste
• To achieve macro-economic objectives using fiscal policy.
The impact of a tax on income can be progressive, regressive or proportional
Annual income $
Progressive % tax
Regressive % tax rate Proportional % tax
rate
rate
$5,000
0%
30%
20%
$20,000
10%
25%
20%
$50,000
20%
20%
20%
$100,000
40%
15%
20%
• If a tax is a progressive tax the effective tax rate rises with income. A person with a high income will pay
proportionally more of their income in tax than a person on a low income
• If a tax is a regressive tax the effective rate of tax falls with income. The tax will impose a higher relative tax
burden on people with low incomes.
• If a tax is a proportional tax everyone, rich, or poor, pays the same effective tax rate.
Direct taxes are levied on their income or wealth of an individual or company, including:
• Personal income tax is levied on income including on interest payments on savings
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Revision notes
Payroll taxes include personal income taxes collected by employers from the wages of their employees , and the
taxes an employer pays from their own funds related to employing workers, including social security contributions
• Corporation tax is levied on company profits. Small companies with low profits can often be made exempt, or pay
a zero rate of tax, to encourage enterprise.
• Capital gains tax is a tax on any gain in value from the sale of assets held by individuals and companies such as
shares and bonds, precious metals and property
• Transfer taxes are applied to the transfer of assets from one person to another. They include gift taxes, estate
taxes and inheritance taxes paid on inherited wealth.
Advantages of direct taxes
Disadvantages of direct taxes
• They are a major source of tax revenue
• Incomes taxes can reduce work incentives
• Many are progressive and help to reduce
• Taxes on profits reduce profit available to
inequalities in incomes after tax
entrepreneurs to re-invest in their businesses
• They take account of people’s ability to pay
• High tax rates can cause tax evasion
•
Indirect taxes are incurred when consumers spend their incomes
Indirect taxes include tariffs and excise duties added to the prices of goods and services. They are normally imposed on
producers who will then pass on as much of the tax as they can to consumers through higher prices.
• Ad valorem taxes include value added tax (VAT) and other sales taxes. They are levied as a percentage of the
selling price of goods and services or on sales revenues. Some necessities, such as many foods and medicines,
may be exempt.
• Tariffs are customs duties applied to the prices of imported goods as they enter a country. Tariffs are often used
to protect domestic firms from overseas competition
• Excise duties are applied to specific goods, such as alcohol, cigarettes, vehicles and petrol. They are normally
fixed charges based on quantity sold rather than price
• User charges, such as tolls for using publicly owned bridges and motorways.
Advantages of indirect taxes
Disadvantages of indirect taxes
• They are cheap for a government to collect
• The cost of collecting taxes falls to businesses
• A wide tax base. Anyone who buys goods and
• They are regressive
services will pay some indirect taxes.
• Tax revenues are less certain because they
• They can be used to discourage consumption
depend on spending patterns
and production of harmful products
• They add to price inflation
Check I’ve got this
a.
b.
c.
d.
Explain the main methods a government can use to raise finances for its spending.
Explain how taxation policy can be used to redistribute income effectively.
Explain the differences between various types of taxation in an economy.
Explain the main objectives for governments’ use of taxation.
And if I’ve really got it…
e.
Discuss whether governments are always able to achieve their main goals when using the various types of taxation
systems today. [It is a hard question and perhaps would not appear in this style. In reality it may appear broken
down into something smaller, such as discuss whether proportional taxation is always effective. However, attempt to
answer this as if it’s worth 10 marks.]
The circular flow of income
This shows how money circulates in a simple economy.
Initially households spend money on goods and services produced by firms. Households get the money to buy these
goods and services by supplying the factors of production (land, labour, capital and enterprise).
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Revision notes
ADDING TO THE CIRCULAR FLOW AND THE VALUE OF THE ECONOMY
-
Businesses may invest money into new equipment or new factories. This allows extra production to take place.
The Government may spend £100 mn on a roadbuilding project. This creates economic activity
An export is a sale of a good or service to a foreigner. This brings money into the economy.
LOWERING THE CIRCULAR FLOW AND THE ECONOMIC ACTIVITY
Savings mean that people are not spending money on goods and services
Taxes are taken out of peoples and businesses incomes. This money cannot be spent on goods and services.
Imports are purchases from abroad. The money leaves the country
Check I’ve got this…
a.
Try to draw the full circular flow without looking at the diagram
And if I’ve really got it…
b.
c.
Explain what is meant by aggregate demand and what the various components are. [5 marks].
If there is an addition of £3million (govt spending or investment) into the circular flow it may create £9 million of
economic activity. This is a multiplier of 3. How does this happen?
Economic growth
Total value of all goods and services produced in an economy is known as the national output.
Factors of production are paid by firms to produce the national output, and owners of firms earn profits if they are
successful. The total income earned in an economy is the national income.
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People use their incomes to buy goods and services. The total amount spend on the national output of an economy is the
national expenditure. Therefore National output = national income = national expenditure. Each is identical
• The total production (output) of all businesses
• The total incomes and profits in the country
• The total of all spending by individuals and businesses
Gross Domestic Product (GDP) is a measure of national income and output. This is the main measure of the
national income or output of an economy used by governments and economists. It measures the final value of all goods
and services produced within an economy over a given period of time, usually per year.
An increase in prices will increase nominal GDP but people will be no better off because increasing prices reduce the
purchasing power of their incomes.
People will only be better off if there is an increase in real GDP because the total output of goods and services will have
increased.
Economic growth occurs as real national income and output expands, i.e. if there is a rise in real GDP.
Most governments want to achieve stable long-term growth in the real GDP of their economies. Plotted against time this
would look like a steadily rising line. However, the rate of growth in real GDP may not be very stable over time.
This is measured by the yearly change in Gross Domestic Product (GDP). It is usually expressed as a % change.
Example: Year 1 Tinseltown produces £1,000 worth of goods. Year 2 Tinseltown produces £1,100 worth of goods.
Economic growth would be 10%
The business cycle or economic cycle refers to the patterns of ups and downs (or ‘cyclical fluctuations’) observed in real
GDP growth over time in many economies.
WHAT CAUSES ECONOMIC GROWTH?
Anything which allows the country to produce more goods and services. • More business investment * Better productivity •
Better machinery * Improved training • Better skills * New technology • New ideas * Increased efficiency
COSTS AND BENEFITS OF ECONOMIC GROWTH
BENEFITS: More income for society, Should create jobs, Could reduce the number of poor people, More goods produced
and probably more choice for customers and businesses, Higher standard of living, Feel good factor in society
COSTS: Extra production could cause extra pollution, Exhaustion of non renewable resources like oil, Only the rich may
gain the benefits The poor stay poor and inequality increases, Greater stress on workers to produce more goods.
The economy tends to experience different trends. These can be categorised as the trade cycle and may feature boom,
slump, recession and recovery. BOOM: A period of fast economic growth. Output is high due to increased demand,
unemployment is low. Business confidence may be high leading to increased investment. Consumer confidence may lead
to extra spending. SLUMP: A period when output slows down due to a reduction in demand. Confidence may begin to
suffer. RECESSION: A period where economic growth slows down and the level of output may actually decrease.
Unemployment is likely to increase. Firms may lose confidence and reduce investment. Individuals may save rather than
spend. RECOVERY: A period when the economy moves between recession and a boom.
WHAT HAPPENS IN A BOOM?
-
Businesses produce more goods
Businesses invest in more machinery
Consumers spend more money. There is a FEELGOOD FACTOR
Less money is spent by the Government on unemployment benefits
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Revision notes
-
More money is collected by the Government in income tax and VAT
Prices tend to increase due to extra demand (page)
WHAT HAPPENS IN A RECESSION?
-
Businesses cut back on production
Some businesses may go bankrupt
Consumers spend less money. Fall in FEELGOOD FACTOR
Individuals may lose their jobs
More money is spent by the Govt on unemployment benefits
Less money is collected by the Govt in income tax and VAT
Prices start to fall
The economic cycle
▼ The economic cycle
Economic recovery: real GDP grows faster
than normal. Demand for goods and services
rises rapidly. Firms increase output and hire
more workers. Profits and other incomes rise
Economic boom: demand for goods
and services rises faster than output can
rise. Profits peak and prices rise as
economy ‘overheats’
Economic recession: real GDP falls.
Demand for goods and services falls.
Firms cut their production and lay off
workers. Profits and other incomes fall
Check I’ve got this
a.
b.
For each cause of economic growth. Try to think why it would allow businesses and the economy to produce a
greater number of goods and services.
For each cost and benefit. Try to think through why it is in reality a cost or benefit.
And if I’ve really got it…
c.
d.
Are you in favour of economic growth? Explain your answer.
What is human capital? How can an economy improve its stock of human capital? Why is it important?
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Revision notes
The causes of unemployment
Falling demand for goods and services is a major cause of unemployment is cyclical unemployment occurs during an
economic recession due to falling consumer demand for goods and services and falling incomes. Firms will reduce their
output and lay off workers.
Unemployed workers may only find new jobs as demand recovers. A government may try to boost demand using fiscal
and monetary policies.
Structural unemployment is caused by changes in the industrial structure of an economy. e.g. In the UK; 1980/ 90’s
Deindustrialisation – coal mining, shipbuilding, or the airline industry. Entire industries may decline and close due to a
permanent fall in demand for their goods or services. This can cause prolonged regional unemployment if most firms in
the industry were located in one particular area, for example, to be close to a supply of raw materials.
Many countries have experienced structural change as old primary and secondary industries such as mining, shipbuilding
and textiles have declined. Workers made redundant from these industries will have skills that are no longer needed. They
may be unemployed for a long period of time unless they retrain in skills required by new and growing industries.
Technological progress has also caused structural change and unemployment in some industries. Labour has been
made redundant as production lines have been mechanized and as consumer demand for the, technologically advanced
products has risen.
Frictional unemployment refers to short-lived unemployment that occurs when people leave jobs they dislike, move to
higher paid jobs, move home or are made redundant.
Seasonal unemployment occurs because consumer demand for some goods and services changes with the seasons.
For example, unemployment among workers in tourist and construction industries tends to rise in winter but fall during
summer months.
Some unemployment may be the result of labour market failures
• People may choose not to work because they would rather receive welfare payments from government. This
results in voluntary unemployment.
• Taxes and other non-wage costs employers must pay to hire and employ workers are too high. This will reduce
their demand for labour.
• Some unemployed workers may find it difficult or costly to obtain information ob job vacancies and the skills they
require.
• Minimum wage laws have increased the wage costs of employing low-skilled workers. Some employers have
argued minimum wages have been set too high in some countries.
• Powerful trade unions may demand high wages that reduce the demand for labour.
Check I’ve got this…
Which type of unemployment are the following examples?
a.
b.
c.
d.
Oscar Hammerhead loses his job due to a recession
Stevie Silk can’t be bothered to work because he can get £130 a week in benefits
Jackie Wilson loses her job because nobody wants video recorders any more
Sally Halfpenny resigns as a doctor to look for work as a teacher
And if I’ve really got it…
e. Discuss whether unemployment is always a sign of a struggling economy. [10 marks]
IGCSE ECONOMICS
Revision notes
Employment and Unemployment
Most governments have an objective to maintain a high and stable level of employment in their economies, and a low
level of unemployment. Employment provides incomes. In contrast, unemployment is a waste of productive resources. It
is not surprising, therefore, that government officials and people planning their future careers will be very interested in
monitoring employment trends. Employment trends are monitored closely by government and economists. An increase
in the labour force or working population in a country means more goods and services can be produced. However, not
everyone of working age will be willing or able to work. They may have the wrong skills or there may not be enough fulltime jobs for them. Rising employment is a sign that an economy is healthy and growing. Rising unemployment, however,
is a sign that economic conditions are deteriorating.
Key indicator
Labour force
Total number of
people of working
age in work or
seeking
employment
Participating rate
The labour force as
a proportion of the
total population of
working age
Recent trends
• Global labour force or working population has risen over time as the world population
has grown
• Between 1995 and 2005 the global labour force grew by 438 million workers to over 3
billion.
•
•
•
•
Employment by
industry
Number of people
employed in
different industrial
sectors
Employment
status
Number of people
employed on fulltime, part-time or
temporary
employment
contracts
Unemployment
Number of people
registered as being
without work
Unemployment
rate
Unemployment as
a proportion of the
labour force
•
•
•
•
•
•
•
•
•
•
Participating in the labour force has risen in many countries and especially among
females
Poverty has forced many women in less developed countries into paid employment.
Female employment has also become more socially acceptable.
The rising cost of living in many developed countries has persuaded many mothers to
return to work after raising children. Younger women are delaying marriage and child
birth in order to work.
The global labour force participation rate fell slightly from 67% in 1995 to just under 66%
in 2005. This was due to an increase in the number of young people in education and
an increase in the number of old and retired people worldwide.
Over 70% of the labour force in developed countries work in service industries. In
contrast, over 61% of employees in less developed countries work in agriculture.
All countries are experiencing the same general trend: employment in services has
been growing while employment in agriculture, mining and manufacturing industries has
fallen.
Most employees work full-time. This means working 5 or more days each week for 7 or
more hours each day.
Part-time employment has grown rapidly in many countries, especially among female
employees
Hiring part-time and temporary employees is often cheaper than employing full-time
workers and allows firms greater flexibility in matching staffing levels to changes in
demand
In 2005 over 192 million were officially registered as unemployed worldwide: up 34
million since 1995
Almost half the unemployed are young unskilled workers
Unemployment tends to rise during economic recessions.
Unemployment rates have been relatively stable in recent years, but began to increase
during 2008 as demand fell in many economies following a global financial crisis
In 2005 over 13% of the labour force in the Middle East and North Africa was
unemployed. IN contrast, only 4.7% of the workforce of South East Asia was
unemployed.
Unemployment has personal and economic consequences
The personal costs of unemployment include:
• Loss of income and reduced ability to buy goods and services
• Unemployed people can de-skill if they spend too long out of work
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Revision notes
•
Unemployed people may become depressed and ill. This can put a strain on their family relationships and local
health services.
The costs to the economy include:
• Unemployment is a waste of human resources: fewer goods and services will be produced
• Total output and income in the economy will be lower
• Government tax revenues will also be lower. People in work may have to pay more tax.
• Government spending on welfare payments to the unemployed may have to rise.
Reducing unemployment
This is a key target for all governments. High unemployment has enormous costs for individuals, businesses, the
Government and the economy.
The way of solving unemployment will depend upon its cause:
• Government support to struggling industries in order to try to save jobs e.g. airline industry
• Provide more training and education to the unemployed. This could help improve computer skills and communication.
These people will become more confident and employable.
• Make more information available in job centres.
• Reduce unemployment benefits or cut benefits all together (see below)
• Try to bring the country out of a recession. The Government needs to try to create demand in the economy. It could;
-
Give grants to businesses to produce goods
Have projects such as road building
Cut interest rates to encourage spending
Cut income tax to encourage spending
• The new deal in some economies: at present an individual is only allowed to claim unemployment benefit for 6 months.
After 6 months they must take any job, which is offered to them or accept a loss of benefit.
Check I’ve got this…
a.
b.
c.
Why do you think the new deal was introduced? Do you agree with this policy?
How could a road building project help create jobs?
What information could be made available in job centres?
And if I’ve really got it…
e.
f.
Discuss whether cuts in interest rates or income tax would always ‘kick-start’ the economy? [6 marks]
Discuss whether the government of a country can effectively reduce all types of unemployment. [10 marks]
Inflation
Inflation is a continuous or sustained rise in the general level of prices of goods and services in an economy.
The rate of price inflation is measured by calculating the average percentage change in price per period of time, usually
per month or each year.
IGCSE ECONOMICS
Revision notes
A consumer price index (CPI) is a measure of price inflation affecting consumers. It is calculated from the movement in
the average price of a ‘basket’ of goods and services purchased by the ‘typical’ household in a country from a
sample of different retail outlets.
The proportion of total household expenditure spent on each good or service is used to weight their individual prices. For
example, if the price of a loaf of bread is $2 and the typical household spends 5% of their weekly or annual spending on
bread, then the weighted average price will be $2 x 0.05= $0.10. Prices are weighted in this way because the more a
household spends on a particular good or service the more an increase in the price of that product will matter.
In the first year of measurement-the base year- the weighted average price of all goods and services in the CPI basket is
calculated and set equal to 100. Monthly or annual changes in the weighted average price of the basket are then
compared to the base year.
Calculating a CPI- a simple example
Imagine the ‘basket’ used to calculate a CPI consists of three main products: food, travel and clothing.
Year 1 (base year)
Products
Average price ($)
Food
Travel
Clothing
$60
$20
$40
Year 2
Products
Average price ($)
Food
Travel
Clothing
$70
$40
$48
Proportion of
household
expenditure
spend on each
product (%)
60%
10%
30%
Weighted
average price ($)
Price index
Total=100%
Average price of
basket=$50
=100
Proportion of
household
expenditure
spend on each
product (%)
60%
15%
25%
Weighted
average price ($)
Price index
Total=100%
Average price of
basket=$60
0.60 x $60=$36
0.10 x $20=$2
0.40 x $40=$12
0.60 x $70=$42
0.15 x $40=$6
0.25 x $48=$12
=120
CPI year 2= weighted average price year 2
= $60 x 100=120
weighted average price base year $50
**the annual inflation rate is 20%
There are three main uses of a consumer price index (CPI):
• As an macro-economic indicator of the rate of price inflation in an economy and change in the cost of living
affecting consumers
• As a price deflator to ‘deflate’ the value of wages and incomes by the impact of price inflation to calculate the
change in their purchasing power. For example, if wages rise by 5% but prices rise by 8%, the real value of
wages will have fallen by 3%
• To index-link income payments so their purchasing power increases at the same rate as inflation. This is called
indexation. For example, some savings rates are index-liked. Some governments also increase pensions and
welfare payments in line with inflation.
Cost and demand pressures cause inflation. There are three main causes of price inflation:
IGCSE ECONOMICS
Revision notes
•
•
•
•
Demand-pull inflation is caused by total demand rising faster than the total output of goods and services,
causing market prices to rise.
Cost-push inflation is caused by an increase in the cost of producing goods and services, for example, from
higher wages or raw material prices. Firms will try to pass these costs onto consumers through higher prices.
Imported inflation results from rising prices of goods and services imported from overseas. This can be due to
an increase in the costs of overseas producers and/or a fall in the exchange rate of the currency of the importing
country.
Monetary inflation happens as a result of the interest rate falls and money supply rises (sometimes from the
central bank printing money and buying bonds, called quantitative easing). Consumption rises and businesses or
individuals borrow more from commercial banks. This all enables businesses to raise prices assuming they can
get away with it due to more money existing in the economy.
Inflation has personal and economic consequences
• Inflation reduces the purchasing power or ‘real value’ of money. This can be especially difficult for people on
low and fixed incomes such as many old age pensioners and people who are unemployed or disabled and unable
to work.
• Inflation reduces the real value of savings. For example, if the annual rate of interest on savings is 4% but the
rate of inflation is 5%, the real value of people’s savings will fall by 1%. People may save less as a result.
• Inflation reduces the real value of loans. To compensate, banks and other lenders will increase their interest
rates on their loans. People and firms with loans will have to pay more. The demand for loans will also tend to fall.
Firms may invest less as a result.
• Inflation may help boost tax revenues. As prices rise so does the tax take from value-added taxes and sales
taxes levied as a percentage of the selling prices of products
• Inflation increase government spending because a government will also have to pay more for the goods and
services it buys, if wages rise for public sector employees and also if state pension and welfare payments are
index-linked.
• Inflation can reduce company profits, if it is caused by rising costs or if consumers reduce their demand for
goods and services as market prices rise.
• Inflation may cause unemployment. As prices rise, people maybe not be able to buy so much and will reduce
their demand for many goods and services. As demand falls firms sell less and make less profit. Firms will cut
production and the size of their workforces to reduce their costs.
• Prices increase therefore people may buy fewer goods, the economy may suffer.
• People need to keep asking for pay increases to match price rises. This can cause problems at work.
• If people are on fixed incomes e.g. pensioners or students. They will be worse off because they will be able to
buy fewer goods.
• Businesses may cut back on production as their costs may increase.
• If the prices of UK goods increase too much then people and businesses may start to import more goods
from abroad because they are cheaper. This will cause major problems for the economy.
Remedies for inflation
REDUCE DEMAND PRESSURES
REDUCE COST PUSH PRESSURES
If inflation is caused by high demand then
If inflation is caused by high costs
* Raise interest rates to reduce consumers disposable
incomes
* Raise interest rates to discourage borrowing and demand
* Raise taxes to reduce disposable income and spending
• Limit wage increases if possible e.g. public sector
workers
• Force electricity and gas companies to hold their prices
• Subsidise oil prices and reduce indirect tax rates on
petrol temporarily
* These policies should all reduce peoples ability to spend
too much money
REDUCE MONEY SUPPLY PRESSURES
RAISE THE EXCHANGE RATE
• Increase the value of £ in order to reduce the cost of
If inflation is caused by too much money in the economy
IGCSE ECONOMICS
Revision notes
importing
• Print less money
• Reduce tariffs and quotas on imports that are more
expensive at the moment
• Withdraw some money from circulation.
Each of the above approaches has its advantages and
disadvantages.
Some policies are effective but will be unpopular with consumers and may cause a minor recession, and also take a long
time. Other policies could be effective but it is very difficult for the government to tell private firms how much to charge for
inputs and also how much to pay their workers. The problems also arise due to actually knowing what caused the inflation
in the first place.
Check I’ve got this…
a. Think of 3 or 4 goods that you buy regularly. What inflation have you experienced i.e. how have the prices changed
over recent years?
b. Which of the problems do you believe is the greatest a) to individuals b) to businesses c) to the economy.
c. In the cost push example, why are workers demanding higher wages?
d. How does a ticket tout use demand pull to increase their ticket prices?
e. How could a demand and supply diagram show demand pull inflation?
f. Explain the various types of inflation, with examples of each one. [8 marks]
g. Explain how inflation is measured in an economy. [6 marks]
Check that I’ve got this…
h. Why will a rise in interest rates reduce demand in the economy?
i. Discuss whether raising interest rates is the best policy to control inflation in an economy. [6 marks]
j. Discuss whether controlling inflation is the most important government macroeconomic policy. [10 marks]
IGCSE ECONOMICS
Revision notes