Edexcel A Level Economics

UNIT 4 - A GLOBAL PERSPECTIVE

4.1.1 Globalisation
Characteristics of Globalisation
• Globalisation is the economic integration of different countries through increasing freedoms in the
cross-border movement of people, goods/services, technology & finance
• This integration of global economies has impacted national cultures, spread ideas, speeded up
industrialisation in developing nations & led to de-industrialisation in developed nations
• Globalisation has been increasing for thousands of years - it is not a new phenomenon
• Improvements in technology & the speed of global connections have exponentially increased the
level of interdependence between nations in the past 50 years
• Consumers now source products globally recognising global brands wherever they travel
The Four Main Characteristics of Globalisation
Increasing movement of labour &
Increasing foreign ownership of
technology across borders
companies
Easy flows of capital (finance) across
Free trade in goods/services borders

Factors Contributing to Globalisation

• In 2000 the value of global trade was approximately $6.45 trillion. By 2020 this figure was at $19
trillion
• Numerous factors have contributed to the rapid increase in the pace of globalisation but
perhaps two of the most significant are the improvements in containerised shipping & the
innovation in communication technology

Factors Contributing to Globalisation in the Last 50 Years

The improved ability for firms to The Increased effectiveness of

easily connect and to promote the World Trade Organisation
Economies of scale generated themselves internationally as a (WTO) in negotiating new trade
by containerisation in the result of the internet agreements & in helping countries
shipping industry & improvements to to open up to free trade (trade
communications technology e.g liberalisation), thus increasing
Skype, WhatsApp, WeChat etc international specialisation & the
volume of trade

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 A rapid growth in the number & The end of the cold war between In the 1990's there
influence of transnational Russia & the West in was deregulation of many financial
corporations 1990 opened up former markets which resulted in
communist countries around the the expansion of global financial
world enlarging the global supply services & provided more access
of labour e.g. more than 800,000 to
people migrated from East capital
Germany to West Germany
between 1990 and 1991

Impact of Globalisation on Stakeholders

• Many of the impacts of globalisation have been positive, however there have been some very
negative ones too
• When considering the impacts, it is useful to acknowledge all of the stakeholders including individual
countries, governments, firms, consumers, workers & the environment

The impacts of Globalisation on Stakeholders

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The impacts of Globalisation on Stakeholders
• Two of the more recent criticisms of globalisation include
o The lack of action by some governments to help workers unable to find new jobs as a
result of structural unemployment
o The use of legal mechanisms (e.g. transfer pricing) & corruption by transnational
corporations is stripping developing countries of their assets & has been called 'new
colonialism'

4.1.2 Specialisation & Trade

Absolute & Comparative Advantage
• International trade decreases prices & increases the variety of goods/services available to a nation
o This results in a higher standard of living
• Comparative advantage is the theory developed by David Ricardo in 1817 which states that a
country should specialise in the goods/services that it can produce at the lowest opportunity cost
• o By specialising, the volume of production increases
• o Excess production can be exported
o Goods/services which are not produced in the country can be imported
• Absolute advantage occurs when a country is able to produce a product using fewer factors of
production than another country
• o A country may well have absolute advantage but still not have comparative advantage

The Assumptions of Comparative Advantage

• As with any economic model, there are underlying assumptions to the theory of comparative
advantage
1. Transport costs are zero: it does not account for moving the goods/services between countries.
Depending on a nation's location this is more or less of a problem
2. There is perfect knowledge: each country knows what it has a comparative advantage in & also
the comparative advantages of other countries
3. Factor substitution is easily achieved: economies can quickly adjust to changing global market
conditions by switching from capital to labour - and vice versa
4. Constant costs of production: the theory does not take into account the economies of scale that
can be achieved with an increase in output

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Using Production Possibility Frontiers to Illustrate Comparative & Absolute Advantage

• Production possibility frontiers can be used to illustrate these concepts

The production possibility frontiers for 2 countries who both produce t-shirts & computer chip

Diagram Analysis
• Country A has an absolute advantage as it can produce more of both products

• Country A can produce either 200,000 t-shirts or 100,000 computer chips o To produce
100,000 computer chips, it gives up production of 200,000 t-shirts

o The opportunity cost of producing 1 computer chip is

2 t-shirts

o The opportunity cost of producing 1 t-shirt is

0.5 computer chip

• To produce 1 computer chip Country A gives up 2 t-shirts & Country B gives up 1 t-shirt o
Country B has a comparative advantage in producing computer chips as it is giving up fewer t-
shirts & so it should specialise in computer chip production
• To produce 1 t-shirt Country A gives up 0.5 computer chips & Country B gives up 1 computer
chip o Country A has a comparative advantage in producing t-shirts as it is giving up fewer

computer chips & so it should specialise in t-shirt production.

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Limitations to the Theory of Comparative Advantage
• Comparative advantage does tend to be one of the main factors that drives a nation's manufacturing in
a global economy. However, there are limitations & drawbacks to the theory

The Limitations of Comparative Advantage

Environmental Distribution of Structural
Over-dependence
damage Income unemployment

Specialisation creates a The impact of negative The GDP/capita is likely Although there should be a
dependence on other externalities of to increase, however net increase in employment,
countries which generates production is not the distribution of the as countries
vulnerability e.g. receiving considered by the theory extra income is likely to specialise certain
gas supplies from Russia & these can significantly be uneven with the industries are likely to shut

works well when relations worsen the quality of life wealthier sections of the down resulting in
in towns, cities & population gaining more unemployment for some
are good but has proven
countries workers. These workers may
otherwise in an unexpected
time of war. There has been not be able to move into
an over-dependence on other occupations & if so the
Russian gas number of long-term
unemployed will rise

Advantages & Disadvantages of International Specialisation & Trade

Advantages of Specialisation & Trade

• The advantages of international specialisation & trade are significant & are backed up by the
large increase in the volume of global trade in the past fifty years
1. Lower prices
2. Greater variety of goods/services
3. More competition leads to better quality products
4. Economies of scale create efficiencies
5. Higher economic growth
6. Improved living standards

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The Disadvantages of Specialisation & Trade
Disadvantage Explanation
As transnational firms grow in size & increase market power, they can dictate
Global Monopolies prices & output in many regions. They are also able to wield their influence
Emerge to influence governments & gain access to raw materials through bribery &
corruption e.g Glencore has recently admitted to multiple allegations of bribery
so as to secure favourable mineral rights deals
Shocks to other economies have a knock-on effect due to
Exposure to external the interdependence that develops with trade e.g. the Russian war on Ukraine
shocks has created global shockwaves in the energy & grain markets

Some countries will import more than they export resulting in a deficit on the
Deficit on the Current current account. When this happens in developed countries, it is usually
Account of the Balance because the income of the citizens is high & they are importing to improve
of Payments their standard of living. In developing countries, this situation is usually as a
result of a lack of global competitiveness & it is importing necessity products
Many firms that were successful in the local market may well fail in a global
Unemployment market. Employment in successful industries will increase & employment in
unsuccessful industries will decrease. Structural unemployment is a particular
concern. Government supply-side policies make a significant difference to the
length and severity of structural unemployment
Some governments support key industries to ensure they are globally
Dumping due to illegal competitive. This support often comes in the form of subsidies which encourage
Government support excess production. This excess production is then dumped on world markets at
low prices e.g The USA subsidises cotton farmers to the extent that they have
put competitors out of business through the sale of below cost cotton
Start-up firms in developing countries (infant industries) find it harder to compete
Challenges for due to global competition - the ones that survive often have government
Developing Countries support. Global monopolies also exert large amounts of pressure on developing
countries through the use of monopsony power & transfer pricing
Developing countries often lack the finance to develop a diversified product
Over-specialisation in base & end up over-specialising in commodity products. This makes the
developing economies country's GDP very dependent on the commodity prices

With an increase in trade, languages & cultures have blended impacting on

Loss of sovereignty & some indigenous languages & cultures. Countries have also lost some
culture sovereignty as they are more easily influenced by dominant trading
partners

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4.1.3 Pattern of Trade

Factors Influencing the Pattern of Trade

• Numerous factors influence the pattern of trade between countries

o Patterns of trade can change significantly over time e.g. up to the 1980s the UK traded
predominantly with Commonwealth Countries. In 2020, 46% of trade was with EU countries &
26% was with the USA
1. Comparative advantage: this is less a grand plan & more a natural market outcome as firms seek
to profit maximise. Where it makes sense to increase production due to natural advantages, firms do.
When it makes financial sense to outsource production because another country does it
better/cheaper, firms do. Over time, this changes what countries produce & trade
2. Impact of emerging economies: Emerging world economies like China, Brazil, India & Thailand have
obtained a much higher share of the global business which means that other countries are losing out
as trading relationships change
3. Growth of trading blocs & bilateral trading agreements: By December of 2016, the World Trade
Organisation (WTO) had helped to facilitate more than 420 regional trading blocs & bilateral
agreements (between 2 countries). This results in trade creation & causes trade diversion
4. Changes in relative exchange rates: If a country's exchange rate appreciates, then its exports are
relatively more expensive & its imports become cheaper. This means that changes to the exchange
rates influence the patterns of trade over time as goods/services either become cheaper or more
expensive in relation to the price of goods/services in other countries.

4.1.4 Terms of Trade

• Terms of trade refer to the ratio of a country’s average price of exports to the country’s average
price of imports

• The relative price of imports & exports can have a direct bearing on the standard of living within a
country
o Exporting goods which are highly priced results in higher incomes & the ability to buy
cheaper imports
• The terms of trade capture the relationship between the average prices of a country's exports
& imports

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Calculation of The Terms of Trade

• The index for exports & imports is created in much the same way that a consumer price index is created
(using a weighted basket of imports & exports)

Worked example
Calculate the terms of trade for Country X. State if the terms of trade have improved or worsened. In the final
column explain what that means for country X

Year Index of Index of Calculation Terms of Improvement or Explanation

average average of terms of trade deterioration?
export import trade
prices prices
2012 100 100

2013 100 107

2014 112 108

2015 115 110

Step 1: Identify the index year as this is the base year & complete calculations for the index year

The index year will be the year in which both the index for export & import prices is 100

Index of Index of
Improvement
average average Calculation of Terms
Year or Explanation
export import terms of trade of trade
deterioration?
prices prices
Both export & import index =
2012 100 100 100 Base year 100
2013 100 107

2014 112 107

2015 115 110

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Step 2: Calculate the terms of trade for each year & state if they have improved/deteriorated
Index of Index of
Improvement
average average Calculation of Terms
Year or Explanation
export import terms of trade of trade
deterioration?
prices prices
Both export & import index =
2012 100 100 100 Base year 100

2013 100 107 93.45 Deterioration

2014 112 107 104.67 Improvement

2015 115 110 104.55 Deterioration

Step 3: Explain what the improvement or deterioration means (explanation)

Index of Index of
Improvement
average average Calculation of Terms
Year or Explanation
export import terms of trade of trade
deterioration?
prices prices
Both export & import
2012 100 100 100 Base year
index = 100
One unit of exports buys
2013 100 107 93.45 Deterioration fewer imports compared
to the previous year
One unit of exports buys
2014 112 107 104.67 Improvement more imports compared to
the previous year
One unit of exports buys
2015 115 110 104.55 Deterioration fewer imports compared
to the previous year

Factors Influencing a Country's Terms of Trade

1. Relative inflation rates: Inflation increases the price of goods/services within a country. This means
that their price is now more expensive to the rest of the world. If the exports are price inelastic in
demand this will improve the terms of trade, if elastic then it is likely to worsen the terms of trade.
2. Relative productivity rates: continuous improvements in productivity can lower costs & these can be
passed on in the form of lower prices. Lower prices for export products will mean that the terms of
trade will deteriorate i.e. fewer imports can be bought with one unit of exports

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 3. Changes in exchange rates: exchange rates constantly change the price of exports & imports.
If prices change then the terms of trade between the two countries change. Specific data would need
to be provided in order to determine if the terms of trade have improved or deteriorated for each trading
partner

Impact of Changes in the Terms of Trade

• Depending on the contribution that net exports make to GDP, changes to the terms of trade can have
far reaching impacts on an economy. These include
o Changes to the current account balance in the Balance of Payments
o Changes to national output (GDP)
o Changes to unemployment levels
o Changes to the level of international competitiveness
o Changes to disposable income
o Changes to standards of living
• The impact of changes to the terms of trade are more complex than assuming that an improvement in
the terms of trade is good & a deterioration is bad
o E.g. Improvement in terms of trade → one unit exports buys more imports → standard of living
improves
▪ However, it depends on what caused the improvement & on the price elasticity of
demand for exports & imports
▪ If the improvement was caused by an increase in the price of exports, then following
the law of demand fewer exports will be consumed by foreigners. How much fewer
depends on the PED for exports. This could worsen the standard of living

PED & Changes To the Terms of Trade

Condition (ToT) Cause PED Value Likely outcome

Improvement Price of exports rises If PED of exports is • Output increases
inelastic then the reduction in • Unemployment
quantity demanded will be less decreases
than the increase in price & the • Standard of living
economy will benefit improves

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 Improvement Price of imports falls If PED of imports is • More disposable
elastic (necessity) then the income
increase in quantity demanded • Standard of living
will be more than the decrease improves
in price & the economy will • Domestic output may
spend more on imports fall as foreign
consumption
increases
Deterioration Price of exports falls If PED of exports is • Output increases
elastic then the increase in • Unemployment
quantity demanded will be more decreases
than the decrease in price & the • Standard of living
economy will benefit improves

Deterioration Price of imports rises Where demand for imports • Domestic output
is price inelastic, consumers unlikely to fall
would demand the goods in • Imports will decrease
similar proportions and slightly
thus spend significantly more • Less disposable
on imports income so worse
standard of living

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4.1.5 Trading Blocs & the World Trade Organisation (WTO)

Types of Trading Blocs

• A trading bloc is a group of countries who come together & agree to reduce or eliminate any
barriers to trade that exist between them
• There are different levels of economic integration ranging from relatively low integration in a bilateral
agreement to high integration in a monetary union e.g. the Eurozone
• Globally, there were more than 420 regional trade agreements in effect in 2022
• The trading blocs below each have an increased level of economic integration

Free Trade Areas

• A free trade area is a bloc in which countries agree to abolish trade restrictions between
themselves but maintain their own restrictions with other countries e.g Canada–United States–
Mexico Agreement (CUSMA)

Mexico, Canada & The USA have a free trade agreement but can deal individually with Cuba as they
see fit
• In the diagram above, Mexico, Canada & the USA have reduced/eliminated many trade
restrictions between themselves
o The USA refuses to trade with Cuba & has placed a complete ban on all exports/imports to
Cuba
o Canada trades with Cuba but imposes tariffs on all imports
o Mexico trades freely with Cuba

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 Customs Unions

• A customs union is an agreement between countries in which all goods/services produced by

members are traded tariff free. Additionally, countries agree on common tariff rates on imports from
all external (third party) countries

Countries within the European Union trade freely between themselves & have common
barriers with all third-party countries e.g. UK

• In the diagram above, countries in the European Union have eliminated all tariff barriers between
themselves but impose common tariff barriers on third party countries such as the UK or China

Common Markets

• Similarly, to a customs union, goods/services are traded tariff free in common markets. Additionally,
the four factors of production flow freely between member countries
o The goal is to improve the allocation of resources between the common market members &
lower costs of production
o The European Union is a customs union & a common market

Monetary Unions

• A monetary union takes integration a step further. Members enjoy all of the benefits of a customs
union & common market, but then also establish a common central bank which issues a common
currency & controls the monetary policy of member countries
o Prior to Brexit, the UK was a member of the European Customs Union & common market but
never joined the Eurozone

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 • Essential Conditions for a Successful Monetary Union Such as the Eurozone

Movement of labour Similar trade cycles

Labour should be able to move freely without The trade cycles of member countries should be
any major barriers e.g. language. The main similar so as to avoid tensions with the union e.g.
languages of the Eurozone are English, after the 2008 Financial Crisis, Southern European
French & German but language is still a countries were in a depression compared to
limiting factor the temporary recession in Northern European
countries. This created extreme pressure on the
survival of the Eurozone
Mobility of finance Fiscal transfers

There should be complete mobility of To maintain stability, there should be automatic

finance with prices & wages free to adjust fiscal transfers to countries that are performing
based on market conditions. This is a strength poorly. This is especially important as members
of the Eurozone & labour markets fluctuate have lost the use of monetary policy to deal with
based on members market conditions a crisis in their nation e.g. fiscal transfers to Spain,
Portugal & Greece post 2008 Financial Crisis were
very weak. Political tensions emerged in which
citizens of wealthier countries (Germany) did not
want their tax revenue used to bail out countries
with perceived poor fiscal history (Greece)

Costs & Benefits of Regional Trade Agreements

Benefits & Costs of Regional Trade Agreements

Benefits Costs
• Trade creation improves efficiency & • Trade diversion occurs as countries
generates higher income reallocate trade to partners in their
agreement. This may worsen global
efficiency
• Tariffs between member states • Some domestic industries
are eliminated experience structural unemployment
• Common tariffs to third party countries • Increased negative externalities of
simplify trading conditions production, resource depletion &
environmental damage
• A monetary union simplifies trading • Transitioning to a monetary union can be
costs & provides pricing transparency expensive & firms may find it hard to

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 • Some member countries gain from adjust/change their menu prices
improved monetary policy conditions • Member countries lose their ability to set
e.g. European interest rates may well be interest rates & control the supply of money
lower than an individual country's rates (monetary policy)
would have been • Loss of sovereignty
• There is less uncertainty
surrounding exchange rates as members
all use the same currency

Role of the WTO in Trade Liberalisation

• The World Trade Organisation (WTO) was established in 1995 to promote free trade
o They believe free trade is the best way to raise living standards, create jobs & improve people's
lives
• Trade liberalisation is the process of rolling back the barriers to free trade e.g. removing tariffs
• The WTO has two main roles in liberalising trade

1. It brings countries together at conferences & encourages them to reduce or eliminate protectionist
trade barriers between themselves e.g. The Doha Round conferences
2. It acts as an adjudicating body in trade disputes. Member countries can file a complaint if they
believe a trading partner has violated a trade agreement. The WTO will then run a hearing & make
a judgement
WTO judgements are not legally binding. Members voluntarily submit to them (or not). A
judgement in favour of a trade dispute does allow the aggrieved nation to put protectionist
measures in place with the WTO's approval. The hope is that these measures will then force the
nation committing the violation to back down and resolve the trade issue.

When evaluating the effectiveness of trade agreements, it is worth noting that larger economies
tend to selectively choose which rulings of the WTO to abide by. Smaller (usually developing)
economies tend not to have that luxury.

Conflicts Between Regional Trade Agreements & the WTO

• In March 2022 there were 320 regional trade agreements globally

• While these are beneficial to the members in the agreement (as they strengthen ties & create more
trade between them), they also create conflicts with the stated aim of the WTO - to liberalise trade
o Regional agreements often shift trade from a non-member who has comparative advantage,
to a member who does not

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 o Regional trade members then often institute common trade barriers on non-members which is
the opposite of trade liberalisation (protectionism)
• Regional trade agreements can be beneficial for member countries but may result in global
inefficiency in the allocation of resources
• The WTO advocates for free trade between all member countries

4.1.6 Restrictions on Free Trade

Reasons for Restrictions on Free Trade (Protectionism)

• Free trade aims to maximise global output based on the principle of comparative advantage
• However, there are numerous reasons why countries would seek to limit free trade in order to protect
themselves from certain outcomes
• This is called protectionism & may take the form of limiting imports, limiting exports, boosting exports
- or putting administrative barriers in place

Reasons for Protectionism

Reason Explanation

Infant industries To protect new firms that would be unlikely to succeed at start-up due to
the level of global competition. Once established support is removed

Sunset industries Similar to above, but at the other end of the life cycle, these firms are on
(declining industry their way out & the government chooses to support them to help limit the
which will likely become economic damage that would occur if they closed abruptly
extinct)

Strategic Industries such as energy, defence & agriculture are essential to self-
industries sufficiency & security. Being reliant on other countries for these creates
vulnerabilities for a nation

Dumping Dumping is anti-competitive & can harm a country's industries

Employment When firms outsource production to other countries or certain industries

are experiencing structural unemployment governments will step in to

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 protect jobs

Current Account When imports > exports the amount of money leaving the country to
deficit support foreign firms is greater than that entering to support domestic
firms. Protectionism aims to correct this imbalance

Labour/environme Many countries offer cheap labour & low-cost production due to poor
ntal regulations environmental regulations. Protectionism can help apply pressure to bring
about change in these countries

Types of Protectionism

• The most commonly used forms of trade protectionism include tariffs, subsidies, quotas &
administrative barriers

Tariffs

• A tariff is a tax on imported goods/services (customs duty)

• Domestic producers/retailers have to pay the tariff when the good/service crosses the border into
the country
o This raises the cost of production for domestic firms
o Firms often pass on the increased costs to consumers in the form of higher prices
o These higher prices allow some domestic firms to increase their output (law of supply)
• More inefficient domestic firms are now producing at the expense of more efficient firms globally who
reduce their output due to the tariff
o With increased domestic output, employment may increase

A tariff raises the price of the world supply from Pw to Pw + tariff. This reduces the quantity of
imports from Q1Q2 to Q3Q4

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Diagram Analysis
• World supply (Ws) is considered to be infinite & this supply curve is added to the domestic demand
(DD) & supply (SD) curves
• The pre-tariff market equilibrium is seen at PwQ2
o Domestic firms supply up to Q1 at a price of Pw
o Foreign firms supply the difference equal to Q1Q2 at a price of Pw (imports)
• After the tariff is imposed, the world price increases from Pw to Pw+ tariff
• The new market equilibrium is seen at Pw+tariffQ4
o Following the law of demand, the quantity demanded contracts from Q2 to Q4
o Following the law of supply, the quantity supplied by domestic firms extends from Q1 to Q3
o The level of imports is reduced from Q1Q2 to Q3Q4

Quotas

• A quota is a physical limit on imports e.g. in June 2022 the UK extended their quota on steel
imports for a further two years in order to protect employment in the domestic steel industry
• This limit is usually set below the free market level of imports
o As cheaper imports are limited, a quota raises the market price
o As cheaper imports are limited a quota may create shortages
• Some domestic firms benefit as they are able to supply more due to the lower level of imports
o This may increase the level of employment for domestic firms

Subsidies to domestic producers

• A subsidy lowers the cost of production for domestic firms
o They can increase output & lower prices
o With lower prices their goods/services are more competitive internationally
o The level of exports increases
o The increased output may result in increased domestic employment

Non-tariff barriers
• There are many strategies that can be used to create barriers to trade using less obvious methods
than tariffs, quotas & subsidies
o Health & safety regulations e.g. in 2017 the EU put a new health regulation in place regarding
the permitted level of aflotoxins in nuts. Aflotoxin levels are naturally higher in southern
hemisphere countries & it effectively blocked the import of southern hemisphere nuts
o Product specifications e.g. Canada specified that all jam imported into Canada needed to be
in a certain size of jar. Many countries do not usually manufacture jars in the required size

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 o Environmental regulations e.g. in November 2021 new regulations were put in place in the EU
& the USA to limit the amount of imports of 'dirty steel' - predominantly this is steel produced
using coal fired power stations which are prevalent in China
o Product labelling can be expensive for firms to apply & may limit their desire to sell into certain
markets

Impacts of Protectionist Policies

• Protectionist policies have a range of impacts on consumers, producers, governments, living
standards, & equality

Tariffs
• The best way to consider the impact of a tariff on stakeholders is to explain it using a diagram

A tariff impacts domestic producers, consumers, foreign producers & the government

Domestic producers
• Before the tariff domestic producers produced output equal to 0Q1 & their revenue was equal
to Pw X Q1
• After the tariff was imposed domestic producers produced 0Q3 & their revenue was equal to Pw X Q3
• Domestic producer surplus has increased by area 2

Domestic consumers
• Before the tariff domestic consumers consumed Q2 products at a price of Pw
• After the tariff domestic consumers consumed fewer products (Q4) at a higher price of Pw+tariff
• Domestic consumer surplus has decreased by areas 1, 2, 3 & 4

Government
• After the tariff is imposed the government receives tax revenue equal to ((Pw+tariff) - Pw) x (Q4-Q3) -
area 3

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Standards of living
• The standards of living for consumers worsen as the value of their income is eroded as they are
paying higher prices
• Domestic firms who benefit from increased production may increase employees' wages
o This would increase the standard of living for employees

Equality
• Workers in industries that have been experiencing structural unemployment due to foreign
competition will feel that the tariff results in them being treated more fairly

The Impact of Quotas, Subsidies & Non-tariff Barriers on Stakeholders

Stakeholder Quota Subsidies Non-tariff

• Increases their • Decreases costs of • Limits foreign competition
Domestic output production • Protects levels of outputs
Producers • Raises the • Increases output • May increase selling price &
selling price • Increases international revenue
• Increases competitiveness
their revenue

• Decreases their • Makes it harder for them to • Acts as a disincentive to sell

Foreign output compete with domestic into foreign markets
Producers • Compared to a firms • Costs of meeting the non-tariff
tariff, those firms barriers may
who manage to significantly reduce profit
export in the margins
quota receive
a higher
price for their
sales
• Results in higher • Lowers prices • May reduce choice/variety in
Consumers prices & less a market
choice
• They do not • This costs the government • They may lose some
Government receive the amount of the subsidy credibility with the WTO
any tariff • There is an opportunity • Enforcing the non-tariff

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 revenue (as cost associated with every barriers may be difficult or
there is no tariff) subsidy provided expensive
• They may
receive higher
tax revenue at
the end of the
financial year
when domestic
firms pay
their corporatio
n tax
• Reduces for • Improves for consumers as • Less choice & higher prices
Standards of consumers as they benefit from lower erode standards of living
Living higher prices prices - their income goes • Product labelling information
erode further may improve decision making
the purchasing & quality of life
power of their
income
• Improves • Domestic firms can • May help improve equality
Equality for domestic compete more equally e.g. environmental standards
firms but help create equal production
worsens inputs which results in
for foreign equality in the costs of
firms production

4.1.7 Balance of Payments

Components of the Balance of Payments

• The Balance of Payments (BoP) for a country is a record of all the financial transactions that occur
between it and the rest of the world
• The BoP has two main sections:
o The current account: all transactions related to goods/services along with payments related to
the transfer of income

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 o The financial & capital account: all transactions related to savings, investment and currency
stabilisation
• Money flowing into the country is recorded in the relevant account as a credit (+) and money flowing
out as a debit (-)

The Current Account of the Balance of Payments

• The Current Account is often considered to be the most important account in the BoP
o It records the net income that an economy gains from international transactions
An Example of the UK Current Account Balance For 2017
Component 2017
Net trade in goods (exports - imports) £-32.9bn
Net trade in services (exports - imports) £27.9bn
Sub-total trade in goods/services £-5bn
Net income (interest, profits & dividends) £-2.1bn
Current transfers £-3.6bn
Total Current Account Balance £-10.7bn
Current Account as a % of GDP 3.7%

• Goods are also referred to as visible exports/imports

• Services are also referred to as invisible exports/imports
• Net income consists of income transfers by citizens and corporations
o Credits are received from UK citizens who are abroad and send remittances home
o Debits are sent by foreigners working in the UK back to their countries
• Current transfers are typically payments at government level between countries e.g. contributions to
the World Bank

The Capital Account

• The Capital Account records small capital flows between countries and is relatively inconsequential
o E.g. debt forgiveness by the government towards developing countries
o E.g. capital transfers by migrants as they emigrate & immigrate

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The Financial Account

• The Financial Account records the flow of all transactions associated with changes of ownership of
the UK’s foreign financial assets & liabilities
• It includes the following sub-sections
1. Foreign Direct Investment (FDI): flows of money to purchase a controlling interest (10% or more)
in a foreign firm. Money flowing in is recorded as a credit (+) and money flowing out is a debit (-)
2. Portfolio Investment: flows of money to purchase foreign company shares & debt
securities (government & corporate bonds). Money flowing in is recorded as a credit (+) and
money flowing out is a debit (-)
3. Financial derivatives: are sophisticated financial instruments which investors use
to speculate & return a profit. Money flowing in is recorded as a credit (+) and money flowing out is
a debit (-)
4. Reserve Assets: are assets controlled by the Central Bank & available for use in achieving the
goals of monetary policy. They include gold, foreign currency positions at the International
Monetary Fund (IMF) & foreign exchange held by the Central Bank (USD, Euros etc.)

Causes of Deficits & Surpluses on the Current Account

• It is called the BoP as the current account should balance with the capital & financial account &
be equal to zero
o If the current account balance is positive, then the capital/financial account balance
is negative (and vice versa)
o In reality, it never balances perfectly & the difference is called 'net error & omissions'
• If there is a current account deficit, there must be a surplus in the capital & financial account
o The excess spending on imports (current account deficit) has to be financed from money
flowing into the country from the sale of assets (financial account surplus)
• If there is a current account surplus, there must be a deficit in the capital & financial account
o The excess income from exports (current account surplus) is financing the purchase of
assets (financial account deficit) in other countries

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 Causes of Current Account Deficits

Relatively low productivity Relatively high value of the Relatively high rate of inflation
country’s currency
• Low productivity • Currency appreciation • A relatively high rate of
raises costs makes a country's exports inflation makes a country's
• Exporting firms with low more expensive relative to exports more expensive
productivity may find other nations than other nations
themselves at a price & • Foreign buyers look • Foreign buyers look for
cost disadvantage in for substitute substitute products which
overseas markets which will products which are priced are priced lower
decrease competitiveness & lower • Exports fall & the balance on
the level of exports • Exports fall & the balance on the current account worsens
• With higher domestic prices, the current account worsens • Similarly, high inflation may
consumers may also buy • Similarly, currency mean that goods/services
abroad thus increasing the appreciation makes imports are cheaper in other
imports cheaper countries
• Domestic consumers may • Domestic consumers may
• Falling exports & rising switch demand to foreign switch demand to foreign
imports creates a deficit goods & as imports rise, the goods & as imports rise, the
balance on the current balance on the current
account worsens account worsens

Rapid economic growth Non-price factors such as

resulting in increased imports poor quality and design
• Rapid economic growth • When a country develops a
raises household income reputation for poor quality &
• Households respond by design, its exports fall as
purchasing goods/services foreign buyers look
with a high- for better
income elasticity of substitutes elsewhere
demand (income elastic) • Domestic buyers who are
• Many of these goods are able to shop abroad also
imported & as imports rise, choose to buy better quality
the balance on the current products elsewhere & the
account worsens level of imports rise
• A fall in exports & a rise in
imports worsens the balance
on the current account

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Measures to Reduce Imbalances on the Current Account

• The Government has several options available to them in order to tackle a current account deficit
o They could do nothing, leaving it to market forces in the foreign exchange market to self-correct
the deficit
o They could use expenditure switching policies
o They could use expenditure reducing policies
o They could use supply-side policies
• The choice of any policy - or any combination of policies generates both costs & benefits

Costs & Benefits of Policies Used to Tackle Current Account Deficit

Policy Option Benefit Cost

Floating exchange rates act as a self- There may be other external factors that
correcting mechanism. Over time a prevent the currency from depreciating. It may
higher level of imports will end up take a long time for self-correction to happen
depreciating the currency causing & many domestic industries may go out of
Do nothing imports to decrease (they are now more business in the interim. The longer it takes
expensive) & exports to increase (they to self-correct, the more firms will delay
are now cheaper). This improves the investment in the economy
deficit
This is often successful in changing Any protectionist policy often leads
the buying habits of consumers, to retaliation by trading partners. This may
switching consumption on imports to consist of reverse tariffs/quotas which will
Expenditure
Switching consumption on domestically produced decrease the level of exports. This may offset
goods/services. This helps improve a any improvement to the deficit caused by the
deficit policy
Deflationary fiscal policy invariably Deflationary fiscal policy also dampens
reduces discretionary income which domestic demand which can cause output to
Expenditure
leads to a fall in the demand for imported fall. When output falls, GDP growth slows &
Reducing
goods & improves a deficit unemployment may increase
Improves the quality of products & lowers These policies tend to be long term policies so
the costs of production. Both of these the benefits may not be seen for some time.

Supply-side factors help the level of exports to They usually involve government spending in
increase thus reducing the deficit the form of subsidies & this always carries
an opportunity cost

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Significance of Global Trade Imbalances

• As global trade is a net sum game where the value of global exports = global imports, it follows that if
one country is running a current account surplus then another country is running a deficit
• Persistent deficits can be problematic as it means that finance from abroad (in the form of loans or
foreign direct investment) is required in order to fund continued imports
o This may mean that a country is gradually selling its assets
o Owning money to a foreign entity creates vulnerabilities

▪ The 2008 Global Financial Crisis demonstrated the impact of fast changing conditions in
which creditors were insisting on being repaid quickly e.g. Greece owed creditors
(including Germany) significant sums & was required to pay these back creating
numerous problems in their economy
• Persistent surpluses can be problematic as it means that the focus of the allocation of a nation's
resources is on meeting foreign demand as opposed to meeting domestic demand
o This can limit availability of goods/services in the local economy which can possibly decrease
the standard of living for some households
o It can also create instability in the foreign exchange market if there is a floating exchange rate
mechanism in operation
o E.g. China ran a surplus for years but did not allow its currency to float freely. In recent years
they have switched their focus to increasing domestic demand
▪ This surplus has resulted in significant foreign direct investment by Chinese firms & the
level of foreign asset ownership is high

4.1.8 Exchange Rates

Exchange Rate Systems

• An exchange rate is the price of one currency in terms of another e.g. £1 = €1.18
o International currencies are essentially products that can be bought & sold on the foreign
exchange market (forex)
• The Central Bank of a country controls the exchange rate system that is used in determining the value
of a nation's currency
• There are three exchange rate systems
o A floating exchange rate (a system where demand supply determines the rate at which one
currency exchanges for other)

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 o A fixed exchange rate (a system which the country’s central bank intervenes in the currency
market to fix the exchange rate in relation to another currency. E.g. US$)
o A managed exchange rate (a system where free market determines the value of currency but
also where central bank intervene from time to time so as to keep the currency value with in a
desired range)

Exchange Rate Systems

Exchange Rate System Explanation

• As with any market, if there is excess demand for the currency
on the forex market, then prices rise (the currency is worth more)
Floating o In a floating exchange rate system this is called
an appreciation
• If there is an excess supply of the currency on the forex market,
then prices fall (the currency is worth less)
o In a floating exchange rate system this is called
a depreciation
• The Central Bank negotiates with the international Monetary
Fund (IMF) to fix (peg) their currency to another one
o Sometimes the peg is at parity e.g. 1 Brunei Dollar = 1
Singapore Dollar
Fixed o Often the peg is not at parity e.g. Hong Kong has pegged
its currency to the US$ at a rate of HK$ 7.75 = US$ 1

• A revaluation occurs if the Central Bank decides to change the

peg and increase the strength of its currency
• A devaluation occurs if the Central Bank decides to change the
peg and decrease the strength of its currency

• This is a combination of the fixed & floating mechanism

• The Central Bank determines the preferred currency value -
Managed
and then the currency is free to fluctuate within a certain range of
this value e.g 0.75%
• If it goes above this range then the Central Bank will
intervene by selling its own currency in forex markets so as to
increase supply

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 o Increased supply of their currency in the forex
market decreases the value of the currency & brings it
back within the range
• If it goes below this value then the Central Bank will intervene
by buying its own currency in the forex market using its foreign
reserves (US$, Euros etc.)
o Increased demand for their currency in the forex
market increases the value of the currency & brings it
back within the range

• Interest rates can also be used to intervene

o Raising interest rates appreciates a currency as returns
on investment/savings become more attractive to
foreigners & they demand local currency
o Decreasing interest rates depreciates a currency as
returns on investment/savings become less attractive to
foreigners & they sell their local currency & move their
money elsewhere

Factors Influencing Floating Exchange Rates

• Numerous factors influence floating exchange rates, resulting in an appreciation or depreciation of a

currency

Factors influencing floating exchange rates

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 1. Relative interest rates: influence the flow of hot money between countries. If the UK increases its
interest rate, then demand for £'s by foreign investors increases & the £ appreciates. If the UK
decreases its interest rate, then the supply of £'s increases as investors sell their £'s in favour of other
currencies & the £ depreciates
2. Relative inflation rates: as inflation in the UK rises relative to other countries, its exports become
more expensive so there is less demand for UK products by foreigners, which means there is less
demand for £s & so the £ depreciates
3. Net investment: foreign direct investment (FDI) into the UK creates a demand for the £ which leads to
the £ appreciating. FDI by UK firms abroad creates a supply of £'s which leads to the £ depreciating
4. The current account: UK exports have to be paid for in £'s. UK imports have to be paid for in local
currencies, which requires £'s to be supplied to the forex market. Due to this, an increasing trade
surplus will result in an appreciation of the £ & an increasing deficit will result in a depreciation of the
£
5. Speculation: the vast majority of currency trades are speculative. Speculation occurs when traders
buy a currency in the expectation that it will be worth more in the short to medium term, at which point
they will sell it to realise a profit
6. Quantitative easing: involves increasing the money supply & much of the new supply is used to buy
back gilts. Many of these gilts are owned by foreigners who then exchange the £s received for their
own currency. The increase in the supply of £'s depreciates the £

Intervention in Markets Using Forex Transactions & Interest Rates

• When using a managed exchange rate system, Government intervention in currency markets takes
place in two ways & is managed by the Central Bank

1. Changing interest rates: if the Central Bank wants to appreciate the country’s currency, it
would raise interest rates thereby making it more attractive for foreigners to move money into the
country's banks (hot money). Decreasing interest rates has the opposite effect & causes a
depreciation
2. Buying & selling currency in the forex market: The Central Bank can change the demand or
supply for their currency using their reserves. If they want to appreciate the currency then they buy
it on the forex market using foreign currencies e.g. to bolster the value of the £, the Central Bank
could take US$'s from their reserves & buy £'s. If they want to depreciate the currency then
they sell their own currency & buy foreign currencies

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The Consequences of Competitive Devaluation/depreciation

• When a currency is intentionally devalued/depreciated by a government, it makes the country's

exports cheaper
o If demand for their exports is price elastic, then the country is likely to experience higher export
volumes & higher export revenues
o E.g. for many years China prevented the value of their currency from appreciating & saw a
boom in their export sales
• Intentional devaluation/depreciation has several consequences
o It is anticompetitive & upsets international competitors
o Large countries usually have more financial resources to manipulate markets & so gain unfair
advantages over smaller countries
o Other countries may respond by also lowering the value of their currencies resulting in very
little change to market share
o The devaluation/depreciation raises the cost of imports used in production & with little change to
the value of exports - profits decrease

Impacts of Changes in Exchange Rates

• Changes to exchange rates may have far-reaching impacts on an economy

The impact of changes to exchange rates on an economy

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 Economic Indicator Explanation
The Current Account • Depreciation of the £ causes exports to be cheaper for foreigners to buy
& imports to the UK are more expensive
• The extent to which this improves the current account
balance depends on the Marshall-Lerner condition
o This follows the revenue rule which states that in order to
increase revenue, firms should lower prices for products that are
price elastic in demand
o If the combined elasticity of exports/imports is less than 1
(inelastic), a depreciation (fall in price) will actually worsen the
current account balance
• It is also important to recognise that there is a time lag between the
depreciation of the £ and any subsequent improvement in the current
account balance
o This is explained by the J-Curve effect
▪ It takes time for firms & consumers to respond to changes
in price
▪ Once it becomes evident that price changes will last for a
longer period of time, firms & consumers switch
▪ E.g. a firm in the USA has been importing electric scooters
from the UK. If the Euro depreciates, the price of scooters
in France becomes relatively cheaper. In the short-term,
the USA firm will not switch immediately to purchasing
scooters from France as the exchange rate may soon
bounce back. They also have a good relationship with their
UK suppliers. In the long term they are likely to switch

Economic growth • Net exports are a component of aggregate demand (AD)

o A depreciation that results in an increase in net exports will lead
to economic growth

Inflation • Cost push inflation is likely to occur as the price of imported raw
materials increases with currency depreciation
• Net exports are a component of aggregate demand (AD)
o A depreciation that results in an increase in net exports will
lead to an increase in aggregate demand

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 o This may lead to an increase in demand pull inflation
• An appreciation of the currency will have the opposite effect

Unemployment • If depreciation leads to an increase in exports, unemployment is likely

to fall as more workers are required to produce the additional products
demanded
• An appreciation of the currency will have the opposite effect

Living standards • The impact of a depreciation on living standards can be muted

o As imports are more expensive, households face higher prices
& less choice, which detracts from living standards
o Rising exports can decrease unemployment & increase
wages/income which means an improved standard of living for
some households
• The impact of an appreciation on living standards will be the opposite
Foreign direct investment • Depreciation of a currency makes it cheaper for foreign firms to invest
(FDI) in the country and can increase the FDI
o The money they have available to invest is worth more when the
currency has depreciated
• An appreciation has the opposite effect

4.1.9 International Competitiveness

Measures of International Competitiveness

• International competitiveness refers to how well a country's products compete in international
markets
o Competitiveness can change over time
• In order to make a comparison between the competitiveness of two countries, two metrics are
commonly used
1. Relative unit labour costs: the total wages in an economy divided by output. This provides a
number that indicates the labour costs for each unit of output produced. It is then possible to look
at the relative unit labour cost for the UK compared to France. If it is lower than the UK is more
competitive in the international market
2. Relative export prices: monitoring export prices provides insight into whether they are rising or
falling over time. If they are rising in the UK relative to other countries, then the UK is
becoming less competitive. If they are falling in the UK, it is becoming more competitive

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Factors Influencing International Competitiveness
• When considering factors that influence international competitiveness, the word relative is important
o If inflation is happening at an equal rate in all competitor nations, there will be little change to
the level of competitiveness
o However, if it increases more in the UK relative to its competitors, then the UK
competitiveness in international markets will decrease

Factors Influencing International Competitiveness

Factor Explanation
• A rise in productivity levels of UK workers, relative to their
competitors, will lower the production cost per unit & increase
competitiveness
Relative unit labour costs
• A decrease or stagnation in productivity, relative to their
competitors, will worsen competitiveness

• Increases in labour costs, relative to other countries, are likely to

make exports more expensive as the costs of production have
increased resulting in a worse level of competitiveness
Relative wages & non-wage • Increases in non-wage costs such as pensions or social security
costs taxes paid by the employer are likely to reduce output or raise costs
of production, thus making exports less competitive
• Decreasing wage & non-wage costs have the opposite effect

• Inflation raises the price of goods/service in an economy

• If inflation increases in the UK, relative to other countries,
Relative rate of inflation then foreign buyers pay more for the exports they purchase & this
worsens competitiveness
• Decreasing inflation has the opposite effect
• Government regulation tends to raise costs of production as it sets
standards/requirements that firms have to meet
Relative level of regulation • Increased costs of production mean that export prices are likely to
rise & competitiveness will worsen
• Deregulation may have the opposite effect

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Significance of International Competitiveness

Benefits of International Competitiveness

1. Export led growth: An increase in exports generates an increase in economic activity resulting
in economic growth
2. Unemployment decreases: Economic growth leads to an increase in employment, incomes & wage
growth
3. Current account surpluses: exports are likely to be greater than imports & the government does not
have to concern itself with difficult policy decisions aimed at reducing a large deficit
4. Increased overseas foreign direct investment (FDI): It provides finance for firms to invest in
overseas assets which in the long-term means they are able to increase their income & profit
5. Standards of living improve: as incomes tend to rise with economic growth, households
gain purchasing power & access to a wider variety of goods/services.

Problems Caused by Being Internationally Uncompetitive

• In many ways, the problems of being uncompetitive are the reverse of the above. The following point
is worth highlighting

1. Government policies: with a current account deficit & a lack of international competitiveness,
governments will focus more of their resources on gaining ground. E.g. more spending on supply-
side policies. Any policy action creates opportunity costs & trade-offs.

4.2. Poverty and Inequality

4.2.1 Absolute & Relative Poverty

Absolute & Relative Poverty

• Absolute poverty is a situation where individuals cannot afford to acquire the basic necessities for a
healthy & safe existence
o These necessities include shelter, water, nutrition, clothing & healthcare
o In 2022, the World Bank defined absolute poverty as anyone who was living on less than $1.90
a day
o Absolute poverty is more prevalent in developing countries than developed ones

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 • Relative poverty is a situation where household income is a certain percentage less than the median
household income in the economy
o Poverty in a household is considered relative to income levels in other households
o The UK defines relative poverty as households that are living with less than 60% of the median
household income
o In May 2022, the median UK monthly household income was £2072/month
▪ This meant that the relative poverty line was any household earning less than
£1243,20/month
o In early 2022, 22% of the UK population was in relative poverty
o Relative poverty is the main form of poverty that occurs in developed countries

Causes of Changes in Poverty

• There has been a significant decrease in absolute poverty since 1990
o There were 1.9 billion people in absolute poverty in 1990. By 2022 it had fallen to 750 million
• Absolute poverty can decrease even while income inequality increases
o This means that the income of wealthier households is rising faster than the income of the
poorer households
• A reduction in absolute & relative poverty requires the benefits of both the workings of the free
market & government intervention

Causes of changes in absolute poverty

• There is a strong correlation between economic growth & a decrease in absolute poverty
o Economic growth increases household incomes
• Government tax & benefit policies can support the most vulnerable groups in society e.g. children,
pensioners, people stuck in long-term unemployment
o In developed economies, benefit policies can ensure that no household is living in absolute
poverty

Causes of changes in relative poverty

• Rising asset prices can decrease relative poverty in households which own their own properties
o Asset prices often increase faster than wages or income
• Trade liberalisation increases potential market size & output in an economy
o This leads to an increase in the demand for labour & a wage rise
o This creates additional income which has a multiplier effect & pulls households out of relative
poverty
• Decreased levels of government benefits can lower household income & increase relative poverty

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4.2.2 Inequality
Inequality

• Income & wealth inequality are two different concepts

o Income inequality refers to the unequal distribution (flow) of income to households i.e rent,
wages, interest & profit
o Wealth inequality refers to differences in the amount of assets that households own
• The two main measures of income inequality are the Lorenz Curve & the Gini coefficient

The Lorenz Curve

• The Lorenz Curve is a visual representation of the inequality that exists between households in an
economy
• Data is commonly presented in quintiles (population divided into 5 groups i.e 20%)
or deciles (population divided into 10 groups i.e 10%)
o E.g. in 2021 42% of the income flow in the UK went to the top 20% of households while only
7% went to the bottom 20%
• Perfect income distribution is not the goal (20 % of the population get 20% of the income; 40% get
40% percent of the income etc.)
o That would equate to socialism & completely remove incentives for work as everyone would
be paid equally
• More equal income distribution is desired as it reduces poverty & social unrest
o What constitutes acceptable income equality is a normative economic issue

An illustration of Income Inequality for the UK (green line) & Sweden (red line) using a Lorenz Curve
Model. The income distribution in the UK is more unequal than that of Sweden

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Diagram Analysis
• The line of equality represents perfect income distribution (not desirable)
• In the UK the bottom 20% of households receive 5% of the income flow while in Sweden they
receive 9% of the income flow
• In the UK the top 10% of households receive 45% of the income flow while in Sweden they
receive 25%
• Sweden has a more equal distribution of income than the UK

The Gini Coefficient

• The Lorenz curve can be used to calculate the Gini Coefficient (Measures the distribution of income in
a population. The closer the value to 1, the worser the income inequality)

The Gini Coefficient is calculated using the area beneath the line of equality

Diagram Explanation
•

• A represents the area between the line of equality & the UK Lorenz curve
• B represents the area under the Lorenz curve
• A value of 0 represents absolute equality (socialism) & 1 represents perfect inequality
• In 2022, the USA coefficient was .41 as compared with the UK value of .35
o The distribution of income in the UK was more equitable than in the USA

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Causes of Income & Wealth Inequality

• Numerous factors cause wealth & income inequality

• It is generally true that developed countries have a larger tax base & are able to provide a better level
of support to the poorest households the economy, than developing countries are able to

Cause of Wealth & Income Inequality

Education, Training &

Trade Unions Benefit system Pension payments
Skills
The higher the skill level Countries with Countries that provide a State pension
the higher the level of strong trade range of benefits (such payments ensure a
income. A country with union membership tend to as unemployment, minimum standard of living
a poor education system have higher levels of disability, child for retirees resulting in a
will see greater inequality income. With low trade support, housing more equal
than one with a good union membership, support etc) raise the distribution of income.
education system the exploitation of income of the lowest 20% Countries without it have a
workers through low of the population resulting much higher percentage of
wages is easier in more equal distribution pensioners living in
poverty
Employment
Wage Rates Tax Structure Asset Ownership
Legislation
The purpose of a national Generally, the more Progressive tax Assets generate income.
minimum wage is to workers are protected by systems allow all income The more equal the asset
improve the equity in the law, the better the income earners to contribute
ownership in an economy
distribution of income. distribution in an economy to public
Without it, more e.g. maternity revenue according to their the less the inequality in
households would benefits ensure that new ability. Decreasing income distribution. This
be earning less & mothers have a higher taxes on the lower end &
was one reason why the
inequality would increase level of income during the increasing it on the upper
first months of leave after end would mean that the UK government changed
a birth system is more the law in 1980 allowing
progressive & there
council house tenants
would be a more equal
distribution of income the right to buy their
property at a discounted
rate. It is also a reason for
the current shared
ownership scheme

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Impact of Economic Change & Development on Inequality

• In the 1950's Simon Kuznets developed a hypothesis that described how income inequality
changed as an economy went through stages of industrialisation & development
o This hypothesis was explained using the Kuznets Curve
• Industrialisation results in increased inequality as some workers move from the lower productivity,
lower paid agricultural sector into the higher productivity manufacturing sector
o There is now greater income inequality with the workers left behind
• However, at some point, inequality starts to decrease
o This is most likely due to government intervention/support funded by increased state tax
revenue brought about as a result of the increased production in the economy

The Kuznets Curve illustrates how income inequality first increases with industrialisation before then
decreasing

Diagram Analysis
• As a country changes sectors from primary (farming) to secondary (manufacturing), productivity
increases & the per capita income increases
• However, inequality is also increasing as the gap in wages between the primary & secondary sector is
significant
• At some point, the economy will reach a turning point of income where inequality begins to fall
o This often occurs as the primary sector diminishes while the secondary & tertiary (services)
sectors increase
o Developed economies tend to generate more income from secondary & tertiary sectors

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 The Kuznets Curve described above is not in the syllabus. However the Principal Examiner
mentions it in the Guide as one way in which critical thinking can be demonstrated when
approaching questions on income inequality in developing nations.

Capitalism & Inequality

• Capitalism is at the heart of free market economics

• Under Capitalism, inequality is inevitable
o Workers with higher skills receive higher wages
o Workers with little to no skills receive little to no wage
o Individuals with higher income will acquire more assets leading to higher levels of income
▪ In turn, they can keep on acquiring assets
o Individuals with lower income will find it hard to acquire assets
• The principles of capitalism are considered important as the incentive to acquire income raises
productivity & output
• The long-term cost of capitalism is that the factors of production become concentrated in ownership
with relatively few individuals developing extreme wealth, at the expense of many who lose out
• It has been argued that capitalism needs checks & balances to limit the income & wealth inequality
that will naturally develop
o This calls for government intervention

4.3 Emerging & Developing Economies

4.3.1 Measures of Development

Measures of Development

• Economic development is the sustainable increase in living standards for a country, typically
characterised by increases in life span, education levels, & income
• There are many measures of economic development
o Single indicators e.g. number of doctors/1000 people; infant mortality rate; % of the population
with access to clean drinking water
o Composite indicators such as the Human Development Index (HDI)

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The Human Development Index (HDI)
• Developed by the United Nations, it is a combination of 3 indicators
1. Health, as measured by the life expectancy at birth e.g.in 2019 it was 81.2 years in the UK
2. Education, as measured by a combination of the mean years of schooling that 25 year old's have
received, together with the expected years of schooling for a pre-school child
3. Income, as measured by the real gross national income per capita at purchasing power parity
(ppp)
• Each indicator is given equal weighting in the index
• The index ranks countries on a score between 0 & 1
o The closer to 1, the higher the level of economic development & the better the standard of
living
o A value of < 0.550 is considered low development e.g. Chad 0.394
o A value of 0.550-0.699 is considered medium development e.g. El Salvador 0.673
o A value of 0.700-0.799 is considered high development e.g Thailand 0.777
o A value ≥ 0.800 is considered very high development e.g. Norway 0.957

Advantages & Limitations of Using the HDI to Compare Levels of Development

The Advantages & Disadvantages Of Using the HDI For Comparison
Advantages Disadvantages
• It is a composite indicator which provides • It does not measure the inequality that exists
a more useful comparison metric than single as it uses the mean GNI/capita
indicators do • It does not measure or compare the levels of
• It incorporates three of the most important absolute & relative poverty that exist
metrics for households i.e. health, education & • For many countries it does not provide
income useful short-term information as gathering
• It is widely used all over the world which the data required for the calculation is
provides an opportunity for meaningful difficult. This means the data often lags
comparisons reality by several years
• It provides a goal for governments to use when
developing their policies e.g. it may help identify
that the education levels are holding back
improvements to the HDI & government
policy can target that
• It provides citizens with an understanding of
how their quality of life compares to other
countries

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Other Indicators of Development
• There are many more single indicators of economic development. These can be used to compare the
relative standing of countries at any point in time. They also serve to provide targets for improving the
lives of citizens. Examples include
o The proportion of the male population engaged in agriculture
o Energy consumption per person
o The proportion of the population with access to clean water
o The proportion of the population with internet access
o Mobile phones per thousand people
o Number of girls completing primary education
• Two other useful composite indicators include
o The inequality adjusted HDI (IHDI)
o The Multi-dimensional Poverty Index (MPI)

Characteristics Of the IHDI & MPI

IHDI MPI
• Created in 2010 to deal with the lack of • Launched in 2010 by the Oxford Poverty &
information that the HDI provides Human Development Initiative at the University
on inequality of Oxford
• The IHDI will be equal to the HDI value • It measures the complexities of poor people’s
when there is no inequality, but falls lives, individually & collectively, each year
below the HDI value as inequality rises • It tracks deprivation across three dimensions & 10
• This means that the IHDI measures the indicators: health (child mortality,
level of human development nutrition), education (years of schooling,
when inequality is accounted for enrolment), & living standards (water, sanitation,
• The difference between the HDI & IHDI electricity, cooking fuel, housing, assets)
can be expressed as a percentage & • It first identifies which of these
represents the loss in potential human 10 deprivations each household experiences
development due to inequality • Then identifies households as poor if they
• It provides greater insight into suffer deprivations across 1/3 or more of the
the differences in human weighted indicators
development that exist in a country as • It can focus in on regions, ethnicities & also any of
opposed to the average human the three dimensions making it a useful tool for
development policymakers & non-government organisation
(NGOs) working to reduce poverty

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4.3.2 Factors Influencing Growth & Development
Economic Factors That Influence Growth & Development
• Data shows that economic growth has a very positive impact on economic development
• In most cases growth precedes development, but his is not always true e.g. Bangladesh used a
range of strategies (including micro-finance) to transform the quality of life for many households
• In some cases (usually in developing countries) economic growth is tied to one industry & generates
so many negative externalities of production that the standard of living decreases for many even as
growth increases
Economic factors That Influence Growth & Development

Factor Explanation
• In 2022 copper exports from Zambia accounted for 70% of their total
exports & primary products in excess of 90%. They are suffering
from over-specialisation
• Primary products tend to have a very low-income elasticity of
demand (YED). As world income rises, there is a less than
Primary product dependency proportional increase in demand
o This means that there is limited scope to continue increasing
demand
• Primary products have very little added value
o Exporting manufactured products raises the added value,
incomes & profits
• Due to the inelastic nature of both the demand & supply
of commodities, small changes in demand or supply can lead to
large changes in price
Volatility of commodity
• In 2020, 25% of Bolivia's GDP was generated by exports.
prices
Commodities accounted for 60% of its exports
o When commodity prices rise, GDP rises - & vice versa
• A more diversified range of exports prevents this
• In the 1950's two economists identified the savings gap as a major
constraint on growth
The savings gap: Harrod- • The Harrod-Domar model identified the following benefits of
Domar model increased savings
o Increased savings → increased investment → higher capital
stock → higher economic growth → increased savings

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 • Based on this, any intervention (foreign or governmental)
to increase the capital stock in an economy will lead to growth
• There are many criticisms of the model including
o It does not account for many other factors such as labour
productivity, corruption, technological innovation
o It was created based on data from wealthier industrialising
nations as opposed to very poor undeveloped countries
o It focused only on physical investment & ignored other types
such as investment in human capital (labour)
• Foreign currency gaps develop for a number of reasons
o Oil importing countries have to pay more (reserves
decrease) when world oil prices rise whereas oil exporting
countries receive less (less flowing in) when world oil prices
fall
o Large international debt payments may require continual
The foreign currency gaps
outflows of currency
o Capital flight due to uncertainty or sanctions
• This means that central banks are forced to use their reserves to buy
vital imports
• Developing a diversified, healthy export market prevents foreign
currency gaps from developing
• Occurs when money or assets rapidly leave a country
• This may happen due to political upheaval, economic sanctions, war,
or changes to government policy (e.g. interest rates)
Capital flight o Sanctions applied to Russia in 2022 resulted in $75 billions
of capital outflows
• Capital flight reduces the money available for investment, reducing
growth & development
• If the dependency ratio is high it means there is less money available
Demographic factors for savings & investment
• Many developing countries have high dependency ratios
• Financial institutions enable individuals & firms to borrow
money which can be used for investment or to generate growth
Access to credit & banking
• A lack of financial institutions prevents this from happening

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 • Good infrastructure reduces business costs & attracts foreign direct
investment
• Some developing countries have such poor infrastructure that it
Infrastructure makes it difficult to generate economic activity
o This is one reason why China has invested so heavily in
infrastructure projects in Asia & Africa as it unlocks economic
potential
• Investing in this supply-side policy increases the potential output of
the country (shifts the production possibility frontier outwards)
Education & skills
• Higher education/skill levels → higher human capital → increased
productivity → higher output → higher income
• In many countries, property is the main household asset which can be
used to secure loans or generate income
Absence of property rights
• A lack of property rights in some developing countries prevents this
from happening

Impact of Non-economic Factors

• Aside from the economic factors discussed above, a range of non-economic factors can have
significant influences on economic growth & development
1. Corruption: this is a major problem in many countries. Often money intended for investment is
siphoned off by corrupt politicians resulting in a lower level of investment. Corruption also diverts
funds to certain groups who have bribed or lobbied officials (e.g. multinational firms) resulting in
projects that deliver a low level of growth & development
2. Poor Governance: leads to inefficient use of resources & poor decision-making. It may also result in
laws/regulation which directly inhibit growth & development
3. Wars: conflict destroys infrastructure, disrupts supply chains & often reduces the post war supply of
labour. Conflict shifts the production possibility curve inwards
4. Political instability: if governments keep changing, it results in constantly changing policies &
priorities. It also reduces confidence in the economy & international investors are slower to invest as
they are fearful of losing their investment
5. Geography: it is harder for landlocked countries to generate economic growth. Often transportation &
administration costs are higher than those with access to ports, which increases the costs of
production & decreases international competitiveness. Natural terrain can also be a limiting factor e.g
the arid, mountainous terrain of Pakistan

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4.3.3 Strategies Influencing Growth & Development

Market-orientated Strategies

• Market-orientated strategies are strategies that create the conditions for private individuals & firms
to pursue economic activity with the aim of maximising profit
Market-orientated Strategies

Trade Liberalisation Foreign Direct Investment Subsidy Removal

More trade increases output, More FDI increases output, Subsidy removal can increase
employment & incomes employment & income competition, efficiency, employment,
profits & income
Floating Exchange Rate
Microfinance Privatisation
Systems
Appreciation can generate An extremely successful May increase competition leading to
higher incomes as the policy in many countries, an increase in output, employment
cost of imported raw especially Bangladesh. & incomes
materials reduces Microfinance helps to
possibly leading to higher break the poverty cycle
income

Interventionist Strategies
• Interventionist strategies are put in place by governments to correct the failings of the free market &
promote the welfare/development of its citizens

Interventionist Strategies
Human capital Protectionism Managed exchange rates
Policies aimed at developing This can intervene in natural In a floating exchange rate
human capital raise the market forces mechanism, rising exports will lead to
potential output of the which lower wage rates. currency appreciation which, in time,
economy which leads to Protecting employees can
will lead to a slowdown or fall in
an increase in income lead to higher levels of
exports. Managing currency prevents
income
appreciation & a slowdown in exports
leading to long periods of growing
income

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 Infrastructure Joint ventures Buffer Stocks
Developing infrastructure Some countries (e.g. India) This is explained in more detail below.
reduces the cost of block foreign ownership of Price stability ensures income
business & makes firms (FDI). Joint ventures stability. It also results in excess
economic activity (JV's) are a way that firms
production which increases levels of
easier. This increases can get around that. JV's
employment. It was used extensively
FDI, output, employment can increase trade,
in Europe post second world
& income output, employment &
war (Common Agricultural Policy) &
incomes e.g Tata
Starbucks allows
is still used extensively in different

Starbucks to sell their markets in India, Thailand (rice),

product through an Indian Vietnam, Indonesia (rice & coal)
global steel giant, Tata.

Buffer Stock Schemes

• Buffer stocks are created when the government buys up supplies of agricultural products when
harvests are plentiful, stores them - & then sells them when supplies are low
o It aims to support agricultural producers, consumers & stabilise the market price of
agricultural products
• While doing good, they create several problems, including
o Storage is expensive
o Transport to & from storage is expensive
o It is difficult to analyse & control market forces
o It requires all producers to participate honestly in the scheme e.g. producers in Vietnam
have been caught importing cheap rice from Thailand & then selling i to the government at a
profit in the buffer stock scheme

A buffer stock scheme for rice in Vietnam with P2 as the floor & P3 as the ceiling

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Diagram Explanation
• The Vietnamese government has set a price ceiling (maximum price) & price floor (minimum price) in
the market for rice
• The equilibrium is initially at P1Q1
• If the price of rice drops below P2, the government will purchase large quantities & store it (FG)
o This will reduce market supply, preventing the price from falling below the minimum price (P2)
• If the price of rice rises above P3, the government releases it from storage (AB) & sells the rice
o This increases market supply & ensures that the price does not rise above the ceiling price

Other Strategies

• Numerous other strategies are also available to increase growth & development
• Contextual factors can influence the effectiveness of any of these strategies & some that work well in
one context may be entirely ineffective in another

Additional Growth & Development Strategies

Strategy Explanation

• Developed in 1955, the Lewis Model described economies as having two

sectors - the rural agricultural sector & the urban industrial sector
• Productivity & incomes are higher in the industrial sector so Lewis argued
Industrialisation: the
countries should transform their structure
Lewis model
• Critics argue that many developing countries have high unemployment in
urban areas; the theory also assumes that manufacturing will be a labour
intensive task when in reality it is often capital intensive

• For many developing countries this is an excellent source of employment,

revenue & income
Development of • Rising global incomes have increased demand for tourism
tourism • Ecotourism is developing as a response to negative externalities of
consumption that tourism creates. e.g. increased waste, noise, use of scarce
resources (drinking water)
• Some countries have successfully developed as a result of GDP growth that
has been driven by relatively few primary industries e.g Zambia has
benefitted from the copper industry; most Middle East countries developed
Development of
entirely due to oil; Ethiopia depends on coffee & cut flowers
primary industries
• Developing these primary product industries is lucrative due to
their comparative advantage

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 • Many developed countries use protectionism to shift profits from developing
nations to developed nations
o E.g. the USA has no tariff on cocoa beans imported into the USA from
Ghana, but does place a tariff of 12% on cocoa powder. It want
manufacturers in the USA to benefit from processing cocoa beans
• The price of many commodities is set far away from where the farmers are -
Fairtrade schemes
the Chicago Board of Exchange. Here, prices are set months in advance &
determine the price buyers will pay sellers on a particular day in the future
• Fair trade schemes aim to bypass these restrictions by connecting ethical
buyers directly with the farmers in developing countries
o They pay them higher prices
o They often help them to develop & market value added products
• Three of the most common forms are humanitarian aid, grants & soft loans
• Aid has proven beneficial in times of distress
Aid
• Critics argue that aid breeds dependency, corruption & disincentivises
individual responsibility
• Many developing nations have borrowed significant sums of money in the past
which have to be repaid (with interest) over a long period of time
• The opportunity cost of these repayments is significant & often includes
o Loss of infrastructure development
o Inability to create a welfare system
Debt relief o Investment in human capital/education
• Countries began to default on their loans in 1982 (Mexico was the first) & this
has led to restructuring of these loans to make it more affordable
• More recently there has been significant progress in writing off the entire
debt of the most heavily indebted poor countries (HIPC) so that they can
focus on building their economies

International Institutions & NGOs

• The World Bank, International Monetary Fund (IMF) & many non governmental organisations
(NGOs) play an active role in economic development

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 An Explanation of Organisations That Assist in Development

Organisation Explanation of what they do

• Founded in 1944 as the International Bank for Reconstruction and
Development to fund postwar redevelopment
• They provide reconstruction loans to countries devastated by war
• They provide loans to developing countries to aid in their development
World Bank
• They provide loans to countries to assist with the development
of infrastructure
• They work with governments & institutions so as to
encourage economic reform & trade liberalisation
• Founded in 1944 with the aim of establishing a stable global financial
system that could help with postwar reconstruction efforts & better deal
with challenges such as the Great Depression of the 1930's
• John Maynard Keynes was one of two founders
• They aim to facilitate a stable global financial system
International Monetary
• They oversee exchange rates & the system of international payments
Fund (IMF)
that occurs between nations & individuals
• They monitor country policies & national, regional & global economic &
financial developments through a formal system known as surveillance
• They provide member countries with currency to help deal with balance
of payments problems
• These are typically voluntary, community based organisations which
do not aim to make a profit but seek to meet a need or provide a
service
• They operate locally, nationally and/or internationally
• With a community based emphasis, they are able to
NGOs o Engage in small scale projects giving control to community
stakeholders
o Draw on local skills
o Encourage sustainability & remove the need for aid
o Tackle environmental sustainability using local knowledge &
resources

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4 The Financial Sector

4.4.1 Role of Financial Markets

Role of Financial Markets

• Financial markets are any place or system that provides buyers & sellers the means to exchange
goods/services & trade financial instruments
o These include bonds, equities, international currencies, & derivatives

1. They facilitate saving: storing money for future use is essential for households & firms. It also
provides a pool of money that financial institutions can lend i.e. one person's savings is another
person's borrowing
2. They lend to businesses & individuals: access to credit is a key requirement for economic growth &
development. Being able to borrow money speeds up consumption by households & investment by
firms. It also allows households or firms to purchase assets & pay them off over an extended period of
time e.g. mortgages on home purchases
3. They facilitate the exchange of goods & services: each purchase of goods/services requires
the movement of money between at least two parties. Financial markets provide multiple ways for this
exchange to happen including phone apps (Google Pay), debit cards, credit cards & bank transfers
4. They provide forward markets in currencies & commodities: forward markets are also
called futures markets. They provide some price stability in commodity markets & enable investors to
make a profit by speculating on future prices
5. They provide a market for equities: equities are shares in public companies that are listed on stock
exchanges around the world. Financial markets facilitate both long term investment & speculation by
providing platforms which connect buyers & sellers e.g. E-Trade

4.4.2 Market Failure in the Financial Sector

Market Failure in the Financial Sector

• Market failure in financial markets has far reaching consequences. The Global Financial Crisis of 2008
highlighted the interdependence & fragility of the global financial system

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 Types of Market Failure in Financial Markets

Market Failure Explanation

• Many financial products are complex & difficult for consumers to understand
• The sellers often have a significant information advantage over the buyers
o E.g. During the financial crisis, financial institutions bundled
thousands of mortgages together & sold them on to investors. The
sellers had more information on the risk profile of each bundle than
Asymmetric information the buyers
o E.g. Mortgage sellers often understand the implications of interest
rate changes to repayments much better than the average
consumer
• The Global Financial Crisis demonstrated that asymmetric information even
exists between financial markets & the regulators set up to monitor them
• Negative externalities of production & consumption exist in financial market
o E.g. When investors speculate on property prices, a negative
consumption externality occurs as young buyers end up paying
more (or being forced out of the market) due to the higher prices
caused by speculation (AirBnB effect)
Externalities
o E.g. When banks in many developed nations relaxed mortgage
lending requirements this helped cause the Global Financial Crisis.
The impact of the crash reverberated around the world causing a
global depression which reduced or eliminated imports from many
developing countries (third parties to the global mortgage market)
• Moral Hazard has increased in the financial sector since 2008 as
Governments have stepped in to save individual banks from failure (e.g.
RBS)
o Banks seem to be considered 'too big to fail' & governments bear
the consequences of their risky behaviour
Moral hazard
o The financial sector returned to questionable practices within two
years: The China Hustle documents how investment funds &
stockbrokers played up obscure Chinese companies who
presented fake financial data. This stimulated investor demand,
temporarily pushing up prices. Many investors lost a lot of money
Speculation & market • The higher the money supply in an economy, the greater the speculation &
bubbles potential for market bubbles

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 o Significant amounts of quantitative easing since 2008 have
increased the money supply & created potential bubbles in different
markets (e.g. property, cryptocurrency, shares)
• There have been allegations that some banks & individual bankers have
been involved in rigging key interest rates or exchange rates in order to
profit maximise
Market rigging
• This is considered to be fraudulent activity but is often difficult to identify or
trace unless there is a whistleblower who reveals the fraud

4.4.3 Role of Central Banks

Key Functions of Central Banks

• Central Banks play a vital role in maintaining stability in the financial system. Additionally, the policy
tools at their disposal help to meet Government economic objectives & create economic growth

Central Banks play four important roles in the economy

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 1. Implementation of monetary policy: This was covered more fully in Sub-topic 2.6.2
2. Banker to the government: The Government sets the annual budget but it is the Central Bank that
manages the tax receipts & payments. In 2022 there were 5.7 million public sector workers in the UK
who had to be paid each month
3. Banker to the banks – lender of last resort: Commercial banks are able to borrow from the Central
Bank if they run into short-term liquidity issues. Without this help, they might go bankrupt leading to
instability in the financial system - & a potential loss of savings for many households
4. Regulation of the banking industry: the high level of asymmetric information in financial markets
requires that commercial banks are regulated in order to protect consumers. One of the key regulatory
actions to manage the money supply & promote stability in the financial system is the implementation
of required reserve ratios. Raising the ratio decreases the money supply in the economy - and vice
versa

4.5 Role of the State in the Macroeconomy

4.5.1 Public Expenditure

Capital Expenditure, Current Expenditure & Transfer Payments

• Public expenditure (government spending) represents a significant portion of the aggregate demand
(AD) in many economies. The expenditure can be broken down into three categories

1. Current Expenditures: These include the daily payments required to run the government & public
sector. E.g. The wages & salaries of public employees such as teachers, police, members of
parliament, military personnel, judges, dentists etc. It also includes payments for goods/services such
as medicines for the NHS
2. Capital Expenditures: These are investments in infrastructure & capital equipment. E.g. High speed
rail projects; new hospitals & schools; new aircraft carriers
3. Transfer payments: Payments made by the government for which no goods/services are
exchanged. E.g. Unemployment benefits, disability payments, subsidies to producers & consumers
etc. This type of government spending does not contribute to GDP as income is only transferred from
one group of people to another

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Reasons for the Changing Size & Composition of Public Expenditure

Factors Affecting The Size & Composition of Public Expenditure

Changing Incomes Changing Age Distributions

• Countries with low incomes have low tax • Many developed countries have had lower birth
revenue leading to low government rates for decades creating a situation where there
expenditure. As incomes in an economy is now a large & growing ageing population
increase, government tax revenues • Life expectancy has also increased due to
increase which allows them to increase advances in medicine & nutrition
their expenditure • This means that government spending on pension
• As incomes increase, citizens demand payments & healthcare will increase to support this
a higher quantity & quality of government elderly population
services (which are very income elastic) -
e.g. library services, cleaner coastal
waters, better recycling facilities

Changing Expectations The Global Financial Crisis of 2008

• As societal norms change, expectations • UK Government borrowing increased significantly
change & this puts pressure on in order to facilitate the government spending
governments to change the substance & required to avoid a long-lasting depression
delivery mechanism of many of their • This borrowing had to be repaid (with interest) & in
services. This often results in increased the years following the crisis, the UK
spending e.g. NHS patients wanted online government cut their expenditure & raised taxes
access to their medical records & the (austerity)
Government had to spend significant sums
on creating the platform to do that

The Significance of the Level of Public Expenditure as a Proportion of GDP

• The size of government spending as a proportion of GDP varies from country to country & can have
numerous impacts on an economy
o In 2020, it accounted for 51.44% of Sweden's GDP, 40% of the UK's GDP, & 25.37% of
Thailand's GDP
• Public expenditure has many positive benefits including

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 o Improvements to the supply-side of the economy through expenditure on infrastructure, health,
education etc.
o It improves the equality of opportunity e.g. education for all children
o It raises the standards of living for all e.g. development of parks, libraries etc
o It reduces poverty & decreases inequality in the distribution of income
o It increases economic growth
o It drives innovation by providing long-term seed funding for firms & investing in applied
research (some estimates say that global innovation has in the majority been created by public
sector funding e.g. the mission to put a man on the moon or the need to keep a soldier safe in a
particular scenario)
• Public expenditure also has the following drawbacks
o It can have a negative impact on productivity & long-term growth as without a profit incentive
the urgency of labour diminishes & resources are used more inefficiently
o It creates opportunity for corruption which can actually decrease the standard of living
o If the government is running a budget deficit they will need to borrow funds from the private
sector. This can create a crowding out
o It may require taxation levels to increase in order to pay for the expenditure
o If the spending is not spread evenly throughout different regions of the country, it can create
inequality of opportunity e.g. the North/South divide in the UK

When evaluating public expenditure, it is overly simplistic to say that the public sector is
inefficient as it is not driven by profit. There are certainly many examples of this being true
but there are likely as many (or more) examples of innovation & efficiencies generated by
public expenditure. This varies from country to country e.g. Singapore public spending is
considered to be highly efficient & sets a benchmark for private firms. Germany's spending
on infrastructure & leisure facilities has made it a desirable place to live which helps to
attract top talent, improving efficiency & profits in the private sector.
As with the private sector, the real conversation should be about improving efficiencies in
vital public sector services and not necessarily replacing them with private sector services.
In many cases replacement by private sector services has resulted in worse product quality
and/or service for consumers e.g. Southern Rail Network.

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4.5.2 Taxation
Progressive, Proportional & Regressive Taxes

• Tax systems can be classified as progressive, proportional or regressive

• Most countries have a mix of progressive (direct taxation) & regressive (indirect taxation) taxes in
place

1. Progressive tax system: as income rises, a larger percentage of income is paid in tax (e.g. UK
Income Tax; UK Corporation Tax). This system is built around the idea of marginal tax rates

UK Progressive Tax Rates - June 2022

Tax Band Taxable Income Tax Rate

Personal Allowance Up to £12,500 0%
Basic Rate £12,501 to £50,000 20%
Higher Rate £50,001 to £150,000 40%
Additional Rate Over £150,000 45%

2. Using this system, a salary of £60,000 would attract a tax bill of £11,499.80, calculated as follows:
First £12,500 - no tax
Next £37, 499 at 20% = £7499.80
Final £10,001 at 40% = £4,000
3. Regressive tax system: as income rises, a smaller percentage of income is paid in tax (e.g. excise
duties on alcohol & petrol in the UK; VAT; Air passenger duty). Regressive taxes can have a big impact
on low-income households. In 2020 they represented 30% of income for the poorest 20% of
households - but only 10% of income for the top 20% of households
4. Proportional tax system: the percentage of income paid in tax is constant, no matter what the level
of income e.g 10% tax is paid irrespective of whether income is £10,000 or £100,000. Bolivia uses this
system & the tax rate is 13%.

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The Economic Effects of Changes in Tax Rates

• Changes in direct & indirect tax rates influence a range of economic variables
o The greater the size of the change, the greater the ripple effects through the economy

Effects Of Tax Rate Changes

Impact Explanation
Incentive to work • The higher the tax rate, the lower the incentive for the unemployed to
seek work - or for existing workers to work overtime
• In 2022, the Adam Smith Institute calculated that average earners in the
UK work from the 1st January to the 8th June (Freedom Day) to pay their
taxes - all income after that point belongs to them
Tax revenues • The Laffer curve illustrates the relationship between increasing tax
rates & the level of government revenues received
• The broad idea is that as tax rates increase, a point will be reached where
disincentivized workers work less resulting in less income & less
government tax revenue. More people will actively seek to avoid paying
tax (tax avoidance) or try to move their income elsewhere

The Laffer Curve demonstrates the relationship between tax revenue & tax rates
• Tax rate increases up to point A, will result in an increase of tax revenue.
Further tax rate increases from A to B result in a loss of tax revenue from C
to D
Income distribution • A progressive tax system redistributes from those with higher income to
those with lower income & reduces income inequality
• Sometimes the benefits of a good progressive tax system are eradicated
by the penalties imposed through multiple regressive (indirect) taxes

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Real output & employment • If the tax rate increases, more money is withdrawn from the circular flow
of income (leakage)
• This will likely cause a reduction of aggregate demand (AD) as firms &
households have less disposable income
• As AD slows down, fewer workers may be required for production
& unemployment may increase

Average price level • An increase in indirect taxes reduces disposable income & so workers
may petition their employer for a salary increase
• If they receive the increase the economy may face a wage-price spiral
• Indirect taxes also increase costs of production for firms possibly leading
to cost-push inflation

The trade balance (X-M) • An increase in taxes can reduce disposable income which is likely to
reduce the level of imports
• This may improve the trade balance (exports - imports)

Flows of Foreign Direct • If the rate of corporation tax increases relative to other countries, it may
Investment (FDI) result in less inward foreign direct investment

4.5.3 Public Sector Finances

Public Sector Finance Terminology

Distinction between automatic stabilisers & discretionary fiscal policy

Automatic stabilisers: these are automatic fiscal changes as the economy moves through stages of the
business/trade cycle
o E.g. A fall in tax revenues during a recession or an increase in state welfare benefits paid
out when unemployment is rising
o They do not require active intervention from the government but happen automatically in the
background
• Discretionary fiscal policy: a demand-side policy that uses government spending & taxation policy to
influence aggregate demand (AD)

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Distinction between a fiscal deficit & the national debt

• A fiscal deficit occurs when the level of government spending is greater than the government tax
revenue in any given year
• The national debt is the accumulation of all previous deficits. The deficit in one year adds to the
national debt from previous years
Distinction between structural & cyclical deficits

• Cyclical deficits occur due to downturns in the business/trade cycle, usually as a result of a recession
o Governments receive less tax revenue as profits & income fall - & government
spending increases
o These deficits tend to self-correct as the economy starts to grow again
• Structural deficits are present even when an economy may be operating at the full employment
level of output
o These deficits are difficult to correct
o These deficits may be caused by a widespread tax avoidance culture, or poor governance

Factors Influencing the Size of Fiscal Deficits

Factors Influencing the Size of Fiscal Deficits

State of the economy Housing Market

Government revenue often increases in a boom The government receives an indirect tax from
& decreases in a recession. Government property sales (stamp duty). This revenue increases
spending often decreases in a boom & increases when an economy is doing well & helps to reduce
in a recession. Fiscal deficits tend to increase fiscal deficits
as the state of the economy worsens
Political priorities Unforeseen events
If political priorities change then the size of the Many unforeseen events occur each year which
fiscal deficit can change e.g. after the UK require government support e.g. The Russian war on
Government has spent billions in rescuing the Ukraine started in February 2022 & by June 2022 the
economy after the Global Financial Crisis of UK Government had spent £2.8 bn. in providing
2008 they prioritised austerity with the focus of assistance (it is worth noting that much of this went
eliminating the deficit to the UK military industry to pay for weapons
which were donated to the Ukraine. This increased
UK GDP)

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Factors Influencing the Size of National Debts
Factors Influencing the Size of National Debts

Factor Explanation
Size of fiscal deficits • As national debt is the accumulation of annual fiscal deficits, the size of
the fiscal deficit each year will grow by the size of the deficit
• If the UK were to run a budget surplus in any year, this additional
revenue could be used to pay back some of the debt - or it may be used
to fund government spending or investment in the following year

Government policies • These directly impact tax revenue & government spending which can
change the level of the fiscal deficit leading to a change in the national
debt level
• E.g. Reducing corporation tax during a boom in the economy
will reduce government revenue & possibly increase the deficit &
national debt at a time when the deficit would naturally be
decreasing due to the automatic stabilisers

The Significance of the Size of Deficits & National Debts

• The size of the deficits & national debt can influence multiple factors in an economy
o These factors tend to be more long-term in nature & can have significant
repercussions should the level of national debt become unsustainable
1. Interest rates: The higher the level of UK Government debt as a proportion of GDP, the more
concerned global lenders will be to continue lending to fund future deficits. This may require the UK
to raise interest rates to entice lenders to make their money available to the UK government
2. Debt servicing: there is an opportunity cost to paying back debt & debt interest. The higher the debt,
the greater the opportunity cost e.g. every £ spent on paying back interest could have been spent
on education improvements instead
3. Inter-generational equity: today's borrowing has to be paid back from tax revenue received from
future generations. The greater the debt, the greater the burden on the next generation of tax payers
4. Rate of inflation: Inflation reduces purchasing power (which is bad) but at the same time it allows the
UK Government to pay back lenders with money worth less than when it was originally borrowed
5. Nation's credit rating: Standard & Poor's is a credit rating agency based in the USA who provides
credit ratings for different Nations. Investors use this to guide their lending. Countries with a good credit
rating will be able to borrow funds at a lower interest rate

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 6. Foreign direct investment (FDI): the higher the level of external debt, the more foreign currency is
required by the Government to pay it (e.g. UK borrowing from the USA in US$ needs to be repaid in
US$). Countries may run short of foreign currency & one way to obtain more is to make foreign
direct investment more attractive. This means more assets are being sold but it does bring in more
foreign currency which can be used to facilitate repayments

4.5.4 Macroeconomic Policies in a Global Context

Macroeconomic Policies in a Global Context

• Due to globalisation, economies do not operate in isolation but are highly interdependent
• This means that the effectiveness of any of the macroeconomic policies & direct controls used by
a government is dependent on the global environment
o The extent to which it is dependent is influenced by the size & development of the economy
• Different approaches are used by different governments to attempt to solve the same problem
o E.g. After the Global Financial Crisis of 2008, the UK Conservative led government initially
used a Keynesian approach to bailing out the banks & then quickly followed this with
a contractionary demand-side policy of austerity. The Democratic led USA Government also
used a Keynesian approach to rescuing financial institutions & then followed it up with
further expansionary fiscal & monetary policy

The Use of Policy Measures To:

Aim Explanation
Reduce fiscal deficits & • Debt is not necessarily bad as it can be used to leverage growth -
national debts
but unsustainable debt is bad
o One study found that once debt exceeds 90% of the annual
GDP, it becomes unsustainable very quickly
• With the recent willingness of Central Banks to print new money to
facilitate quantitative easing, questions have been raised about the
need to borrow to finance capital expenditure - why not print it?
• The use of austerity to reduce deficits & debts has long term effects
& creates hardship for many households. It also increases
inequality as many government services are cut e.g. 800 libraries
have closed in the UK since austerity was implemented in 2010

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 Reduce poverty & inequality • Countries have different approaches
• Some have a progressive tax system which helps to redistribute
income based on financial need (means tested)
• Others have a progressive tax system plus free education &
healthcare for all
• The measures taken to reduce poverty & inequality are very much
influenced by political ideology & normative economics e.g. there
is a strong bias against free healthcare in the USA as many people
believe that equates to socialism
o Meanwhile data shows that the healthcare system in the USA
is one of the most inefficient in the top 50 wealthiest
countries in the world
Changes in interest rates & the • Central Banks can change interest rates & the supply of money
supply of money
based on the internal needs of their economies - & they often do
• However, sometimes they have to react to global dynamics that
present problems e.g. the exchange rate may depreciate as other
countries raise interest rates. They may wish to keep interest rates
lower but to stabilise the currency they have to respond by raising
interest rates
• There is also some debate about the extent to which the money
supply can be controlled
• Different views exist on the role that an increase in the money
supply plays in creating inflation
o Milton Friedman (a Monetarist) held the view that "Inflation is
always and everywhere a monetary phenomenon in the sense
that it is and can be produced only by a more rapid increase in
the quantity of money than in output"
o This opposes the Keynesian view that inflation is the result of
a change in output
o The global money supply has increased enormously since
2010 as a result of quantitative easing e.g. between March
2020 & the end of 2021 the USA had increased the money
supply by $6.3 trillion
▪ In early 2022 inflation began to spike globally
confirming the fears of many monetarists

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 Increase international • These typically include protectionism, currency depreciation & the
competitiveness
use of supply side policies
• The effectiveness of these policies depends on the response
of trading partners
• Policies to improve international competitiveness can result in
creating internal domestic conflicts which are difficult to resolve e.g.
by protecting the steel manufacturing industry in the UK, the cost of
steel as an input for broader industry increases
o Employment gained in steel manufacturing is very likely
surpassed by employment lost in steel related industries as
a result of the increased costs of production

Use of Policies in Responding to External Shocks

• The following recent external shocks to the global economy have forced governments to
respond with a range of policies in order to steer their economies through the crisis

1. The Global Financial Crisis of 2008

2. The Arab Spring which started in 2011: This was a further development of the Iraq War & the long
running war on terror. It continued to develop into a major conflict centered in Syria, raising
geopolitical tensions. Many Western economies benefitted through an increase in gross domestic
product as governments increased spending on military hardware
3. The Asian Tsunami of 2011 had major impacts on the supply chains of many automotive &
electronic industries
4. The Global Trade War that developed under President Trump & continued from 2016 to 2020
5. The Global Pandemic, Covid19, which started in January of 2020
6. The Russian War on the Ukraine which started in February 2022. The Ukraine is one of the world's
largest producers of grain & Russia is one of the world's largest exporters of natural gas

Measures to Control Global Companies

• The ability of governments to control global companies is dependent on a range of factors including
o The power of the government in relation to the power of Transnational Corporations
o The absence of corruption e.g. Singapore is ruthless in stamping out corruption but Romania &
Democratic Republic of Congo are well known for their high levels of corruption. The latter allow

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 Transnational Corporations to influence legislation & to decide how the factors of
productions are used/exploited
o The state of development of the legal, financial, media & political institutions e.g. many of these
institutions remain undeveloped in Cambodia & Transnational Corporations are stripping the
country of its resources
o The state of development of the economy as a whole (developing or developed)
• Transnational Corporations are well known for using their power, wealth & access to the world's best
lawyers to secure (& protect) favorable trading conditions that will maximise their profits
o They often engage in monopoly & monopsony behaviour

Reducing The Use of Transfer Pricing

• A corporation will set up multiple sub-corporations which it owns

• The corporation then extracts resources from a country & sells it to their own sub-corporation at a
low price
• This results in low taxes or low revenue share in the resource rich country e.g. Chinese & Singaporean
firms working in DRC have an arrangement to pay the government 40% of the revenue received for the
sale of cobalt
o If they sell it to their own sub-corporation at a low price, the government receives less revenue
o It is hard for less developed countries to challenge this kind of power & the World Bank is now
helping governments to negotiate deals that bring transparency

Other Measures to Reduce Transnational Abuse of Power

• Setting more rigorous labour protection laws as well as ensuring that transnationals are using local
labour & not labour from their own country
• Establishing more rigorous laws around technology transfer between local & transnational firms
• Establishing limitations or targets on the level of exports by the transnational firms

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Problems Facing Policymakers

Problems Facing Policymakers When Applying Policies

Problem Explanation
• Data often lags reality as underlying economic conditions
can change quickly
• Data on unemployment, inflation, GDP growth etc. is useful
Inaccurate information for identifying trends, but the reason for the trend may not
always be clear & policy decisions may be based
on incorrect assumptions

• Identifying risks & establishing the uncertainties contained

within any policy decision can be a very difficult task indeed
• The risks may be greater than expected
• The uncertainties may not even be identifiable when the
policy is instituted e.g. the impact of the Brexit
Risks and uncertainties vote contained many foreseen outcomes (e.g. loss of free
movement), but there were also many uncertainties which
were not recognised e.g. the need for many small UK firms
to relocate operations to Europe in order to avoid excessive
export costs

• As mentioned above, external shocks have a ripple effect

Inability to control external on economies around the world & globalisation makes it
shocks very difficult to protect against them

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