WJEC AS Macroeconomics Revision
Notes
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Macroeconomics Revision Notes
Macroeconomics = This is the branch of economics that studies the behaviour and performance of the
economy as a whole.
1. Macroeconomic Theory
Topics include: the circular flow of income – 1.1; aggregate demand (AD) - 1.2; aggregate supply
(AS) – 1.3; AD/AS Analysis – 1.4.
1.1. Circular Flow of Income
The circular flow of income = This is how money moves between various economic agents in an
economy through the process of trade and exchange.
Domestic consumption = This is when money flows to firms from households in exchange for goods
and services.
Income = This is when money flows to households from firms in exchange for the supply of labour.
The model:
Injection = This is money that enters the model, e.g:
Investment = This is money spent on firms to
increase their output (I).
Government spending = This is money in the
form of fiscal policy (G).
Exports = This is money spent on UK products
by other countries (X).
Leakages/withdrawals = This is money that leaves, e.g:
Savings = This is money people put in the bank to earn interest (S).
Taxes = This is money taken by the government (T).
Imports = This is money spent by the UK on products from other countries (M).
Gross Domestic Product (GDP) = This is the value of the country’s economy; it is all the aspects of
the circular flow of income model added together. You can calculate a country’s GDP by:
•
•
•
•
National income = This is the value of what is earnt in an economy (NI).
National expenditure = This is the value of all spending in an economy (NE).
National output = This is the value of everything produced in an economy (NO).
They are all the same thing: NI = NE = NO.
Closed economy = This is when money cannot enter or leave the circular flow of income.
Open economy = This is when money can enter and leave the economy.
•
When injections > withdrawals the economy will get bigger.
•
When injections < withdrawals the economy will get smaller.
•
When injections = withdrawals the economy will stay the same size.
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Economy Growing
More jobs are created, so there is more
spending.
Less need to spend on benefits.
More government tax revenue for investment.
Higher firm profits to expand, so they will
become more internationally competitive.
Economy Shrinking
Fewer jobs, so there is less spending.
More need to spend on benefits.
Less government tax revenue for investment.
Lower firm profits to expand, so they will
become less internationally competitive.
1.1.1. The Multiplier Effect
The multiplier effect = This is when a change in injections causes a larger final change in GDP.
Fiscal multiplier = This is when the initial trigger is caused by government expenditure.
•
Multiplier (K) = Change in real GDP (Y) / Change in Injections (J)
•
K = Y/J
Factors affecting the multiplier include:
1. Propensity to spend on domestic products = In the UK, we tend to favour imports over
domestic, whereas in USA people are more passionate about buying domestic products.
2. Propensity to save = In Japan, people are very quick to save any extra income, whereas
people in the UK are far more likely to spend.
3. Marginal rate of tax = The UK has a fairly high rate of tax meaning a lot of extra income will
simply leave the economy, whereas in parts of Eastern Europe it is much lower.
4. Consumer confidence = Typically, during a time of economic growth the multiplier will be
larger than in a recession.
1.2. Aggregate Demand
Aggregate demand = This is the total amount of demand for goods and services in the economy.
The five categories:
Category
Domestic Consumption (C)
Investment (I)
Government Spending (G)
Imports (M)
Exports (X)
Explanation
This is the domestic produce purchased by
people within the UK.
This is the money spent by firms on buildings,
machinery and improving the skills of the
labour force.
This is money spent by the government on a
product or service.
These are the goods and services that are
purchased from other countries.
These are the goods and services sold to other
countries.
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1.2.1. Calculating Aggregate Demand
Everything is added to the total except from the imports,
which is subtracted:
AD = C + I + G + (X – M)
1.2.2. The AD Curve
• At a price level of PL1, there is an aggregate demand
of Y1.
• As the price level falls to PL2, people increase con-
sumption (C)
• As prices fall, other countries look to purchase from
the UK and exports rise (X)
• As the price of goods from other countries has not
changed, people turn towards the relatively cheaper local produce and imports fall (M)
• For all of these reasons, aggregate demand extends
to point B (Y2)
Anything that triggers a change in a component of AD
other than the price level will lead to a shift of the AD
curve:
•
To the right if more is demanded (or imports fall).
•
To the left if less is demanded (or imports rise).
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1.2.3. Reasons for AD Shifts
Consumption is affected by interest rates, credit availability, income levels and consumer confidence.
Interest rates = This is the percentage that a bank charges for a loan or a credit card that they give out,
and the reward they give to people who save with them.
Credit availability = This is the willingness of banks to lend money to consumers.
Income levels = This is how much money a consumer makes over a period of time and how it varies
between people.
Consumer confidence = This is how willing consumers are to purchase luxury products such as cars
and holidays. This can be affected in a number of ways such as:
•
If the economy is said to be in a recession, then people associate it with hard times and so
confidence falls.
•
Rising house prices make homeowners feel wealthier, and so they are confident in their ability to repay loans – this is referred to as a wealth effect.
Factor
Interest Rates
Right Shift Explanation
Credit Availability
Income Levels: Income Tax
Income Levels: Minimum
Wage
Consumer Confidence
Left Shift Explanation
Lower interest rates encourages less
saving and more borrowing.
Therefore, lower interest rates lead to
more consumption.
Higher interest
rates encourages more saving
and less borrowing. Therefore,
higher interest rates lead to less
consumption.
If banks feel more confident about
Banks will not automatically
giving out loans, perhaps because the give out a loan just because
economy is growing, they will make it someone applies for one. If
easier to get a loan, the number of
banks lack confidence in
people who take out a loan increases
people’s ability to pay money
and consumption rises.
back, they will raise the criteria
for being given a loan, meaning
fewer people are able to borrow
money and so consumption
falls.
If income tax falls, then people have
Any rise in income tax means
more income, and their consumption
people have less income to
increases.
spend and so consumption falls.
This increases annually so it has a
significant impact on consumption as
people on low incomes tend to spend
all of their income, so the rise in
earnings will lead to an almost
identical rise in consumption.
When consumers are confident about When consumers are not
their earnings and jobs, they are more confident about their earnings
likely to spend, so a rise in confidence and jobs, they are less likely to
triggers a rise in spending.
spend, so a fall in confidence
triggers a fall in spending.
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Investment is affected by interest rates, credit availability, likely spending, business confidence, and
profit levels.
•
Interest rates affect firms as they do consumers, as firms use banks to store their profits and to
borrow money in order to fund investment.
•
Credit availability also affects firms, though banks are typically more confident about lending
to firms as there are more assets to seize of the firms default on the loans.
•
Firms are also aware of the impact interest rates have on likely spending; they know a cut in
interest rates is likely to trigger more spending so there is more of a need for them to borrow
money, whilst higher interest rates means less consumer borrowing so less need to invest.
o
Firms will invest more when they expect spending to rise and less when they expect
spending to fall.
•
Business confidence is like consumer confidence; firms will cut investment spending during a
recession as they look to store profits in case they are needed, and increase it during an
economic boom.
•
Profits are used to fund investment so a firm’s profit levels determine how much investment
they can afford to fund:
o
Firms pay 19% of all of their profits to the government in the form of corporation tax.
A rise in corporation tax will lower profits and investment, whilst cutting corporation
tax will have the opposite effect.
o
The more regulations in place, the more costs a firm faces and the lower their profits.
Removing regulations should lower a firm’s costs.
Government spending is affected by the state of the budget, the state of the economy, and their electoral position.
The state of government budget is a sign of if the government is spending too much (in deficit) or too
little (in surplus).
•
•
A deficit should lead to a cut in government spending (or a rise in taxation) as it avoids getting further into debt.
A surplus suggests the government is not spending enough money and so government spending should rise.
The state of the economy may require government intervention in the form of spending.
•
When the economy is not performing (commonly referred to as a recession) we are likely to
have high unemployment and firms going out of business.
•
The government may try to solve this by spending money.
•
When the economy is doing better (boom) they are likely to cut back on their spending.
Governments is not far away; the governments’ electoral position is not secure.
•
In order to persuade people to vote for them, they often increase spending in key areas to
show voters they are making a difference.
•
Shortly after an election when their position is now secure, they often cut back on spending as
they have achieved their goal of getting re-elected.
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Net exports are affected by the prosperity of its trading partners, the value of the pound, protectionism, quality, and domestic incomes.
A trading partner is a country that trades internationally with the UK, and the willingness of people
in other countries to buy UK products depends heavily on the state of their economy e.g., their prosperity.
•
If trading partners are experiencing economic growth, they are likely to look to buy UK products and our export sales will increase.
•
This will fall when trading partners are experiencing low growth as people living there cut
back on luxuries.
The value of the pound is usually quite strong.
•
This means it is good for buying other currencies and makes imports cheaper, but it also
means it is expensive to buy and puts other countries off from buying our exports.
•
If the value of the pound rises then net exports are likely to fall, whilst a fall in the value of
the pound will have the opposite effect.
The government can influence our consumption of imports by implementing protectionism measures;
the more in place, the more expensive imports become in comparison to domestic produce and demand for imports fall.
•
Joining a trading bloc like the EU means there is free trade, so imports are easier to purchase.
•
Measures include tariffs and quotas.
The quality of products affects demand from other countries, not just the price.
•
If the UK releases new products that are demanded internationally then we should see a rise
in export.
•
If another country brings out a product that becomes more desirable than what the UK produces, then demand for the UK export will fall.
When domestic incomes are rising, people will not only more domestic products but imported products also.
•
This will lead to a fall in net exports as we cannot affect our export sales.
•
Lower domestic incomes will see less spending and so a decline in the amount of imports purchased.
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1.2.4. The Multiplier Effect
Multiplier = This is when there is a rise in one component of aggregate demand leads to an overall
greater increase in real GDP.
• The initial injection shifts the aggregate demand
curve to AD2 e.g. a boost in government spending due
to low economic activity.
• This generates further spending which shifts the AD
curve to AD3 e.g. workers spend their wages on domestic products (consumption) which boosts a firm’s
profits and triggers a rise in investment.
• The larger the multiplier, the further and more fre-
quently the AD curve will.
1.3. Aggregate Supply (AS)
Aggregate supply (AS) = This is the amount that will be produced by firms in the whole economy at a
given price level.
•
It is referred to as the ‘Long Run Aggregate Supply’ curve (LRAS – or sometimes just AS).
•
This is the Keynesian view on the AS curve.
•
The shape reflects the cost of hiring resources in order to make output, and the maximum the
economy can produce with the amount of resources that are available.
1.3.1.
The LRAS Curve
•
The price level represents the cost of
producing each output level and is linked to the
cost of buying resources in order to produce that
output level.
•
The LRAS starts out flat at low output
levels, starts to rise when output goes beyond Y1,
until gradually becoming vertical at Yf.
•
This can be explained with reference to three
distinct stages.
Stage 1:
•
Between 0 and Y1 there is a large amount of spare capacity in the economy.
•
Output can therefore increase at any point along this stage without having any real impact
on the price level.
•
Firms costs will not increase significantly if they want to increase output, as resources are
surplus in supply and there is no scarcity.
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•
The supply curve is therefore drawn as being perfectly elastic for low output levels.
Stage 2:
•
Between Y1 and Yf resources are starting to become scarce, meaning that if firms seek to increase output now their costs are going to start to rise significantly – competing over scarce
materials, paying workers over time.
•
This creates a bottleneck in the economy and the price level will rise more and more as output
increases further.
•
The curve here becomes increasingly inelastic.
Stage 3:
•
At Yf the economy has reached full output level (Yf refers to the full employment output
level – all resources are being employed).
•
This represents the maximum amount the economy can produce given its current level of resources.
•
Effectively, output cannot increase any further; there are no more resources available to increase output.
•
The aggregate supply curve has become perfectly inelastic (vertical).
1.3.2.
Shifts in the LRAS Curve
The position of Yf depends upon:
The amount, quality, and productivity of our 4 economic resources:
Land
Labour
Capital
Enterprise
•
If there is a rise in resources the LRAS will
shift to the right, and the point which it becomes vertical moves further along the x-axes.
•
The economy can increase output to a higher
level than before (Yf2 > Yf1).
•
If there is a fall in resources the AS will shift
to the left, and the point which it becomes vertical
moves back along the x-axes.
•
The economy can only increase output to
a lower level than before (Yf3 < Yf2).
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1.3.3.
Reasons for LRAS Curve Shifts
Migration:
•
If levels of migration into the UK increases then there are more potential workers in the country, meaning the maximum capacity will increase and the LRAS can shift to the right.
•
If levels of emigration from the UK increases then there are fewer potential workers in the
country, meaning the maximum capacity will decrease and the LRAS can shift to the left.
Labour productivity:
•
If the productivity of workers was to increase, then each worker can produce a greater
amount in the same time period meaning the LRAS would shift to the right.
•
If the productivity of workers was to decrease, then each worker can produce a smaller
amount in the same time period meaning the LRAS would shift to the left.
Labour force participation:
•
If more people are encouraged to work and work for longer, then the number of workers will
increase, meaning the economy is capable of producing a greater amount and the LRAS
would shift to the right.
•
If more people are discouraged to work and retire earlier, then the number of workers will decrease, meaning the economy is capable of producing a smaller amount and the LRAS would
shift to the left.
Machinery investment:
•
If firms increase investment levels in machinery, then the economy is capable of producing
more and so the LRAS would shift to the right.
•
If firms decrease investment levels in machinery, then the economy is capable of producing
less and so the LRAS would shift to the left.
Factor flexibility:
•
If factors of production become more flexible, then there is a greater possible output level
with the resources and so the LRAS would shift to the right.
•
If factors of production become less flexible, then there is a lower possible output level with
the resources and so the LRAS would shift to the left.
New firms:
•
If there is a rise in the number of new firms being created, then there is a greater level of enterprise in the economy and the LRAS will shift to the right.
•
If there is a fall in the number of new firms being created, then there is a lower level of enterprise in the economy and the LRAS will shift to the left.
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Increasing crop yield:
•
Whilst the quantity of land available to a country is unlikely to increase, and the productivity
of land in terms of its ability to produce crops can be improved through fertilisers and mechanisation; this can lead to a rightwards shift of the LRAS.
•
Land that is damaged or overused, perhaps through deforestation or a natural disaster, will
shift the LRAS to the left.
1.4. AD/AS Analysis (Equilibrium)
Equilibrium = This is when AD is equal to the LRAS.
• The value of the economy – measured using the x-
axes – movement to the right would be referred to
as economic growth – achieving growth is a key objective.
• The price level – measured using the y-axes – move-
ment upwards would be referred to as inflation – stable
prices is a key objective.
• Conflict may occur if one objective comes at the ex-
pense of another.
1.4.1.
Rightwards AD Shifts
•
At AD1 there is much spare capacity in the economy.
•
A boost to AD2 keeps prices roughly the same, the
rise in real output is significant (Y1 to Y2).
•
A further boost to AD3 leads to a higher price level
(PL2 to PL3) and a smaller rise in real output.
•
Further boosts in AD will only lead to a higher price
level – limited benefit (multiplier effect).
1. Real output increases because with more demand there is an incentive for firms to produce
more.
2. The price level increases as firms incur greater costs to produce more and resources are becoming scarce which raises their value.
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1.4.2.
Leftwards AD Shifts
• At AD1 there is little spare capacity in the economy
– the economy is at risk of high inflation.
• A fall to AD2 sees a significant price drop (PL1 to
PL2) and a drop in real output (Y1 to Y2).
• A further drop to AD3 has no impact on price (much
spare capacity) but a larger drop in real output (Y2 to
Y3).
• Further drops in AD will only lead to a lower
level of real output.
1. Real output decreases because with less demand there is less of an incentive for firms to produce.
2. The price level decreases as firms incur fewer costs when producing less and resources are
becoming surplus which lowers their value.
1.4.3.
Rightwards LRAS Shifts
•
A boost in economic resources moves the AS curve
from AS1 to AS2.
• Firms are capable of producing more given current
resources, the price level drops (PL1 to PL2) and real
output increases (Y1 to Y2).
1. The price level falls as resources are now less scarce, and firms charge a lower price to stimulate demand.
2. Real output increases because more is demanded as the price decreases.
1.4.4.
Leftwards LRAS Shifts
•
A fall in economic resources moves the AS curve
from AS1 to AS2.
The price level rises as firms are less produc•
tive (PL1 to PL2) and real output falls as less is demanded
at the higher price (Y1 to Y2).
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1. The price level rises as resources are now scarce, and firms charge a higher price to cover
their costs.
2. Real output decreases because less is demanded as the price increases.
1.4.5.
Sustainable Economic Growth
•
When both curves shift the economy achieves growth (Y1 to
Y2) without incurring high inflation (PL1).
•
The government wishes to move along the x-axis at
approximately 2.5% annually to achieve economic growth.
1.4.6.
Macroeconomic PPFs
• Consumer goods and capital goods represent all output in the
economy.
• The current output in the economy is represented by a point
e.g. A – this is where AD is positioned.
• The boundary of the PPF represents the maximum output the
economy can produce with given resources – this is where the
LRAS becomes vertical.
• A movement of the point we are operating towards the PPF
shows a rise in output and mirrors a rightwards AD shift.
•
If the point were to move in the opposite direction it would be mirroring a leftwards AD shift.
•
An expansion of the PPF from PPF1 to PPF2 mirrors a rightwards LRAS shift – more potential output.
•
If the PPF were to shift in the opposite direction
it would be mirroring a leftwards LRAS shift.
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2. Macroeconomic Objectives
Topics include: Economic growth – 2.1; Reducing unemployment – 2.2; Stable Prices – 2.3; Reducing
Current Account Deficit – 2.4; Conflict – 2.5.
Examples of macroeconomic objectives include:
•
Price stability (CPI inflation of 2%).
•
Growth of Real GDP (National Output).
•
Reducing Unemployment/Raising Employment.
•
Higher Living Standards (GDP per capita).
•
Stable Balance of Payments on the Current Account (Exports & Imports).
•
Equitable Distribution of Income and Wealth.
•
Balancing the Budget and Reducing National Debt.
•
Improving Economic Well-being.
•
Better Regional Balance in the UK Economy.
•
Improving Access to Public Services.
•
Improving Competitiveness.
•
Environmental Sustainability.
2.1. Economic Growth
Economic growth = This is the increased capacity of a country to produce goods and services.
•
The economy’s output refers to the amount/value of the goods and services it produces – it is
measured using GDP (Gross Domestic Product); this means it includes the value of production from both UK firms and foreign firms operating in the UK.
•
The value of the UK economy at the end of 2020 was an estimated £2.1trn e.g. the UK’s
GDP.
•
Economic growth refers to a rise in GDP over a period of time – usually in terms of a quarter
(3 months) or a year.
•
GDP is often represented as per capital – this is when the GDP for the country is divided by
its population.
•
The UK GDP per capita is approximately £33,000.
The aim for sustainable growth is 2.5% per year:
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•
We are only concerned here with real GDP –
this means that the change in GDP has been adjusted
for inflation. If GDP goes from £200 to £220 then it
has grown by 10% - we refer to this as nominal data.
•
To get an accurate understanding of the
change we must adjust for inflation – if inflation in
that time was 6% then we subtract 6 from 10 to give
us a value of 4% - this is the real change in the value
of the economy.
2.1.1.
Short-Term Economic Growth
Short-Term Economic Growth = This is an increase in the amount of goods and services at a specific
point in time – bringing idle resources into production – often called actual growth.
•
We show economic growth by a rightwards movement along the x-axis.
•
Economic growth triggered by a rise in AD is referred to as actual/short-term growth and the amount the
economy is producing at a point in time has increased.
•
This can also be shown by a movement towards a
PPF.
•
A strong multiplier can create a large amount of ST
growth in a short space of time.
2.1.2.
Long-Term Economic Growth
Long-Term Economic Growth = This is an increase in the maximum potential output of the economy
– often called potential/trend growth.
•
Economic growth triggered by a rise in AS is referred to as potential/short-term growth and the amount
the economy is capable of producing has increased.
•
This can also be shown by an expansion of the PPF.
•
LT growth often triggers higher output as firms
cut prices to stimulate demand.
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2.1.3.
Sustainable Economic Growth
•
Simply boosting AD will be of limited benefit as
the economy will eventually operate at full capacity
and rapid inflation is likely.
•
Simply boosting AS will be of limited benefit as
firms are likely to require fewer workers if they become more efficient and demand does not rise significantly.
•
The 2.5% economic growth target refers to a movement of both curves, not just one.
2.1.4.
Low Rate of Economic Growth
Low rate of economic growth = This is when the economy is growing but at less than the
government’s 2.5% target.
• Often, there is a rightwards shift of the LRAS at a greater
rate than the AD is shifting.
• This means that we are still experiencing economic growth,
but the amount of spare capacity in the economy is increasing,
suggesting higher unemployment.
2.1.5.
Advantages and Disadvantages of Economic Growth
Advantages
Disadvantages
The UK is more likely to attract foreign investment if it is
growing as it therefore seen as a more lucrative location for
business. Foreign investment can help boost infrastructure
such as roads, allows new products and technologies to
enter a country, and can create long-term trade ties with
other countries.
In order to make the output, firms need to hire more
workers. This leads to a fall in unemployment and the
issues that coincide with it e.g. crime rates, benefit
dependency. With more jobs, people have more money to
spend on luxuries such as holidays and cars, raising living
standards.
As firms grow, they often become more efficient which
can allow prices to drop. This increases people’s access to
products and boosts consumer welfare.
As demand for finite resources rises there is a likelihood
of long-term scarcity which could lead to inflated prices in
the near future as stocks cannot be replenished.
The government will be receiving more money in the form
of income tax, corporation tax and VAT, meaning more
The environment often suffers as a result of increased
growth, with higher levels of manufacturing polluting the
air and water sources, whilst increased waste leads to large
problems associated with landfill.
As firms grow the investment in technology is ever
increasing. This is leading to a rise in the number of
workers being replaced by technology, which could
generate long-term unemployment problems. Experts
predict figures in the region of 25% of all jobs lost to
technology by the year 2050.
As economies grow the population becomes wealthier and
more educated. This can lead to a rise in expectations in
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money can be spent on public services such as NHS and
education, and can lead to long-term projects such as HS2
being financed that can help reduce the north/south divide.
The ability of the government to boost the earnings of the
poorest is increased as they have more money from tax
revenue to fund welfare payments and help prevent people
from getting into extreme poverty.
Firms are likely to making higher profits during times of
economic growth. This should trigger a rise in investment
and the creation of new products which can help boost the
UK’s international competitiveness.
terms of wages and working conditions, which can often
lead to foreign firms seeking to invest elsewhere, where
standards aren’t as high. It also has the effect of lowering
the number of children people have, which can lead to an
ageing population and strains on healthcare and pensions in
the future – it also leads to ‘diseases of affluence’ e.g.
obesity, heart disease.
Economic growth tends not to be spread evenly throughout
a country, yet its impacts on the price level does. When the
UK’s economy grows it tends to be focussed in the south
and London, meaning people in the south get wealthier
whilst people in the north are forced to experience higher
prices.
As economies grow and become wealthier, the amount of
imports will generally rise as people look to buy more and
more from other countries, which should worsen the trade
balance.
2.2. Reducing Unemployment
Unemployment = This is those of working age who are actively seeking employment, but do not have
a job.
•
The most recent data shows an unemployment rate of 5%, and an unemployment level of
1,720,000.
•
The UK’s unemployment target is 4% - it is unlikely the figure will fall much below this for
any sustained period of time.
People excluded from unemployment levels are:
•
Retired/retirement age.
•
Underage of 16.
•
Students/full-time education.
•
Disabled/handicapped.
•
Parental responsibilities.
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•
Those in prison.
2.2.1. Demand-Side Unemployment
Demand-side unemployment = This is unemployment caused by a lack of aggregate demand, during a
time of low economic growth, is referred to demand-deficient unemployment.
•
It is represented by the difference between the current level of output in an economy and the
maximum potential output.
Seasonal unemployment = This is when certain occupations are only in demand at certain times of the
year.
•
Yf represents the total amount of workers in
an economy.
At point A we have a low level of AD – we
have unemployment equal to the distance Y1-Yf.
•
•
When AD is boosted the level of output increases to Y2, meaning unemployment has dropped
to Y2-Yf.
2.2.3. Supply-Side Unemployment
Supply-side unemployment = This is unemployment caused by issues on behalf of workers to fill
vacancies. This is caused by:
•
Structural unemployment = This is typically long-term unemployment caused by a lack of relevant skills, very often because of a large shut-down of a certain industry e.g. closure of coal
mines in South Wales.
•
Real-wage unemployment = This is when the supply of workers exceeds the demand for
workers due to a high minimum wage.
•
Technological unemployment = This is when existing jobs are replaced by machinery and
technology.
•
Frictional unemployment = This is when people are temporarily unemployed as they search
for a new position.
2.2.4. Positive Impacts of Unemployment
Workers often find it in their best interests to learn and acquire new skills when they are unemployed
to make themselves more employable; something they are in less of a need to do when they are employed.
•
This could mean that the long-run growth is positively rather than negatively affected.
In a similar way to above, unemployment can act as an incentive for entrepreneurial activity, with
people using redundancy money to start up their own business.
•
The loss of security is more likely to convince people that the risk is worth taking than when
they have the security of employment in place.
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A large pool of available workers is something that may attract foreign investment and the opening up
of new factories as there is sufficient labour available, and likely to be relatively cheap.
•
This can have long-term benefits for the country as there may be further investment projects
to follow.
•
Alternatively, it may revitalise poor areas such as the north and reduce the north/south divide,
whilst introducing new skills into an area.
Unemployment can also help ease inflationary pressures, so unemployment rising in a positive output
gap and moving the country towards rapid inflation would be seen as a worthy compromise as unemployment may only fall by a small amount, yet ease inflation by a considerable level.
Rising unemployment can help to reduce a balance of payments deficit, as with less spending on imports the UK’s balance of trade will improve.
With less consumption there is a reduced amount of waste being created, as well as less pollution from workplaces if output is lower.
2.2.5. Negative Impacts of Unemployment
Lost output: Labour is classed as one of the four factors of production. In order for the economy to be
working at maximum capacity, it requires the productive use of all of its factors.
•
Therefore, any labour that is not employed implies an economy that is producing at below full
capacity.
•
This leads to a shortfall in goods and services, low economic growth, and a loss of economic
welfare.
Hysteresis effect: This is a deep-rooted decline in the productivity of a group of workers. There is a
general agreement that stored skills and knowledge deteriorate over time when they are not being utilised.
• Therefore, the longer that people are unemployed, the more the skills they have acquired will
deteriorate.
•
When they are eventually employed again, they are less productive than they were previously,
and are likely to require retraining, which is a waste of money and resources.
•
As the skills deteriorate, the LRAS shifts gradually to the left as the productive capacity of the
economy is falling.
Budget deficit: The tax revenue generated from income tax and national insurance accounts for almost
50% of the government’s annual income.
•
With a fall in employment, there is a stark fall in the level of tax revenue received.
•
In addition, the government is also faced with the rising demand for welfare payments, which
exacerbates the problem further.
Negative multiplier effect: With high unemployment, demand will fall due to the reduced spending
power that comes from unemployment.
•
Areas that are affected particularly hard will be the non-essential and luxury industries.
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•
This leads to many of those in employment beginning to fear for their jobs as unemployment
is rising around them, and there is a ‘we might be next’ culture.
•
To offset the impacts, those in work look to build up a savings buffer, leading to a further fall
in demand.
•
The economy gradually shrinks, and the possibility of a damaging recession is a reality.
Reduced investment: the competitiveness of the UK can suffer as months of high unemployment
means a long period of low productivity for firms.
•
The most likely action of firms to ensure survival is to cut spending on potentially non-essential areas, in this instance investment.
•
This can lead to reduced development of state-of-the art technologies in comparison with
other countries, and some long-terms issues in terms of international competitiveness.
Poverty: As firms are quick to offload the least essential workers, those on low-incomes are most
likely to experience unemployment, those with few savings or alternative sources of income to fall
back on.
•
This can lead to a loss of home, the break-up of families, and a stark reduction in the standard
of living.
•
People are often forced to move to low-income areas where the housing is cheaper but is often an area prone to crime and social degradation.
•
With little income in these areas, there is often a stark decline in the quality of education in
health, businesses relocate elsewhere, and a ‘spiral of decline’ sets in.
•
The rich/poor divide will often widen as unemployment increases as it is those on low incomes that are most at risk of job losses.
Declining quality of public services: The government will often compensate for the rise in demand for
unemployment benefits by cutting spending on public services, leading to a decline in the quality of
the services they offer.
•
There is also likely to be a rise in their demand, as crime rates increase and the need for health
care rises (a result of lower living standards), meaning they become stretched even further.
Unfavourable contract agreements: The 2008 recession saw the rise of zero-hour contracts, a result of
people desperate for work at times of high unemployment and willing to accept any potential employment opportunities.
•
People on these contracts are not eligible for unemployment benefits but may actually receive
no pay some weeks.
Increased north/south divide: The south of the UK is largely service-dominated and private-sector
firms dominate, whereas the north relies far more on the public sector and manufacturing.
•
Unemployment rising tends to be more concentrated in the north due to public sector cuts and
less demand for factory-produced products.
2.3. Stable Prices
Inflation = This is a persistent increase in the general price level or a fall in the real value of money.
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Deflation = This is a persistent decrease in the general price level or a rise in the real value of money.
Disinflation = This is when the price level is rising but at a decreasing rate.
Hyperinflation = This is when the rate of inflation is sufficiently high to disrupt the function of
money.
2.3.1.
Inflationary Pressures
Inflationary pressures = This is the term for anything that changes that can potentially trigger higher
prices in an economy. They generally fall into two categories:
Demand-side factors = These are factors which lead to a higher level of aggregate demand and trigger demand-pull inflation.
•
Prices rise because, in response to higher demand, firms need a financial incentive to increase
output, and also are likely to see resources become scarce and increasingly expensive in order
to do so.
•
Demand-pull inflation is a sign of a growing economy so is often seen as a good thing, but it
can become a problem as the economy approaches full capacity (when rapid inflation becomes a possibility). Likely causes include:
o
o
o
o
o
Lower interest rates.
Lower tax rates.
Depreciation of the pound (boost export sales).
Rise in government spending.
Rising house prices (triggering a wealth effect).
Supply-side factors = These are factors which raise a firms’ costs and trigger cost-push inflation.
•
Prices rise because firms face a higher cost to produce each output level, and pass these onto
consumers in the form of higher prices.
•
Cost-push inflation often leads to a fall in aggregate demand as people can afford less, meaning it is often seen as a very bad thing for an economy to experience. Likely causes include:
o
o
o
o
o
Higher wage rates.
Higher tax rates.
Depreciation of the pound (imported raw materials more expensive).
Rising oil prices.
Increased interest rates (more expensive loan repayments).
2.3.2.
Nominal vs Real Data
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•
A nominal change in a variable is one that has not had the impact of inflation factored in e.g.
a rise in the value of an economy from £100bn to £105bn is a rise of 5%.
•
Real data then adjusts the nominal change with inflation to give its true value e.g. if inflation
was 3% in the same period, the real change in GDP is only 2% (5% - 3%).
•
Real data should always be considered as nominal changes caused simply by higher prices
does not trigger any real benefit.
2.3.3. Measuring Inflation
•
A ‘basket of goods’ is decided upon of approximately 700 items that the average household
will consume in some quantity over the course of a year.
•
An average price change of these products is calculated over the course of 3 months.
•
Some products are given a weighting as they impact us more than others e.g. changes in petrol prices would have a far greater impact than changes in car prices.
•
The basket is updated every year in responses to changes in demand e.g. sat-navs have recently removed, whilst bottled water has recently been added.
•
Some products are grouped (e.g. blu rays and DVDs have been combined to form one product), and some are amended in line with changes in purchasing habits e.g., rise in significance of
takeaway food.
•
The end result is a percentage which is known as ‘Consumer Price Index’ (CPI).
•
An alternative measure is the ‘Retail Price Index’ (RPI) – the two are very similar but RPI
also includes house prices which typically means RPI is almost always higher than CPI.
2.3.4. Positives and Negatives of Stable Inflation
Positives
Price rises encourage innovation = inflation
means firms can charge higher prices for
products, which encourages them to release new
products as they need the higher prices to cover
the extra costs of development, marketing etc.
Negatives
Can be restrictive for SR growth = an economy
stuck in a recession needs a large boost of AD to
help it recover. However, such a boost would
probably trigger inflation well in excess of 2%.
If the government sticks to its inflation target
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With greater innovation there can be long-run
economic growth (due to more capital),
and short-run economic growth via a boost in
export sales (with better products to sell).
Fund wage increases = This is productive
workers can be rewarded for their efforts with
wage increases and bonuses, which are funded
via the extra profits from charging higher prices.
It can encourage people wo work harder and be
more productive, which has LRAS benefits.
Higher wages also encourage more people to get
a job, which can help lower unemployment.
Stable environment for investment = a 2%
inflation gives firms a fair idea that there will be
no sudden changes in demand, and so their
investments are likely to pay off. Inflation well
in excess of 3% is likely to trigger a fall in
consumption as people have a lower level of
disposable income, whereas inflation below 1%
often suggests people delaying their purchases
in hope of lower prices. Either way, inflation
extremes discourage investment.
UK products remain competitive = if inflation is
well above that of other countries, it would
mean our export prices were rising much higher
than other countries/ This will mean countries
will switch from UK products as they are
becoming too expensive.
Maintains the value of savings = This is when
inflation is high, the value of people’s savings is
being slowly eroded (as every year the balance
in your bank buys you less and less). This can
discourage people from saving, meaning there is
little money in the bank that can be loaned out,
so long-term investment may fall. To encourage
saving, banks may need to offer a higher interest
rate, which will raise the cost of loans.
that means AD can only be boosted by a small
amount, so the economy cannot grow as much
as it needs.
If higher than other countries can lead to a lack
of competition = if other powerful EU countries
such as Germany and France are experiencing
inflation of below 1%, then sticking to the UK’s
inflation target of 2% means out prices are
rising higher than theirs, and is likely to lead to
a fall in UK export sales.
If maintained with high interest rates it can lead
to long-term problems = the main tool for
controlling inflation is interest rates. When
inflation is high, the government raises interest
rates to lower AD and lower inflation. However,
this can discourage firms from borrowing,
which means there can be long-term damage to
innovation and economic growth.
Creates problems for those on fixed incomes
= inflation is not an ongoing process, whereas
the incomes of people on welfare payments
(pensioners, the unemployed) are updated every
year as a result of the previous years’ level of
inflation. This means throughout the year people
on fixed incomes are worse off each
week/month as prices slowly rise but their
incomes cannot change. A lower inflation rate
would mean they are less negatively affected.
Ignores regional variations = inflation is
calculated on a national basis, but very often
occurs at different rates in different regions.
Inflation is typically far higher in areas around
London, and much lower in areas further north.
The government makes decisions based on a
national rate, meaning people in the north may
be worse off by decisions to control inflation
that is only really affecting people in the south
e.g., raising interest rates.
Erodes the value of debt and encourages
borrowing = inflation helps make a longterm debt more affordable, as it is effectively
lowering the value of what you have borrowed.
When inflation is very low, the debt is not
falling very much, meaning it make long-term
borrowing very expensive.
Avoids deflation problems = The common
human behaviour to deflation is to hold back
and wait for things to become cheaper. This can
lead to a long-term negative multiplier, with AD
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shifting left as people hold back. This has been
recently witnessed in Japan.
2.4. Reducing Current Account Deficit
Why do other countries trade with others?
Factor endowments = This is when raw materials, skills and climate differ between countries e.g.
Saudi Arabia has vast oil reserves, Japan has none.
Price = Some countries naturally find it more difficult to produce some products than other countries,
so purchasing from abroad allows them to get the product much cheaper e.g. UK would need to vast
greenhouses to meet fruit demands.
Product differentiation = This is when different countries may produce similar products but not identical ones, so quality may be better elsewhere.
Political reasons = To help/hinder relations, countries may choose to trade with other countries, or refuse to e.g. USA & Cuba.
Specialisation = As countries don’t need to produce everything themselves, they can become specialists in certain fields e.g. Japan in electronics.
The Current Account = This measures a country’s flow of exports and imports.
•
Export sales add to the account, import purchases subtract from the account. It falls into 4
categories:
•
•
•
•
Trade in goods e.g. guns.
Trade in services e.g. accounting.
Primary Income e.g. profits from overseas investment.
Secondary Income e.g. disaster relief.
The state of the account:
•
When the value of export sales exceeds the value of import purchases, the account has a positive
figure and is said to be in surplus e.g. £20bn.
o
•
If this surplus gets larger over time the account is said to be improving the surplus is widening e.g. £30bn, if it gets smaller the account is said to be deteriorating e.g. £10bn.
When the value of import purchases exceeds the value of export sales, the account has a negative
figure and is said to be in deficit e.g. -£50bn.
o
If this deficit gets larger over time the account is said to be deteriorating, if it gets smaller
the account is said to be improving.
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•
If the value of exports equals the value of imports the account is said to be balanced.
2.4.1.
Rightwards AD Shift
•
If there is a fall in imports and/or a rise in exports, then the state of the account will improve
This can be shown by a rightwards shift of the AD curve
movement.
•
Imagine point A represents a small deficit
If exports rise then AD shifts to the right – this moves us
into a surplus at point B.
•
It has the added benefit of reducing unemployment
but can lead to rapid inflation.
Reasons why the current account may improve:
1. A fall in the value of the pound:
o
This makes imports more expensive and exports cheaper. The result is a rise in exports
and a fall in imports.
2. Domestic incomes:
o
The more money people have, the more they spend on imports. If domestic incomes fall,
then people cut back on import purchases and the BoP improves.
o
This can be achieved by raising income tax, cutting benefits and lowering the minimum
wage.
3. Low inflation:
o
If the UK is experiencing low inflation, then our prices will seem relatively cheap compared with countries experiencing high inflation.
o
This should encourage people to buy UK products and leading to a rise in export sales.
o
However, this inevitably causes prices to rise so will only be a temporary boost.
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4. Labour productivity:
o
If the UK workforce becomes more productive, then firm’s costs will fall.
o
This causes our prices to fall and suddenly UK exports become more affordable.
5. Innovation:
o
If the UK comes up with new products that are seen as ‘must haves’ by other countries,
then people will look to buy from the UK and so export sales will rise.
o
This should also encourage UK people to switch from foreign products to domestic, triggering a fall in import purchases also.
o
This is long-term benefit as exports that are high quality are likely to be quite inelastic.
6. Prosperity of trading partners:
o
‘Trading partners’ are other countries that buy from us – the UK has good trading links
with the EU, other parts of Europe, SE Asia and Australia.
o
How much they look to buy from the UK depends upon the state of their economy – if
their economy is booming, their population have a high level of disposable income, and
so demand for UK exports will rise.
7. International controls:
o
Many countries have protectionist policies in place which make it more difficult for them
to import e.g. tariffs and quotas.
o
If other countries remove their international controls, it is easier for people in that country to buy from other countries and so should increase demand for UK exports.
o
If the UK places import controls, then there will be fewer imports and more domestic
consumption.
2.4.2. Leftwards AD Shift
•
If there is a fall in exports and/or a rise
in imports, then the state of the account will deteriorate.
•
This can be shown by a leftwards shift of the
AD curve movement.
•
Imagine point A represents a small surplus
If imports rise, then AD shifts to the left –
this moves us into a deficit at point C.
Whilst unemployment may rise, it can help
•
ease inflationary pressure.
Reasons why the current account may deteriorate:
1. A rise in the value of the pound:
•
This makes exports more expensive and imports cheaper. The result is a rise in imports and
a fall in exports.
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2. Domestic incomes:
•
The more money people have, the more they spend on imports.
•
If domestic incomes rise, then people have more money to spend on import purchases.
•
This is often caused by lowering income tax, raising benefits, and increasing the minimum wage.
3. High inflation:
•
If the UK is experiencing high inflation, then our prices will seem relatively expensive compared
with countries experiencing low inflation.
•
This should discourage people from buying UK products, leading to a fall in export sales.
•
However, this inevitably causes prices to fall so will only be a temporary issue.
4. Labour productivity:
•
If the UK workforce becomes less productive, firm’s costs will rise and so will prices. UK exports will become less affordable, leading to fewer export sales.
5. Innovation:
•
If a country other than the UK comes up with new products that are seen as ‘must haves’ by other
countries, then people will look to buy from them instead of from the UK and our export
sales fall.
This should also trigger a rise in imports as the UK population looks to purchase it also.
•
This is can be quite a long-term problem as it suggests the UK is not very competitive.
6. Prosperity of trading partners:
•
If the UK’s main trading partners are suffering from low economic growth, their population have
a lower level of disposable income.
•
This decreases demand for UK products and export sales fall.
7. International controls:
•
If other countries increase their international controls, it is more difficult for people in that country to buy from other countries and so should decrease demand for UK exports.
•
If the UK removes import controls, then there will be more imports and less domestic consumption.
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2.5. Conflict
Conflict = This is when the pursuit of one macroeconomic objective comes at the expense of another.
Primary Objectives
Economic growth
Stable prices
Reducing unemployment
Reducing BoP deficit
Secondary Objectives
Environmental sustainability
Higher living standards
Reducing budget deficit
Improve economic wellbeing
Improved access to public serEquitable income and wealth
vices
Better UK regional balance
International competitiveness
2.5.1. The Short-Run Conflict
• A boost in aggregate demand from AD1 to
AD2 helps a country achieve economic growth by the amount Y1-Y2.
• It has the added benefit of reducing unem-
ployment as more workers will be needed to
meet the increased demand. Two economic objectives have been achieved.
•
In doing so, the price level has increased from PL1 to PL2. This means the stable prices objective is in conflict. It is also likely to trigger a fall in export sales as prices have risen, meaning reducing the BoP deficit is in conflict.
•
Reducing aggregate demand from AD1 to
AD2 helps a country achieve stable prices by
the reducing the threat of rapid inflation.
•
It has the likely added benefit of reducing the BoP deficit as falling prices are likely to
encourage more export sales. Two economic objectives have been achieved.
•
In doing so, the economic output has decreased from Y1 to Y2, meaning there has been
a reduction in economic growth.
•
It is also likely to trigger a rise in unemployment as fewer workers are needed.
Other likely conflicts in the short run:
•
Economic growth is likely to negatively impact on economic sustainability, as it means more
pollution from industry and more waste form consumption to send to landfill.
•
An attempt to create a more equitable distribution of income and wealth by raising income taxes may generate unemployment as there is less spending in an economy.
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•
An attempt to boost living standards via economic growth may widen regional inequalities as
growth in the UK tends to be more heavily focused in the south.
•
Reducing the budget deficit may lead to a decline in the standard of public services as typically less money will be available to spend.
•
Attempting to reduce the BoP deficit by putting an import tariff in place may reduce international competitiveness as it raises a firm’s costs in terms of imported materials.
2.5.2. The Long-Run Conflict
The initial conflict
growth, stable prices,
and reducing
resolved in the longAD and AS curves
•
between economic
reducing unemployment
the BoP deficit can be
run by shifting both the
perhaps through:
Lower
interest rates which boost
consumption and investwith a rise in capital from
ment (AD)
investment (AS).
•
Lower income tax which boost consumption (AD) and encourages more people to enter the workforce (AS).
•
A boost in government spending on infrastructure which initially boost AD but
then improves the UK efficiency and boosts AS also.
Other ways conflict examples can be overcome:
•
Economic growth can lead to the development of greener technologies in the long-run, reducing environmental damage.
•
The extra money from higher taxes can be offset with a cut in corporation tax, allowing firms
to be more profitable and hire more workers.
•
The money generated form economic growth can be used to fund development projects in the
north and reduce immobility e.g. HS2.
•
Public services can become more efficient and less wasteful with less funding so can improve
in the long run.
•
Development of the domestic market in response to higher import tariffs can help to reduce
the reliance on other countries.
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3. Macroeconomic Policies
Topics include: Fiscal Policy – 3.1; Supply-Side Policy – 3.2; Monetary Policy – 3.3; Exchange Rate
Policy – 3.4; Free Trade and Protectionism – 3.5.
3.1. Fiscal Policy
Fiscal policy = This is the use of government spending and taxation to affect macroeconomic
performance.
3.1.1. Government’s Annual Budget
At the beginning of each ‘fiscal year’ (March/April), the government announces its ‘annual
budget’. The purpose of this is to announce:
•
Any changes to taxation e.g. decreasing the rate at which people start paying income tax.
•
Changes to spending e.g. cuts in spending to local councils.
•
The gap between spending and revenue, for example:
o
Whether the budget is in deficit; more money is being spent than earnt.
o
Whether the budget is in surplus; more money is being earnt than spent.
o
Whether the budget is balanced; spending is equal to earning.
Government spending allocation:
Government tax revenue allocation:
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•
Whenever spending exceeds revenue the government and the budget is in deficit, the government
then needs to ‘find’ the money needed to bridge the gap between spending and revenue.
•
The amount it needs to find is known as the public sector net cash requirement (PSNCR).
Key sources of funding a budget deficit include:
•
HM treasury bonds = This is when an individual ‘lends’ the government money and receives
a rate of interest every 6 months before receiving the money back in full.
•
Borrowing from the BofE = This is the UK’s central bank and can lend the government
money at a base interest rate.
•
Borrowing from other institutions = This may be from firms, other banks, and other countries
•
Sale of government assets = This is the sale of industries (privatisation) can raise funds.
•
Recall of debt = This is when the government may have lent money to another country and
may ask for some back.
•
National savings and investments = This is like saving in a bank you put your savings in a
government bank for them to use.
As the above graph shows, the UK government has run a budget deficit every year since 2001. Reasons for this include:
•
The UK has an increasingly ageing population, meaning more money every year needs to be
spent on pensions and healthcare.
•
The UK has a fairly large public sector and therefore a large amount of funding is required –
1 in 7 people work in the public sector.
•
The UK is argued to have a generous welfare system = In order to meet a ‘minimum standard
of living’, the UK government spends a lot of money topping up incomes.
•
Attempts to stimulate the economy = This is because budget deficits have increased at times
of recession in attempts to help it recover e.g. 2009.
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3.1.2. National Debt
•
•
Each year the value of the budget deficit is added onto the country’s ‘national debt’. This refers to
the total amount of money a country owes.
o
Every year the budget is in deficit the larger the country’s national debt becomes as
the value of the deficit is ‘added onto’ national debt.
o
A budget surplus can then be put towards national debt so the value of national debt
should fall during a surplus.
The UK currently has a national debt in excess of £2trn; national debt is often displayed as a % of
a country’s GDP for ease of comparison.
3.1.3. Government Spending
Capital expenditure = This is the money spent to build infrastructure and improve productive
capacity e.g. hospitals, schools, roads – AS Impacts.
•
This type of spending is typically represented by shifts of AD leading to shifts of the AS e.g.
the building of a road will boost AD as the wages of the workers are funded, but then
boosts AS as the mobility of workers is increased.
Long-Term Benefits
Boosting international
competitiveness with money spent building
ports that can transport materials quicker.
Improving the skills of the workforce with
better educational facilities to increase the
quality of output and make workers more
employable.
Lowering the rate of inflation by making the
economy more efficient.
Achieving environmental sustainability with the
construction of green energy projects like dams
and solar farms.
Issues
Projects often end up being more expensive than
originally thought if they take several years to
be built.
Funding of them often gets cut in favour of
short-term solutions to problems.
The benefits often take a long time to
materialise.
Due to the rate of technological improvements
many capital projects that seem innovative at
the time of conception are largely redundant by
the time of completion.
Reducing unemployment by creating ‘shovelready’ jobs in the construction of the projects,
and also long-term jobs running the projects
afterwards.
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Current expenditure = This is the day-to-day running of public services e.g. wages, medicines,
electricity, petrol.
•
This type of spending tends to be more focused on AD as it refers to spending in response to
demand for a good (e.g. stationary order in a school) or service (e.g. paying the wage of a
nurse).
Benefits
Creates revenue for local businesses who supply
the materials.
Higher wages in the public sector
will attract more skilled workers who would
have otherwise worked in the private sector.
Acts as a more immediate injection into the
economy so can help achieve economic growth
very quickly.
The quality of public services should increase
with more funding.
Criticisms
There are few long-term benefits to the
economy, the benefits are mainly in the shortterm.
Too much spending can cause demand-pull
inflation.
Increasing the budgets of local schools and
hospitals can often lead to them becoming
wasteful and less efficient.
As society improves and regulations increase
the cost of running the public sector is
increasing rapidly.
The larger the public sector becomes the less
room for the private sector to grow.
Transfer payments = This is the money passed in the form of benefits e.g. unemployment, pensions.
•
This type of spending has no direct impact on either AD or AS as it does not represent the
payment for a good or service (so no AD) and in no way improves the quality of resources
(no AS), though the impacts will occur indirectly e.g., unemployment benefits will be spent
and then contribute to AD.
Benefits
Reduces the number of people in absolute
poverty.
Supports young parents and encourages people
to have children (which will help boost the
workforce in the future).
Encourages people to work and spend knowing
they will have a support in place, and therefore
not need to save too heavily.
Without it, fewer people would risk buying their
own homes (as a loss of job would effectively
mean they would lose their home) which helps
boost people’s wealth.
Issues
The current pension system is
largely unsustainable.
There is a clear opportunity cost as money spent
on transfer payments is money that could have
been used to boost AD or AS.
Acts as a disincentive to work as people can live
a comfortable lifestyle on benefits.
As benefits rise in line with inflation, funding
extra spending often leads to cuts in other
areas.
3.1.4. Government Revenue
Direct taxes = These are taxes paid straight to the government based on earnings by a tax-paying
individual or firm e.g. income tax, corporation tax, national insurance.
•
They very often take the form of a specific percentage, which is typically either fixed (e.g.
19% corporation tax) or pro (e.g. income tax).
Indirect taxes = These are taxes dependent on spending e.g. VAT, excise duties. They typically take
the form of a % of the final value (e.g. VAT is 20%).
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3.1.5. Expansionary (Loose) Demand-Side (Keynesian) Fiscal Policy
When the government aims to increase the level of aggregate demand in an economy through:
1. Increasing spending = This is an extra injection into the economy.
2. Decreasing taxation = This is a smaller withdrawal from the economy.
1. Increasing public sector wages means
more consumption can take place.
2. With greater budgets schools can order
more supplies meaning firms have more money
to invest.
3. With lower corporation tax firms have
greater profits to pay workers more who then
consume more.
4. A new port means more exports can be sold
to other countries.
5. Cutting income tax triggers more spending
and consumption.
Benefits
Generates actual economic growth =
Particularly beneficial during a time of
economic decline, which is when Keynesian
economists firmly believe it should be used.
Creates jobs = Both directly (more money for
the council means more workers can be hired)
and indirectly (more consumption means shops
need more workers).
Create confidence = A rise in government
spending creates a sense of job security as an
economy is recovering and means others are
more likely to spend.
Protect industries = Some industries may be
struggling (public transport due to low demand,
manufacturing due to competition from abroad)
so providing support in the form of subsidies
can help them survive.
Attract foreign investment = With lower tax
rates foreign firms may look to setup in the UK
which can create long-term jobs.
To target specific problems = The government
can address regional inequalities, for example,
by spending more money in a deprived area.
Criticisms
Weak multiplier effect = The money to fund any
extra spending may have to come at the expense
of higher taxes, or any tax cuts means less
government revenue which may have to mean
less spending.
Crowding out = As an economy has a fixed set
of resources, many argue that the more being
used by the public sector is simply decreasing
the availability for the private sector.
Rising imports = There is no guarantee extra
income will be spent domestically, it may
simply lead to more exports.
National debt = This leads to a large budget
deficit and more debt, which means more
money will be sent repaying the debt, this often
leads to higher interest rates (as the government
looks to raise borrowing funds) which can be
bad for investment and borrowing.
Inflation = Too much pending focused on AD
will simply trigger demand-pull inflation.
Inefficiencies = Higher budgets for public
services means they can become increasingly
inefficient.
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What does the success of expansionary demand-side fiscal policy depend upon?
1. The state of the economy = It can give the economy the boost it needs to prevent further decline
and avoid a deep-rooted recession which could mean long-term unemployment.
2. The focus of any spending = Spending which can also lead to supply-side improvements (such as
boosting public transport can lead to an increase in transport efficiency) means the benefits can be
long-term.
3. Propensities to save/import = The more likely any extra income is to be spent domestically rather
than saved or spent on imports, the greater the impact of tax cuts on the economy.
4. Confidence = The effects of extra spending are more likely to multiply if confidence is high and
firms respond with higher investment, and consumers with higher spending – low interest rates will
help.
5. The current state of the budget/debt = A government can pursue expansionary fiscal policy with
few negative side effects if it is running a budget surplus, or even just a small deficit, and national
debt is low.
3.1.6. Contractionary (Tight) Demand-Side (Keynesian) Fiscal Policy
When the government aims to decrease the level of aggregate demand in an economy through:
1. Decreasing spending = a smaller injection into the economy.
2. Increasing taxation = a larger withdrawal from the economy.
1. Decreasing public sector wages means more consumption can take place.
2. With smaller budgets schools can order less supplies
meaning firms have less money to invest.
3. With higher corporation tax firms have fewer profits
to pay workers more who then consume less.
4. Fewer subsidies can make domestic products
more expensive, so people purchase more imports.
5. Raising income tax triggers less spending and consumption.
Benefits
Eases inflation = With less aggregate demand it
can avoid the risk of inflation rising
significantly above its target.
Boosts the private sector = This can increase
demand for private sector industries as less
people want to use the public sector, which has
a stronger multiplier effect
Reduces national debt = This can mean a
government can lower its national debt which, if
rising, can mean long-term problems of
Criticisms
Increasing unemployment = With less revenue
for firms and public service departments they
are likely to hire fewer workers.
Loss of international competitiveness = With
less profits from higher taxes firms are less able
to fund investment, meaning fewer new
products in the future to sell as exports.
Declining council services = The areas that
councils cut are often seen as the ‘least
essential’ elements such as youth centres and
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financing it (as the higher it goes, the more
difficult to borrow in the future).
Increasing efficiency = The public sector may
need to find ways to be more efficient with a
smaller budget, so the quality of service can be
maintained but it just costs less.
Incentive to work = With less spending on
benefits more people may be encouraged to
work, acting as a boost to the economy’s
potential.
Reduce rich/poor divide = If people in higher
income tax barriers pay more tax then the
rich/poor divide is reduced.
public parks, which can be damaging to
population welfare.
Bad for the environment = Long-term projects
are the most likely areas to be cut, such as
investing into green energy like tidal barrages.
Less foreign investment = Fewer firms will look
to invest in the UK if taxes are higher and so
projects that may have created many jobs will
fail to materialise.
Increased poverty = Many people on low
income rely on public sector support which may
not be available following spending cuts.
What does the success of contractionary demand-side fiscal policy depend upon?
1. The state of the economy = If the economy is performing well then there is little need for government spending so a decline in spending will have few negative impacts.
2. The focus of any spending cuts = Cutting spending on benefits may be highly beneficial with
greater motivational impacts, though less spending on wages can lead to fewer people willing to work
in key public sector areas.
3. Quality of information = If the government has a clear understanding of how tax rises and spending
cuts can be achieved with minimal side effects then the policy can be successful.
4. The current state of the budget = The negative side effects of less spending may be short lived, in
comparison to the long-term debt problems of allowing a large budget deficit to persist.
5. The rate of tax rises = A small tax increase may have quite a marginal impact on the earnings of
many firms/individuals and so cause few long-term problems, whereas a large tax rise can have large
problems (see Laffer curve).
3.1.7. The Laffer Curve
The Laffer curve = This is a curve that shows the trade-off between tax rates (y-axis) and tax revenue
(x-axis).
•
As tax rates rise, the governments revenue will
initially increase (the same number of people work, but
each individual pay more in tax).
•
However, if taxes rise beyond a certain level, people
will be discouraged from working and tax revenue will
fall.
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3.1.8. Advantages and Disadvantages of Demand-Side Fiscal Policy
Advantages
It can be used to quickly alter the pattern of the
economy. This is because any injection has a
relatively swift response in terms of altering
aggregate demand as it is being placed into the
economy directly.
It can be targeted at certain areas in order to
overcome specific problems e.g. a rise in
unemployment can be overcome by spending on
construction projects, whereas spending on
imports can be reduced by increasing income
tax.
It is often seen as a fair tool as it allows people
to contribute what they can afford. Those on
low incomes pay very little tax through income,
whereas the wealthiest pay a large percentage.
Disadvantages
Repeated use of expansionary fiscal policy can
get the government into a high level
of government debt. Like with any debt, it must
be financed through interest payments, meaning
money spent repaying loans is money that could
have been better spent elsewhere.
Although the effects can be almost immediate,
any major changes to fiscal policy should only
be done on an annual basis, in the March/April
budget. This does limit the use of fiscal policy
as a reactive tool.
The effective use of fiscal policy
requires accurate information on the problems
that need solving, and also what the outcomes
are going to be. As this is often not the case in
reality, the government has been known to make
bad decisions due to a lack of information
beforehand, or unforeseen circumstances
affecting the success of projects.
The use of fiscal policy can be
Fiscal policy is often accused as
relatively precise as it is not relying on the
being politically biased, with governments using
actions of individuals and banks in order to meet it as a tool to engineer a boom prior to an
its outcomes. This enables the government to
election and getting into debt in the process.
more accurately raise/lower AD to meet its
requirements.
Fiscal policy is often said to self-correcting,
Fair is only an opinion, with many seeing it
meaning that it does not require constant care an as unfair. Those on high incomes not only pay
attention. This is because any rise in
the most tax towards NHS, pensions, and
government spending in an attempt to stimulate education, they are also the least likely to use it
an economy, will naturally fall once
with their preference for private services.
employment levels are raised and taxation
revenue rises to cover the cost of the initial
injection. This is referred to as ‘automatic
stabilisers’.
It may be focused on the demand-side, but many The multiplier effect associated with
changes will have supply-side benefits in the
government spending is said to be very weak.
sense that it can fund investment, act as an
This is because the money used to fund it ‘must’
incentive to join the labour force, and increase
have been taken form the economy in the first
the productivity of workers through training.
place (e.g., taxation), therefore any initial
injection is technically merely reintroducing
money that was already there. Also, any
injection in the form of transfer payments has no
immediate impact so requires spending before it
is said to have affected the economy.
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3.2. Supply-Side Policies
Supply-side policies = This is any attempt by the government to increase the productive capacity of
the economy, by either:
1. Increasing the amount of resources available.
2. Raising the productivity/quality of existing resources.
3.2.1. Supply-Side Policies Shown in Diagrams
Any policy with the specific intention of increasing:
• The amount of resources in an economy.
• The efficiency/quality of existing resources in an economy.
• SS policies can be illustrated using a rightwards AS shift.
• The maximum capacity of the economy has increased
from Yf1 to Yf2.
• The same changes can be shown with PPF analysis.
• PPF1 initially represents the constraints to economic growth
– it cannot grow beyond A as there are insufficient resources
available.
• A SS policy causes an expansion of the PPF and allows the
economy to grow beyond A.
3.2.2. Supply-Side Policy Categories
•
Interventionist policies which specifically aim to overcome a type of market failure e.g. building a road boosts the AS curve with greater mobility of resources to reduce congestion (a type of
market failure). Interventionist policies are highlighted in orange.
•
Market-oriented policies which allow markets to function more efficiently by making them
more competitive as competition means more firms meaning more enterprise and more capital
spending. Market-oriented policies are highlighted in purple.
•
Many fiscal policies are also supply-side policies, these refer to any policies that use taxation
and spending in order to boost the AS curve. Fiscal policies are highlighted in the notes in blue.
Examples of supply-side policy:
1. Labour Market Incentives/Reforms
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The government can attempt to get more people to enter the workforce, perhaps encouraging the existing population to join or get new members:
•
Lowering income tax = With more money to earn, it may encourage more people to
join the workforce, such as single parents who may be reluctant to do so as they would need
to pay for childcare.
•
Decreasing welfare payments = If the incomes people receive form not working is
lowered, such as those on disability benefits, it may encourage more people to seek employment instead.
•
Encourage immigration = If more people move to a country the labour force is
boosted. This can be achieved by granting more work visas and making it easier to achieve
permanent residency.
•
Increasing the retirement age = if people have to work for longer the labour force is
increased.
The government can help improve the flexibility of the working environment so that firms can hire
more workers, and people who are unable to work strict 9-5 contracts can find work (and can encourage those who can only work a few hours a day to enter the workforce, such as parents). Examples
include:
•
Removing laws that make it difficult for firms to fire unproductive workers can encourage firms to hire more.
•
Giving greater rights to people on flexible working contracts so that more people are
encouraged to work.
•
Reducing the amount of pension contributions firms have to make towards each
worker so they can hire more.
•
Reducing trade union power, so firms are less at the mercy of the demands of workers, such as higher wages.
The government can help reduce the number of people struggling to find work by overcoming occupational immobility and funding the training of people, perhaps by paying firms to offer work experience, or paying for training courses to run. With more skills, the AS is boosted (more productive labour).
The government can help reduce frictional unemployment by increasing the amount of information
available for people without jobs, such as through job centres and government career websites, meaning it is easier for people to enter the workforce, and get the training they require to enter certain careers
The government can help reduce geographical immobility by making it easier for people to move to
locations where job vacancies exist, by placing rent controls so they can afford rented properties in
expensive areas, and ensuring all new housing estates must contain a certain % of low cost and council housing
2. Capital Spending
The productive capacity of the economy can be boosted by improving the UK’s infrastructure through capital government sending. The government can spend money on:
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•
An efficient transport network (motorways, railways, airport runways) so that less time taken
to transport materials, meaning output can rise. It also helps lower a firm’s costs, so there is more
money to spend on capital and training greater the level of output.
•
Funding more hospitals can reduce waiting times and potentially lead to a healthier, more productive workforce, with less output lost through sick days.
3. Capital Incentives
As well as the government, spending by private firms can boost the productive capacity of the economy. The government can encourage investment from firms by lowering rates of corporation tax,
meaning they have a greater level of profits to spend. This could also attract foreign firms to the UK
who may have been initially put off by the high tax rates.
4. Encouraging Entrepreneurship
If new firms are setup then this will mean there is more enterprise, as well as more spending on capital equipment. The government can help encourage entrepreneurship by:
•
Start-up grants and information to new firms to help new business owners overcome the early
hurdles.
•
Restrictions on monopoly power to reduce the likelihood that firms will block new entrants to
the market by lacing artificial ‘barriers to entry’ in place.
5. Privatisation
The government can sell any industries it is control of to the private sector, as they have the potential
to be more innovative and, with a profit incentive there should be more investment spending.
6. Deregulation
Rules in an industry often make firms more restrictive and raise their costs. Removing unnecessary
rules that firms face, such as concerning excess administration and paperwork they must complete,
can help to boost their productivity and encourage investment.
3.2.3. Overcoming Short-Run Conflict
•
Most SS policies initially trigger a boost in
AD e.g. a rise in government expenditure to build a
road will initially trigger a rightwards AD shift and actual
growth (Y1-Y2) but also lead to high inflation (PL1-PL2).
•
However, the eventual improvement will shift
AS right and help ease inflation (PL3) whilst also stimulating additional growth (Y3).
•
The SR conflict between growth and inflation has
been overcome.
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• SS policies at a time of recession and low growth
can make things worse.
• Initially the level of unemployment is equal to Y1-
Yf1.
• The boost to AS increased capacity but with
low confidence there is no real boost to AD.
• Firms will therefore need fewer workers if demand
has not really increased, leading to a larger unemployment level of Y2-Yf2, as well as deflation.
3.2.4. Positives and Negatives of Supply-Side Policies
Positives
Reduced unemployment when labour markets
are targeted as firms can hire more workers,
workers are able to acquire the skills they need
to fill existing vacancies, and people find it
easier to move to areas where job vacancies
exist.
Increased international competitiveness as
policies aimed at increasing firms profits and
funding investment should mean we have a
greater number of exports to sell.
Help reduce the budget deficit long-term as
whilst many require a cut in tax or increased
spending, the potential outcomes should help
boost revenues (more profitable firms so more
corporation tax) and cut spending (less people
requiring benefits) in the future.
Attract foreign investment as other countries
will see the improvements to the workforce and
the UK’s infrastructure as something that will
benefit them (less to send on training, lower
costs from better transport facilities) and so look
to setup in the UK.
Reducing the rich/poor divide as poorer people
have greater earning potential, plus it reduces
barriers to high paid careers as they are more
able to acquire the skills they need.
Reduce regional inequalities as people in
deprived areas are more able to fill job
vacancies, which means there is more spending
in these places, triggering more firms to locate
there, and an overall positive multiplier.
Negatives
Very costly for the government to fund
spending, and the benefits may not pay off e.g. a
train line may be built that few people end up
using.
There is the potential for government failure if
the information used to make the decisions is
not accurate or influenced by political bias.
Can increase unemployment if not matched by
demand, as firms may need fewer workers to
meet demand if they are more efficient.
Takes a long time for the outcomes of supplyside policies to emerge, and very often they are
not needed when they do
e.g. training unemployed people with specific
skills may take years, by which time the skills
may no longer be needed.
No guarantee of what firms spend money
on when we encourage them to invest with
higher profits, it may just lead to greater
dividends for shareholders, or the investment in
labour-replacing technology which leads to
long-term technological unemployment.
Reduce working environment as firms with
fewer restrictions in place may abuse workers,
and workers may be under increased pressures
to perform if they know that firms can easily
fire them if they wish.
May cause demand-pull inflation with the initial
injections of government spending and
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investment, which can be quite damaging if the
supply-side policies are used at a time of high
economic growth.
Overall, the effectiveness of supply-side policies may depend upon:
1. Accuracy of government information: the better the information the government is using, the
more likely the policies will be successful.
2. Time delays: the quicker the impacts can be seen, the less likely they are to become redundant.
3. State of the economy: supply-side policies tend to be more effective when an economy is growing
but with a fair amount of spare capacity, giving the policies time to work without triggering too much
inflation as they are being financed.
4. The response of the private sector: firms need to be confident to invest their extra profits and use
the opportunities to hire more workers rather than seek to replace them.
3.3. Monetary Policy
Monetary policy = This refers to the control of three money variables, including:
•
Interest rates = This refers to the reward people receive when they save, and the cost people
pay when they borrow.
•
The money supply = This refers to how much money is available in an economy and thus how
much there is available to spend – this will be explored in year 2, but in brief:
1. When the money supply increases there will be more borrowing, more consumption
and more investment, leading to a rise in the rate of economic growth.
2. When the money supply decreases there will be less borrowing, less consumption and
less investment, leading to a fall in the rate of economic growth.
•
Exchange rates = This refers to the value of the pound against another currency, this will be
explored in the final lesson of the unit.
The main aims of monetary policy:
•
Control the rate of inflation in an economy = This is done by manipulating aggregate demand,
so it remains between 1% and 3%.
•
Maintain sustainable economic growth = This ensures there is an equal balance between the
demand and the supply side of the economy.
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•
Maintain a stable exchange rate = This is done by trading in currencies, so the pound does not
fluctuate beyond an (unpolished) extreme rate.
Inflation that is too low can be seen as a sign of a stale economy. This:
•
Prevents firms from rewarding productive workers = It can be quite demoralising for workers
and can prevent skilled workers from moving to the UK.
•
Discourages spending and encourages saving = The real interest rate (nominal interest rate –
inflation) will usually be positive with low inflation.
•
Acts as a disincentive to look to improve products = If firms can’t charge more then they are
unlikely to invest in new and improved products.
•
Is unlikely to attract foreign investment = Low inflations suggests a stale economy, so
with few people spending domestically then firms from other countries will look elsewhere to invest.
•
Puts the country at risk of deflation = During deflation, consumption falls dramatically as
people wait for prices to drop even lower.
Inflation that is too high can be seen as being out of control. This:
•
Creates uncertainty = Firms may be unwilling to invest if they fear that rising prices
will eliminate demand for their products.
•
Erodes the value of savings = As the value of their money is falling, fewer people save so
there is less money for banks to loan out.
•
Makes those on fixed incomes significantly worse off = They cannot get a pay rise so will see
their incomes worth considerably less every month.
•
Creates worker unrest as pay demands rise = If their demand cannot be met it may lead
to strikes and firms closing down.
•
Discourages export sales = If our prices persistently rise then other countries will look to secure long-term deals elsewhere.
3.3.1. The Monetary Policy Committee (MPC) and Price Stability
Interest rates are controlled by a group of 9 people who form the ‘monetary policy committee’.
They meet every month and attempt to ‘predict’ any changes to inflation over the next 18 months/2
years.
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To do this they study changes in a variety of factors that are likely to affect AD, and decide that:
1. If aggregate demand is likely to rise significantly over the next 2 years, then the economy will
be at risk of a high rate of inflation. They will then pursue ‘contractionary monetary policy’ in an
attempt to reduce AD.
2. If aggregate demand is likely to rise slowly over the next 2 years, then the economy will be at
risk of a low rate of inflation. They will then pursue ‘expansionary monetary policy’ in an attempt
to boost AD.
3.3.2. Factors Affecting Monetary Policy
Factor
GDP
Bank lending
House prices
Wages
Employment
levels
Exchange
rates
International
data
Why it suggests high inflation
If GDP has risen by more than 2.5%
recently then resources are likely to
become scarce.
If this has risen it suggests more consumption and investment is taking
place.
Rapidly rising house prices will likely
be followed by a boost in demand
(wealth effect).
If real wages have been increasing,
then not only should demand rise but
also a firm’s costs.
If unemployment levels are falling it
suggests more confidence and more
consumption.
If the pound has been falling in value
then a rise in export sales are likely,
plus imports will become more expensive.
If major trading partners are experiencing growth, then a rise in exports is
likely.
Why it suggests low inflation
If GDP has risen by less than 2.5% recently then spare capacity is likely to
be rising.
If this has fallen it suggests less consumption and investment is taking
place.
Slowly rising house prices suggests
there is less risk of a wealth effect occurring.
If real wages have been decreasing,
then not only should demand fall but
also a firm’s costs.
If unemployment levels are rising it
suggests less confidence and less consumption.
If the pound has been rising in value
then a fall in export sales are likely,
plus imports will become less expensive.
If major trading partners are experiencing decline, then a fall in exports is
likely.
3.3.3. Contractionary (Tight) Monetary Policy
• Here the economy is over performing, and inflation is high –
perhaps 4%.
• Monetary policy will look to restrict demand and lower infla-
tion to below 3% by increasing interest rates.
• Once they do this, AD shifts to the left and the rate of infla-
tion is decreased.
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How does contractionary monetary policy conflict with other macroeconomic objectives?
Objectives supported
Lower prices means the value of savings is not
eroded so a rise in economic wellbeing.
As prices drop it can trigger demand for exports
and reduce a current account deficit.
With less consumption there will be less waste,
and the environment can improve.
Beneficial for regional inequalities as lower
spending power in these areas means they benefit more from lower prices.
Objectives conflicted
Will create unemployment as firms demand
fewer workers when AD falls.
The budget deficit may increase with more
spending on benefits and less taxes received.
Economic growth is restricted so we see a lower
rate of actual growth, and with less investment it
should be damaging to aggregate supply also.
Low-skilled jobs most at risk (retail, hospitality)
so can widen the rich-poor divide.
Other evaluations of contractionary monetary policy:
1. There is a large time lag between cutting interest rates and a drop in AD (often 2
years) as firms are unlikely to cut projects they are in the process of funding so will continue to
borrow, making it a limited tool in terms of reacting to high inflation.
2. It depends on the current rate of interest. If interest rates are already high (e.g. 5%), then raising interest rates further are unlikely to have much impact (as people seem happy to borrow at
high interest rates) – this is a form of the liquidity trap.
3. Does little to reduce cost-push inflation. Raising interest rates at a time of high inflation
should lower AD, but if the cause of inflation is higher costs, such as global oil prices increasing,
then higher interest rates will achieve nothing.
4. Effectiveness is limited due to regional inequalities. Areas of London are typically less affected by interest rates as the high levels of wealth and earnings mean they can continue to borrow at high interest rates, meaning demand is only likely to fall in poorer regions.
5. Cannot predict unforeseen events, such as the recent COVID pandemic, meaning interest
rates could have been increased if inflation was expected to rise, yet a huge fall in global demand
means inflation actually falls and the act of raising interest rates would have made things worse.
6. Cannot be targeted as interest rates are consistent across the country, meaning we may want
to lower demand in one area (perhaps an area in the south experiencing prosperity) but perhaps cannot if inflation is low in many other parts of the country.
7. An imprecise tool as the MPC cannot be certain the exact impact interest rates will have on
demand, only that is should fall – this means it could potentially cause AD to fall so much that we
enter a recession.
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3.3.4. Expansionary (Loose) Monetary Policy
Here the economy is under performing and inflation
is low – perhaps 0.3%.
Monetary policy will look to boost demand and
•
raise inflation above 1% by decreasing interest rates.
•
Once they do this, AD shifts to the right and the rate
of inflation is increased.
•
How expansionary monetary policy impacts on other objectives:
Objectives supported
Objectives conflicted
Should reduce unemployment as firms demand
Rising prices means the value of savings is bemore workers when AD rises.
ing eroded so a fall in economic wellbeing.
The budget deficit should decrease with less
As prices rise it can lower demand for exports and
spending on benefits and more taxes received.
increase a current account deficit.
Economic growth is encouraged so we see a
With more consumption there will be more waste,
higher rate of actual growth, and with more invest- and the environment should be negatively afment AS may be boosted also.
fected.
Low-skilled jobs most benefited (retail, hospital- Damaging for regional inequalities as lower
ity) so can reduce the rich-poor divide.
spending power in these areas means they are
more impacted by rising prices.
Other evaluations of expansionary monetary policy:
1. There is a large time lag between cutting interest rates and a rise in AD (often 2 years) as
many firms will wait for things to improve and for assurances that the recovery will be sustained
before funding investment projects, making it a largely ineffective tool for reacting to low inflation.
2. It depends on the current rate of interest. If interest rates are already low (e.g. 0.2%),
then lowering interest rates further are unlikely to have much impact (as people are likely to have
already taken out loans to meet their needs so are unlikely to borrow more) – this is a form of
the liquidity trap.
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3. Depends highly on confidence. Cutting interest rates at a time of low confidence is unlikely to
trigger a surge in demand for loans as people are wary of getting into debt. Confidence is more
likely to be low during low economic growth, which is precisely the time that interest rates will be
cut to boost demand.
4. Can lead to debt-fuelled growth, which can be problematic if unemployment rises and people
lose their homes as they cannot afford repayments. It also suggests short-lived growth, as there is
often a huge rise in demand for loans, then the demand immediately falls as all borrowing demand
have been met, and there’s only so many things people need loans for.
5. Depends on the behaviour of banks. Lower interest rates will only trigger a rise in demand for
loans, it doesn’t guarantee the loans will be approved. Banks that are low on funds may have little
to lend out, so lower interest rates may have little effect on borrowing.
6. Cannot be targeted as interest rates are consistent across the country, meaning we may want
to boost demand in one area (perhaps an area in the north suffering from regional decline) but
cannot if inflation is rising rapidly in another part of the country.
7. An imprecise tool as the MPC cannot be certain the exact impact interest rates will have
on AD, once rapid inflation.
3.3.5. The Transmission Mechanism of Monetary Policy
The process by which a change in interest rates eventually leads to a change in aggregate demand is
referred to as the ‘transmission mechanism’. It has a series of steps:
Lowering interest rates
Raising interest rates
The Bank of England lowers its base rate of inter- The Bank of England raises its base rate of interest.
est.
Commercial banks follow by lowering also.
Commercial banks follow by raising also.
1. Demand for consumer loans increases and
1. Demand for consumer loans decreases and
fewer people save.
more people save.
2. Firms look to invest in anticipation of
2. Firms cut investment in anticipation
higher demand.
of lower demand.
3. More people look to buy assets and their
3. More people look to sell assets and their
value increases, triggering a wealth effect.
value decreases, triggering a negative wealth
effect.
4. Fewer people save in UK banks and de4. More people save in UK banks and demand for currency falls, triggering a weaker
mand for currency rises, triggering
currency.
a stronger currency.
Aggregate demand shifts right (more consumpAggregate demand shifts left (less consumption, more exports, more investment).
tion, less exports, less investment).
Firms require more workers and people work
Firms require fewer workers and people
longer hours, triggering higher wages.
work shorter hours, triggering lower wages.
Resources become increasingly scarce and prices Spare capacity increases and prices fall (deflarise (inflation).
tion/disinflation).
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Why is monetary policy seen as an effective tool?
•
What can make monetary policy useful is that the rate of interest can be adjusted on a regular basis in accordance with the demands of the economy. This means that the policy is
not restricted to certain times of the year, unlike fiscal policy, and can therefore be called
upon whenever required.
•
The policy can be sustained for a long period of time without having to be changed. The
recent cut in interest rates to 0.5% was maintained for almost a decade until unemployment levels fell to a sufficient level. This means the policy can be useful when giving
firms confidence as they can be informed that low interest rates will be maintained for the
near future so they can expect long periods of increased demand through borrowing.
•
The policy is not a particularly costly one for the government as it merely involves the
changing of interest rates. This means it can be used during periods of high budget deficit
without making matters even worse.
•
The MPC, the group of individuals that make the decisions, is independent from the government in the sense that it cannot be influenced by them to make them look good. This
means that the policy is less likely to be geared towards political self-interest and more
likely to be successful in its economic aims as a result.
•
With the exception of extreme changes in global costs and a need to boost economic
growth after the recession, inflation has been maintained at fairly stable rate for the past
few decades, suggesting it has a proven track rate of success.
3.3.6. The Bank of England (BofE)
Bank of England (BofE) = This is the UK’s Central Bank and the institution through which monetary
policy is decided upon and enforced. Its key responsibilities include:
1. Setting interest rates
2. Influencing exchange rates
3. Determining the money supply
The additional that the Bank of England are:
1. Acting as a ‘lender of last resort’ to commercial banks – if banks need to borrow money to
meet a sudden surge in demand for withdrawals, the BofE can lend them money at the base rate of
interest to avoid the panic that would result if the bank were unable to meet demands for withdrawals.
2. Storing money for commercial banks – ‘the bank for the banks’ – banks with excess cash (liquid money) can store money in the BofE and earn interest on it. This usually happens during a
time of high interest rates when demand for loans is low and savings are high.
3. Loaning money to the government to help meet its budget – this occurs when the government
cannot raise sufficient funds to cover its spending from other sources (e.g. treasury bonds).
4. Attempting to influence the exchange rate through the purchase of currency – typically to
maintain the high value of the pound that helps us to purchase imported products so cheaply.
5. Controlling the amount of money in the economy at a point in time – usually by influencing
the amount of money that banks can loan out.
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6. Designing and issuing bank notes in England and Wales (not coins) – currently there are £71
billion of bank notes in circulation.
7. Monitoring and regulating the UK financial system and ensuring financial institutions are behaving accordingly – the BofE can fine banks that are not following their strict code of conduct.
8. Storing and securing the UK’s gold reserves – with over £200bn, the US fed reserve bank is
the only bank with more gold than the BofE.
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