Government Roles in a Mixed Economy

 Nearly every economy in the world is a mixed economy & has varying degrees of
government intervention

 Governments intervention is necessary for several reasons & occurs on three

distinct levels
o Local intervention
o National (macroeconomic) intervention
o International intervention

The Role of Government In A Mixed Economy

Area of Examples of
Explanation
Intervention Intervention

Local  Local health  Local governments

services are responsible for
 Refuse delivering government
collection services on a town/regional
 Parking fines basis
 Local  They usually receive funding
prosecutions from the central government
 Parks & & are held accountable for
recreation the quality of goods/services
 Public services provided by the voters in
their area
 Local government branches
are often referred to
as 'councils', 'federal' or
'state'
National  Central  Determining the best
Government combination of policies that
 Fiscal Policy will help them to meet all of
 Monetary their macroeconomic aims
Policy
 Supply-side
Policy
International  Exchange rate  International trade is vital to
interventions economic growth in many
 Protectionism economies
 Governments have a role to
both protect domestic
industry & to help it compete
internationally

Economic Growth
  Economic growth is a central macroeconomic aim of most governments

 Many developed nations have an annual target growth rate of 2-3%

o This is considered to be sustainable growth
o Growth at this rate is less likely to cause excessive demand pull
inflation

 Politicians often use it as a metric of the effectiveness of their policies &

leadership

 Economic growth has positive impacts on confidence, consumption,

investment, employment, incomes, living standards & government budgets

A diagram showing the economic growth rate of the UK since 1998

Source: Macrotrends

A Table Highlighting Some of the Economic Growth Trends in the UK Since

1998

1998-2007 2008-2015 2016-2019 2020 -

Steady Global Gradual disinflation possi Supply chain issues due to

growth fluctuati financial bly due to future Brexit. Decreased consumption
ng between 2- crisis followe expectations regarding the due to the impact of Covid 19.
4% d by rapid impact of the Brexit vote These created
bounce back a deep recession (short-lived due
due to government intervention)
to governme
 nt
intervention
- and then
steady
growth

Low Unemployment
 Someone is considered to be unemployed if they do not have a job &
are actively seeking for one

 The target unemployment rate often depends on the size of the economy
e.g. India finds a rate of 6.5% good whereas Singapore aims for it to be under
2%

 The closer an economy is to the full employment level of labour, the better
(more efficiently) it is using its human resources

 Within the broader unemployment rate, there is an increased emphasis on

the unemployment rate within different sections of the population
o E.g. youth unemployment, ethnic/racial unemployment by group
 In 2021, black unemployment in the USA was 8.7% & white
unemployment was 4.7%

A diagram showing the unemployment rate in the UK from 1998 - 2020

Source: Macrotrends

 Unemployment tends to be inversely proportional to real GDP growth

 o When real GDP increases, unemployment falls
o When real GDP decreases, unemployment rises

 Unemployment in the UK remained relatively high for the six

years following the global financial crisis of 2007

Low & Stable Rate of Inflation

 Most economies have a target inflation rate of 2% using the Consumer
Price Index (CPI)

 A low rate of inflation is desirable as it is a symptom of economic growth

 The different causes of inflation (cost push or demand pull) require different
policy responses from the Government
o Demand-side policies ease demand pull inflation
o Supply-side policies ease cost push inflation

A diagram illustrating the inflation rate in the UK from 2012 to 2021 using the
CPI

 In the UK, a continual deviation from the target of 2% would not be

considered as stable
o An inflation rate in April 2022 of 4-5% was considered to be unstable,
eroding household purchasing power
  A low & stable rate of inflation is important as it
o Allows firms to confidently plan for future investment
o Offers price stability to consumers

Balance of Payments Stability On The Current Account

 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
o The current account focuses mainly on the financial transactions
related to exports and imports of goods/services

 Governments aim for Balance of Payments equilibrium on the Current

Account
o If exports > imports it will create a current account surplus
o If imports > exports, it will create a current account deficit
 Each one of these conditions has advantages/disadvantages
associated with it
 However, a current account deficit is more problematic in the
long-run

 The UK has traditionally run a small deficit

o As a % of GDP the UK current account deficit is insignificant so has
not been problematic
A diagram showing the UK Trade Deficit from 1998 to 2020. The bottom graph
illustrates the trade deficit as a % of GDP and the top one illustrates the
absolute value expressed in US$
Source: Macrotrends

 In the diagram above the trade deficit has been falling steadily since 2016
o During this time period the value of exports was increasing slightly
faster than the value of imports

The Redistribution of Income

 The redistribution of income aims to reduce income inequality in an
economy
o High levels of income inequality create social unrest and can
ultimately lead to revolutions
o Perfect income equality is not desirable as it removes the incentive
to work & study

 Governments aim to redistribute income by taxing the wealthy & providing

welfare payments to the poor

 Unchecked capitalism has a natural outcome of high income inequality

o The wealthy are able to keep buying factors of production
o The concentration of ownership becomes more & more narrow with
fewer individuals owning the bulk of the world's wealth

 There is a need for governments to intervene to maintain acceptable levels of

income inequality

 Absolute poverty is usually worse in developing countries. However, in a

developed economy such as Germany, a 1% increase in income inequality
can push a lot more households into relative poverty

Trade-offs Between Macroeconomic Objectives

 Policy decisions by governments often create a trade-off in
the macroeconomic objectives
 Achieving one objective may come at the cost of worsening progress in
another objective

An Explanation of the Common Trade-offs That Exist Between the

Macroeconomic Objectives

Trade-off Explanation
 Economic Growth &  Increasing economic growth causes the
Inflation economy to move closer to full
employment
 Prices for remaining resources are bid up
leading to inflation which may outpace
the target inflation rate of 2%

Economic Growth &

Environmental
Sustainability  Economic growth often
increases pollution, negative
externalities & the depletion of non-
renewable resources
 The higher the growth, the faster the
depletion

Economic Growth &

Inequality
 During periods of high economic growth,
the profits the owners of the factors of
production receive are disproportionate to
any increase in workers' wages leading to
greater inequality
Economic Growth &  Economic growth usually leads to higher
Balancing the Current incomes which leads to an increase
Account in imports by households
thereby worsening the current account
balance

Low Unemployment &  The closer an economy moves to full

Low Inflation employment the less workers will be
available for hire & wage inflation will
help increase overall inflation

Low Unemployment &  When unemployment is low, incomes are

Balancing the Current higher & imports increase which worsens
Account the current account balance
 Additionally, with low
unemployment wages tend to
increase which increases costs of
production for firms & if they increase their
prices, then the level of exports is likely to
fall

Definition of the Government Budget

  The Government Budget (Fiscal policy) is presented each year as a
balanced budget, a budget deficit, or a budget surplus
o A balanced budget means that government revenue = government
expenditure
o A budget deficit means that government revenue < government
expenditure
o A budget surplus means that government revenue > government
expenditure

 A budget deficit has to be financed through public sector borrowing

o This borrowing gets added to the public debt

Reasons for Government Spending

 Public expenditure (government spending) represents a significant portion of
the total (aggregate) demand 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 government hospitals

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

Reasons for Taxation

 Nearly every economy in the world is a mixed economy & has varying
degrees of government intervention
 One of the main forms of government intervention is taxation & there are
many reasons why it is necessary
 A diagram showing several reasons for government taxation in mixed
economic systems

 Correct market failure: in many markets there is a less than optimal

allocation of resources from society's point of view
o The government aims to subsidise merit goods & tax demerit
goods to address this market failure

 Earn government revenue: governments need money to provide essential

services, public & merit goods
o Revenue to fund this is raised through taxation

 Promote equity: the wealthy are taxed to provide funds that can be utilised in
reducing the opportunity gap between the rich & poor

 Support firms: in a global economy, governments choose to support key

industries so as to help them remain competitive & taxation provides the
funds to do this

 Support poorer households: poverty has multiple impacts on both the

individual & the economy
o Intervention seeks to redistribute income (tax the rich and give to the
poor) so as to reduce the impact of poverty

The Classification of Taxes

 The main source of government revenue is taxation

 Direct taxes are taxes imposed on income and profits

o They are paid directly to the government by the individual or firm
 E.g. Income tax, corporation tax, capital gains tax, national insurance
contributions, inheritance tax
  Indirect taxes are imposed on spending
o The less a consumer spends the less indirect tax they pay
o Examples of indirect tax include Value Added Tax (19% VAT rate in the
European Union in 2022), taxes on demerit goods, excise duties on fuel etc.

Progressive, Regressive & Proportional Tax Systems

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

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

An Explanation Of Tax Systems

System Explanation Diagram

Progress  As
ive income
rises, a
larger
percenta
ge of
income is
paid in
tax
 In the
diagram,
when
personal
income
rises fro
m Y1 to
Y2,
the tax
rate
rises fro
m TR1 to
TR2
Regressi  As
ve income
rises, a
smaller
percenta
ge of
income is
paid in
tax
  In the
diagram,
when
personal
income
rises fro
m Y1 to
Y2,
the tax
rate
falls fro
m TR1 to
TR2
 All
indirect
taxes are
regressiv
e
 In the
USA, Fed
eral
income
tax is
progressi
ve but
almost
all State
taxes are
regressiv
e (the
bottom
20% of
income
earners
pay as
much as
6x the %
of their
income
than the
top 20%)
Proporti  As
onal income
rises, the
same
percenta
ge of
income is
paid in
tax
 In the
 diagram,
when
personal
income
rises fro
m Y1 to
Y2, the
tax rate
remains
constant
at 20%
 In 2022,
Bolivia
was
using this
system
with
a propor
tional
tax rate
of 13%

 Progressive tax systems are built around the idea of marginal tax rates
 The calculation of an individual's personal income tax requires several calculations
 Using this system, a salary of £60,000 would attract a tax bill of £11,499.80,
calculated as follows:

Calculation Using UK Progressive Tax Rates - June 2022

Tax Paid on
Tax Band Taxable Income Tax Rate
£60,000

Personal Allowance Up to £12,500 0% 0

£12,501 to £50,000 20% £37, 499 at
Basic Rate 20% =
£7499.80
£50,001 to £150,000 40% £10,001 at 40%
Higher Rate
= £4,000
Additional Rate Over £150,000 45% 0
£7499.80 +
Total Tax Paid on
£4,000
£60,000
= £11,499.80
Principles of Taxation
 In order for the population to accept a tax system & pay into it, the taxes imposed
need to be considered to be 'good'
 There are several principles which should be applied when developing a 'good' tax
system

1. Simple: taxpayers should know what, when, where & how to pay the tax
2. Fair (equity): taxes should reflect a taxpayer’s ability to pay - progressive taxation
aims to achieve this as the wealthy can afford to pay more than the poor do
3. Convenient: systems to collect payment should be easy & provide choice for
taxpayers e.g. monthly payments spread over 12 months or tax collected by the
employer each month before the salary is paid
4. Efficient: the management of the tax system by the government should not be overly
expensive or wasteful
5. Fit for purpose: there should not be any unintended side effects of the system e.g.
disincentivising workers from working
6. Flexible: it should be easy to adjust/change as required by changes in the economy

The Impact of Taxation

 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 felt by
households, firms & 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
Government tax  There is a relationship between increasing tax
revenues 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 lower incomes
& less government tax revenue
 More people will actively seek to avoid paying
tax (tax avoidance) or try to move their
income elsewhere
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 lost by the penalties imposed
through multiple regressive (indirect) taxes
 Economic growth  Tax rate increases will likely cause a reduction
of total (aggregate) demand as firms &
households have less disposable income
 Tax rate decreases will have the opposite effect
 As total demand slows down, fewer workers
may be required for production
& unemployment may increase
Inflation  Increasing Indirect tax rates increase costs of
production for firms possibly leading to cost-
push inflation
 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
The trade balance  An increase in taxes can reduce disposable
(X-M) income which is likely to reduce the level of
imports
 This may improve the trade balance (exports -
imports)
Business location  If the rate of corporation tax increases relative
to other countries, it may result in less
inward foreign direct investment by multi-
national corporations

Fiscal Policy Defined

 Fiscal Policy involves the use of government spending & taxation (revenue) to
influence total (aggregate) demand in the economy

 Fiscal policy can be expansionary in order to generate further economic growth

o Expansionary policies include reducing taxes or increasing government
spending

 Fiscal policy can be contractionary in order to slow down economic growth or

reduce inflation
o Contractionary policies include increasing taxes or decreasing government
spending

 Fiscal Policy is usually presented annually by the Government through

the Government Budget
o A balanced budget means that government revenue = government
expenditure
o A budget deficit means that government revenue < government
expenditure
o A budget surplus means that government revenue > government
expenditure

 A budget deficit has to be financed through public sector borrowing

o This borrowing gets added to the public debt
The Effects of Fiscal Policy on Government Macroeconomic
Aims
 To understand the effects of fiscal policy on an economy, it is useful to know how
total demand (gross domestic product) is calculated

 Total (aggregate) demand = household consumption (C) + firms investment (I) +

government spending (G) + exports (X) - imports (M)
o Total demand = C + I + G + (X - M)

 From this, it is logical that changes to fiscal policy can influence any of these
components - & often several of them at once

Examples of The Impact of Contractionary Fiscal Policy

Example 1 The Government increases income tax levels

Effect on the Consumers pay more tax → discretionary
economy income reduces → consumption reduces → total
demand reduces

Impact on  Economic growth slows down

macroeconomic aims  Inflation eases
 Unemployment may increase as output is falling &
fewer workers are required
 Current Account Improves (with less income,
imports may fall)

Example 2 The Government freezes/reduces public sector

workers pay
Effect on the Wages stagnate or reduce → Consumer confidence falls
economy → consumption decreases → total demand decreases

Impact on  Economic growth slows down

macroeconomic aims  Inflation eases
 Unemployment may increase as output is falling
 Current Account Improves (with less income,
imports may fall)

Example 3 The Government cuts Government spending in their

Budget
 Effect on the Less demand for goods/services → less income for
economy firms → output & profits decrease → total demand
decreases

Impact on  Economic growth slows down

macroeconomic aims  Inflation eases
 Unemployment may increase as output is falling
 Current Account Improves (with less income,
imports may fall)
 Less corporation tax available for redistribution

Examples of The Impact of Expansionary Fiscal Policy

Example 1 The Government decreases corporation tax

Effect on the Firms net profits increase → investment by firms
economy increases → total demand increases

Impact on  Economic growth increases

macroeconomic aims  Inflation rises
 Unemployment may decrease as output is rising
which requires more workers
 Current Account - unsure - exports may rise due to
new investments in the economy, but imports may
rise due to higher income generated by the
investment

Example 2 The Government increases unemployment benefits

Effect on the Household income increases → consumption increases
economy → total demand increases

Impact on  Economic growth increases

macroeconomic aims  Inflation rises
 Unemployment may decrease as output is rising
which requires more workers (although increased
unemployment benefits may discourage some
people from entering the labour market)
 Current Account unlikely to change as this policy
helps the poorest & imports are unlikely to increase
 Redistribution of income has increased & there is
more equity in society
 Strengths of Fiscal Policy
 Spending can be targeted on specific industries
 Short time lag as compared with monetary policy (effects of fiscal policy are seen
sooner)
 Redistributes income through taxation
 Reduces negative externalities through taxation
 Increased consumption of merit/public goods
 Short term government spending can lead to an increase in the total supply of an
economy
o E.g. Building a new airport immediately increases government spending and
total demand, but when it is built, the potential output will have increased
(Production Possibility Curve has shifted outward)

Weaknesses of Fiscal Policy

 Policies can fluctuate significantly when new governments are elected
o Long term infrastructure projects may lack follow-through
 Increased government spending can create budget deficits

o Repaying this debt may lead to austerity on future generations

 Conflicts between objectives
o E.g. Cutting taxes to increase economic growth may cause inflation

Monetary Policy Defined

 Monetary policy involves adjusting the money supply so as to influence total
(aggregate) demand
o The money supply is the amount of money in an economy at any given
moment in time
o It consists of coins, banknotes, bank deposits & central bank reserves

 The Central Bank in each economy is responsible for setting monetary policy
o
 The Bank's Monetary Policy Committee usually meets 4-8 times a
year to set policy

The Three Main Instruments of Monetary Policy

1. Interest Rates: Incremental adjustments to the interest rate (usually not more
than 0.25%)
2. Quantitative easing (QE): Increases the supply of money in the economy. The
Central Bank creates new money & uses it to buy open-market assets such
as bonds. When they buy the bond back early, there is an injection of new
money into the economy (investors get their money back & can now spend it)
3. Exchange Rates: Adjustments to the exchange rate. The Central Bank is able to
influence the exchange rate through buying or selling its own currency. This in turn
influences the level of exports/imports
  Monetary policy can be expansionary in order to generate further economic growth
(also referred to as loose monetary policy)
o Expansionary policies include reducing interest rates, increasing QE,
or depreciating the exchange rate

 Monetary policy can be contractionary in order to slow down economic growth or

reduce inflation (also referred to as tight monetary policy)
o Contractionary policies include increasing interest rates,
decreasing/stopping QE, or appreciating the exchange rate

The Effects of Monetary Policy on Government

Macroeconomic Aims
 When a policy decision is made, it creates a ripple effect through the
economy impacting the macroeconomic objectives of the government

 To understand the effects of monetary policy on an economy, it is useful to know

how total demand (gross domestic product) is calculated

 Total (aggregate) demand = household consumption (C) + firms investment (I) +

government spending (G) + exports (X) - imports (M)
o
 Total demand = C + I + G + (X - M)

 From this, it is logical that changes to monetary policy can influence any of these
components - & often several of them at once

Examples of The Impact of Contractionary Monetary Policy

Example 1 The Central Bank increases interest rates

Effect on the  Existing loan repayments for households become
economy more expensive → discretionary income reduces
→ consumption decreases → total demand falls
 Firms are less likely to borrow → less investment in
capital takes place → total demand falls
 Hot money flows increase → the exchange rate
appreciates → exports more expensive & imports
cheaper → net exports reduce → total demand
decreases
Impact on  Economic growth slows down
macroeconomic aims  Inflation eases
 Unemployment may increase as output is falling &
fewer workers are required
 Current Account is likely to worsen as both exports
& imports reduce (exports more expensive &
imports cheaper - but households have less income
for imports)
 Examples of The Impact of Expansionary Monetary Policy

Example 1 The USA Federal Reserve Bank commits to $60bn a

month of QE
Effect on the Commercial banks receive cash for their bonds →
economy liquidity in the market increases → commercial banks
lower lending rates → consumers & firms borrow more
→ consumption & investment increase → total
demand increases
Impact on  Economic growth increases
macroeconomic aims  Inflation rises
 Unemployment may fall as output is increasing &
more workers are required
 Current Account worsens (with more income,
imports may rise)

Strengths of Monetary Policy

 The Bank of England operates independently from the Government (political
process)
 Is able to consider the long-term outlook
 Targets inflation & maintains stable prices
 Depreciating the currency can increase exports

Weaknesses of Monetary Policy

 Conflicting goals e.g economic growth caused by lower rates puts upward pressure
on inflation
 Time lags between policy & the desired impact (up to 2 years)
 Firms & consumers may not respond to lower interest rates when confidence is low
 Cheaper loans may inflate asset prices (e.g. property) in the long term
 The interest rate has limitations on downward adjustment - the closer the rate gets
to zero, the less effective

Supply-side Policy Defined

 Supply-side policies aim to increase the total supply (productive potential) of the
economy
o This is achieved by increasing the quality or quantity of the factors of
production
o It can be represented by an outward shift of the productive possibility curve
o More consumer goods & more capital goods can now be produced using
all of the available resources
 Outward shifts of a PPC show an increase in the total supply of an economy

 The strategies used to increase total supply include education and training, labour
market reforms, lower direct taxes, deregulation, improving incentives to work &
invest, and privatisation

Supply-side Policy Measures

 When successful, supply-side policies have the following effects on the
government's macroeconomic objectives

1. Economic growth: potential national output increases leading to higher real gross
domestic product (rGDP)
2. Inflation: a greater supply in the economy results in reductions in the prices of
goods/services leading to disinflation
3. Unemployment: this should fall as more workers are required to produce the higher
levels of output
4. Current Account Balance: due to the increased supply, the prices of goods/services
often decrease which makes them relatively more attractive to foreigners - so exports
increase & the current account balance improves
5. Redistribution of income: this often worsens with the use of supply-side policies as
wages fall & government tax revenue has fallen too

Specific Types of Supply-side Policies

Supply-side Policy Explanation

 Education &  Increasing government spending on education &
training retraining raises the quality of the workforce
 Increasing government spending on healthcare so that
worker productivity improves
Labour market  Decreasing trade union power so wages can be
reforms decreased encourages firms to hire more workers as
they are cheaper
 Decreasing minimum wages to lower costs of
production encourages firms to hire more workers as
they are cheaper
 Increased government spending on
improving occupational mobility
Lower direct taxes  Reducing income/corporation tax rates incentivises
workers to work harder (they keep more money for
themselves) & provides firms with extra funds which
they can use to invest in new machinery/technology
Deregulation  This is the process of removing government
controls/laws from markets in order to increase
competition
 Any regulation increases costs of production for firms
& deregulation decreases costs which may result in
greater supply
Improving  Restructuring the unemployment benefits system to
incentives to work incentivise the unemployed to seek work
& invest  Increased government spending on innovation
increases the supply of potential jobs in the economy
 Direct support to firms (subsidies) increases output &
promotes international competitiveness
Privatisation  Government firms are usually so big that private
enterprise refrains from trying to compete with
them. Privatisation encourages new firms to enter the
market & compete, thus increasing the total supply in
the economy

Strengths of Supply-side Policies

 They increase the rate of growth of an economy
 They reduce inflation
 They often reduce unemployment
 They often increase the value of net exports as an increase in total supply usually
results in lower prices leading to greater exports

Weaknesses of Supply-side Policy

 The distribution of income worsens as labour market reforms & wage policies
lower worker's wages
 They are expensive to implement
 There are significant time lags between government expenditure & seeing the
benefits e.g. education & training often take a long time
  Due to the long-term nature, changes in government often result in changes to
budgets & scope of projects
 Vested interests can result in less effective outcomes e.g. There are many
examples of privatisation occurring in such a way that the government's preferred
bidders obtained an asset at a knock down price

Economic Growth
 Economic growth is the annual increase in the level of national output as measured
by the gross domestic product (GDP)

 GDP is the total value for all goods/services produced in an economy in a year

The Components of GDP

 GDP can be calculated using the value of the expenditure in an economy
o GDP = Consumption (C) + Investment (I) + Government spending (G) +
Exports (X) - Imports (M)
o GDP = C + I + G + (X-M)
o If any of the components of GDP increase, then economic growth is likely to
occur

 Consumption is the total spending on goods/services by consumers (households)

in an economy

 Investment is the total spending on capital goods by firms

 Government spending is the total spending by the government in the economy:

o Includes public sector salaries, payments for provision of merit & public goods
etc.
o It does not include transfer payments

 Net exports are the difference between the revenue gained from selling
goods/services abroad & the expenditure on goods/services from abroad

The Relative Importance of the Components of GDP

 Depending on the country, the value of each component & its contribution to
GDP can vary significantly:
o Government spending in Sweden is 53% of GDP & in the UK it is 25% of
GDP

 The % that each component contributes to GDP in the UK is approximately

o Consumption: 60%
o Investment: 14%
o Government spending: 25%
o Net Exports: 1%
  A 1 % increase in consumption or government spending will have a much larger
impact on economic growth than a 1% increase on net exports

Real Gross Domestic Product (GDP)

 In economics, the use of the word nominal refers to the fact that the metric has not
been adjusted for inflation
 Nominal GDP is the actual value of all goods/services produced in an economy in
a one-year period
o There has been no adjustment to the amount based on the increase in
price levels (inflation)

 Real GDP is the value of all goods/services produced in an economy in a one-

year period - and adjusted for inflation
o For example, if nominal GDP is £100bn & inflation is 10% then real GDP is
£90bn

GDP/Capita
 GDP per capita = GDP / the population
 It shows the mean wealth of each citizen in a country
 This makes it easier to compare standards of living between countries
o For example, Switzerland has a much higher GDP/capita than Burundi

Causes of Economic Growth

1. Growth Caused by a Change in Total Demand

 Actual economic growth occurs when there is an increase in the quantity of

goods/services produced in an economy in a given period of time
o This is often measured by the percentage change in real gross domestic
product (GDP)
o If any component of real GDP increases (consumption, investment,
government spending, net exports), there will be an increase in total
demand
 Any movement from Point E towards the PPC boundary represents actual
economic growth & is caused by an increase in output (rGDP)

Diagram Explanation

 Previously unused factors of production are now being employed

 This is demonstrated by a shift from inside the production possibilities curve
(PPC) such as Point E, towards the boundary of the PPC
 At any given point in time, the actual economic growth may be less than
the potential growth available to the economy

2. Growth Caused by a Change in the Quantity/Quality of Factors of

Production

 Potential growth is the increase in the productive potential of an economy

 This occurs when there is an increase in the quantity or quality of the factors of
production available in an economy

o One example of how the quality of a factor of production can be improved is

through the impact of training and education on labour. An educated
workforce is a more productive workforce and the production
possibilities increase
o One example of how the quantity of a factor of production can
be increased is through a change in migration policies. If an economy
 allows more foreign workers to work productively in the economy, then
the production possibilities increase
 Investing in new capital machinery increases the quality of capital
 Investing in new technology results in an improvement to productivity

Outward shifts of a PPC show economic growth caused by changes to the

quantity/quality of the FOP

Diagram Explanation

 Economic growth occurs when there is an increase in the productive potential of

an economy
o This is demonstrated by an outward shift of the entire curve represented by
A
o More consumer goods & more capital goods can now be produced using
all of the available resources

The Consequences of Economic Growth

 Economic growth is considered to be the main contributor to an improvement in
the standards of living
 Due to the negative aspects of economic growth, there is much controversy about
maintaining it as a central macroeconomic aim
o Instead, arguments for a focus on societal well-being are gaining traction

A Table Summarising the Benefits & Costs of Economic Growth

 Benefits of Economic Growth Costs of Economic Growth
 Increased incomes lead to better  Rising total demand
standards of living causes demand pull inflation &
the purchasing power of people
on fixed incomes may fall
 Decreased levels of absolute  Lack of equity in the distribution
poverty of income - the rich may get
richer & the poor poorer
 Improvement in the  Environmental damage caused
quality/quantity by negative externalities of
of environmentally friendly production & consumption
technologies increases
 Higher sales revenue for firms &  Increased inflation can harm
greater profits export sales
 Increased investment by firms  The level of imports usually
increases the potential output of increases negatively impacting the
the economy current account
 Reduced expenditure by  Increased income usually leads
governments on benefits to greater consumption of
demerit goods
 Higher government tax  Greater output often
revenue due to rising incomes requires more time from
and surging corporate profits workers and can decrease leisure
time & well-being
 Increased employment resolves  Resources are depleted more
some of the negative social rapidly
impacts of unemployment

Causes of Recessions
 A recession is a period of at least six months (2 quarters) of economic
decline which causes a decrease in the real gross domestic product (rGDP)

 It can be caused by a fall in any of the factors that influence total

demand (consumption, investment, government spending, net exports)
e.g. consumption fell during Covid 19 lockdowns causing many economies to
experience a recession

 It can also be caused by supply-side shocks that create challenges for firms &
consumers e.g. The Russian war on the Ukraine has reduced the supply of natural
gas, oil & petrol resulting in major disruptions & increased energy costs

Factors That Reduce Total Demand & Total Supply

Demand-side Factors Supply-side Factors

 A fall in consumer confidence reduces consumption  Unexpected supply shocks such as the war on
 A fall in business confidence reduces investment Ukraine or the Japanese Tsunami of 2011
 Increasing levels of unemployment reduce  A gradual decline in the productive capacity of the
consumption economy when capital (machinery) grows old & is
 Decreasing levels of government spending not replaced
 Increased interest rates require borrowers to repay  A gradual decline in the level of education/training
higher amounts on their loans - this available in an economy
reduces discretionary income which reduces  On-going industrial action such as worker strikes
consumption which disrupt the supply of labour to an economy
 Shocks to other economies can reduce demand for a  Weather events which destroy agricultural products
country's exports thus reducing total demand or interrupt supply chains

 The economic decline (recession) caused by supply-side interruptions can be

illustrated using a production possibility curve (PPC)

Outward shifts of a PPF show economic growth & inward shifts show
economic decline (recession)

Diagram Explanation

 Economic decline occurs when there is any impact on an economy that reduces
the quantity or quality of the available factors of production as depicted by the
movement A
o One example of how this may happen is to consider how the Japanese
tsunami of 2011 devastated the production possibilities of Japan for many
years. It shifted their PPC inwards causing economic decline

Consequences of Recessions
  The consequences of a recession depend on the severity & length of the
recession e.g. The Great Depression lasted from 1929 to 1939 whereas some
economies are in & out of recession within a year

1. National output (rGDP) falls

2. More firms go bankrupt
3. Both unemployment & underemployment increase
4. Both exports & imports fall
5. Domestic & foreign investment by firms decreases/stops
6. Deflation may become an issue leading to even lower wage levels
7. Government spending on unemployment benefits increase
8. Opportunities for entrants to the workforce decrease (youth unemployment
increases)
9. Governments may have to spend significant amounts of money to support the
economy which carries several major opportunity costs

Demand-side Policies
 Demand-side policies aim to influence the total demand in an economy

 The two demand-side policies are fiscal policy & monetary policy

 Any policy that increases consumption, investment, government spending or net exports is
likely to cause an increase in real GDP

Examples Of Specific Types of Fiscal Policy Used to Boost Growth

Example Explanation

Many taxes on imports (import tariffs) Costs of production for firms are reduced & they can produce more
are eliminated goods/services at lower prices - which will increase total demand
Subsidies are provided to manufacturers Car manufacturers are able to produce their cars more cheaply &
of electric cars sell them at lower prices - which will increase total demand
A government increases the level of Unemployed workers have more income available & increase their
unemployment benefits consumption - which will increase total demand
A government creates a free port zone Both multi-national & domestic companies are incentivised by the
low/no tax promise & seek to invest in free port zones - which will
increase total demand
A government announces that it will build Building companies have to be employed & building materials
14 new schools in the next financial year consumed which is all paid for by the government - & will increase
total demand

Examples Of Specific Types of Monetary Policy Used to Boost Growth

Example Explanation
The housing market is subdued & so the With cheaper loans now available, house buyers demand more
Central Bank lowers interest rates by 1% loans to purchase properties & to renovate/furnish the properties -
consumption increases & total demand increases
The Central Bank intervenes in the The nation's currency is now cheaper for foreigners to purchase &
exchange rate to depreciate it this boosts exports - which will increase total demand

The nations currency is now stronger for domestic firms who import
raw materials & they are able to lower prices & sell more
goods/services - which will increase total demand
The Central Bank commits to a new Commercial banks, firms & private investors receive this money as
Quantitative Easing program of $75bn a the government purchases their bonds - they use some of it to invest
month & consume resulting in greater total demand

Supply-side Policies
 Supply-side policies aim to influence the total supply in an economy

Examples Of Specific Types of Supply-side Policy Used to Boost Growth

Example Explanation

The Government reduces the level People who rely on benefits for survival are more likely to make
of welfare benefits themselves available for work. With more workers in the economy
there can be a higher level of output & economic growth
The Government launches a new This provides a pool of skilled labour in AI & helps to grow a new
'Education & Training' fund to help fund industry resulting in greater national output & economic growth
University students studying artificial
intelligence (AI)
The Government decides to The removal of this protection lowers prices & encourages more
remove quotas on all imports competition leading to higher output & economic growth
The Government decides to build an An additional runway means that more planes can land which
additional runway at the national airport generates more economic activity (e.g. transport of goods/services)
leading to higher output & economic growth

Employment Terminology
 Key terms to understand are employment, labour force, unemployment, & full employment

1. Employment: refers to the economic use of labour as a factor of production

2. Unemployment: Someone is considered to be unemployed if they are not working but

actively seeking work
 3. Labour force: A country's population is divided into the labour force - & non labour force
o The labour force consists of all workers actively working PLUS the unemployed
(who are seeking work)
o The non labour force includes all those not seeking work e.g. stay at home parents,
pensioners, school children (these people are economically inactive)

4. Full employment: describes the ideal situation when everyone in the economy who is willing
& able to work has a job

Changing Employment Patterns

 Many economies are experiencing changing patterns of employment within their workforce
& there are numerous reasons for this

Causes of Changing Employment Patterns

Structure of the Economy Proportion of Women Employed Formal & Informal Work
 As Economies develop over  Changing social attitudes have  Workers doing informal
time, they tend to progress increased the number of work are not included in
through the different women entering the workforce employment statistics
sectors (primary, secondary &  The proportion of women in the  Informal employment is much
tertiary) resulting in changes to workforce still varies higher in less developed
the employment pattern significantly between different economies & tends to decrease
 E.g. More manufacturing jobs in economies e.g. Sweden has a as an economy develops
the secondary sector attract much higher proportion of
workers who had previously women in the workforce than
worked in the primary sector India or Saudi Arabia
Proportion of Workers in the Public &
Part-time & full-time Work from home
Private Sector
 Between the Second World War  Working part-time provides  Covid 19 caused many people to
& the late 1980's, the number more flexibility to workers & in think about their pattern of
of public sector employees was recent years, there has been work. Many workers are
large in many economies an increase in the number of reluctant to return to a
 With an increase part-time workers commuting lifestyle & wherever
in privatisation & a move  In some economies workers possible, are continuing to work
towards more market based may not be able to find full-time from home
economies, the percentage of work & may be working 2 or 3
employees in public sector work part-time jobs to pay the bills
has decreased in many
countries

The Claimant Count & Labour Force Survey

 Unemployment is often measured using two different approaches
o The International Labour Organisation (ILO) Survey
 o The Claimant Count

The Differences Between the ILO Labour Force Survey & The Claimant Count

The ILO Labour Force Survey The Claimant Count

 An extensive survey is sent to a random sample of ≈  Counts the number of people claiming
60,000 households every quarter unemployment benefits
 Respondents self-determine if they  More stringent requirement to be considered
are unemployed based on the ILO criteria unemployed than with the ILO survey
o Ready to work within the next two weeks  Requires claimants to meet certain criteria &
o Have actively looked for work in the past excludes many e.g.
one month o Those with savings
 The same survey is used globally so it's useful for o People who claim pensions
making international comparisons o Married women who are looking for a job

Calculating the Unemployment Rate

Three Metrics Are Commonly Used When Analysing the Labour Market in an
Economy

Employment rate
Unemployment rate
Labor force participation rate

= no. actively seeking/total labor force x = no. in employment/population of = labor force/total population x 100
100 working age x 100

 The employment rate could be increasing even as the unemployment rate is

increasing:
o May be caused by increased immigration which causes working age
population to increase
o May be caused as people move from being economically inactive to
employed

 Unemployment rates do not capture the hidden unemployment that occurs in

the long term
o Workers look for a job but may eventually give up and
become economically inactive
 o This actually improves the unemployment rate as fewer people
are actively seeking work

Types of Unemployment
 It is possible to classify the causes of unemployment into three categories

1. Structural unemployment occurs when there is a mismatch between jobs and

skills in the economy
o It usually happens as the structure of an economy changes e.g. the
secondary sector is declining and the tertiary sector is growing
o There is no longer a need for a specific type of worker e.g. ship builders in
Glasgow
o Many Western industries have relocated production to China causing
structural unemployment in their economies
o Unless workers receive help to retrain, they are often
left unemployed or underemployed

2. Cyclical unemployment is caused by a fall of total (aggregate) demand in an

economy
o This typically happens during a slow down or recession
o At least one of the components of real gross domestic product (rGDP) is
falling (consumption, investment, government spending or net exports)
o The demand for labour is a demand derived from the demand for
goods/services
o As output falls in the economy, firms lay off workers

3. Frictional unemployment occurs when workers are between jobs

o This is usually short-term unemployment
o Workers have voluntarily left their previous job to search for another

Consequences of Unemployment
 The effects of unemployment, especially long-term unemployment, are extremely
damaging
o There are impacts on the individual, the economy, the government, and firms
Long term unemployment affects individuals, the economy, government, and
firms

 Government's receive less tax revenue & have higher expenditure in the form of
welfare payments
 Individuals suffer significant emotional, relational & financial consequences
 Firms may find it harder to find workers to employ (as they have moved on) once
the economy starts to recover
 The economy contracts as there is a higher level of inefficient use of available
resources

Demand-side Policies
 Expansionary fiscal policy & expansionary monetary policy aim to increase total
(aggregate) demand in an economy
 o The demand for labour is derived from the demand for goods/services
o If total demand for goods/service increases there will be a higher demand
for labour leading to lower unemployment

 Total demand can be increased through any policy which increases one of the
components of real gross domestic product (rGDP)

Examples of Demand-side Policies Which Are Likely To Reduce

Unemployment

Broad Policy
Specific Policy Explanation
Type

Expansionary Government decreases corporation Firms pay less tax →

Fiscal Policy tax firms have more profit →
firms hire more
workers → firms increase
output → unemployment
falls
Expansionary Government increases expenditure Defence firms receive
Fiscal Policy on national defence more orders from the
government → they
hire more workers to
produce the output →
unemployment falls
Expansionary Government decreases personal Households have more
Fiscal Policy income tax discretionary income
→ consumption
increases → in order to
produce the extra
goods/services, firms hire
more workers →
unemployment falls
Expansionary The Central Bank lowers interest Household repayments on
Monetary rates existing loans fall →
Policy Households have more
discretionary income
→ consumption
increases → in order to
produce the extra
goods/services, firms hire
more workers →
unemployment falls
Expansionary The Central Bank increases the Many firms receive money
Monetary money as the Central Bank buys
Policy supply through quantitative back their bonds → they
easing decide to use the extra
 money to invest in new
equipment & technology
→ investment
increases allowing the
production of the more
goods/services → firms
hire more workers →
unemployment falls

 Demand-side policies are very effective at dealing with unemployment caused by a

fall in total (aggregate) demand
 They are not effective at dealing with frictional & structural unemployment
 One conflict caused by expansionary policy is that demand pull inflation is likely to
occur
 Expansionary monetary policy tends to increase inequality in the distribution of
income as the poor are usually unable to benefit from it (banks do not necessarily
lend to the poorest households)

Supply-side Policies
 Supply-side policies aim to improve the quantity/quality of the factors of
production thereby raising potential output
o If output increases then firms will require more workers to produce that
output & unemployment may fall

Examples of Supply-side Policies Which Are Likely To Reduce Unemployment

Specific Supply-side Policy Explanation

The Government Trade union power weakens → firms lower wages

reduces trade union → costs of production decrease → firms can
power produce more output with the same input → firms
hire more workers as they are cheaper →
unemployment falls
The Government Regulations removed → costs of production
reduces regulation on decrease as firms no longer need to spend money
the oil & banking meeting requirements → firms can produce more
industries output with the same input → firms hire more
workers as they are cheaper → unemployment falls
The Government Cheaper to study green technology → more students
introduces new long develop their skills → supply of skilled workers in
term training subsidies the industry grows → new firms launch → output
for students of green increases & more workers are required →
technology unemployment falls
  Supply-side policy tends to be long term e.g. breaking trade union power is a long
term process, as is training
 It is most effective in dealing with unemployment caused by frictional & structural
unemployment
 It does not help deal with unemployment caused by demand side issues e.g. a
recession

Protectionist Policies
 Protectionism involves the use of government policies that restrict international
trade in order to protect domestic industries, including employment in domestic
industries
o Some firms are unable to compete with international firms & without
protection, go out of business
o Their workers become unemployed
o To avoid this, governments help domestic firms to survive
by subsidising them, or placing import tariffs on a range of products
which raises the price of the goods/services provided by foreign competitors

 Protectionist policies may well protect employment of some workers in the industry
targeted, but create even higher unemployment in related industries
o E.g. in 2016, The Trump Administration placed tariffs on all steel
imports which protected around 1,600 jobs in the steel industry. However,
the raised price of imported steel, which is used as a factor of production in
many industries, reduced output & increased unemployment in many
related industries

Inflation & Deflation

 Inflation is the sustained increase in the general price level of goods/services in
an economy
o The general price level is measured by checking the prices of a 'basket' of
goods/services that an average household will purchase each month
o This basket of goods is turned into an index and it is called the consumer
price index (CPI)
o The UK has an inflation target of 2% per annum
 Low inflation is better than no inflation as it is a sign of economic
growth

 Deflation occurs when there is a fall in the general price level of goods/services in
an economy

o Deflation only occurs when the percentage change in prices falls below
zero %

Using the Consumer Price Index (CPI) to Measure Inflation &

Deflation
 Inflation is the sustained increase in the general price level of goods/services in
an economy
  The inflation rate is the change in general price levels in a given time period
o The inflation rate is calculated using an index with 100 as the base year
o If the index is 100 in year 1 and 107 in year 2 then the inflation rate is 7%

 The consumer price index (CPI) is used to measure inflation

The Consumer Price Index (CPI)

 A 'household basket' of 700+ goods/services that an average family would
purchase is compiled on an annual basis
o A household expenditure survey is conducted to determine what goes into
the basket
o Each year, some goods/services exit the basket & new ones are added

 Goods/services in the basket are weighted based on the proportion of household

spending
o E.g. More money is spent on food than shoes, so shoes have a lower
weighting in the basket

 Each month, prices for these goods/services are gathered from hundreds of
locations across the country
o These prices are averaged out

 The price x the weighting determines the final value of the good/service in the
basket
o These final values are added together to determine the price of the 'basket'

 CPI = Cost of basket in year X/Cost of basket in base year x 100

 The percentage difference in CPI between the two years is the inflation rate for
the period

The Causes of Inflation

 An increase in the general price level in an economy can be caused by demand
pull inflation or cost push inflation

1. Demand Pull Inflation

 Demand pull inflation is caused by excess demand in the economy
 Total (aggregate) demand is the sum of all expenditure in the economy
o rGDP = Consumption (C) + Investment (I) + Government spending (G) + Net
Exports (X-M)

 If any of the four components of rGDP increase, there will be an increase in the
total demand in the economy leading to an increase in the general price level
 Demand pull inflation has occurred
An Example of Demand Pull Inflation

 If the Central Bank lowers the base rate, there is likely to be increased
borrowing by firms & consumers
o This will result in an increase in consumption & investment which will
increase the rGDP
o It is likely to lead to a form of demand-pull inflation

2. Cost Push Inflation

 Cost push inflation is caused by increases in the costs of production in an
economy
 If any of the costs of production increase (labour, raw materials etc.), or if there is a
fall in productivity, the total supply will decrease
 With less supply, prices rise leading to an increase in the general price level
 Cost push inflation has occurred

An Example of Cost Push Inflation

 Trade Unions negotiate higher wages for workers

 The wage increases represent an increased cost of production for firms
 With the inputs, firms now produce less & supply reduces leading to higher general
price levels
 Cost push inflation has occurred

Demand-side Deflation
 Deflation occurs when there is a fall in the average price level of goods/services in an
economy as measured by the consumer price index (CPI)

o Deflation only occurs when the percentage change in prices falls below zero %

 Deflation can be caused by either demand-side or supply-side factors

o The two different causes of deflation have very different consequences for the
economy

Demand-side Deflation (Bad Deflation)

 Demand-side deflation is caused by a fall in total (aggregate) demand in the economy

 Total (aggregate) demand is the sum of all expenditure in the economy as measured by
the real gross domestic product (rGDP)
o rGDP = Consumption (C) + Investment (I) + Government spending (G) + Net
Exports (X-M)
 If any of the four components of rGDP decrease, there will possibly be a decrease in the
total demand in the economy leading to a decrease in the general price level
o Demand-side deflation has occurred
 The Consequences of Demand-side Deflation

Consumers Lose
Unemployment Debt
Confidence

With a decrease in With falling output & Debt feels more

output, fewer workers rising unemployment, burdensome as the value
are required & so households lose of any debt is worth
unemployment increases confidence choosing to more. Real cost of
save instead of spend. borrowing increase as
Consumption falls real interest rates rise
& rGDP reduces even when the price level falls
more e.g. if interest rates are
1.5% & the inflation rate
is –1.5%, then the real
interest rate is 3%

Firms Lose Confidence Bankruptcies Exports

Falling output & falling Falling output & falling Persistently falling prices
prices cause firms to lose prices reduce the can prove attractive to
confidence & so profits of firms. Some foreigners & the level of
they delay investment, firms will be unable to exports may increase (this
further reducing rGDP continue & will go out of helps offset some of the
business reduction in rGDP)
Supply-side Deflation
 Supply-side deflation is caused by increases in the productive capacity of the economy
o This is brought about by any increase in the quantity/quality of the factors of
production
o It effectively creates a condition of excess supply in the economy
o General price levels fall
o National output (rGDP) increases

The Consequences of Supply-side Deflation

Consumers Gain
Unemployment Debt
Confidence

With a decrease in costs, With rising output & Debt still feels
the output of firms falling price levels, more burdensome as the
increases. More workers households become more value of any debt is worth
 are required & so confident & consumption more
unemployment falls increasing - increasing
rGDP even more

Firms Gain Confidence Exports

Rising output & falling Persistently falling prices

costs of production cause boosts international
firms to gain confidence competitiveness &
& increase investment, exports increase
thereby increasing rGDP

Policies To Tackle Inflation

 Demand pull inflation is best addressed using contractionary demand side policies
o Contractionary fiscal policy & contractionary monetary policy aim to reduce total
(aggregate) demand in an economy
o If total demand for goods/services decrease there will be a fall in the general price
level thereby reducing the level of inflation

 Total demand can be decreased through any policy which decreases one of the components
of real gross domestic product (rGDP)

Examples of Demand-side Policies Which Are Likely To Reduce Demand Pull Inflation

Broad Policy Type Specific Policy Explanation

Contractionary Government increases corporation Firms pay more tax →

Fiscal Policy tax firms have less profit →
firms invest less →
rGDP falls → inflation
decreases
Contractionary Government decreases expenditure Government spending
Fiscal Policy on national defence decreases → defence
firms receive fewer
orders from the
government → national
output falls → inflation
decreases
Contractionary Government increases personal Households have less
Fiscal Policy income tax discretionary income
→ consumption
decreases → national
output falls → inflation
 decreases

Contractionary The Central Bank increases Household repayments

Monetary interest rates on existing loans rise →
Policy households have less
discretionary income
→ consumption
decreases → national
output falls → inflation
decreases
Contractionary The Central Bank decreases the Firms receive less money
Monetary money supply by from the sale of bonds
Policy stopping quantitative easing → investment decreases
→ national output falls
→ inflation decreases

 Demand-side policies are more effective in the short term at dealing with inflation caused by
a rise in total (aggregate) demand
 They are less effective at dealing with cost push inflation
 One conflict caused by contractionary policy is that reducing demand pull inflation also
reduces output & employment

Examples of Supply-side Policies Which Are Likely To Reduce Cost Push Inflation

Specific Supply-side Policy Explanation

The Government Regulations removed → costs of production

reduces regulation on decrease as firms no longer need to spend money
the oil & banking meeting requirements → national output (total
industries supply) rises → inflation reduces
The Government More workers move into the country → the price of
changes migration labour (wages) falls → costs of production reduce
policies to allow more for firms → national output (total supply) rises →
workers into the inflation reduces
country
The Government Speed & capacity of transport infrastructure is
builds a new rail improved → costs of production decrease as firms
network serving ports benefit from the improvements → national output
& airports (total supply) rises → inflation reduces

 Supply-side policy tends to be long term, but highly effective in reducing price levels
 They do not help deal with inflation caused by demand side issues
Policies To Tackle Deflation
 Deflation caused by a fall in total demand (e.g. during a recession) is best addressed using
expansionary demand-side policies

 Expansionary fiscal policy & expansionary monetary policy aim to increase total
(aggregate) demand in an economy
o When total demand increases, general price levels also increase
o This reduces or eliminates the deflation

 Total demand can be increased through any policy which increases one of the components
of real gross domestic product (rGDP)

Examples of Demand-side Policies Which Are Likely To Reduce Deflation

Broad Policy
Specific Policy Explanation
Type

Expansionary Government increases expenditure Defence firms receive

Fiscal Policy on national defence more orders from the
government → total
demand increases →
deflation is
improved/eliminated
Expansionary Government decreases personal Households have more
Fiscal Policy income tax discretionary income
→ consumption
increases →total demand
increases → deflation is
improved/eliminated
Expansionary The Central Bank lowers interest Household repayments on
Monetary rates existing loans fall →
Policy Households have more
discretionary income
→ consumption
increases → total demand
increases → deflation is
improved/eliminated

 Demand-side policies can very effective at dealing with deflation

 Expansionary monetary policy tends to increase inequality in the distribution of income as
the poor are usually unable to benefit from it (banks do not necessarily lend to the poorest
households)
Real GDP Per Capita
 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 living standards

o Single indicators e.g. real gross domestic product/capita, 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)

The Distinction Between Real, Nominal & Per Capita GDP

 In economics, the use of the word nominal refers to the fact that the metric has not
been adjusted for inflation
 Nominal GDP is the actual value of all goods/services produced in an economy in
a one-year period
o There has been no adjustment to the amount based on the increase in
general price levels (inflation)

 Real GDP is the value of all goods/services produced in an economy in a one-

year period - & adjusted for inflation
 o For example, if nominal GDP is $100bn and inflation is 10% then real
GDP is $90bn

 Real GDP per capita = rGDP / the population

o It shows the mean wealth of each citizen in a country
o This makes it easier to compare standards of living between countries:
 For example, Switzerland has a much higher GDP/capita than Burundi

 It is useful to know the rGDP/capita, however it has the following disadvantages

o It is a single indicator so provides very limited information
o It is an average so there may be significant poverty in many parts of a
country that has a high rGDP/capita

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 olds have received, together with the expected years of schooling for a pre-
school child
3. Income, as measured by the real GDP

 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

An Evaluation of HDI

1. It is a composite indicator & includes several important indicators of living standards

2. It includes rGDP/capita which is an average - so the HDI still does not take into
account inequality in the distribution of income
3. It does not measure environmental damage or resource depletion
4. It does not take into account cultural differences or measure qualitative
factors such as happiness or equal rights

Reasons for Differences in Living Standards & Income Distribution

 There are many reasons that cause differences in living standards & the income
distribution within & between countries

1. Economic system: a mixed economy provides the highest quality of living

standards. There is much debate on how much government planning there should
 be. However, countries in Scandinavia with a more mixed economic system score
very highly on HDI & living standards. With completely free markets (unchecked
capitalism), wealth inequalities increase exponentially. With planned economies,
shortages abound

2. The Government: the values of a government influence their economic agenda, tax
system & government spending. Governments are more easily held accountable by
the citizens in countries with a low level of corruption

3. Corruption: significantly undermines quality of life & the standards of living

4. Tax system: most countries have a progressive tax system for corporate &
personal income tax. However, there can be many indirect taxes which completely
change the quality of life for the poorest households

5. Productivity levels: differences in skills result in difference in productivity & higher

levels of productivity are rewarded with higher wages, which leads to a better
standard of living

6. Size of the population: more densely populated countries or cities face more
challenges. A larger population can mean higher tax revenues but at the same time,
government expenditure on services is spread across more people often resulting
in less government spending/capita

7. Education levels: These directly influence productivity & wages

8. Inflation: Tends to impact poorer households more as any increase in general

price levels represents a larger absolute value of their wages when compared to
wealthier households

9. Regional differences: Many countries have historically poor areas, as well as

wealthier ones. Poverty in certain regions can be much higher

10. Personal freedoms: religious, economic, personal, political & civil freedoms improve
the quality of life within a nation

Absolute & Relative Poverty

 Poverty is a situation where a person lacks the financial resources to sustain a
basic standard of living

 Economists distinguish between 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
 In 2022, the World Bank defined absolute poverty as anyone who
was living on less than $1.90 a day

 Absolute poverty is more prevalent in developing countries than

developed ones
  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 E.g. The UK defines relative poverty as households that are living with less
than 60% of the median household income
 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

 Relative poverty is the main form of poverty that occurs in developed countries

Causes of Poverty
 There are many causes of poverty. However, poor countries have several common
characteristics which can be summarised in a poverty cycle diagram

Poverty is caused by a lack of both economic growth & human development

 Low wages represent the intersection of economic growth & human development &
are the major cause of poverty
o Low wages are usually the result of unemployment, informal employment,
a lack of skills, or a primary sector based economy

 Education & healthcare cost money & with lower wage levels these are not
accessible, resulting in poor human capital
o People find it harder to stay well or to recover from illness resulting in lower
productivity & shorter life expectancy
  Low productivity results in low wages & the cycle continues

 Populations with a large number of dependents (old people & children) for each
working household tend to experience higher levels of poverty

Policies Aimed At Alleviating Poverty

 The poverty cycle diagram (below) was introduced in the previous subtopic & helps to
explain the causes of poverty
 Any policy that helps to break the poverty cycle at any point will help to improve
the standards of living within a country

 Policies used to alleviate poverty include promoting economic growth, improving education,
providing more generous state benefits, progressive taxation, & the establishment/increase
of a national minimum wage

Policies which help to improve any factor in the diagram will help to alleviate poverty

How Different Policies Alleviate Poverty

Policy
Explanation Impact on Poverty Cycle

Promoting economic  Removing protectionism or engaging Higher growth → higher

growth in expansionary demand & supply- wages → better
side policies will promote growth education/healthcare →
better human capital →
  Data shows that economic better productivity →
growth has a very positive impact higher income
on economic development
 In most cases growth precedes
development

 Often in less developed countries,

economic growth is linked to one
industry & generates many negative
externalities of production possibly
resulting in decreased living
standards
Improving education  Investing in this supply-side Higher education/skill
policy increases the potential output levels → higher human
of the country (shifts the production capital → increased
possibility frontier outwards) productivity → higher
output → higher income
More generous state  State benefits are usually given to More benefits → higher
benefits the poorest & most wages → better
vulnerable people in society education/healthcare →
 State benefits better human capital →
include unemployment & disability better productivity →
payments, pension payments, higher wages
heating discounts, public transport
subsidies etc.
Progressive taxation  A progressive tax Higher redistribution
system redistributes from those with → better
higher income to those with lower education/healthcare →
income & reduces income inequality better human capital →
 Redistribution often starts with the better productivity →
provision of free education & higher income
healthcare
 Sometimes the benefits of a
good progressive tax system are
eradicated by the penalties imposed
through multiple regressive (indirect
) taxes
Establishment/increase  Minimum wages are set above the Higher wages → better
of national minimum free market rate education/healthcare →
wage  Firms are not allowed to pay anyone better human capital →
less than the legal rate better productivity →
higher wages

Factors that Affect Population Growth

 Population refers to all of the inhabitants of a particular country
 The population growth rate is the size of the change in the population of a country,
expressed as a percentage
  The following factors affect population growth
o The annual birth rate
o The annual death rate
o The net migration
 A higher birth rate & lower death rate would both increase the
population
 More immigration than emigration would increase the growth rate

 All countries have different rates of population growth

o Population growth rates are currently highest in less economically
developed countries such as Niger, Mali and Zambia
o Population growth rates are lowest in more economically developed
countries
o In some MEDCs such as Italy and Japan, the population is decreasing as the
number of deaths is higher than the number of births

Reasons For Different Rates of Population Growth

 There are two broad causes of population change
o Migration (explained above)
o Natural population change (birth rates & death rates)

Natural Causes of Population Change

 Natural change in population is calculated by deducting the death rate from the
birth rate

 The following factors led to a decrease in the death rate

o The agricultural revolution led to higher yields & healthier, more varied diets
o Improvements to medicine & medical care
o Improvements to technology & transport, leading to a wealthier population
which increases life expectancy
o Improved housing & sanitation

 The birth rate has remained high in LEDCs due to

o Lack of access to family planning & contraception
o An increase in women surviving childbirth
o Families continuing to have large numbers of children to look after their
parents in old age & to help support the family
o Culture of having larger families which takes many years to change
o Religious reasons

 The birth rate has fallen significantly in many MEDCs due to

o Increased access to family planning & contraception
o Changing social norms which include starting families later, having fewer
children, or remaining single
o Increased costs of child rearing & university education

The Optimum Population

  Overpopulation occurs when there are more people in a country/region than can be
supported by its resources & technology & leads to
o Higher levels of pollution
o Higher crime rates
o Higher unemployment or underemployment
o Higher levels of food & water shortages
o Higher pressure on services such as hospitals & schools

 Underpopulation occurs when there are more resources available than the
population can use effectively & may lead to

o Fewer people paying tax which can lead to higher taxes

o Underused resources, which can lead to wastage
o A shortage of workers
o Lower levels of exports & production which affects the wealth of an area
o Fewer customers for goods & services

 Optimum population occurs when there is a balance between the number of people
& the resources/technology available

Optimum Theory of Population

 The optimum population results in the highest standard of living

o There are not so many people or so few resources that the standard of living
falls
o There are enough people to develop the resources of the country

The Optimum Population

  Overpopulation occurs when there are more people in a country/region than can be
supported by its resources & technology & leads to
o Higher levels of pollution
o Higher crime rates
o Higher unemployment or underemployment
o Higher levels of food & water shortages
o Higher pressure on services such as hospitals & schools

 Underpopulation occurs when there are more resources available than the
population can use effectively & may lead to

o Fewer people paying tax which can lead to higher taxes

o Underused resources, which can lead to wastage
o A shortage of workers
o Lower levels of exports & production which affects the wealth of an area
o Fewer customers for goods & services

 Optimum population occurs when there is a balance between the number of people
& the resources/technology available

Optimum Theory of Population

 The optimum population results in the highest standard of living

o There are not so many people or so few resources that the standard of living
falls
o There are enough people to develop the resources of the country

Population Distribution
 The characteristics of a population (the distribution of age, sex, ethnicity, religion
etc), is known as the population structure

 The population structure is the result of changes in:

o the birth rate
o the death rate
o net migration

 The two main characteristics of age & sex can be shown on a population pyramid

Population Pyramids
 Population pyramids are used to display the gender & age structure of a given
population
o They illustrate the distribution of population across age groups and
between male/female

 Population pyramids can be used to identify the following groups:

o Young dependents
o Old dependents e.g number of retired people
o Economically active (working population or labour force)
o Dependency ratio

Example 1 - Niger As A Less Economically Developed Country (LEDC)

 Population Pyramid - Niger

 LEDCs like Niger have a concave pyramid shape which indicates

o High birth rate
o Low life expectancy
o High death rate but starting to decrease (people dying through every age
group)
o High infant mortality rate (significant decrease between 0-5)
o Young dependent population dominates the distribution

Example 2 - USA As A More Economically Developed Country (MEDC)

 Population Pyramid - USA

 This population pyramid indicates:

o Decreasing birth rate - there is a smaller population reading down from age
29
o Increasing life expectancy - indicated by the relatively straight sides
reaching the age of 70, followed by a good proportion of people living much
longer
o Decreasing death rate - indicated by the relatively straight sides reaching
the age of 70
o Low infant mortality - hardly any change between 0-9 years
o Larger working age population - 15 to 69 represents a large proportion of
the population

Example 3 - Japan As A More Economically Developed Country (MEDC)

 Population Pyramid - Japan

 This population pyramid indicates

o Decreasing birth rate - indicated by decreasing population levels from age
29
o Increasing life expectancy - indicated by the relatively straight sides
reaching the age of 74, followed by a good proportion of people living much
longer
o Death rate is higher than the birth rate due to the ageing population
o Low infant mortality
o Ageing population - older dependent population with large proportion of the
population older than 40

Effects of Population Changes

 Population changes can have major impacts within the economy resulting in
changes to consumption, production, lifestyle, standards of living & government
policies (fiscal, monetary & supply-side)

 Typical changes that occur are

o Progressively ageing populations as economies develop

o Falling birth rates as economies develop
 o Swings in net migration as influenced by war, famine, natural disasters &
government policy

Ageing Populations
 Many developed economies are experiencing ageing populations & an increase in
the older dependent population
 The implications of this include
o Increased pension payments by governments
o Increased need for care homes (public & private)
o Increased pressure on the healthcare service & social care results in
higher government spending
o It also results in a smaller labour force & often Governments collect less tax
o Firms suffer worker shortages
o Labour shortages result in increased wage costs for firms

Falling Birth Rates

 Falling birth rates have the following impact on an economy
o School closures due to fewer children
o Future labour shortages
o Governments typically put in place incentives that encourage families to
have more children
o Governments may change the migration laws to encourage immigration so
that labour shortages are prevented
 Excessive immigration can change the nature & culture of different
regions within a country

Migration
 In some countries migration can lead to an imbalance in the population
structure e.g. the UAE has significantly more males than females
 Rapid population growth caused by migration can lead to
o Increased pressure on services such as healthcare & schools resulting in
increased costs for government
o A shortage of housing which generates social issues in society
o Increased traffic congestion which is a negative externality
o Increased water & air pollution which are negative externalities
o Food shortages

Causes of Differences in Development

 Economic development is the sustainable increase in living standards for a country, typically
characterised by increases in life span, education levels, & income
o Two indicators used to compare development are the real GDP & the Human
Development Index (see sub-topic 5.1.1)

 Countries are all at different points of development & economists distinguish between
them using different criteria
 o E.g. HDI has five categories of development based on the HDI score
 Low human development (<0.550)
 Medium human development (0.550–0.699)
 High human development (0.700–0.799)
 Very high human development (>0.800)

 There are numerous reasons for these differences including differences in income,
productivity, population growth, size of primary, secondary & tertiary sectors, saving &
investment, education & healthcare

Causes of Differences in Development

Factor Explanation

Differences in  Countries with a higher GDP/capita tend to be more

income developed
 Even with high GDP/capita, there may be
significant inequality in the distribution of
income resulting in poor living standards for many
Differences in  Differences in skills result in difference in productivity
productivity  Higher levels of productivity are rewarded with higher
wages, which leads to a better standard of living
Differences in  More densely populated countries or cities face more
population growth challenges
 A larger population can mean higher tax revenues for
the government but at the same time, government
expenditure on services is spread across more people
 Poorer economies are characterised by less
government spending/capita
Differences in  Economies with a larger proportion of secondary &
economic sector tertiary activity tend to be more developed due to
sizes the wages associated with each sector
 Primary sector workers are usually paid low wages
due to the unskilled nature of the job & the fact that
raw materials often generate the lowest profits in the
production chain
 Secondary sector workers add value to the raw
materials & these products sell for higher profits.
Therefore wages tend to be higher than primary
sector wages
 Tertiary sector workers are paid the highest. Their
jobs often require highly valued skills that take years
to acquire & the products they sell or services they
provide can be complex & expensive e.g. artificial
intelligence coders
Differences in  Higher savings result in higher investment &
saving & economic growth. It is believed that as economies
 investment develop, savings increase
 Increased savings → increased investment → higher
capital stock → higher economic growth → increased
savings
 If the dependency ratio is high it means there is less
money available for savings & investment
Differences in  These directly influence the level of skill in an
education economy
 Improved skills results in higher productivity & wages
Differences in  The level of health directly impacts productivity of
healthcare labour
 Productivity influences output & income
 Developed economies tend to have healthy
workforces
 The less developed the economy, the more sickness &
disease there is

Reasons for National Specialisation

 Specialisation occurs on several different levels
o On an individual level where a worker specialises in a particular task
o On a business level, e.g. one firm may only specialise in manufacturing drill bits for
concrete work
o On a regional level e.g. Silicon Valley has specialised in the tech industry
o On a national level as countries seek to trade e.g. Bangladesh specialises in textiles
and exports them to the world

 The two main factors which allow a country to specialise are:

1. Superior resource availability: If the quality of the resource is relatively better than other
nations, the country will be able to charge higher prices for it. Alternatively, if a country has
a higher quantity of the resource then it may be able to lower prices & drive competitors
out of business by specialising in its extraction & sale
 2. Cheaper production methods: If the country has lower costs of production, then it is very
likely that they will be able to lower selling prices & gain a lead in the international market
share. Some countries are able to produce cheaply using machinery or technological
innovation, whilst others do so by providing large labour force which can perform manual
tasks very cheaply

Advantages & Disadvantages of National Specialisation

Pros & Cons of National Specialisation

Pros Cons

Greater competition may increase International trade is beneficial for the

productivity. Higher firms that can compete globally.
productivity lowers cost / unit for However, some industries will
firms, which makes their goods more be unable to compete & will go out of
competitive internationally (exports) business

Increased exports can result Many firms in an entire industry may

in economic growth for the nation close leading to structural
unemployment
Economic growth usually leads Specialisation may create over-
to higher income and a better standard dependency on other countries'
of living resources. This may cause problems if
conflict arises (For example, Europe's
reliance on Russian natural gas during
the Ukraine crisis)

Income gained from exports can be Specialisation using a country's own

used to purchase other goods from resources will lead to resource
around the world (imports). This depletion over time. Specialisation will
increases the variety of increase the rate of resource depletion
goods available in a country

Global efficiency in the use of scarce As multinational firms grow in size &
resources improves as resources are increase market power, they
extracted by nations who have the can dictate prices & output in many
competitive advantage regions. They are also able to wield
their power to influence governments
& gain access to raw materials through
bribery & corruption
With an increase in specialisation & Start-up firms in developing
output, it is possible to generate countries (infant industries) find it
significant economies of scale which harder to compete due to
further lower production costs global competition - the ones that
survive often have government
support. Global monopolies also exert
 large amounts of pressure on
developing countries
Over-specialisation in developing
economies often occurs as they lack
the finance to develop a diversified
product base & end up over-
specialising in commodity products.
This makes the country's GDP very
dependent on the commodity prices

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

1. Increasing foreign ownership of 2. Increasing movement of labour &

companies technology across borders

3. Free trade in goods/services 4. Easy flows of capital (finance) across

borders

Multi National Corporations (MNCs)

 A multinational corporation is business that has production facilities in two or more
countries e.g. Apple
 Globalisation has made it easier for firms to do business on a global scale & the number &
size of MNCs continues to increase
 There are advantages & disadvantages linked to the economic activity of MNCs, both in their
home country as well as in their host country

The Advantages & Disadvantages of MNCs

The Advantages of MNCs

 1. Economies of scale: as they operate globally they are able to increase their output & benefit
from lowered costs created by economies of scale
2. Increased profit: much of their profit is sent back to their home country. This point is
debatable as many MNCs have offshore bank accounts & do not bring the profit back home
3. Create employment: new jobs are created in host countries each time a new facility is setup
& this raises income which helps to improve the standard of living in that country
4. New markets: MNCs can identify potential markets & begin to sell there
5. Transportation costs: MNCs are able to setup facilities closer to their customers which
reduces transportation costs
6. Risk management: By selling in many national markets, the risk of failure is reduced e.g. if
Egypt goes through a recession (with sales falling there), then this could be less impactful
due to rising sales in a strong German market
7. Tax incentives: MNCs are able to increase their profits by setting up in countries with low
corporation tax - or countries that offer MNCs a tax break (no tax) for their first 5-10 years of
operation
8. Avoidance of protectionism: MNCs can establish bases in countries that are
operating protectionistmeasures & by doing so, they avoid the measures e.g. A Chinese MNC
may setup in the USA & produce there, thus avoiding import tariffs on their products
exported from China to the USA

The Disadvantages of MNCs

Worker exploitation Resource plundering Political power

Many MNCs Many MNCs extract large Many MNCs enjoy

provide poor working quantities of host nation revenue that is higher
conditions & pay very natural resources providing than the GDP of the
low (sweatshop) wages very little host nation & this gives
compensation/payment them immense political
power which can be
used to their advantage
Lack of local Over reliance on MNCs
Reduce competition
knowledge/culture for jobs

MNCs are so large that This may result Many developing

they can out-compete in problematic local nations have an over-
domestic firms in the relationships or flawed reliance on MNCs to
host country. This puts advertising campaigns or provide jobs for their
many firms out of product offerings citizens. If the MNC
business & reduces leaves it creates
competition in that significant
country & may increase unemployment
unemployment
Diseconomies of scale Exchange rate fluctuations Negative Externalities

The challenges of Unexpected exchange rate MNCs are associated

operating a business fluctuations can have severe with many negative
over different time zones impacts on the costs & externalities of
& cultures can create profits of MNCs production in
significant diseconomies developing countries
 of scale

The Benefits of Free Trade

 International trade refers to the exchange of goods & services between countries
 International trade involves the exchange of goods/service
through exports & imports
 International trade is 'free' when there is no government intervention (quotas, taxes
etc.) to reduce or limit trade

The benefits of free trade

 Greater choice: with access to a wider variety of goods/services, the standard of

living improves
  Lower prices: with international competition prices fall giving households the ability
to buy more
 International cooperation: required for trade helps countries to build better
relationships which leads to lower levels of hostilities
 Flow of new ideas: innovative ideas & technology can be shared between countries
 Access to resources: output can increase & costs of production can fall with
increased access to raw materials
 Increased efficiency: international competition allows the most efficient firms to
emerge & this improves the use of global resources
 Economic growth: exports are a key component of the gross domestic product of
many countries & an increase in exports can lead to economic growth
 Economic development: Increased output leads to lower levels of unemployment
which leads to higher incomes & a higher standard of living

Reasons for Protection

 Free trade aims to maximise global output through national specialisation
 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 import tariffs, export subsidies,
the use of quotas or embargoes

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 their way out & the government
chooses to support them to help limit the economic
damage that would occur if they closed abruptly

Strategic industries Industries such as energy, defence & agriculture are

essential to self-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 protect
jobs

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

Labour/environmental Many countries offer cheap labour & low-cost

regulations production due to poor environmental regulations.
Protectionism can help apply pressure to bring about
change in these countries

Methods of Protection
 The most commonly used forms of trade protectionism include tariffs, subsidies,
quotas, embargoes & administrative barriers

1. Tariffs

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

 With the price of imports higher, domestic firms find it easier to compete & increase
their market share as consumers switch from buying imports to buying domestically
produced goods/services
 Less efficient domestic firms are now producing at the expense of more efficient
international firms
 A tariff increases the costs of production for domestic firms, resulting in a
shift of the supply curve from S1 → S2

Diagram Analysis

 The pre-tariff market equilibrium for plantains is seen at P1Q1

 After the tariff is imposed, costs of production for domestic firms increase (as they
pay the tariff when the plantains enter the country) - the supply curve shifts
from S1 → S2
 The new market equilibrium is seen at P2Q2
o Following the law of demand, the quantity demanded contracts from Q1 to
Q2
o The price increases from P1 → P2

 Tariffs are one of the most widely used forms of protectionism & their impact on
stakeholders can be evaluated as follows

An Evaluation Of The Use Of Tariffs To Protect Domestic Firms

Stakeholder Explanation

Domestic  Before the tariff domestic manufacturers are less

producers targeted competitive & produce less
by the government  After the tariff was imposed the targeted domestic
action e.g. steel manufacturers increase their output
manufacturers  These firms may need more workers to produce the
extra output & so unemployment in that industry falls
Domestic  Before the tariff domestic manufacturers are able to
producers who purchase the raw materials at cheaper prices
have to pay higher  After the tariff, the costs of production of domestic
prices e.g. car manufacturers increase resulting in a fall in output
manufacturers who  These firms may require fewer workers & so
use steel for unemployment in several related industries may rise
production
Foreign producers  Tariffs decrease demand for their products & so their
output falls
 With less supply from efficient foreign producers,
the global allocation of resources is now more
inefficient
Domestic  Before the tariff domestic consumers consumed more
consumers products at lower prices
 After the tariff domestic consumers consumed fewer
products at higher prices
 The standards of living for consumers worsen as
the value of their income is eroded as they are paying
higher prices
The Government  After the tariff is imposed the government
receives tax revenue from each unit imported

Quotas, Subsidies, Embargoes & Administrative Barriers

2. 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

An Evaluation Of The Use of Quotas To Protect Domestic Firms

Stakeholder Explanation

Domestic  Increases their output

Producers  Raises the selling price
 Increases their revenue
Foreign Producers  Decreases their output
  Compared to a tariff, those firms who manage to
export in the quota receive a higher price for their
sales
Consumers  Results in higher prices & less choice
Government  They do not receive any tariff revenue (as there is no
tariff)
 They may receive higher tax revenue at the end of the
financial year when domestic firms pay
their corporation tax
Standards of living  Reduces for consumers as higher prices erode
the purchasing power of their income
Equality  Domestic firms can compete more equally

3. 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

An Evaluation Of The Use of Subsidies To Protect Domestic Firms

Stakeholder Explanation

Domestic  Decreases costs of production

Producers  Increases output
 Increases international competitiveness
Foreign Producers  Makes it harder for them to compete with domestic
firms
Consumers  Lowers prices

Government  This costs the government the amount of the subsidy

 There is an opportunity cost associated with every
subsidy provided
Standards of living  Improves for consumers as they benefit from lower
prices - their income goes further
Equality  Domestic firms can compete more equally

4. Embargoes
 An embargo is a complete ban on trade with a certain country usually as the result of
political fall out e.g. the USA ran an embargo for many decades on Cuban products
 An Evaluation Of The Use of Embargoes To Protect Domestic Firms

Stakeholder Explanation

Domestic  Increases output due to less foreign competition

Producers
Foreign Producers  They are unable to legally trade with the country
running the embargo
 They lose sales & profits
 They may go out of business or need to reduce their
number of workers
Consumers  Prices will rise - & in some cases the product may no
longer be available at all
Government  The government has to spend money enforcing the
embargo

5. Administrative 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
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

Foreign Exchange Rates (Forex)

 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

 Two of the main exchange rate systems are

o A floating exchange rate
 o A fixed exchange rate

1. A Floating Exchange Rate System

 Different currencies can be bought & sold, just like any other product
 The forces of demand & supply determine the rate at which one currency exchanges for
another
 As with any market, if there is excess demand for the currency on the forex market, then
prices rise (the currency appreciates)
 If there is an excess supply of the currency on the forex market, then prices fall (the
currency depreciates)

The relationship between the US$ & the Euro shows that as Europeans demand the $ it
appreciates but by supplying their own currency it depreciates

Diagram Analysis

 The Euro/US$ market is shown by two market diagrams - one for the USD market on the left
& one for the Euro market on the right
 The initial exchange rate equilibrium is found at P1Q1 in both markets
 When Europeans visit the USA, they demand US$ & supply Euros
o The increased demand for the US$ shifts the demand curve to the right which
results in the value of the $ appreciating from P1 → P2 in the USD market & a new
market equilibrium forms at P2Q2
o The increased supply of the Euro shifts the supply curve to the right which results in
the value of the Euro depreciating from P1 → P2 & a new market equilibrium forms at
P2Q2
2. A Fixed Exchange Rate System
 A system in which the country’s Central Bank intervenes in the currency market to fix (peg)
the exchange rate in relation to another currency e.g US$
o When they want their currency to appreciate, they buy it on forex markets using
their foreign reserves, thus increasing its demand
o When they want their currency to depreciate, they sell it on forex markets, thus
increasing its supply
 Sometimes the peg is at parity e.g. 1 Brunei Dollar = 1 Singapore Dollar
 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 & increase the strength of
its currency
 A devaluation occurs if the Central Bank decides to change the peg & decrease the strength
of its currency

Evaluating Exchange Rate Systems

 Each exchange rate system has advantages & disadvantages attached

An Evaluation of A Floating Exchange Rate Mechanism

Advantages Disadvantages

 Natural fluctuations in the  Fluctuations in the exchange rate

exchange rate based on demand can create uncertainty for firms,
& supply help to maintain stable leading to a reduction in
current account balances investment e.g. if a firm provides
 If a currency appreciates, the a quotation to a foreign
country's exports fall & imports buyer based on today's exchange
rise rate, but the exchange rate then
 If a currency depreciates, the appreciates, the domestic firm
country's exports rise & imports will not make as much profit as
fall expected
 Currency appreciation may  Currency depreciation may
allow costs of imported raw cause costs of imported raw
materials to decrease which may materials to increase resulting
help lower prices in the economy in cost push inflation
 Lower exchange rates (or a  Higher exchange rates (or an
depreciating currency) may help appreciating currency) may
to increase economic growth as reduce/slow down economic
export sales increase growth as export sales decrease
 Government does not need
to monitor & maintain a fixed
exchange rate
 An Evaluation of A Fixed Exchange Rate Mechanism

Advantages Disadvantages

 Even with an increasing demand  In order to maintain the fixed

for a country's exports, the price exchange rate, the Central Bank
of its exports will remain fixed as has to regularly intervene in the
the currency will not appreciate currency market by buying or
with more demand selling its own currency
 This can boost export sales over  This can be an expensive policy to
time e.g. China did this for many maintain
years & its products remained
artificially cheap to buy
 Firms (foreign & domestic) benefit  Changing the interest rate can
as they can agree prices with a also influence the exchange rate
high level of certainty as the  Changing the interest rate to
exchange rate will not fluctuate maintain a fixed exchange
rate can have negative
consequences on consumption,
investment, lending, saving &
borrowing

Causes of Exchange Rate Fluctuations

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

Factors influencing floating exchange rates

 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 net exports will result in an appreciation of the £ & falling net exports will
result in a depreciation of the £

5. Changes in tastes/preferences: As global demand for quinoa increased as it became

fashionable, Bolivia's exports of quinoa increased dramatically which put upward pressure
on their currency. Foreigners demanded the Boliviano in order to pay for the quinoa

6. 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

7. 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 £

8. MNCs: An increase in the number of MNCs globally will result in more money flows between
countries, each of which influences exchange rates

Consequences of Foreign Exchange Rate Fluctuations

 Changes to exchange rates may have far-reaching impacts on an economy
 The impact of changes to exchange rates on an economy

Economic Indicator Explanation

The Current  From a UK perspective, the depreciation of the £

Account causes exports to be cheaper for foreigners to buy
& imports to the UK are more expensive

 The extent to which a currency depreciation improves

the current account balance depends on the price
elasticity of demand for exports & imports
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 price elasticity of demand for UK
exports is elastic, then a depreciation of the
currency will result in a larger than
proportional increase in demand for UK
exports, which will rapidly improve any current
account deficit
Economic growth  Net exports are a component of total (aggregate)
demand
o A depreciation that results in an increase in
net exports will lead to economic growth
Inflation  Cost push inflation can be caused by a depreciating
currency as the price of imported raw
 materials increases with a weaker currency
 Net exports are a component of total (aggregate)
demand
o A depreciation that results in an increase in
net exports will lead to an increase in total
demand
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  Depreciation of a currency makes it cheaper for
investment (FDI) foreign firms to invest in the country which can
increase investment & real GDP
 An appreciation has the opposite effect

The Current Account

 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
o The financial & capital account: which is not part of your syllabus

 Money flowing into the country is recorded in the relevant account as a credit
(+) and money flowing out as a debit (-)
 A current account surplus occurs when the credits (money in) are higher than the
debits (money out)
 A current account deficit occurs when the credits (money in) are less than the
debits (money out)
 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

A. Net trade in goods (exports - imports) £-32.9bn

B. Net trade in services (exports - imports) £27.9bn

C. Sub-total trade in goods/services (A+B) £-5bn

D. Net income (interest, profits & dividends) £-2.1bn

E. Current transfers £-3.6bn

Total Current Account Balance (C+D+E) £-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 &
send remittances home
o Debits are sent by foreigners working in the UK back to their countries
o (Income credits - Income debits) are often referred to as net primary income
 Current transfers are typically payments at government level between countries
e.g. contributions to the World Bank
o (Transfer credits - transfer debits) are often referred to as net secondary
income

 The current account balance = net trade in goods + net trade in services + net
primary income + net secondary income

Reasons for Deficits & Surpluses

 If there is a current account deficit, the value of imports must be greater than the
value of exports
 If there is a current account surplus, the value of exports must be greater than the
value of imports
 Causes Of Current Account Deficits

Relatively low Relatively high value of the Relatively high rate

productivity country’s currency of inflation

 Low productivity  Currency appreciation  A relatively

raises costs makes a country's exports high rate of
 Exporting firms more expensive relative to inflation makes
with low other nations a country's
productivity may  Foreign buyers look exports more
find themselves for substitute expensive than
at a price & cost products which are priced other nations
disadvantage in lower  Foreign buyers
overseas  Exports fall & the balance on look for
markets which the current account worsens substitute
will decrease  Similarly, currency products which
competitiveness appreciation makes imports are priced
& the level of cheaper lower
exports  Domestic consumers may  Exports fall &
switch demand to foreign the balance on
goods & as imports rise, the current
the balance on the current account
account worsens worsens
 Similarly, high
inflation may
mean that
goods/services
are cheaper in
other countries
 Domestic
consumers ma
y switch
demand to
foreign goods
& as imports
rise, the
balance on the
current
account
worsens

Rapid economic Non-price factors such as poor

growth resulting in quality & design
increased imports
 Rapid economic  When a country develops a
growth reputation for poor quality &
raises househol design, its exports fall as
d income foreign buyers look
for better
  Households substitutes elsewhere
respond by  Domestic buyers who are
purchasing able to shop abroad also
goods/services choose to buy better quality
from abroad products elsewhere & the
& the balance level of imports rise
on the current
account worsens

Causes Of Current Account Surpluses

Relatively high Relatively low value of the Relatively low rate

productivity country’s currency of inflation

 High  Currency depreciation make  A relatively low

productivity s a country's exports less rate of
decreases costs expensive relative to other inflation make
 Exporting firms nations s a country's
with high  Foreign buyers increase their exports less
productivity purchases & the level of expensive than
may find exports rises other nations
themselves at  Similarly, currency  Foreign buyers
a price & cost depreciation makes imports increase their
advantage in ,ore expensive purchases &
overseas  Domestic consumers may the level of
markets which switch demand to locally exports rises,
will increase produced products & improving the
competitiveness the level of imports falls balance on the
& the level of current
exports account

Consequences of Deficits & Surpluses

 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

 Consequences of current account deficits include

1. Increasing unemployment: with falling demand for locally produced goods/services,

fewer workers will be required & unemployment will rise
2. Slow down in economic growth or a recession: exports are a key component of
the real GDP of many countries & a fall in exports may significantly reduce the level
of economic growth
3. Lower standards of living: a fall in economic growth usually leads to a reduction in
wages which leads to a decrease in the standards of living
 4. Increased levels of borrowing: if the deficit is caused by continually increasing
levels of imports, then it is likely that these imports are being paid for through higher
levels of borrowing
5. Depreciating exchange rate: while this may ultimately help to increase exports
again, it makes the cost of imported goods/raw materials more expensive and may
cause cost push inflation

 Consequences of current account surpluses include

1. Increasing employment: with increasing demand for locally produced

goods/services, more workers will be required & unemployment will fall
2. Economic growth: exports are a key component of the real GDP of many countries
& a rise in exports may significantly increase the level of economic growth
3. Higher standards of living: a rise in economic growth usually leads to a rise in
wages which leads to an increase in the standards of living
4. Demand pull inflation: economic growth caused by a rise in exports will lead
to demand pull inflation
5. Appreciating exchange rate: rising exports will appreciate the exchange rate which
leads to imports now being cheaper which causes the demand for imports to rise

Policies Which Stabilise the Current Account Balance

 The Government has several policies (fiscal, monetary & supply-side policy) available to them
in order to address a current account deficit or to stabilise the current account balance.
Overall, their choices are:

1. They could do nothing, leaving it to market forces in the foreign exchange market to self-
correct the deficit

2. They could use expenditure switching policies. These include:

• Protectionist policies which raise the price of imports, so consumers switch to buying
domestic goods
• Currency devaluation which makes the price of imports more expensive & so consumers
switch to buying domestic products

3. They could use expenditure reducing policies. These include:

• Raising taxes which cause consumers to have lower disposable income & so they spend
less on imports
• Raising interest rates which reduces the level of borrowing resulting in a fall in the level of
imports

4. They could use supply-side policies. These include

• Investment in education which raises productivity making exports cheaper & more
attractive
• Investment in infrastructure which lowers costs for firms making exports cheaper & more
attractive

 The use of any policy - or any combination of policies generates both advantages &
disadvantages
 Advantages & Disadvantages of Policies Used to Tackle Current Account Deficits

Policy Option Advantage Disadvantage

Floating exchange rates act as There may be other external

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