Macroeconomic Essay
Prepared for Christina
May 2023
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List of Questions
1. Using the data and your own knowledge, evaluate the effectiveness of
monetary policy in achieving macroeconomic stability in the UK. (25) 3
2. Discuss the view that achieving full employment will inevitably cause
trade-offs with other macroeconomic objectives. (25) 5
3. Evaluate whether economic growth will reduce poverty? 7
4. Compare the effectiveness of supply side and demand side policies to
correct deficits on a country’s current account of the Balance of Payments
(25) 10
5. Assess the economic effects of a significant increase in taxation on the UK
economy (25) 11
6. Discuss the impact of globalisation on UK economy (25) 13
7. Both the UK and US balance of payments accounts are recording large
deficits on their trade in goods balance. Do such deficits matter? (25) 15
8. Explain how countries benefit from international trade even though they
may produce similar goods and services. [10] 17
9. Discuss the factors that determine the trade competitiveness of the UK
economy. (15) 17
10. Discuss the importance of promoting free trade through organisations
such as the WTO (25) 18
11. A Government is faced with an unacceptably high level of unemployment,
but does not wish to increase its overall expenditure. Discuss alternative
policies for reducing unemployment. (25) 20
12. Explain possible economic reasons for government borrowing. (10) 22
13. Evaluate the possible problems for the UK economy of increased
government borrowing. (25) 23
14. Explain possible causes of economic growth. (10) 25
15. Evaluate the potential impact on the economic growth of the UK
economy if it were to adopt the single European currency. (25) 27
16. Discuss policies to reduce inflation (25) 28
17. Evaluate the impact on UK macroeconomic performance of a sustained
rise in the value of the Pound against the dollar and Euro (25) 30
18. Evaluate the possible consequences of a falling rate of inflation for the
performance of the UK economy. (25) 32
19. Discuss the impact of an increase in interest rates (25) 34
20. Discuss how the government might improve the UK’s long term
economic growth. 36
21. Discuss factors that may limit economic growth rates in different
countries. (25) 38
22. Discuss the problems an economy might face in recovering from a period
of recession? (25) 40
23. Assess the impact on UK macroeconomic performance of a prolonged
period of deflation. (25) 42
24. Evaluate market-based and interventionist policies for promoting
economic development (25) 44
25. Evaluate whether the receipt of remittances benefits developing
economies. 46
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1. Using the data and your own knowledge, evaluate the effectiveness
of monetary policy in achieving macroeconomic stability in the UK.
(25)
Graph 1
Graph 2.
Monetary policy involves attempts to control and influence the money supply and
demand for money. The main tools of monetary policy are changing base interest
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rates and also other policies such as quantitative easing. Monetary policy is operated
by the Bank of England and seeks to meet the government’s objectives for
macroeconomic stability. This involves meeting an inflation target of CPI 2% +/-1. It
also involves maintaining a stable and sustainable rate of economic growth and
achieving a low rate of unemployment. Macro-economic stability can also involve a
stable exchange rate and a manageable current account deficit.
Since the early 1990s, monetary policy has been relatively successful in keeping
inflation low and close to the government’s target of 2%. When inflation rises above
the government’s target, the Central bank can increase interest rates. A modest rise in
interest rate can help to reduce inflationary pressure. This is because higher rates
increase the cost of borrowing and discourage firms from investing. Higher interest
rates also increase the cost of mortgage payments and loan repayments – leading to
less disposable income for households and therefore, households tend to cut back on
consumer spending. This slowdown in consumer spending reduces the rate of
economic growth and therefore reduces demand-pull inflationary pressures.
Since 1992, the UK has avoided the boom and bust cycles which characterised the
late 1980s when inflation rose to nearly 10%. The independent Central Bank has,
therefore, gained a reputation for keeping inflation under control. The independence
from political pressures means people in the economy have more confidence that
inflation will be low. This helps to reduce inflationary expectations and this makes the
job of achieving low inflation easier.
Graph 2 shows that there have been times when the UK has had inflation above the
government’s inflation target, e.g. in 2008 and 2011. This inflation was due to costpush factors – rising oil prices, rising taxes and devaluation, causing rising import
prices.
On the one hand, this inflation of 5%, suggests that monetary policy is not guaranteed
to keep macro-economic stability. Due to circumstances beyond its control, inflation
rose above the target; monetary policy is ineffective for both solving cost-push
inflation and keeping the economy growing. However, on the other hand, the Bank’s
decision to allow temporary cost-push inflation could be seen as the best way of
achieving macro-economic stability due to more difficult external circumstances. If
the Bank had tried to reduce inflation – it would have caused lower rates of economic
growth.
The other element of macroeconomic stability is avoiding recession and maintaining
economic growth close to the long-run-trend rate of 2.5%. Graph 1 shows that from
1997 to 2007, economic growth was positive and averaging around 0.75% per quarter
or 3% per year. However, in 2008/09, the UK economy went into a deep recession. At
this time, the Bank of England cut interest rates drastically to 0.5%. In theory, lower
interest rates should boost aggregate demand. With cheaper borrowing costs, firms
will find it more profitable to invest, and consumers will be more willing to take out
loans and spend. However, despite a small recovery in 2010, the economy remained
stagnant in 2011. This suggests that monetary policy alone may be insufficient to
ensure a return to normal growth. In this period, there was still a credit crunch with
banks unwilling to lend. Confidence was also very low, so even though it was cheap
to borrow, consumers and firms were reluctant to take out loans. Also in 2011, the
government pursued fiscal austerity (cutting government spending) so this counter4
acted the effect of monetary policy trying to increase aggregate demand. This shows
that monetary policy alone, may not be sufficient to ensure stable economic growth.
A difficulty of monetary policy is the limitations of achieving several objectives at
once. In the lead up to 2007, there was a boom in house prices and bank lending.
However, inflation stayed relatively low. Therefore, monetary policy did not increase
interest rates – the Bank are focused on keeping inflation at a target of 2% - the Bank
of England can not deal with a boom in asset prices and bank lending through
monetary policy and interest rates alone. This requires a different type of intervention,
e.g. building more houses to deal with a shortage in supply or regulations to limit the
lending of banks.
In conclusion, monetary policy has been fairly successful in keeping inflation close to
the government’s target of 2%. However, it is only one aspect of economic stability –
instability in the banking sector was a cause of the 2008 recession and slow recovery.
In this regard, monetary policy is limited in its ability to prevent an asset bubble and
to ensure a quick economic recovery.
2. Discuss the view that achieving full employment will inevitably
cause trade-offs with other macroeconomic objectives. (25)
Full employment is a situation where everyone who wants employment is able to
work; in practice there will only be a small amount of frictional unemployment of say
3%. Full employment also means that the economy is operating close to the
production possibility frontier – there is no spare capacity in the economy, e.g. firms
working close to full capacity.
If full employment is achieved by increasing aggregate demand, then it is likely that
the economy will experience inflation. As the economy reaches full employment,
firms face a shortage of workers and so have to increase wages to attract workers to
take jobs; this wage inflation leads to higher costs and higher spending – two factors
that lead to inflation.
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Initially, the increase in AD doesn’t cause much rise in prices. But, at Y3 (where the
economy is near full employment, a rise in AD, causing a rapid rise in prices from P3
to P4.
However, this model of economic growth implies that AD is increasing faster than
LRAS. However, in theory, it is possible to have both an increase in aggregate
demand and long-run aggregate supply. If productive capacity meets the growth in
aggregate demand, then the economy can achieve full employment without inflation.
This simple AD and AS diagram shows economic growth without inflation.
A key factor is the rate of economic growth compared to the sustainable rate of
growth. If there is a burst in economic growth, then there may be a rapid fall in
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unemployment. However, if demand is growing at 5% a year, but LRAS is increasing
at 2.5%, then this will cause inflationary pressures. Therefore, if economic growth is
close to the sustainable rate, then the economy can get close to full employment
without inflationary pressures. If there is cost-push inflationary pressures or low
productivity growth, then it is harder to achieve full employment without inflation.
However, if productivity growth is high and cost-push inflation low, then it will be
more likely to occur.
As the economy reaches full employment, there is also likely to be a trade-off with the
current account on the balance of payments. With a rise in consumer spending and
AD, there is likely to be a rise in imports. With domestic inflation, consumers will
prefer to buy cheaper goods from abroad, leading to a rise in imports and deterioration
in the current account on the balance of payments.
However, it depends on the nature of economic growth. If the economy reaches full
employment through the expansion of the export sector and investment-led growth,
then it is possible to achieve full employment without a deterioration in the current
account. For example, export-led economies such as Germany and China have
frequently achieved high rates of economic growth with a current account surplus.
The UK is more prone to a current account deficit because in the UK there is a high
marginal propensity to import. When incomes rise, there is a bigger percentage rise in
demand for foreign goods.
If the economy grows, and gets close to full employment level – reducing the negative
output gap, then we would expect unemployment to fall. Higher output leads to more
demand for workers. Therefore, unemployment should fall and we should get an
unemployment rate of close to 3%. However, if there is structural unemployment,
then no matter what the rate of economic growth – there will be unemployment
persisting. For example, if unskilled workers are made redundant, they may be unable
to take jobs, because they lack the relevant qualifications. In this case, to achieve full
employment will need supply-side policies to solve the structural unemployment and
enable a fall in the natural rate of unemployment.
In conclusion, it is possible to achieve full employment without trade-offs of other
macro-economic objectives, however, it requires a certain type of economic growth.
The growth needs to be sustainable and not inflationary – in particular, the economy
needs improvement in productivity, flexible labour markets and an ability to increase
output without causing shortages. If we get this productivity led growth, then
unemployment can fall, government borrowing can fall and the economy will reduce
the negative output gap without inflation and a current account deficit. But, if there
are structural inflationary pressures, then achieving full employment can cause tradeoffs – such as inflation.
3. Evaluate whether economic growth will reduce poverty?
Economic growth is an increase in real output, measured by real Gross Domestic
Product (GDP). As well as an increase in national output, economic growth also
means an increase in national income and national expenditure. There are two main
forms of poverty – absolute and relative. Absolute poverty measures a level which is
the minimum necessary to maintain a basic standard of living. Absolute poverty could
be defined as a situation when people survive on less than $2 a day. If people have
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less than $2 a day, they may struggle to meet the basics of food, accommodation and
clothing. Economic growth is highly likely to reduce absolute poverty. If there is a
consistent increase in average incomes, you would expect more people to earn more
than $2 a day. Also with economic growth, the government should be able to gain
more tax revenues to be able to spend more on social spending which in the long term
can help to reduce poverty.
Graph showing fall in absolute low income (same concept to absolute poverty) in UK
However, it is possible that economic growth fails to reduce absolute poverty. But it
would require an increase in national income that does not lead to any benefit or
higher income for the poorest. For example, if an economy saw a rise in incomes for
the richest but not the poorest – then levels of absolute poverty would remain the
same. It is unlikely that a prolonged period of economic growth would have no effect
on levels of absolute poverty. Usually, economic growth will lead to a rise in incomes
for the poorest – even if levels of inequality remain. Economic growth in China, India
and other Asian economies has definitely reduced levels of absolute poverty in the
past 50 years.
Relative poverty is more complicated. Relative poverty is measured by those with
incomes less than a percentage of average incomes. For example, relative poverty
may be defined as an income of less than 50% of average incomes. If average national
income was $10,000. Then relative poverty would be an income of less than $5,000.
With relative poverty, the definition is constantly changing. If there is economic
growth and average incomes rise, then so will the definition of relative poverty. If
average incomes rise to $12,000 a year, then relative poverty defined as 50% of
average incomes, will now be incomes less than $6,000. Therefore, if incomes are
evenly spread out and there is no change in the equality of distribution, you would
expect economic growth to have no effect on relative poverty.
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It is possible that economic growth could lead to an increase in relative poverty. If
economic growth is based on increased demand for skilled labour, then unskilled
workers may see little increase in pay and get left behind. Another possibility would
be if there were economic growth but a rise in structural unemployment. Those who
were unemployed would fall in the category of relative poverty – despite the
economic growth which benefits higher income earners.
However, it is equally likely that economic growth could cause a fall in relative
poverty. Economic growth is more likely to reduce unemployment. With higher
output, firms demand more workers and therefore employment rises. Gaining
employment is the biggest single factor which is likely to lift people out of poverty.
Income from a job is significantly more than receiving unemployment benefits,
therefore, relative poverty is likely to fall. Also, with economic growth, the
government may feel more inclined to pursue a more progressive tax and benefit
system. With rising incomes, high income earners will pay more progressive income
tax (e.g. UK higher rate of 50%), this income can then fund welfare payments to those
on low incomes (e.g. unemployment benefits). Developing economies often do not
have the luxury of having a welfare state. A prolonged period of economic growth can
give the country the confidence to have a greater welfare state. In the first seven
decades of the Twentieth Century, many western economies, such as the UK, US and
western Europe, saw a decline in relative poverty as economic growth led to higher
paid jobs for working people and the implementation of more progressive tax and
benefit systems.
However, these gains in reducing inequality were often offset in the 1980s, 90s and
00s. Globalisation, increased demand for skilled labour and decline of manufacturing
industries (with well paid manual jobs) and decline of trade unions, has seen a
stagnation in pay for those on low incomes – meaning the benefits of economic
growth are less fairly distributed and so in some cases relative poverty has increased.
Relative poverty in UK
Rise in relative poverty in 1980s.
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4. Compare the effectiveness of supply side and demand side policies to correct
deficits on a country’s current account of the Balance of Payments (25)
A current account deficit means the country imports a greater value of goods, services
and investment incomes than it exports. To reduce a current account deficit we need
to either increase the value of exports and or reduce imports.
Supply side policies aim to increase the productivity of the economy. If the
manufacturing sector becomes more productive, the relative cost of British goods will
fall and therefore they will become more competitive. This will help increase exports
and reduce the current account deficit. For example, the government could increase
spending on education and training. Vocational training schemes may help increase
labour productivity because workers will have more skills. A more productive
workforce can improve the competitiveness of UK exports. Alternatively, the
Government could introduce a free market supply side policy such as reducing the
power of trades unions. If unions are powerful, productivity may be lower due to
frequent strikes and disruptive working practises such as working to rule. If union
power is reduced it helps reduce time lost to strikes, increases labour market
flexibility and therefore should help increase UK exports.
A third supply side policy could be increasing labour mobility. The nature of the UK
housing market means that it is often difficult for workers to move to areas where jobs
are available. Greater provision of cheaper rented accommodation would make the
labour market more flexible and help increase the competitiveness of firms.
The problem of supply side policies is that they will take time to have effect. For
example, spending on education and training may take several years before the effects
are noticed. Also, there is no guarantee that education spending may actually increase
labour productivity, especially if the money is misspent or the workers don’t want to
learn.
Also in the UK, trades unions are no longer very powerful, so this policy would only
have limited impact. Also, some argue trades unions can actually help introduce new
working practises and thereby increase productivity. Therefore reducing union power
in the UK would unlikely have any significant impact on improving the current
account deficit.
Current account deficits often occur during times of economic growth and therefore
high consumer spending on imports. Fiscal policy can be used to reduce consumer
spending and therefore reduce demand for imports. For example, higher income tax
would reduce consumer’s disposable income and therefore reduce imports. In the UK,
consumers have a high marginal propensity to import (people spend a high % of extra
income on imports), therefore, a reduction in disposable income would have a big
impact in reducing import spending.
Deflationary fiscal policy would also reduce inflation and thereby help to make UK
goods more competitive.
However, the problem with using fiscal policy is that it will conflict with other
macroeconomic objectives. Higher taxes will reduce growth and could cause
unemployment. Furthermore, unemployment and growth are considered more
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important than the current account deficit. Also fiscal policy doesn’t address the
fundamental underlying problem, which is a lack of competitiveness. This needs to be
addressed through supply side policies.
Another way to deflate the economy and reduce consumer spending is to increase
interest rates. (monetary policy). Higher rates would increase cost of borrowing and
discourage consumer spending, however, higher rates would cause an appreciation in
the exchange rate – this would make exports more expensive and imports cheaper –
the exchange rate effect would be to worsen the current account (assuming demand is
relatively elastic) Therefore, to improve a current account deficit through demand side
policies – fiscal policy would be better because it doesn’t affect the exchange rate,
however using fiscal policy may be politically unpopular – e.g. difficulty of
increasing taxes just to reduce a current account deficit.
It also depends on the type of current account deficit. If the deficit is a persistent trade
deficit due to a lack of competitiveness then this needs supply side policies to increase
productivity. If the current account deficit is the result of a consumer led economic
boom, then fiscal policy can be effective in reducing the economic boom and reducing
import spending.
5. Assess the economic effects of a significant increase in taxation on
the UK economy (25)
An increase in taxation would affect both aggregate demand (AD) and Aggregate
Supply (AS).
If tax was increased, but spending remained the same, it is likely that aggregate
demand would fall. For example, an increase in income tax would reduce the
disposable income of consumers and cause a fall in aggregate demand and therefore
lower growth (Y1 – Y2)
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However, it depends on the state of the economy. If the economy was in a boom, and
the economy was growing above the long term trend rate, an increase in taxes would
help reduce inflation without causing a recession.
If the economy was at Y1, a fall in AD from AD1 to AD2 would reduce inflation
without much decline in Real GDP. But, a fall in AD from AD3 to AD 3 would lead
to a big fall in GDP.
Also, the impact of higher taxes may vary due to several factors. For example, if
consumer confidence is very high, an increase in taxes might not reduce consumer
spending very much because consumers may simply borrow more.
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If an increase in tax was met by an equivalent increase in government spending then
AD may not change. Higher taxes lower AD, but higher government spending
increases AD. Therefore, the impact on growth and inflation would be neutral.
The supply side effects of higher taxes are disputed. Some argue that an increase in
income tax reduces the incentive for people to work because the take home pay is
reduced. However, income tax in the UK is quite low - 22%, therefore a moderate
increase may not reduce incentives to work because the income effect (people need to
work more to maintain a certain income) counters the substitution effect. An increase
in VAT or excise duties would not effect incentives to work, but, it could affect
demand for goods which are heavily taxed.
If indirect taxes (VAT and excise duty) are increased it is likely to reduce income
equality. Excise duties tend to be regressive (people on low income pay a higher % of
income). However, if the government increased income tax it may improve the
distribution of income. Income tax tends to be more progressive – it takes more tax
from those on high incomes.
Some argue higher tax and spending could cause a more inefficient economy. This is
because it is argued the government is more inefficient at spending money than the
private sector. However, others argue the government can overcome market failure
such as spending on public transport and education. It depends on what and how the
extra tax revenue is spent. If extra tax is used to invest in new infrastructure – it could
boost long-term productive capacity.
Higher taxes will enable a reduction in national debt and therefore lower debt interest
payments in the long term. This could be important for a country facing a high level
of government borrowing to GDP.
Comment: This question is quite open ended. Does higher tax mean higher government
spending? What kind of tax is increased? It is easy to get evaluation marks by considering
different possibilities.
6. Discuss the impact of globalisation on UK economy (25)
Globalisation is hard to precisely define, but it involves the increased integration and
interdependence of economies throughout the world. The process of globalisation has
led to increased trade, increased inward investment and greater communication.
Globalisation has led to an increased mobility of labour and capital between different
economies. There has also been an increased role for multinational corporations and
international bodies such as the IMF.
Globalisation has been characterised by an increase in international trade. This has
created several benefits for the UK. The law of comparative advantage states that
there will be an increase in economic welfare if countries specialise in the goods
where they have a lower opportunity cost. Globalisation has enabled a reduction in
tariffs and transport costs leading to cheaper imports. This increases the consumer
surplus of UK consumers. It has also enabled a wider choice of goods and services;
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for example, supermarkets are now able to stock a wide range of fruit and veg
throughout the year.
However, although globalisation gives a greater choice of goods and services, some
have criticised globalisation for an increased homogeneity of products. Critics argue
multinational corporations have been able to dominate, leading to big multinationals
pushing out smaller independent retailers to the detriment of local firms. For example,
the growth of coffee chains like Starbucks has made it more difficult for smaller
independent coffee shops. But, others may say globalisation isn't really to blame for
the decline of small shops, it may be due to other factors like out of town shopping
centres; also small shops can still exist even with process of globalisation.
Globalisation has enabled firms to benefit from greater economies of scale. Due to
globalisation, production is increasingly specialised; for example, the manufacture of
a car has increasingly been split up into different countries so that different parts of
the car are assembled in different countries. This process of increased specialisation
and economies of scale have enabled lower average costs of production leading to
lower prices for UK consumers.
Another benefit of globalisation is that it has increased the competitiveness of certain
markets. For example, domestic monopolies now face competition from firms in other
countries. This increased competitiveness has helped lower prices for consumers. A
potential drawback of this increased competitiveness is that some British firms have
become uncompetitive and closed down leading to job losses. For example, British
industry has struggled to remain competitive against countries such as China, which
benefit from lower wage costs. This has led to a decline in textiles and other
manufacturing sectors in the UK. This is reflected in a persistent UK trade deficit.
This decline in manufacturing output has also led to some structural unemployment,
especially amongst the low skilled manual workers in the UK.
However, this process of changing industries is not a new phenomenon and whilst
globalisation has led to the decline of some industries, it has also led to the growth of
others. For example, the UK has increasingly specialised in financial services and
higher education. Therefore, whilst some sectors have lost from globalisation others
have benefited.
Another feature of globalisation is the increased mobility of capital and labour. For
example, the UK has experienced net migration of workers from Eastern Europe.
These workers have often undertaken low paid jobs that British workers have been
reluctant to do. This process of migration helps to make the UK labour market more
flexible; it has helped fill shortages in sectors such as nursing. However, the migration
of labour has created other impacts. People fear it has led to shortages of housing in
places like London; politicians are under pressure to place caps on migration
numbers.
Another feature of globalisation is the increased integration of the world economy. It
means monetary policy decision in Europe and the US can easily impact the UK
economy. Because the UK is an open economy, a recession in the EU and US is likely
to impact the UK economy. This has both positive and negative effects. When the rest
of the world is growing, the UK benefits from growth in trade; when the rest of the
world enters recession or suffers a credit crunch it effects the UK economy. The
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fortunes of the UK economy are increasingly tied to the rest of the world, especially
the EU where most of our trade occurs.
Because globalisation is quite a vague concept, it is sometimes hard to pin down
exactly its effects. In a way globalisation has always been with us, since trade began.
But, overall the increased globalisation of the world economy, means the UK
economy is increasingly affected by events in other economies.
Comment. This question is quite open ended because globalisation has many different
aspects such as trade, capital / labour mobility, multinationals e.t.c. The examiner
won’t expect a comprehensive answer which covers everything to do with
globalisation. However, to avoid common exam mistakes, it is important to:
• Mention both advantages and disadvantages of globalisation.
• Make sure you specifically say how globalisation affects the UK economy.
Don’t just talk about globalisation in general.
7. Both the UK and US balance of payments accounts are recording
large deficits on their trade in goods balance. Do such deficits
matter? (25)
Graph 1
A deficit on trade in goods mean the countries are importing a greater value of goods
than they are exporting. Firstly, a deficit on trade in goods, usually implies a current
account deficit. However, if the deficit in goods was offset by a surplus in services, it
would be much less of a problem because there wouldn’t be a current account deficit.
It is argued that a trade deficit is damaging to the economy. Firstly, it indicates a lack
of competitiveness in the economy. It means consumers are preferring to buy imports
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rather than domestic production. Secondly a deficit on the current account means that
the country requires a surplus on the financial account (used to be called capital
account). This could involve short term capital inflows from abroad which might dry
up. E.g. the US has financed a current account deficit by attracting capital inflows
from China. This makes the US vulnerable to China withdrawing its dollar holdings.
However, a trade deficit could be financed by encouraging long term investment such
as a Japanese firm building a factory in the UK, this has benefits to the UK economy
such as greater investment and job creation.
A deficit on the goods account can cause a depreciation in the currency. This is
because more currency is flowing out of the economy than coming in. The US has
recently had a current account deficit of over 5%, during this period the US dollar
depreciated significantly as the US struggled to finance the deficit. A depreciation in
the exchange rate could lead to inflation as imports become more expensive.
However, others argue a goods deficit is not a matter of concern. They argue that in a
modern economy, capital flows can more easily finance the deficit. For example,
Chinese investors have been willing to purchase US securities and effectively finance
the US deficit. If there weren’t the capital flows, the currency would devalue and help
to reduce the deficit. A devaluation is not necessarily a bad thing. In the US, the
depreciation in the dollar helped to boost exports and avoid a recession. However, a
depreciation is a bad thing if it causes inflation.
Graph 1 shows the UK has had a persistent current account deficit since 1987 (despite
a short period of surplus) However, the persistence of the current account deficit
suggests that it is not a matter of immediate concern. The UK’s current account deficit
is matched by a surplus on the capital/financial account. Capital flows (e.g. saving in
UK banks or foreign direct investment) are enabling the UK to run a current account
deficit. This is not necessarily a problem so long as foreign capital flows continue to
enter the UK. If capital flows dried up – it would be a problem as it would likely
cause a depreciation in the exchange rate to make UK goods more competitive.
A deficit in the goods account may indicate the economy is growing too quickly.
Because insufficient domestic goods are being produced, people buy from abroad. It
also indicates an unbalanced economy. The UKs largest current account deficit was in
the late 1980s – a time of economic boom and rising inflation. Countries with trade
deficits typically have a low savings ratio and a high rate consumer spending. This
suggests they have a low rate of investment and are enjoying higher GDP now at the
expense of long term investment in the economy.
However, you could also argue a goods deficit is the sign of a strong economy –
better than having a large surplus but sluggish growth. For example, Japan has had a
large trade surplus in the 90s and 00s, but this was due to slow growth and the fact
consumers were reluctant to spend.
To get a better idea about the state of the economy, it is important to look at other
variables such as inflation, economic growth and unemployment. If the UK economy
has a current account deficit, but is recording low inflation, high growth and full
employment – this suggests the economy is doing very well. However, if there is a
current account deficit and rising inflation – this suggests the economy is unbalanced.
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8. Explain how countries benefit from international trade even
though they may produce similar goods and services. [10]
The law of comparative advantage states that there will be a gain in economic welfare
if countries specialise in producing goods with a lower opportunity cost. Even if the
difference is quite small, producing goods with a lower opportunity cost enables
greater efficiency and scope for trading. Domestic exporters will benefit from greater
sales increasing employment in these sectors. Consumers will benefit from a greater
choice and lower price of imports.
Through specialising in producing certain goods and services there will also be further
economic advantages. For example, by specialising in producing a good like cars and
aeroplanes, firms will be able to benefit from economies of scale. In industries with
high fixed costs, specialisation enables lower average costs and more efficient
production. Ultimately, consumers benefit from lower prices.
Specialisation can also enable goods to be produced in several different countries. For
example, producing cars is not just confined to one country. Tyres may be made in
one country and fitted in another with low labour costs.
International trade also opens up domestic monopolies to international competition.
This increase in competition helps to cut costs and keep prices low. For example, the
UK may have one car manufacturers. Without trade it would have a monopoly, but,
with international trade, the market is relatively competitive.
9. Discuss the factors that determine the trade competitiveness of the
UK economy. (15)
The trade competitiveness refers to the relative export prices of the UK compared to
other countries.
The exchange rate plays an important role in determining the short term
competitiveness of an economy. For example, an appreciation in the exchange rate
makes exports more expensive and therefore less competitive. However, in the long
term an exchange rate may appreciate because a country is becoming more
competitive and therefore people demand more of the currency. A depreciation in the
exchange rate will give a boost to competitiveness because exports will become
cheaper. However, a depreciation may reduce incentives for firms to cut costs.
Therefore, in the long term inflation may rise and competitiveness declines. This is
why often the exchange rate affects competitiveness in the short term.
Labour costs play an important role in determining competitiveness, especially in
labour intensive manufacturing goods. For example, the past two decades have seen
China become the most competitive manufacturer because of low wage goods.
However, labour costs are not the only factor to consider. As well as labour costs, it is
important to bear in mind labour productivity. For example, some goods require
17
skilled labour, for these goods the education, skills and productivity of the workers is
more important than their basic wage.
The infrastructure of a country plays an important role. Good transport links and
networks help to reduce the cost of exporting goods. For example, a landlocked
country is at a significant disadvantage when it comes to exporting goods. Quality of
Goods is another factor that determines trade competitiveness. Countries which can
add a high value added to goods, will be able to sell more goods. Price is not the only
factor in determining sales of exports.
10. Discuss the importance of promoting free trade through
organisations such as the WTO (25)
Free trade involves removing all tariffs on trade between different economies.
Supporters of free trade argue there are many economic benefits for all countries
involved in free trade. The World Trade Organisation exists to help promote free trade
and provide a forum for countries to resolve trade disputes and promote free trade.
However, critics argue free trade can actually create disadvantages, especially for
developing economies.
If tariffs are removed, there will be an economic advantage. Firstly, consumers will
see a reduction in price and increase in consumer surplus (1+2+3+4). Some domestic
exporters will lose out (1). The government will also lose some tax revenue (3).
However, the diagram below shows that overall there will be an increase in economic
welfare of areas 2+4.
Diagram of Trade Creation
18
In addition, an economy will benefit from greater exports in the areas where the
country has a comparative advantage (can produce goods at lower opportunity cost).
Although free trade may lead to a decline in some industries, other industries will
grow and compensate for this. This is a more efficient allocation of resources. For
example, the UK has seen a decline in its clothing industry because of cheaper
competitors in China. However, it has benefited from growth in financial services.
Free trade also enables firms to specialise and benefit from economies of scale. This
is important for industries with high fixed costs such as automobiles and aeroplane
manufacture. The greater economies of scale will lead to lower costs and lower prices
for consumers.
Free trade also helps to promote competition. With tariffs a domestic monopoly may
be protected from international competitors. However, if tariffs are removed it will
have a greater incentive to cut costs and become more efficient to remain competitive
and stay in business.
For these reasons free trade has been an important engine of growth and has enabled
many developing economies, especially in the Far East to see an increase in living
standards and economic development.
However, despite the advantages, free trade also has some drawbacks. Firstly, some
developing economies may struggle to remain competitive if tariffs are reduced. Some
economies may have a comparative advantage in producing primary products (e.g.
Food). However, they may have good reasons to try and develop a better
manufacturing base. However, to develop a manufacturing industry they may struggle
to remain competitive against foreign competition in the short run. Tariffs enable a
new (infant) industry to sell to the domestic market before facing international
competition. After a few years of tariff protection, when the industry has developed, it
may be OK to remove these tariffs.
Without tariffs to protect infant industries, developing economies may be unable to
diversify their economy. If an economy relies on one foodstuff, the economy may be
subject to fluctuations in foreign earnings depending on food prices. For this reason,
many argue free trade gives a greater benefit to developed economies (who don't need
to develop infant industries). But developing economies, in Africa can struggle as a
result.
However, it is worth bearing in mind, developing economies have often struggled due
to high tariffs placed on EU and US agriculture. If these tariffs were reduced, it would
help farmers in developing economies.
Another potential disadvantage of free trade is that it could lead to environmental
problems. It may encourage firms to produce in countries with the least environmental
protection and then export to the developed world. Thus free trade can be a way to
overcome environmental laws. However, this is not strictly a problem of free trade but
a lack of sufficient regulation.
19
Often the EU has experienced surplus of foodstuffs. These have then been 'dumped' sold very cheaply on world markets. This depresses food prices and therefore incomes
of farmers. In this case tariffs can be justified to protect against dumping.
In conclusion, free trade has many potential advantages for consumers, firms and
general economic welfare. However, in certain situations, tariffs can be justified. In
particular, developing economies, which try to diversify away from relying solely on
agriculture, may well benefit from a period of tariff protection until they can compete
on an international scale.
11. A Government is faced with an unacceptably high level of
unemployment, but does not wish to increase its overall expenditure.
Discuss alternative policies for reducing unemployment. (25)
If the unemployment is caused by an economic downturn (low or negative economic
growth), the government should pursue demand side policies to try and increase
aggregate demand. For example, the government could cut income tax. This would
boost consumers’ disposable incomes and hopefully boost consumer spending. The
increase in aggregate demand will lead to higher economic growth and therefore firms
will need to employ more workers. This policy will be effective for reducing demand
deficient unemployment without causing higher spending.
Expansionary fiscal policy increases AD leading to higher Real GDP. As output
increases firms demand more workers.
Diagram showing an increase in AD leading to higher GDP. As firms produce more,
they require more workers.
20
However, tax cuts may not always work. In a recession confidence may be low, so tax
cuts may be saved rather than spent, therefore there will be no increase in AD and no
jobs created. Also, it is possible that tax cuts could cause crowding out. To pay for the
tax cuts the government has to borrow from the private sector by selling bonds. This
may reduce private sector investment and cancel the gain in aggregate demand. Also
expansionary fiscal policy will not solve unemployment if it is due to supply side
factors. The government could also cut interest rates because lower rates should also
boost aggregate demand, but in the UK monetary policy is now set by the Central
bank.
Unemployment could be voluntary, e.g. high unemployment benefits create an
incentive to remain unemployed rather than get a job. If this is the case, the
government could cut benefits and make it harder to claim them. Also to increase the
incentive to take a job, the government could increase the national minimum wage. A
higher wage increases the gap between benefits and work so might reduce voluntary
unemployment. However, in the UK, benefits are already quite low compared to the
national minimum wage therefore a cut in benefits may not solve the problem. Also
cutting unemployment benefits could lead to an increase in income inequality as the
poorest section of society see a fall in their real income. However, it might be
effective in reducing unemployment for a country like Germany with generous
unemployment benefits.
If unemployment is caused by real wage unemployment (wages kept above
equilibrium levels), the solution is to reduce the power of trades unions and minimum
wages. These policies enable wages to fall to their equilibrium levels and increase
demand for labour. However, in the UK, trades unions have little power to keep
wages above equilibrium levels.
Finally, the government could consider tax credits to firms who train workers. Better
education and training are a way to boost labour productivity and help overcome
structural unemployment. Tax breaks for firms who train workers are a way to
encourage training without spending money. However, there is a worry firms may
misuse the tax breaks for their own ends. Also there is no guarantee that subsidies on
training will actually increase the productivity of labour and reduce structural
unemployment; for example, workers may be unreceptive to training schemes.
Another supply side policy the government could adapt is to try and make labour
markets more flexible. For example, if the government reduce bureaucracy
surrounding the hiring of workers and prevent restrictive job contracts, firms will
have a greater incentive to hire workers. This could reduce structural unemployment.
However, by making labour markets more flexible, it could make work more
temporary and volatile; workers may become demotivated because they know there
job is only temporary and they have no security of a permanent contract.
21
12. Explain possible economic reasons for government borrowing.
(10)
Government borrowing occurs when spending is greater than tax revenue so they have
to make up the shortfall by borrowing from the private sector (Government sell bonds
through the Bank of England)
The first reason is to finance investment in the country’s infrastructure. For example,
increased spending on roads and transport could help increase the efficiency of
industry, leading to higher rates of economic growth in the future. Therefore, the
investment would lead to higher tax revenue in the future. Therefore, borrowing can
be justified to finance the investment.
Government borrowing is likely to occur during an economic downturn or recession.
In a recession, there is negative economic growth. For example, after 2008, the UK
has a sharp rise in public sector debt due to the effects of the credit crunch and
recession. A recession leads to lower tax revenues. Firstly, people earn less so income
tax falls. Secondly, firms make less profit so corporation tax falls. Thirdly, people
spend less so VAT revenue declines. Furthermore, in a recession, unemployment rises
so the government will face higher spending on unemployment benefits. These are
known as automatic stabilisers.
Also in a recession, economists advise pursuing expansionary fiscal policy, e.g.
cutting taxes rates and / or increasing government spending. This should, in theory
help increase Aggregate Demand and stimulate economic growth. This is known as
discretionary fiscal policy. Therefore, a recession can cause a rapid increase in
government borrowing.
22
Demographic changes can also lead to higher government borrowing. An ageing
population tends to need more government spending but pays less in tax. Retired
people earn little so income tax revenue is low; however, they are entitled to a state
pension so government spending is higher. Also, old people are more likely to need
expensive health care treatment. Therefore, if the average age increases, government
borrowing will increase - even if tax rates and government spending stay the same.
A final reason may be because the government is bailing out the financial sector. E.g.
banks like Northern Rock needing to be nationalised. This is an example of an
unexpected financial shock to government finances.
Another reason for higher government borrowing could be political expediency. For
example, before an election a government may try to appear more popular by cutting
tax and increasing spending. This will lead to government borrowing.
13. Evaluate the possible problems for the UK economy of increased
government borrowing. (25)
Government borrowing occurs when government spending is greater than tax receipts.
Generally governments finance their deficit by selling bonds to the private sector. In
return, the government pay interest on the bonds.
Higher government borrowing could be due to expansionary fiscal policy
(government spending is higher than tax revenue.) In a period of high growth,
expansionary fiscal policy will increase AD further and is likely to exacerbate the
problem of inflation. However, if the economy is in a recession, expansionary fiscal
policy could help the economy to recover. When the economy is in recession,
inflation is unlikely to be a problem; therefore in this situation an increase in
government borrowing is unlikely to cause inflation. Also if inflation does become a
problem the Central Bank could increase interest rates.
23
The impact of Government borrowing will depend on situation of economy.
Expansionary fiscal policy from AD3 to AD4 causes inflation (P3 to P4). But, in a
recession, AD1 to AD2 helps increase growth (Y1 to Y2).
Higher borrowing may lead to crowding out. Firstly if the government has to borrow
more, it may put upward pressure on interest rates as rates on bonds need to rise to
attract sufficient lenders. If interest rates are forced upwards because of high
borrowing, this will reduce consumer spending and investment and curtail economic
development. This is known as financial crowding out.
There could also be resource crowding out. This will occur because the government
has to borrow from the private sector. If banks and individual buy bonds and lend
money to the government, they may have less to invest in private sector schemes.
Therefore, government borrowing doesn’t increase aggregate demand, but just
switches resources from the private sector to the (often more inefficient) public sector.
However, Keynesians argue that in a recession, crowding out is unlikely to occur.
This is because resources are idle. Therefore, if the government borrows, it does not
reduce private investment. In a recession, the private sector save more. Therefore,
government borrowing is offsetting the rise in private sector saving. Furthermore,
government borrowing can cause a positive multiplier effect to cause a bigger final
increase in GDP.
It is argued that the government sector is more inefficient than the private sector. This
is because of a lack of incentives for people in the private sector. Therefore,
government borrowing is not good because it switches resources from the efficient
private sector to the less efficient public sector. However, the government spending
may be to overcome market failure such as transport and health care. If the
government is borrowing to invest in new infrastructure projects this is beneficial.
Higher borrowing presents a burden on future taxpayers. Future taxpayers will have to
pay the debt and the interest payments on the debt. In the UK, debt interest payments
are already over £40 billion a year. A crucial issue is whether government borrowing
24
rises faster than economic growth. If it does, national debt as % of GDP will increase
making it harder to pay back in the future.
Higher borrowing makes it difficult to finance expansionary fiscal policy in the time
of a recession. For example, the government increase borrowing during economic
growth of 2002-2007. When the economy entered recession in 2008, it had little room
for expansionary fiscal policy because borrowing was already quite high.
A key issue is whether bond markets feel government borrowing is sustainable. If
markets feel the government will be able to meet its borrowing requirements, bond
yields are likely to remain low and it will remain relatively cheap for the government
to borrow. However, if markets fear that borrowing is too high, they may worry the
government may default or print money and create inflation. In this case markets may
require higher interest rates to compensate for the increased risk. In this case, the
governments may find it very difficult to borrow. They may need to introduce painful
austerity packages (cut spending) or even require a bailout from IMF. In 2010, EU
countries such as Greece and Ireland were in this situation. Markets worried they
borrowed too much so bond yields rose quickly.
Some countries may respond to excessive government borrowing by printing money.
This can create inflation making it easier to pay back the bond holders of government
debt. However, it means the real value of bonds falls making investors reluctant to
buy debt from that country again. For example, Zimbabwe and Germany in 1920s,
had run away inflation due to high government borrowing and the printing of money.
14. Explain possible causes of economic growth. (10)
Economic growth means an increase in Real GDP. It requires an increase in
Aggregate Demand (AD) and or an increase in AS. In the short term, economic
growth may be caused by an increase in Aggregate Demand.
25
For example, rising house prices would give most households an increase in wealth.
This would increase their confidence to spend; it would also enable them to remortgage to gain equity withdrawal. This would cause a rise in consumer spending
and therefore aggregate demand. Alternatively, aggregate demand could rise due to
higher global economic growth. Higher global growth would cause a rise in demand
for UK exports, therefore increasing AD. A third factor that may increase economic
growth could be a change in monetary or fiscal policy. For example, a cut in interest
rates is likely to stimulate consumer spending and investment because of the lower
borrowing costs and less incentive to save; this would cause economic growth.
As well as demand side factors, it is also important to look at supply side factors.
Long term economic growth requires an increase in the productive capacity of the
economy and an increase in long run aggregate supply. For example, an increase in
the population, due to immigration, would increase the labour force and increase
aggregate supply. Also better education and training would help to increase labour
productivity, enabling faster rates of low inflationary growth.
The above diagram shows economic growth in the long run. The rate of growth in the
long run depends on the growth of long run aggregate supply (LRAS) – this is a
measure of how much productive capacity increases.
Technology also plays an important role; improvements in technology are one of the
best ways to increase aggregate supply and productivity.
Countries like Japan and China have often had economic growth driven by export led
growth. Their competitiveness in manufacturing has enabled them to export to the
West and this has been an important factor in their growth rates. In the period 200026
06, growth rates in the UK and US, were mainly caused by rising domestic demand –
often funded by low savings ratios, high borrowing and rising house prices.
15. Evaluate the potential impact on the economic growth of the UK
economy if it were to adopt the single European currency. (25)
If the UK joined the single currency, there could be some factors which help boost
economic growth. Firstly, a single currency lowers transaction costs of trade and
therefore, helps exports. Since exports to the EU account for 60% of the UK’s trade it
is important. However, transaction costs for trade between the UK and the EU are
already low. Therefore, a single currency would only have a relatively modest impact
on increasing exports and therefore growth.
A bigger benefit could be the stability in exchange rates. At the moment, UK
exporters could suffer from rapid appreciations in the exchange rate against the Euro.
If we join the Euro, this will not occur. Therefore, this gives us greater stability and
might encourage investment. However, firms already hedge (insure) against exchange
rate volatility so the impact is not going to be huge.
If the UK adopts a single currency it might encourage foreign direct investment from
firms (e.g., Japanese or Chinese) looking to invest in the Euro area. Investment would
boost both aggregate demand and aggregate supply. However, the Euro is only one
factor of many which determines inward investment. Another benefit of the Euro is
greater price transparency. If we joined the Euro, it would be easier to compare prices
throughout the Eurozone. This may help increase competitive pressures and keep
prices low.
Economic growth could be influenced to a greater extent by the impact of the single
monetary policy. This means, if we join the Euro, UK interest rates would be set by
the ECB (European Central Bank). The concern is that interest rates set by the ECB
may be unsuitable for the UK economy. For example, if the UK economy entered a
recession, but the rest of the Euro zone was still growing, interest rates are likely to be
too high. If this is the case, UK growth could suffer. Higher interest rates would cause
lower spending and investment and make the recession worse. Furthermore, because
of the nature of the UK housing market (many people have large variable mortgage),
higher interest rates would have a big effect on reducing growth rates.
On the other hand, if the UK economy was growing and inflation in Europe was low.
Interest rates may be kept low. This would cause the UK economy to expand more
quickly, at least in the short run, and cause problems such as inflation and a housing
boom.
In the boom period of 2002-2007, ECB interest rates were lower than UK interest
rates; if we had been in the Euro, we would have had a bigger bubble in the property
market. Also, when the UK went into recession in 2008/09, we were able to devalue
the Pound helping the economy to recover. The UK could also pursue its own
monetary policy - quantitative easing to help the economy recover. If the UK had
been in the Euro we wouldn’t have been able to benefit from weaker pound and
quantitative easing.
27
If the UK economy harmonises with the EU economic cycle, then a common
monetary policy may not be such a problem, and UK economic growth would not be
affected very much. However, there is no guarantee that the UK economy will be able
to harmonise with the EU. For example, there is a lack of labour mobility between the
UK and EU. If there is structural unemployment in the UK but jobs created in
Germany, it is not easy for UK workers to move to Germany.
Overall, membership of the Euro has several benefits, however, a common monetary
policy has potentially a very high cost. The deep recession of 2009/10 showed that an
independent monetary policy is important to give UK economy flexibility in dealing
with economic shocks.
16. Discuss policies to reduce inflation (25)
Inflation means a sustained increase in the price level. The Bank of England have a
target of CPI 2% +/- 1. If inflation increases above this target they are likely to change
interest rates to try and reduce inflation.
If the Bank of England wished to reduce the inflation rate they would increase the
Bank of England base rates (this would push up most of the different commercial
interest rates in the economy). Higher interest rates would make borrowing more
expensive and increase the incentive to save. With higher borrowing costs, firms and
consumers would spend and invest less, leading to lower consumer spending and
investment. Householders with variable mortgages would see an increase in mortgage
interest payments and this would cause lower consumer spending.
28
In theory, higher interest rates should reduce consumer spending and reduce
inflationary pressure. However, an increase in interest rates may not be effective if
consumer confidence is very high. If confidence is high, people may continue to
borrow, despite higher borrowing costs. Also it depends on other variables in the
economy. For example, if interest rates rise, but house prices continue to rise,
consumer spending may remain strong and the Bank will fail to reduce spending.
Finally, interest rates typically have a time lag of up to 18 months. If the Bank of
England increases interest rates, it will take time for firms and consumers to respond
to the higher interest rates. For example, homeowners may have a two year fixed
mortgage deal; it will only be at the end of their mortgage term that they would realise
the increase in interest rates. Firms who had started investment projects are unlikely to
stop projects, however, if the increase in interest rates is permanent then this may
discourage future investment projects.
Alternatively, deflationary fiscal policy could be used. For example, the government
could increase the rate of income tax. Higher income tax will reduce consumer
disposable income and therefore reduce consumer spending and aggregate demand.
This will have a similar effect of reducing inflationary pressures.
However, higher income tax could have a supply side disincentive effect. Higher
income tax may reduce the incentive to work, leading to lower labour productivity.
On a positive side, increasing tax to reduce inflation, would help improve the
government’s budget deficit.
Supply side policies could also help to reduce inflation. For example, a policy of
privatisation and deregulation may enable greater competition and incentives to cut
costs. If firms are privatised, they have a profit incentive to cut costs. Deregulation
enables an increase in competition and creates an incentive to cut costs. This could
lead to lower prices for consumers and therefore lower inflation. To some extent, this
was achieved after electricity privatisation in the UK, although the price cuts have
recently been reversed and lower prices for telecoms and electricity may partly be due
to better technology.
If wage inflation is a problem, reforming labour markets to increase labour market
flexibility could be a solution. For example, reducing power of trades unions could
reduce wage price spirals and therefore keep inflation lower. However, reducing
power of trade unions could leave labour exploited by monopsonist employers and
increase income inequality.
Supply side policies may also help shift AS to the right, leading to lower inflation
29
17. Evaluate the impact on UK macroeconomic performance of a
sustained rise in the value of the Pound against the dollar and Euro
(25)
A rise in the value of the pound against our main trading partners would be important
because they account for over 75% of the total UK trade.
A higher value of the pound would make UK exports more expensive; therefore, there
would be a fall in the quantity demand for exports. Similarly imports would become
cheaper, encouraging UK consumers to buy more imports and travel to EU / US. If
demand is price elastic, if the Marshall-Lerner condition is satisfied
(PED x + PED m > 1) then the appreciation will cause a fall in X-M. Therefore, an
appreciation will cause a fall in aggregate demand or cause the growth of AD to slow
down.
30
Slower growth of AD will lead to lower economic growth; there could also be higher
unemployment and lower inflation.
This diagram assumes a fall in AD, (though in practical terms a slower growth in AD
is more likely). It shows how a rise in the value of the pound causes lower economic
growth.
A rise in the value of the pound will help to reduce inflation for three reasons. Firstly,
there will be lower aggregate demand; secondly the price of imports will be lower
(e.g. TVs imported from abroad). Imports make up about 40% of the CPI, so are quite
important. Thirdly a higher value of the pound may encourage firms to try and cut
costs and be more efficient in order to remain competitive. If this occurs, then the UK
may not lose out in the long run, but gain from increased productivity. However, there
is no guarantee that a higher pound will force increased efficiency.
The impact on the current account again depends on the Marshall Lerner condition
and the elasticities of demand. If demand for exports and imports is price elastic then
the current account deficit is likely to deteriorate.
A key question is the elasticity of demand for UK exports. Arguably, demand for
exports has become more inelastic over past few decades; therefore an appreciation in
the exchange rate will have less impact on the current account. The J Curve effect
suggests demand can become more elastic over time. In other words, initially demand
is inelastic and following an appreciation, the current account may improve. But, after
time to adjust to the higher price of exports, the current account deteriorates, as
demand becomes more price elastic.
The impact of a higher value of pound also depends on what else is happening in the
economy. For example, if the economy is also experiencing higher interest rates and
31
falling house prices then consumer spending is likely to be falling. In this situation a
fall in X-M could push the economy into recession. However, if the rest of the
economy is booming a rise in the value of the pound could be helpful in reducing
inflationary growth.
It also depends on why there is an increase in the value of the pound. If the pound
increases in value due to a long-term improvement in productivity and
competitiveness then the economy should be able to absorb the rise in the value of the
pound. If the rise in the pound is a short-term response to higher interest rates, then it
is more likely to lead to a fall in AD.
18. Evaluate the possible consequences of a falling rate of inflation
for the performance of the UK economy. (25)
A falling rate of inflation can have various benefits for the UK economy. For
example, the above graph shows that in the 1970s, the UK experienced high inflation
of over 10%. This kind of inflation rate causes significant economic costs.
Firstly a lower inflation rate creates greater stability and confidence. With lower
inflation, it encourages firms to undertake investment. This investment will help boost
the long term potential of the UK economy.
A lower inflation rate will help make UK exports more competitive. This will boost
exports and help reduce the current account deficit. However, this depends on relative
32
inflation rates. If UK inflation falls, but other countries are also seeing a fall in the
inflation rate – there will be not improvement in competitiveness. Also
competitiveness doesn’t just depend on the rate of inflation, but the quality of goods.
Lower inflation is desirable because it avoids menu costs (costs of changing price
lists) and also prevents redistribution of income from savers to borrowers. For these
reasons the government have an inflation target of 2% +/-1. For example, an inflation
rate of 8% would be seen as undesirable because it would create instability and
discourage long term investment. A high inflation rate would also require high
interest rates; these high interest rates would reduce investment further. Therefore,
lower inflation would avoid these problems.
However, it depends why inflation is falling. If inflation is falling because of weak
consumer demand then there will be lower economic growth and the possibility of
recession. For example, between 2010 and 2014, the UK had a fall in the inflation rate
– but this was a period of weak economic growth. If consumer spending falls too
much then the economy may go into recession, with higher rates of unemployment.
If the inflation rate fell too much and became deflation, then the economy may really
begin to stagnate. As prices are falling, people are reluctant to spend. (e.g. Japan in
1990s) This is why the government have an inflation target of 2%. They don’t want
interest rates to be too high and low inflation to be at the expense of low growth.
However, some argue, if inflation is high, then it is necessary to reduce it, even if it
means the short term pain of lower economic growth.
However, if inflation is falling because of improved productivity and higher economic
growth, this would be very desirable, because it would lead to improved economic
growth. Lower costs and higher productivity will help increase the long run trend rate
of growth and create new job opportunities.
33
It is good to reduce inflation, so long as it doesn’t conflict with negative growth.
Ideally inflation will fall due to increased productivity rather than a fall in AD.
Lower inflation because of increased Productivity enables higher economic growth.
19. Discuss the impact of an increase in interest rates (25)
An increase in interest rates will impact on all the main macroeconomic objectives of
the government – inflation, economic growth, balance of payments and
unemployment.
An increase in interest rates makes borrowing more expensive, therefore it will deter
firms and consumers from borrowing and therefore this will lead to lower spending
and investment. Saving will be more attractive because you gain a higher rate of
return on savings. Also people with variable mortgages will have higher mortgage
interest payments. Therefore, this will leave them with lower disposable income. The
combination of higher borrowing costs, more saving and lower disposable income
will lead to a fall (or slower growth) in consumer spending and investment. Therefore,
AD will fall (or increase at a slower rate). This will lead to lower economic growth
and lower inflation.
34
If there is a fall in economic growth, we would expect the inflation rate to fall, and
unemployment to increase.
Also, an increase in interest rates would cause an appreciation in the exchange rate.
This is because with higher interest rates, it becomes more attractive to save money in
the UK, increasing demand for Sterling. The appreciation in the exchange rate would
make exports more expensive leading to a further fall in AD and also lower inflation.
The impact on the balance of payment is mixed. Higher interest rates will reduce
consumer spending on imports, this will improve the current account. However, on
the other hand, the appreciation in the exchange rate tends to worse the current
account because exports are more expensive. In practice, the negative impact on
import spending tends to outweigh the exchange rate effect.
The impact of higher interest rates depends on a few factors. For example, if the
government increased interest rates during a boom and high consumer confidence,
there may be little decrease in consumer spending. However, if house prices were
falling and confidence was low, even a small increase in interest rates would have a
drastic effect on reducing consumer spending.
If there was a fall in consumer spending, the impact would depend on the state of the
economy. If the economy was in recession (Y3), higher interest rates would lead to a
big rise in unemployment. However, if the economy was in a boom (Y1), higher rates
may just reduce inflation but not cause lower growth.
35
In the above diagram an increase in interest rates at AD1 would reduce inflation but
not cause lower growth. However, reducing AD from AD3 to AD4 does cause a fall
in real GDP (Y3 to Y4).
Finally, some people may benefit from a rise in interest rates. Savers would get more
income from their savings and therefore, there disposable income would rise, this
could increase their consumer spending. However, these days the savings ratio is low
and borrowers tend to outnumber savers.
20. Discuss how the government might improve the UK’s long term
economic growth.
Long term economic growth primarily depends on growth in aggregate supply.
Therefore, the government should focus on policies to improve productivity growth
and help increase AS.
36
Diagram showing shift in LRAS to the right.
The government could try to increase incentives to work and incentives for people to
join the labour force. For example, the government could make it harder to claim
unemployment, sickness and disability benefits. They could reduce benefits and make
receiving benefits more rigorous. This could be controversial because it will lead to
increased relative poverty. Also, there is a danger genuinely sick people will be left
with no income because they don’t qualify for benefits and can’t work. However, if
successful it could increase the size of the labour force and enable an increase in AS.
Another strategy may be to make work more attractive. For example, higher minimum
wages, better protection for part time workers, better childcare provision. This may
encourage women into the labour market and increase the size of the labour force.
However, childcare would be expensive and may not justify the small increases in
labour supply. Also higher minimum wages and protection for workers could increase
costs for business and actually damage growth prospects.
The government could try to make markets more competitive. For example, they
could privatise industries such as London Underground. Privatisation should increase
the incentives for firms to be more efficient because the firms will have a profit
motive. However, there is a danger the government merely creates private monopolies
who don’t actually reduce prices and help the economy.
A third policy could be to try and enhance the skills of workers. The government
could try and increased educational standards, especially focusing on vocational
training relevant to the modern labour market. If successful, this would increase
labour market flexibility and labour productivity helping to increase the
competitiveness of the economy.
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However, these policies would be quite expensive and there is no guarantee spending
more money actually increases the skills of workers. Workers may be reluctant to
undergo training schemes.
Another policy could involve seeking to overcome market failure in the economy. For
example, the free market may underinvest in transport infrastructure such as trains
and roads. The government needs to provide greater infrastructure because of the
external benefits of these schemes. Better infrastructure can help to reduce business
costs and increase productivity.
Finally, to improve long-term economic growth, it is also important to think of the
demand side of the economy. If the economy is prone to boom and busts, it will harm
the long-term economic growth, because resources will be misused. Instead, the
government should aim at stable growth. For example, they could make the Central
Bank independent to set interest rates. They could also try and use fiscal policy to
‘fine tune’ the economy. The UK government could try to reform the housing market
to make it less prone to boom and bust. However, this is quite difficult to achieve.
21. Discuss factors that may limit economic growth rates in different
countries. (25)
Economic growth rates measure the annual increase in GDP. Growth rates vary
between different countries depending on their infrastructure and state of economic
development.
In the long term, the rate of economic growth is determined by the growth of
Aggregate Supply, which is determined by the growth in productivity.
Different rates of growth illustrated by different increases in LRAS and AD.
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Growth in the labour force is an important determinant of economic growth. For
example, one reason for the high rates of growth in China is the large quantity of
labour that is migrating from the country to manufacturing jobs in the south and East
of China. This elastic supply of labour helps firms to expand without having to put up
wages and lose competitiveness. Other European countries, like Italy, have a
declining labour force due to declining birth rates; this will be a limit to economic
growth over the next few decades.
However, it is not just supply of labour, but also labour productivity that is important.
If a country has good technology and good education, then the workforce will become
more skilled and productive leading to higher rates of economic growth. For example,
a country like Germany has a good education system and this helps the strong growth
in labour productivity. Countries which lack basic education and training standards,
such as Sudan in Sub-Saharan Africa, will struggle to develop higher skilled
industries and so will rely on low growth industries like agriculture.
Countries, which have a comparative advantage in primary products, tend to face
limits to growth. This is because primary products, like food, tend to have a low
income elasticity of demand. Therefore, higher global incomes don’t lead to higher
demand for primary products, and earnings will stagnate. However, oil rich countries
have benefited from the high foreign revenues they earn from oil exports.
Strong investment and economic growth requires political stability. One of the biggest
constraints to growth is civil war or political turmoil. African countries, which have
suffered civil wars, have often seen reduced GDP during the conflict. The former
members of Yugoslavia have seen much stronger growth after the end of their
damaging civil war. Similarly levels of corruption and bureaucracy will have an
impact in determining the attractiveness of business in any economy.
Another factor which determines economic growth is the degree of competition and
openness in a country. China saw a large increase in economic growth when it
privatised state owned industries. When firms have a profit motive, then tend to
become more efficient and responsive to market needs. China’s high rate of growth is
partly due to the fact they have a lot of ‘catch up’ – improving efficiency in old state
owned industries. Also, removing barriers to competition can act as a spur to
increasing growth. In a global economy international trade is increasingly important;
when countries remove tariff barriers, it helps to provide a boost to growth. However,
openness to trade can also leave a country vulnerable to a global economic downturn.
For example, a slowdown in growth will affect all countries who rely on exports, such
as Germany, China and Japan.
Models of economic growth, such as Harod-Domar suggest that capital ratios and
saving ratios are important for determining growth. Higher saving and investment
levels help promote an increase in productive capacity and higher growth. However,
the link between savings and growth is not always clear. Sometimes, countries can
have a high savings ratio, but struggle to grow. Countries with a low savings ratio
benefit from higher demand in the short term.
A final factor is demand. Though AD traditionally affects growth in the short term. If
there is persistent difficult in maintaining robust growth in consumer spending, then
growth levels will stagnate. For example, Japan grew quickly in the post war period.
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But, during the 1990s and 2000s, growth rates were much lower because the economy
suffered from slow consumer spending and deflation.
22. Discuss the problems an economy might face in recovering from a
period of recession? (25)
A recession is a period of negative economic growth, associated with rising
unemployment, low inflation and higher government borrowing.
To recover from a recession there needs to be either a rise in Aggregate Demand or a
readjustment in prices and wages. To increase Aggregate Demand, the Central bank
and government could use a combination of Monetary and Fiscal policy.
Classical economists argue that a recession will only be temporary because labour and
product markets are flexible. However Keynesians argue that wage and price rigidity
can keep the economy below full capacity for a long time. Therefore, a recession may
persist for longer.
In a recession there will be rising unemployment and a fall in consumer confidence.
This will cause a rise in the savings ratio. In other words, people will spend less of
their disposable income and save more leading to a bigger fall in AD. If confidence
remains very low for a long time, then it will be difficult for the government to
increase AD. For example, if the government cut income taxes this would increase
disposable income, but if confidence was low people would not be willing to spend
any extra and the economy would remain in a recession. Keynes called this a paradox
of thrift - in a recession, people try to save more - but this makes it more difficult for
economy to recover.
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In a recession the Bank of England could cut interest rates to stimulate demand.
Lower interest rates reduce the cost of borrowing and therefore people should be more
willing to spend and invest. However, Monetary policy could be ineffective. Firstly,
firms may be reluctant to invest, even though it is cheap to borrow because they
cannot see any increase in demand. If a country is a member of the EURO it may
make it more difficult to increase AD in a recession. This is because interest rates will
be set by the ECB and the member country would lose control over interest rates and
monetary policy. In the recession of 2009/10, interest rates were cut to 0%, but this
often didn't cause a big increase in demand.
Keynesians argue that expansionary fiscal policy can be used to increase AD and get
the economy out of a recession. For example, the government could increase
government spending on public work schemes to stimulate demand and economic
growth. However, there may be many problems of using fiscal policy to increase AD.
Firstly there will be time lags. It takes time for the govt to change its spending plans
and once implemented it will take time for this spending plan to actually increase AD.
Also increasing AD may cause crowding out. This means that if the govt increases its
spending then it will lead to a corresponding fall in private sector spending. This is
because the govt borrows off the private sector to finance its spending. However
Keynesians reject this argument, saying that in a recession, with rising saving rates,
the govt will only be using previously unemployed resources, therefore there will be
no crowding out. However, another problem with fiscal policy is that in a recession,
government borrowing increases due to high tax rates, this may make it difficult for
the government to borrow more to finance expansionary fiscal policy.
If there is deflation this makes it difficult to increase demand. This is because people
will not spend if they feel that prices will be cheaper in the future. Also, Monetary
policy will become ineffective because interest rates cannot fall below 0% therefore
with deflation real interest rates may remain high. E.g. Japan has experienced
deflation during the 1990s and this made it very difficult to increase AD and
economic growth. Also deflation increases the real value of debt which can lead to
more bank losses and reduced investment. Economists say that a positive inflation
rate is important for overcoming a recession.
If there was a fall in AS as well as AD this would make the recession more severe.
For example if there was a rapid rise in the oil price like in the 1970s then AS would
shift to the left causing lower growth and higher inflation. It is difficult to deal with a
supply-side shock, as you need to reduce inflation and increase growth at the same
time.
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However, although recessions can be difficult to get out of, sometimes economies can
be quite resilient. If a recession was caused by a rise in interest rates, such as UK in
1991, then reducing interest rates and devaluing exchange rate can enable a quick
recovery. However, if a recession is caused by falling asset prices, and a serious credit
crisis which damages bank balance sheets, then it is more difficult to get out of
recession because firms and consumers are less responsive to traditional policy
measures.
23. Assess the impact on UK macroeconomic performance of a
prolonged period of deflation. (25)
Deflation means a fall in the price level; it is a negative rate of inflation. Currently,
the MPC target an inflation rate of CPI 2% +/-1
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If deflation is caused by a fall in aggregate demand or sluggish growth, then there
could be several economic problems. Firstly, when prices are falling, consumers tend
to delay spending, especially big purchases; this is because they expect goods to be
cheaper in the future. This delay in spending can cause lower aggregate demand and
lower economic growth. The MPC target an inflation rate of 2% because moderate
inflation helps encourage a reasonable level of spending.
Another problem of deflation is that it increases the real value of debt. Firms and
consumers with high debt will find it more difficult to pay off debt; debt interest
payments will take a higher % of their disposable income. This can be a significant
drain on spending and investment leading to lower growth. This might also be a
particular problem in the UK, because of the relatively high rates of personal and
business debt. In addition, deflation will make it more difficult for the government to
reduce its debt/GDP ratio. Though, at least bonds should appear more attractive in a
period of deflation.
Another potential problem of deflation is that it makes it harder for nominal wages to
adjust and avoid real wage unemployment. Trade unions resist nominal wage cuts so
with falling prices, we tend to get rising real wages, and this can cause real wage
unemployment. An inflation target of 2%, helps real wages to adjust more easily.
Deflation is likely to make conventional monetary policy ineffective. Interest rates
cannot fall below zero, therefore if we have deflation, real interest rates (nominal inflation) are likely to be too high for that stage in the economic cycle. This high real
interest rate may be another factor leading to lower growth. However, there are
alternatives to cutting interest rates. The Central Bank could resort to quantitative
easing - increasing the money supply - this should increase the supply of money.
However, evidence from Japan suggests that in a period of deflation, increasing the
money supply may be insufficient to overcome deflation and promote growth. This is
because banks don't lend the money but just increase their reserves.
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Deflation is not necessarily a bad thing. If deflation is caused by increased
productivity, lower prices can be compatible with increased output and economic
growth. For example, if there was a period of exceptional technological innovation,
the decline in costs could be passed onto consumers in the form of lower prices, this
leads to deflation but can help increase living standards.
A prolonged period of deflation will also help the countries exports become more
competitive; this should lead to an improvement in exports and improve the current
account. Sometimes countries pursue deflation as a policy of internal devaluation.
This enables them to improve competitiveness without reducing value of exchange
rate.
However, overall the cost of deflation is often potentially high. The rise in real value
of debt can be a significant problem for banks and business leading to a potentially
damaging period of negative or stagnant growth. It is interesting to note, that the UK's
longest period of deflation was in the 1920s and 1930s - an era of high unemployment
and low growth.
24. Evaluate market-based and interventionist policies for promoting
economic development (25)
Economic development involves an increase in living standards for the general
population. Economic development requires an increase in real incomes, but also an
improvement in key measures of economic welfare, such as a reduction in poverty
and improvement in social services such as health care and education. Market-based
policies focus on ways to enable free-markets to work more efficiently and may
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involve the reduction of regulations and government intervention. Interventionist
policies involve government spending or regulation.
Free market economists argue that free-market policies, such as privatization and
deregulation can increase the rate of economic growth and lift people out of poverty.
State owned industries lack profit incentives and tend to be inefficient. Therefore, this
leads to under-investment, inertia and unwillingness to cut costs. Privatisation means
the firm is owned by the private sector and therefore has a profit incentive to cut costs
and respond to consumer preferences. This can lead to an improvement in economic
efficiency and higher economic growth. The Chinese economy has benefitted from
widespread privatisation of former state-owned assets. The private firms have shown
more innovation and dynamism – investing in production the economy wants. The
higher growth increases real wages, provides jobs and more tax revenue to be used for
public services such as education and health care.
However, there is a danger that privatisation of public utilities, such as water,
electricity and gas, could damage economic development. Privatised firms have a
profit incentive and may be more willing to cut off basic amenities to people who
can’t pay. For an industry like water, this could be damaging to those who rely on free
access to water. Also, there is no guarantee that privatising firms will make them
more efficient. Privatising public transport may lead to private monopolies who are
able to increase prices and reduce services at unprofitable hours. This may lead to
external costs of people being unable to afford more transport – which damages
economic growth.
Another market-based policy to promote economic development is the reduction of
tariff barriers to promote free trade. Lower tariffs will reduce the price of imports.
This will increase the living standards of those who need to buy imports. If a country
is a net food-importer, it can substantially increase living standards of the very poor
who benefit from cheaper food prices. In the long term, lower tariffs on exports, can
lead to the development of new industries, which create new jobs and prosperity.
However, for developing economies, free trade could be problematic. Cheaper
imports could damage developing industries which cannot compete with global
multinationals. It could make the economy reliant on imports and stuck in producing
goods with a comparative advantage like primary products. The problem with
exporting primary products is that they have a lower income elasticity of demand and
limited scope for growth. Protecting infant industries enables a developing economy
to diversify into new industries and promote wider economic opportunities. In the
long-run, this can promote economic development as it allows an economy to be less
reliant on a small number of primary products which may be subject to price
volatility.
Free market policies reduce government intervention, but the free market cannot solve
problems relating to market failure. For example, the provision of public goods such
as law and order and public transport will be underprovided in a free market.
Lawlessness and lack of infrastructure will hold back economic growth and economic
development. This requires government intervention to build better roads and
railways. With better transport and infrastructure, firms can transport goods with
lower costs, and it will encourage more business investment. This public investment
helps economic growth and will increase living standards in the long term. However,
higher spending will require higher taxes, and it may be difficult for developing
economies to collect tax without reducing incentives to work. E.g. Higher corporation
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tax may discourage multinationals investing in the economy. Also there is a potential
problem of government failure. Large scale public schemes may be subject to
corruption and mismanagement of resources. The investment may be misplaced and
do little to improve transport links – unless it is carefully managed.
Another interventionist policy is to spend more on education and training. This is
important for improving labour productivity. Without an educated workforce, it is
hard for the economy to develop and diversify into higher-value production. If
workers are skilled, then the economy can attract multinational investment. For
example, high levels of English language skills in India have led to investment in call
centres by foreign companies, and this creates higher paid jobs and foreign income
flows. Improving education is itself a measure of economic development. Increased
literacy and numeracy increase the opportunities and sense of freedom for people. A
problem of spending on education and training is the potential for government failure
– the government may struggle to direct the spending to where it is needed most. For
example, there may be a reluctance for the poorest families to allow their children to
go to school because they need children to work on the farm. In some developing
countries, there is a social resistance to the education of women. Also, education on
its own cannot solve the problems of economic development. It requires firms to have
the confidence to invest in taking part in new investments which can make use of the
more educated workforce.
In conclusion, both market-oriented and interventionist policies can play a role.
Government intervention can help overcome areas of market failure – dealing with
gaps in education, health care, law and order and transport. However, for most
businesses, there needs to be a vibrant market economy, without onerous government
regulations and taxes which might discourage investment.
25. Evaluate whether the receipt of remittances benefits developing
economies.
Remittances are foreign currency transfers from workers in the developed world back
to the developing world. The World Bank estimates that remittances totalled $534
billion in 2015. This is a substantial flow of money to the developing world and is
similar to the level of foreign direct investment flowing to developing economies. The
value of remittances is three times greater than foreign aid.
The first benefit of foreign remittances is that it increases the national income of
developing economies. It helps to reduce the gap between average incomes in the
west and in the developing world. Foreign currency flows enable families who receive
remittances to gain higher living standards. This may be sufficient to lift them out of
poverty – both absolute and relative poverty. Remittances can be used to fund
education and health care which increases life chances for recipients and in the longterm can lead to improved labour productivity – which benefits the long-run
performance of the economy. Although not everyone in a developing economy will
receive remittances, they can also lead to a trickle down effect. When families receive
remittances, they are likely to spend it on goods and services within the developing
economy – thereby creating higher demand and more jobs. This boost to national
income will also enable higher tax revenues. The government can tax income and
expenditure, using the tax revenues to fund public services, such as infrastructure and
public education. This increase in a nation’s capital is considered an important factor
in economic development. Growth theories such as Harod-Domar suggest that
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increasing capital investment is a key factor in improving investment, economic
growth and economic development.
The flow of foreign remittances will also strengthen the currency of developing
economies. Foreign workers will exchange dollars for the local currency to return
money. This will lead to an appreciation in local currencies. A benefit of a stronger
currency is a fall in import prices. Countries which rely on imports will see a rise in
living standards as imports of raw materials are cheaper. However, if a developing
economy relies on exports, the appreciation in the currency will make exports less
competitive and could hold back the development and diversification into new
exporting industries. On the other hand, you could argue an appreciation in the
exchange rate may create incentives for business to try and cut costs or increase
productivity to remain competitive. Whether developing economies have the capacity
to boost productivity is not certain.
One drawback of remittances is that it is unlikely to benefit the very poorest. The very
poorest families are unlikely to be in a situation to enable anyone in their family to go
and work in a developed economy. Remittances could lead to increased inequality
with only families with educated and mobile young adults able to send remittances
back. There is no guarantee that remittances will be funnelled into productive
channels and investment. A proportion will be saved or invested in schemes to
increase the wealth of families.
Perhaps the main drawback of remittances is that it involves the most skilled,
educated and mobile workers leaving the developing country in order to work abroad.
Remittances are only a small percentage of the value added by the young workers
abroad. Most of their income will be spent or taxed in the developed economy. The
drawback is that developing economies lose a significant proportion of their best
workers and potential entrepreneurs. This means economic development is held back
by a loss of young workers and potential young entrepreneurs. The prospect of
earning higher salaries abroad may discourage local investment and young people
setting up business in the developing world. This means developing economies
become reliant on remittances from abroad – rather than developing productive
capacity in its own country.
However, on the other hand, foreign workers may decide to return after a few years.
They will return with work experience and greater knowledge than before they left.
Therefore, the process of leaving, sending remittances and coming back can benefit
the developing economy in the long-term.
In conclusion, remittances do provide important foreign capital that could be used to
help boost incomes, investment and economic growth. The foreign currency flows
enable a developing economy to afford more imports which may be necessary for
better living standards and economic growth. However, remittances is a second-best
option of encouraging young workers to stay in the developing economies and work
directly for new firms in the developing economy. If developing economies suffer a
‘brain drain’ and lose their best workers, they may lose out on significant benefits.
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General Tips for Macro Economic Essays
Don’t forget the main macro economic objectives
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Economic growth
Inflation
Unemployment
Balance of Payments
Exchange Rates
Government borrowing.
For example, if a question asks the effects of higher interest rates, consider how
interest rates will affect all of these.
Do draw AD/AS diagrams where appropriate.
Evaluation
This is worth 40% of most essays. It involves looking at essays with critical distance.
These are questions which begin with:
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Discuss..
Evaluate…
To what extent..
Assess..
Macro Evaluation
Evaluation for macro economic essays can include:
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Time Lags. E.g. the effect of an increase in interest rates can take up to 18
months to have an effect.
Depends on other variables. e.g an increase in interest rates may cause lower
consumer spending. However, if house prices are rising, consumer spending
may not fall.
Depends on position of the economy. The effect of higher rates will be
different if economy is in boom compared to if it is close to recession.
Side Effects. Higher taxes may reduce consumer spending. But, as an
unintended side effect may cause lower incentives to work as well.
Monetarist vs Keynesian. A monetarist may say expansionary fiscal policy
will not increase Real GDP, but, A Keynesian will say it is quite possible.
Conflicts of objectives. Higher interest rates may reduce inflation but, cause
stronger exchange rate and unemployment
Significance of a factor. For example, a fall in exports to Australia is not a
significant factor affecting UK economy. But, a fall in UK house prices is
significant because houses are the biggest form of wealth.
Note it is important to explain evaluation. E.g. it is insufficient to say
(however, there may be time lags). Explain why time lags may make monetary
policy less effective e.g. people on fixed rate mortgages for two years.
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