Unit 3: Government and the Economy

Chapter 25: Economic growth

• National income: is the value of all incomes added together in a country.
• Economic cycle: fluctuation of an economy between growth and decline (recession)
• Unsustainable growth: growing by using all the resources available (Non-renewable resources) without
sparing anything for the future generations to come.
• Economic growth is the increase in a country’s productive potential. It is measured in terms of GDP. When
economic growth is experienced, the national income of a country will rise.

Why do countries experience economic growth?

• Higher tax revenues
• Higher profits for business
• Higher income for citizens therefore, improved living standards
• Improved current account balance
• Fall in unemployment

GDP (Gross Domestic Product) as a measure of economic growth

GDP is the total value of all goods and services produced in an economy. It is known to be as the national
income of a country and a measure of economic growth. It ONLY includes the value of the final products and not the
value of components (raw materials) used to make the product.

Inflation: If prices tend to increase then the GDP value may be overstated which means a wrong
figure may be calculated.
• Countries may use different accounting conventions to calculate the national income
• The value of home-produced goods such as subsistence farming (farming in the backyard) should be
considered
• National income figures should be adjusted for the size of population
• National income statistics takes no account of externalities created by different economies
• Hidden economy: black market activities which taken place in an individual level and not registered to
taxation is not considered.
• External costs: as the economy grows the eternal costs such as pollution may affect the third parties
• The living standards cannot be completely dependent on the GDP as other important factors such as the
amount of leisure time citizens have must also be taken into account.

Impact of Economic Growth

• Economic growth: Employment levels would rise as businesses would need more workers to produce high
levels of output. Also, government will spend more on education and health care sector which may
consequently increase the jobs created.
• Standards of living: this would improve as consumers have more income, they may purchase better quality
products helping them to improve their living standards. And the emergence of new technology has also
helped in improving the standard of living during an economic growth.
 • Poverty: the level of poverty would reduce drastically. This is because as business have high demand, they
may employ more people. As a result, poor people may get employed in businesses and earn an income
which could be used to fund the necessities for life. (Such as food)
• Productive potential: the productivity of an economy would rise significantly if an economic growth is
experienced. This is because workers are more productive as they have more incentive to work.
(Motivational schemes used by businesses)
• Inflation: during a high growth, the prices of products would increase significantly due to high demand.
Businesses may increase the price as they are unable to cope up with the demand causing a demand-pull
inflation.
• Environment: during a peak/economic growth the costs such as pollution and use of non-renewable
resources can increase the spending for the government. This is because the government may have to
spend more on health care sector to treat the people who have health issues caused by pollution and so on.
Also, unsustainable growth will be experienced.

Chapter 26: Inflation

• Aggregate demand: the total demand in an economy
• Interest: costs of borrowing and the rewards for savings
• Purchasing power: amount of goods and services that can be bought with a fixed amount
• of money

• Inflation is the general rise in the price level in an economy. Governments may want a lower level of
inflation rates. Typically, between 2% to 4%.
• Deflation is a general fall in the price level in an economy.
• Reasons for inflation
• Ensure that costs of production for firms don’t rise
• Value of money remains doesn’t deteriorate
• Appreciation of currency doesn’t happen and worsen the current account balance

CPI and RPI as a measure of Inflation

• Consumer price index (CPI) is the measure of general price level in an economy which excludes the retail
costs such as council taxes. Whereas, the Retail price index is the measure of general price level in an
economy which includes the house costs such as council tax etc.

There are 2 main causes/types of inflation:

• Demand–pull inflation: this is caused by the increase in Aggregate demand for a product. As businesses are
unable to cope up with increased demand, they increase their prices. Some reasons for higher Aggregate
demand are lower taxes, increase in income and rising demand for firms.
• Cost-push inflation: this is when the costs of materials and other costs for businesses increases. This would
increase the costs and lower the profits. In an effort to increase the profits or maintain the profits,
businesses would increase their prices. This is mainly caused by rising costs of imports, wages and taxation.

Relationship between interest rates and inflation

• When inflation rates are high, the interest rates may be increased. This is because, if the interest rates are
high, borrowing would reduce as it is costly. Therefore, people have less money to spend on goods and
services and thus, reducing the inflation.
• When inflation rates are high, the interest rates may increase. This will attract people save more money as
the rewards are higher. Therefore, they would spend less which can result in lower spending on goods and
services. As a consequence, inflation rates would fall.

Impact of Inflation:
• Prices: as the prices increase, the value of the money would fall which means the purchasing power would
reduce. As a result, less goods can be purchased with the same amount of money used last year to purchase
more goods.
• Wages: as the inflation level increases, employees may demand for higher wages as they are unable to fulfil
their needs with the same amount of money, they earn due to the fall in purchasing power. Hence, business
costs would rise which could further increase the inflation rates.
 • Exports: inflation may reduce the exports. This is because countries will be reluctant to purchase the exports
of this country as the prices are higher. Hence, the international competitiveness would be lost. Therefore,
the current account balance would worsen.
• Unemployment: they can have 2 types of effects. One effect is the increase in unemployment as
businesses may face higher costs due to the inflation as the costs of raw materials and wages would rise
significantly. Therefore, they may lay off workers in order to cope up with the rise in costs. However,
unemployment levels may fall as inflation is caused by an increase in the aggregate demand. Therefore,
more workers will be employed by businesses to increase the production.
• Menu costs: if inflation increases, then the prices may have to be changed continuously. Therefore, menus
will have to be updated and costs of printing would increase.
• Shoe leather costs: consumers may spend time walking in and out of stores to find the best deals in periods
of high inflation. It’s a cost as it takes time and wears out the leather in the shoes.
• Uncertainty: businesses will not be able to take better decisions regarding the future. This is because of the
uncertainty caused by inflation which cannot ensure that profits may continue to fall or can rise in the
future. As a result, investment decisions may be postponed.
• Business and consumer confidence: Inflation may make consumers more anxious and they may not borrow
money rather save money. Also, businesses will postpone all their projects and have no hopes for the future
as the returns would be low. Therefore, growth rates in the country may fall.
• Investment: due to high levels of inflation, the investments in the country would reduce drastically. This is
because investors may shift to other countries as they may have less or no returns for their investments. As a
result, growth rates would drop significantly.

Chapter 27: Unemployment

• Redundancy payments: they are payments provided by the business for employees who leave after 5 or
more years of service to the organization.
• Unemployment is the amount of people who are not employed and do not contribute to the national
income of the country. Government may want to reduce the unemployment rates.

Reasons
• Lower government spending
• Increase in social harmony
• Higher income leading to an increase in Aggregate demand
• Higher economic growth

There are 5 main types of unemployment that can occur in an economy:

• Cyclical or demand-deficient unemployment: This is an unemployment that is caused due to a fall in
demand which is caused by a downturn or a recession in an economy. This is because, when the AD
(Aggregate demand) in an economy falls, businesses may have to face higher costs as their profits are lower.
Therefore, they may lay off more workers to cope up with the high costs.
• Structural unemployment: this is caused by the changes in the structure of an economy. They are of 3 main
types:
o Geographical immobility: this refers to some people finding it difficult to move from one region to
another to get jobs.
o Technological changes: Fall in demand for labours as work that was previously done by workers are
now being replaced by machineries.
o Structural changes in the economy: decline in an industry for e.g.: Coal mining industry has led to
many coal miners finding it difficult to get job as they only have skills in jobs related to coal mining.

• Seasonal unemployment: This is when the demand for certain workers may fall as outputs produced fall in
some seasons. For example, farmers may have less revenues at certain time of the year and therefore, they
may lay off some workers.
• Voluntary unemployment: This is an unemployment that is resulted from people deliberately choosing not
to work. This is because they are not prepared to work for the given salary or they don’t like to work.
• Frictional unemployment: This unemployment is caused when people to move between jobs. This is not
necessarily an unemployment because people have already obtained the job.
Impact of Unemployment
• Outputs: the productivity if the country would reduce as more people are not working. However, the
outputs can be high as most of the unemployment is caused due to technological developments which could
increase the productivity further.
• Use of scarce resources: the number of resources wasted would be high as people are resources are they
are not maximized. As a result, the growth would be lower hence, the GDP rates would fall.
• Poverty: as unemployment increases in a country, the level of poverty would also rise significantly as people
do not have money to fund the necessities of their daily lives such as food and shelter.
• Government spending: the government expenditures will also rise drastically as they may have to spend
more on providing welfare benefits to the poor and unemployed. Hence, less amount of money will be
available to spend other parts of the economy.
• Tax revenues: the tax revenues may also fall as most of the tax is related to income. If people have no
income, then they are not eligible for any tax payments. As a result, less amount of money will be available
to spend other parts of the economy.
• Consumer confidence: this may fall as people are unemployed and may suffer to fund the basic needs. Also,
employed people may lose confidence as they may fear their job to be lost. Consumers cannot purchase
whatever they want as the state provision will be less than wages or salaries earned from employment.
• Business confidence: business confidence may also fall as the redundancy payments have to be made which
may increase the costs to the business and also revenues have fallen due to lower income for citizens.
Therefore, they are not likely to invest on projects.
• Society: people may be affected psychologically. The social harmony will be disrupted as stealing will
become common for survival. If a company that employs many people in the community closes down, then
the whole community will be affected. Environments may not be taken care and so on.

Chapter: 28 Current account deficit or surplus

• Balance of payments: they are the record of transactions relating to international trade.
• Primary income: the money received from the loan of production factors abroad
• Secondary income: government transfers between countries
• Balance of trade: the difference between visible exports and imports (tangible goods)
• Current account is a part of the balance of payments where all exports and imports are recorded. There can
be a current account deficit which means that the import expenditures are greater than the export earning
which is not good for the country. Whereas, there can also be a current account surplus where the export
earnings are greater than the import expenditures.

The international transactions can be of 2 types:

• Visible trade: trade in tangible products
• Invisible trade: trade in services

The relationship between current account and interest rates

• Exchange rate is the value of a currency in terms of another. The country’s exchange rate can appreciate
which means they may become stronger. Therefore, imports will increase and current account balance will
worsen. (Increase in deficit)
• The country’s exchange rate can depreciate which means they may become weaker. Therefore, exports will
increase and current account balance will improve. (Increase in surplus)

Reasons for Deficits and Surpluses

• Quality of domestic goods: If country produces better quality products, then the overseas demand
would rise which would help to increase the exports. Imports would reduce as consumers may purchase the
goods produced in the country as they may be cheaper and of better quality. The current account balance
will improve.
• Quality of foreign goods: if the quality of the foreign goods is better, then the imports would rise as citizens
may prefer to purchase better quality products. While, exports will be lower as countries will purchase the
goods that are more superior. As a result, the current account balance would worsen.
• Prices of domestic goods: if domestic goods are cheaper, citizens will import less and exports would rise due
to lower prices. Hence, current account balance would improve.
• Prices of foreign goods: if foreign goods are priced lower comparative to the domestic products,
citizens may import more. This will worsen the current account balance.
 • Exchange rates: if a country’s exchange rate is weak (depreciating) then exports will rise significantly.
Imports may become expensive and thereby, fall. As a consequence, the current account balance will
improve.

Impact of current account deficit

• Leakages from the economy: this is when consumers spend money out of the economy. Therefore, the
national income would fall while the unemployment levels would rise, both of which are dangerous for an
economy.
• Inflation: due to high demand for imports, prices may be increased. This can have an increase on the prices
of goods and services in the country as resources may be imported which would increase the costs,
consequently increasing the inflation levels.
• Lower demand for exports: demand for exports may be lower which can cause many domestic businesses to
fail. As a result, they may lay off workers which would increase the unemployment levels in an economy.
Also, as they no longer contribute to the national income, the economic growth rates may also fall.
• Funding the deficit: there may funding problems that would arise. Therefore, governments may have
borrowed an international loan which they may have to pay high interest payments. This may increase the
costs to the government and provide them less money to spend on other parts of the economy.

Chapter 29: Protecting the Environment

• Mining: this is the extraction of resources from the earth. They use advanced machineries that produce huge
amount of sound and dust particles get into the air. Therefore, Noise pollution and air pollution is
experienced.
• Power generation: This is the burning of fossil fuels such as coal and oil to generate power. It produces a lot
of toxic gases such as carbon monoxide which means Air pollution will be experienced. It may create noise
which means Noise pollution could also be encountered.
• Chemical processing: they are produced to cure and prevent diseases and improve the quality of life. They
release hazardous air pollutants which can cause Air pollution. Factories can also cause visual pollution as
they may release the pollutants through pipes which will be unattractive to the eyes.
• Agriculture: Pesticides and fertilizers are used to increase the yield of the crops that are planted. They also
kill some aquatic life and continuous exposure to these chemicals can cause various diseases such as
headaches.
• Construction: this is the process of building premises with bricks and high use of machineries that
release very dangerous pollutants. Therefore, Air pollution is caused. Water may also be polluted as some of
waste materials may be washed in the rivers or lakes which could contaminate the water causing water
pollution. Noise pollution is also common as more machineries are being used up.

Government intervention to overcome the problems

• Park provision: This is where the government can provide parks which completely makes it illegal for any
business to locate their premises at. This preserves the natural beauty of a country and attracts many
tourists from all over the globe.

Chapter 30: Income inequality

• Regressive taxation: this is where the amount of tax charged increases as the income fall. (Burden is higher
on the poor than the rich as tax is fixed)
• Income inequality is the differences in the income level of the rich and the poor that exists in a country.

Reasons for income inequality

• Education, skills and natural talent will help people get into employment easily and therefore, earn higher
income.
• People who don’t work such as prisoners will receive lower income than other employed workers.
• People who own properties, shares and capital may enjoy higher income in terms of rent, share dividends or
interest payments.

Poverty is of 2 types:
• Absolute poverty is where people do not have enough finance or the resources to meet the basic needs of
survival. They are also deprived from education, health care and other services.
 • Relative poverty is where people have enough resources and finance to meet their basic needs but unable
to fund the average lifestyle of a citizen in a country. This may change overtime as the income of people may
increase.

Reasons to reduce the income inequality

• To meet basic needs: if people can meet their basic needs for survival, they will be able to come
out from the crisis of hunger and poverty.
• Raise living standards: when people are taken out of poverty the global living standards could increase. This
will also increase the level of education and thereby, increase the economic growth for countries.
Government revenues also may be high as they earn more tax revenues from highly qualified workers.
• Ethical reasons: it is a moral duty of everyone to help reduce the poverty. Several charity organizations are
formed to raise funds and provide to people who live in extreme poverty line.

Government intervention to reduce poverty

• Progressive taxation: this is where the tax is higher for the people of higher income while the tax is lower for
the people with lower income. In this way, the government can collect a proportion of the income from the
higher income earners and distribute them among the poor people. This will help to reduce the income
inequality gap as the poor will get richer and rich will face a fall in their income. However, as the income of
the rich is increasing year-on-year, this may further widen the gap.
• Redistribution through benefit payments: the governments can also earn tax revenues by imposing tax on
profitable businesses and using the progressive tax system. The revenues could be used to provide welfare
payments and benefits to the poor people and thereby, helping them to get richer and meet their basic
needs for survival. However, businesses may discourage form operating in the country due to higher taxes
and thereby, leave the country resulting in a fall in the GDP.
• Investment in health and education: investing on education will provide free schooling and other tuition for
poor children. Therefore, they can afford to learn and develop a range of skills from problem solving,
decision making to analytical skills which will help them to become more employable and thus, assisting
them in an earning a steady income. Also, investing on health care will help to provide free vaccinations to
poor children which will aid in reducing the spread of dangerous diseases such as the COVID -19. As a result,
both of which will reduce the rich-poor gap and thereby, help to improve the state of an economy.

Chapter 31: Fiscal Policy

• Debts servicing: this is when government use its revenues to pay the national debt owed to other
countries.
• Fiscal policy is the use of government expenditures and taxation to control the aggregate demand in an
economy.

Government revenues
• The main source of government revenues is through taxation. Government imposes 3 types of taxes to earn
their revenues:
• Direct taxation: these are the taxes that are charged on the income or profits of individuals or firms.
Example: Income taxes are charged on the income of a citizen or a resident and corporation tax is charged
on the profits of firms.
• Indirect taxation: these are taxes that are charged on the consumer expenditures. (Spending) Example:
Value Added Tax. (VAT) They can be of various forms such as Business rates that are annually paid by
businesses for operating and council tax paid by households.
• Environmental tax: these taxes are charged on businesses (especially) to protect the environment from
harmful substances polluting them. For example, Landfill tax is imposed on the disposal of waste on landfill
sites.

Government expenditures
• The government will incur expenditures in various forms. One form is when they directly provide some
services which are failed to be provided by the private sector due to some problems. instance, to provide the
public transport, police services and fire services.
Fiscal deficit and surpluses
• Fiscal deficits are the amount by which the government expenditures exceed the government revenues.
• Fiscal surpluses are when the government revenues exceed the government expenses.

Impact of Fiscal deficits and Fiscal surpluses

Fiscal Deficits
• As more money is to be borrowed, the national debt increases which means that most of the government
revenues earned should be used on debt servicing. Future generations will be overburdened with the debt of
the previous generations. Hence, Improvements will be restricted.

Fiscal Surpluses
• Money generated could be used to spend on public services and provide subsidies to growing businesses
helping them to expand and improve their international competitiveness.

Fiscal policy and the Macroeconomic objectives

• This policy uses 2 policy instruments to control aggregate demand. They are taxation and government
expenditures. Expansionary fiscal policy is when the taxation is recued and the government spending may
be increased. Contraction fiscal policy is when the taxation is increased and therefore, government spending
is reduced.

• Economic growth: Expansionary fiscal policy can be used to stimulate the economic growth. This is because
lower taxes will help increase the aggregated demand and thus, increase the profits and investments which
would result in higher growth rates.
• Inflation: Contraction fiscal policy should be used. This is because the higher taxes will discourage buyers
from purchasing as their income will be lower due to higher taxes. As a result, the Aggregate demand fall
and thus, prices start to drop.
• Current account deficits: Contraction fiscal policy should be used as the higher taxes will lower the
disposable income for consumers and thereby, discourage them to purchases goods from other countries.
Hence, demand for the imports would reduce helping to reach a current account equilibrium.
• Unemployment: Expansionary fiscal policy should be used as lower taxes would increase the aggregate
demand. Therefore, to cope up with higher demand and increase the production, firms may employ more
workers. Thereby, reducing the unemployment rates.
• Fiscal policy and the government: Environmental problems can be solved by Contraction fiscal policy as the
taxes imposed will discourage firms from polluting. Therefore, environment will be protected. Also,
Expansionary fiscal policy can be used to increase competition as the government will increase their
spending on providing subsides to start-up or small firms. As a result, more competition and lower prices.

Chapter 32: Monetary Policy

• Quantitative easing: purchase of financial assets from the commercial banks by the central banks to increase
the flow of money into the commercial banks from the central banks. Therefore, more loans can be
facilitated.
• Monetary policy is the use of interest rates and money supply to control the level of aggregate demand in
an economy. Money supply is the total amount of money that is circulating in the economy. Interest rates
are the rewards for savings and the costs for borrowings.

Important point to remember: Interest rates and Exchange rates are directly proportional.
(I.e. when interest rates increase, the currency becomes stronger (Appreciates))

Functions of Central Banks

• Implementation of the monetary policy.
• Achieving the inflation target.
• Acting as a government’s banker: They handle government department accounts such as preparation of
budgets, provides financing for the government when the government has the short-term deficit, it
represents a country in international conferences and provides financial advice to the governments at times
of financial crisis.
• Banker to banks: central banks only provide the license and approval for commercial banks and all
commercial banks are under the supervision of the central bank.
 • Lender of last resort: when commercial banks face financial issues they will expect the support of central
bank to maintain their liquidity.
• Setting the interest rates: Interest rates are set by the Central bank which involves a Monetary Policy
Committee (MPC) who are of 9 experts. When setting interest rates, the following will be taken into the
consideration by the MPC:
o Inflation rate
o Economic growth
o Unemployment

Impact of changes in Interest rates on Macro-economic variables

• Inflation: the increase in price will begin to slow down. This is because due to high interest rates
consumers are reluctant to borrow money as they are costly. Also, they may want to save more as the
rewards are higher. As a result, both of which will reduce the Aggregate demand which is the main cause for
increasing prices.
• Economic growth: when interest rates are lower, the growth rates will be higher. This is because borrowing
is cheaper, hence, businesses may borrow more money to expand or invest on projects. Consumers may also
borrow money to purchase more goods. Bot of this will increase the Aggregate demand and thereby,
increase the economic growth rates.
• Unemployment: due to higher aggregate demand caused by lower interest rates, businesses are more
willing to employ people as to cope up with the increased demand. Hence, unemployment rates fall.
• Current account: as mentioned in the beginning, interest rates are directly proportional to the exchange
rates. Therefore, higher interest rates will appreciate the currency. (Currency is stronger) Therefore, imports
will be increased which will cause a severe current account deficit. However, there is a contradiction here.
When interest rates are increased the Aggregate demand will fall. So, imports will fall helping to improve the
current account.

It depends on:
• The income elasticity of the imports: if the demand for the imports were income elastic, then higher
interest rates would reduce the imports.
• The strength of the link between the interest rates and exchange rates: if this link is stronger than higher
interest rates will increase the imports.
• The price elasticity of demand for imports and exports: if the PED for the exports and imports are elastic,
then increase in interest rates would increase the imports.

How changes in interest rates affect consumers and firms

When interest rates fall,
• Consumers
o Demand for Loans increases and better-quality products are purchased
o Mortgage payments fall
o However, the rewards for savers will be lower.

• Firms
• Interest costs fall, therefore, higher profits
• Increase business confidence and investments will be higher
• Currency appreciates, therefore, importing raw materials will become cheaper
• Investment returns will be higher
• However, the rewards for saving retained profits will be lower.
(Vice Versa for increase in interest rates)

Why is quantitative easing used?

• It is used to help an economy to recover from a recession and to help monetary policy committee to achieve
the target inflation rates. (Which may be higher than the current rate)

The process of Quantitative easing

• First central bank estimates by how much money is to be increased in the country to stimulate the aggregate
demand.
 • Then central bank creates money (Can be by printing notes) and use this money to purchase financial assets
such as: securities and bonds from commercial banks.
• Commercial banks now have more money.
• This helps commercial banks to lend more money to the general public for lower interest rates.
• As a result, borrowing becomes cheaper which would attract individuals, investors and businesses to borrow
more money from these banks.
• As a consequence, Aggregate demand increases and this helps an economy to recover from a recession due
to higher profits, better living standards and a higher investment as costs of borrowing reduces.

Chapter 33: Supply side polices

• Aggregate supply: this is the total amount of supply in an economy.
• Supply side policies are the policies that are used to increase the Aggregate supply in the economy.

Impact of Supply side policies (SSP) on Productivity and Total output

Productivity
• This is to increase the productivity of businesses in an economy. They can improve flexibility by reducing
intervention of the government on the labour market such as imposing minimum wage laws and so on.
• This will help to reduce the costs for firms. Another approach is to increase investments on training and
education.
• This will make employees less anxious and be more familiarized with their jobs. As a result, productivity can
be maximized.

Total Outputs
• By using effective supply side policies such as reduction in taxes the productive potential of the economy
could be increased by the government. Therefore, firms start to increase their production and produce more
outputs. Hence, inflation is likely to be avoided.

Impact of SSP’s on Macroeconomic Objectives

• Privatization: this is the transfer of public assist or businesses to private sector businesses. By doing so, the
competition can be increased. Therefore, consumer may get better quality products for reasonable prices.
Also, production may be increased as private firms are more efficient which will help to reduce the inflation
rates in a country.
• Deregulation: this involves reducing the paper work and unnecessary licenses to be obtained. This helps new
start-up businesses to easily begin trading which will help to increase the total output in a country and also
promote competition which may provide a wide range of goods and services to consumers. However, less
regulation can also cause serious issues such as the financial crisis of 2008.
• Education and Training: By investing on education, governments in various countries can ensure that their
citizens or youth are educated and develop a range of skills from writing to analysing information. This will
make them more employable and thus, unemployment levels may fall. Training will help to reduce anxiety at
work place and thereby, improve the productivity of the workers. However, investment on education is
expensive and the returns will take a long time to be enjoyed.
• Polices to boost regions with high unemployment rates: SSP’s can be targeted specifically to certain regions
of a country. This will help them to ensure that the right treatment is given to the right part of the country.
As a result, the overall performance of the country would boost.
• Infrastructure spending: Investment on infrastructure helps a country to improve its transport and
communication. Therefore, private sector firms may find it easier to distribute goods between retail shops
and the warehouses. As a consequence, the delivery and the production process are faster.
• Lower taxes to stimulate investments: Investments are the main driving force of economic growth. If
investments are increased then economic growth can be accelerated. Therefore, governments have to
reduce the taxes and make the economic state more favourable for investors, so that they invest more.
• They can do this by:
o Reducing the taxes on profits
o Providing tax incentives to encourage people to save more and buy more shares
 • Lower taxes on income: to encourage working: by reducing the taxes, government can increase the output
levels. This is because more citizens will be encouraged to work due to lower income taxes which means
higher income. As a result, more workers will help to increase the overall productivity.

Chapter 34: Relationship between objectives and Policies

Conflicts between Macroeconomic objectives
• Governments may have to face unexpected conflicts when trying to achieve the macroeconomic objectives.
They are:
• Inflation and unemployment: when central bank wants to control inflation, they may use the contraction
monetary policy. This would increase the interest rates in the country. Therefore, the costs of borrowing will
be higher. Hence, citizens will be reluctant to borrow money and thereby, reduce their spending. Hence,
profits fall for firms and thereby, they may lay off workers to cope up with increased costs. As a
consequence, this can have an impact on the unemployment rates. OR firms’ costs would increase when
interest rates increases as they have to pay higher interest payments for the loans borrowed. To cope up
with the increased costs they may lay of some workers, increasing the unemployment levels in the country.
• Economic growth and protection of environment: when governments use expansionary fiscal policy to
increase economic growth rates, this may lower taxation and increase the government expenditures.
Therefore, firms will have more profits and they may increase their investments. As a result, more jobs are
created and citizens who were previously unemployed would now be employed. Therefore, their income
would rise which could encourage them to different mode of transport such as Air transport and Land
transport. Hence, more CO2 is emitted which will increase the pollution in the environment.
• Inflation and equilibrium on current account: when government wants to control inflation, they may use
the contraction monetary policy. This would increase the interest rates in the country. As interest rates and
exchange rates have a link (directly proportional) this may appreciate the currency. As a result, import
expenditures would increase as imports become cheaper and export earnings would fall as exports become
expensive and uncompetitive in the international market. Therefore, import expenditure would exceed the
export earning causing a current account deficit.
• Economic growth and income inequality: when governments use expansionary fiscal policy to increase
economic growth rates, this may lower taxation and increase the government expenditures. Therefore,
when income tax is lower the rich will become richer and poor will become poorer. This is because reduction
in taxation would increase the income earned by rich people and would reduce the income earned by poor
as welfare benefits would be lower due to lower tax revenues.
• Economic growth and Inflation: When expansionary fiscal policy is used to increase the economic growth by
reducing the taxation, consumers may have more disposable income which will increase their purchasing
power. Hence, they may purchase more goods and services which may increase their Aggregate demand. As
a result, therefore, due to higher aggregate demand, businesses may increase the prices to cope with limited
goods and unlimited demand. Hence, inflation rates may rise.

Evaluation for the Conflicts

• Trade-off between inflation and unemployment: In order ensure that unemployment rates don’t rise the
Governments can spend more infrastructure development of the country which would help attract more.
Foreign direct investment (MNC’s) which would create more job opportunities. Also, subsidies can be
provided for small firms to expand and thereby, create more jobs.
• Trade-off between economic growth and protection of environment: subsidies can be provided to the firms
to invest in green technologies and bring out more environmentally friendly products. E.g. electric cars
• Trade-off between inflation and current account balance: Governments can increase the exports by
providing export firms tax incentives and other incentives to increase their export and reduce the prices of
the export products. Hence, this will help them become competitive in the international market. As a result,
current account balance would improve.
• Trade-off between economic growth and income inequality: government can charge progressive taxation
(which involves charging higher tax on rich people incomes and lower on poor people’s income) to increase
their tax revenues and to provide welfare benefits and other benefits to these people who live in poverty
and thereby, narrowing the rich-poor gap OR reducing the income inequality.
• Trade-off between economic growth and inflation: government can provide subsidies to firms which will
help them to reduce the costs. As a result, they may increase their supplies which can result in a fall in prices
while the needs of consumers are being met.
Unit 4: Global economy
Chapter 35: Globalization
• Interdependence: this is where the action of one country influences the other countries.
• Tariffs and Quotas: they are trade regulations that restricts the entrance of foreign products
• Multinational companies (MNC’’s): these are large companies who have their headquarters in one
country and their operations all over the world. (Explained in detail in the next chapters)
• Offshoring: Practice of getting the work done in another country to save more money as they are
Cheaper

• Globalization is the growing interconnection of the world’s economies. Some of the main features of
Globalization are:
o Goods and services are traded freely across all international borders.
o People are free to live and work on the country they chose
o There is a high level of interdependence between nations
o Capital can flow between different countries
o There is a free exchange of technologies and intellectual properties across borders

Reasons for Globalization

• Fewer Tariffs and Quotas: these regulations/restrictions restrict the flow of foreign into the country.
Globalization helps firms to set their operations in other countries and thus, they can avoid these trade
barriers and grow drastically.
• Reduction in the costs of transports: the transport network has improved over the years and this has helped
to increase the number of destinations and make transport of goods much easier. Hence, the costs have
lowered and this has enabled companies to trade internationally.
• Reduction in the costs of communication: over the years the advancement of technology has helped to
improve the communication process. Emails for instance, helps to send messages within fractions of seconds
from one part of the world to another. As a result, the costs and the time that it takes to communicate has
fallen and thereby, increasing the international trade.
• Significance of MNC’s: these large giants has helped to increase the international trade as they dominate the
international markets by supplying goods all over the world.

Impact of Globalization and Global companies

Individual countries
• Increase in national income as MNC’s make high profits and invest heavily
• Reduce in Unemployment in the country
• As outputs may be sold out of the country, the foreign currency reserves will rise
• Improvement in current account balance – As exports rises
• The facilities of suppliers will be modernized with the assistance of MNC’s
• However, the events of one country can affect the events of other countries E.g. Financial crisis 2008.

Governments
• Tax revenues – helps to increase the spending on other parts of the economy such as infrastructure and
education.
• New business development – Help increase the national income
• Reduce government expenditures on unemployed
• However, repatriation of profits and the avoidance of taxation can make the government lose more from the
MNC’s

Producers (MNC’s)
• Access to huge markets: Higher revenues as the products can be sold globally
• Lower costs: EOS can be exploited as they produce in large quantities to serve the global market
• Access to labour: MNC’s can gain access to labours from different countries with high qualification and
experience
• Reduce taxation: they can do this by locating some of their operations in countries where the tax rates are
lower. Hence, profits can be maximized.
Consumers
• Prices will be lower: this is because of EOS
• Wider range of goods and services
• Better living standards – Better quality products
• MNC’s may dominate the market and thereby, charge higher prices

Workers
• Creation of new jobs
• Labors can move freely between countries in search of better jobs
• Minimum wage laws of developed countries have helped to encourage workers to work
• Workers learn new skills through the training schemes offered by MNC’s
• However, when off shoring happens some workers are made redundant

Environment
• MNC’s are usually involved in extraction of resources which would cause Air pollution
• Transport of goods and services can increase the greenhouse gases in the atmosphere
• Non-renewable resources may be extracted which will reduce the availability of resources for the future
generations (Unsustainable growth)
• However, as MNC’s are giants they can afford to use latest green technologies which will help to reduce the
negative impact on the environment.

Chapter 36: Multinational companies and foreign direct investments

• Host countries: this is the country that the MNC would enter into.
• Multinational companies (MNC’s) are firms that have their Headquarters in one country and their
operations all over the world. Some of their prominent features are:
o Huge assets
o Highly qualified employees
o Powerful economically and politically
o Efficient as they can exploit the EOS
o Advertisements and marketing capabilities
o Highly advanced and up-to-date technology

• Foreign direct investments (FDI’s) occurs when a company makes an investment in a foreign country in
expectations of higher returns ion the future. (Examples: MNC’s)

Reasons for the emergence of MNC’s/FDI’s

• Economies of scale: as businesses are able to lower their costs when they produce a greater number of
outputs, this reduces the overall costs. Hence, they begin to trade globally by selling goods out of the
country.
• Access to natural resources and cheap resources: businesses may require huge number of resources to
produce goods and services. As a result, they may locate their firms in countries where these resources are
cheaper. Hence, they are able to lower their costs. Also, countries import the food materials that they don’t
have access to.
• Reduction in the costs of transports: the transport network has improved over the years and this has helped
to increase the number of destinations and make transport of goods much easier. Hence, the costs have
lowered and this has enabled companies to trade internationally.
• Reduction in the costs of communication: over the years the advancement of technology has helped to
improve the communication process. Emails for instance, helps to send messages within fractions of seconds
from one part of the world to another. As a result, the costs and the time that it takes to communicate has
fallen and thereby, increasing the international trade.
• Global reach (larger customer base): businesses locate their firms in different countries as to earn higher
revenues. This is because there a wide number of customers all around the world. Hence, this increases their
profits.
Advantages of MNC’s/FDI’s
• Job creation: When these global giants enter a country they create huge number of jobs. This helps a
country to reduce its unemployment rate.
• Investment in infrastructure: governments in different countries may want to attract FDI’s who may bring
greater benefits to the country. In order to attract these FDI’s, they may invest heavily on the building proper
transport networks and better premises. Hence, this will benefit all people in an economy.
• Developing skills: Government may spend highly on education and vocational training to attract MNC’s.This
may help enhance the skills of workers and students which will attract more investment into the country.
When MNC’s enter the country, they provide the required help and training to the suppliers.
• Developing capital: When MNC’s enter a country, they may invest on facilities or factories which may be
updated with installing of new technologies and so on. Also, suppliers may invest on more capital projects to
expand their production capacity which may help them to attract MNC’s orders.
• Tax revenues: as MNC’s enter a country, their profits will be taxed by the host country. Hence, there will be
a surge in the tax revenues which may provide the government of the host country a lump sum of money
which could be invested on education or infrastructure which may help to boost the economic growth rates
of the country.

Disadvantages of MNC’s/FDI’s
• Repatriation of profits: This is when the profits made by the MNC’s are transferred to the countries where
the MNC is based on. Therefore, host country loses out. This is because their resources are used to make
profits but there are no rewards for using it.
• Tax avoidance: this is when powerful MNC’s such as Apple and Google avoid paying their taxes. Hence, the
host country would lose from this as well. As a result, developing countries where the government is weak or
corrupt may lose a massive amount from these powerful giants.
• Environmental damages: MNC’s who are usually involved in extraction of natural resources and so on may
damage the environment. This is because they may cause various types of pollution from Air pollution to
noise pollution. This can increase the amount of health issues which may cost the government and increase
their expenditures.

Chapter 37: International Trade

• Free trade: this is when the goods coming into or going out from the country are not taxed.

Reasons for countries to trade internationally (free trade)

• Obtain goods that cannot be produced domestically: Due to lack of resources many countries find it difficult
to produce some goods. Therefore, they can easily import these from other countries. Example: Diamonds
cannot be produced in all countries.
• Obtain goods that can be bought more cheaply from overseas: this is when countries have the ability and
resources to produce the goods but they can purchase these goods from overseas for cheaper prices as
other countries may specialize in the production of these goods therefore, their costs may be lower. Hence,
saving a lot of money.
• Selling off unwanted commodities: this is when countries have a lot of resources where they cannot use it
all by themselves. Hence, they can sell it overseas which will help to increase revenues.

Advantages of Free trade

• Lower prices and increased choices for consumers: goods purchased from overseas may be of lower prices
as the costs of production may be lower due to lower prices of raw materials. Therefore, consumer’s living
standards may improve. As there are variety of choices, consumers can choose the best quality product for
reasonable prices.
• Lower input prices: this is because the raw materials produced in other countries may be of lower prices.
This is as a result of specialization. Therefore, the costs of production for businesses importing raw materials
may be lower. Hence, profits can be maximized.
• Wider markets for business: if free trade is enabled, businesses will have a larger consumer base. This will
help them to sell their products and tailor them according to the needs of customers in different locations.
As a result, revenues can be maximized.
Disadvantages of Free trade
• Competition for domestic businesses: due to the free trade (open economy), domestic firms will face higher
competition. This can be damaging to their revenues as they have to compete with larger giants which may
be difficult. As a consequence, their profits margins would lower drastically.
• Unemployment: due to free trade, unemployment rates would rise. This is because as the revenues for
domestic businesses fall and the total costs stats to rise, they may lay off workers to reduce the costs. As a
consequence, the unemployment levels in the economy will begin to rise due to the changes in demand
patterns. (Caused by increased imports of quality products from abroad)

Chapter 38: Protectionism

• Protectionism: it is an approach that is used by governments to protect the domestic producers from
overseas competitions.
• Trade barriers: they are the methods used to restrict the imports into the country.
• Dumping: this is where an overseas firm sells a large amount of goods in a country below the costs in a
domestic market
• Tariff: it is a tax that is paid on exports or imports
• Quotas: restriction on the quantity of imports
• Retaliation: this is when the trade barriers will be imposed on countries that impose trade barriers just to
take revenge.

Reasons for protectionism

• Prevent dumping: government may use trade barriers to protect the domestic industries from
dumping. This is when an overseas firm sells a large amount of goods in a country below the costs in a
domestic market. This will make it difficult for domestic businesses to survive in the market and thus, they
may leave the industry which will affect the government’s tax revenues and increase the unemployment
rates.
• Protecting employment: governments may use trade barriers to ensure that employment is protected. Due
to free trade, unemployment rates would rise. This is because as the revenues for domestic businesses fall
and the total costs stats to rise, they may lay off workers to reduce the costs. Hence, ensuring that
unemployment rates are low and stable.
• Protecting infant industries: Infant industries are small industries that have just begun to grow.
Governments must protect them from large overseas rivals. Therefore, by imposing import restrictions, this
will give these industries a chance to expand and grow.
• To gain tariff revenues: imposition of trade restrictions would involve the use of tariff or quotas. This will
help the government to raise huge amount of revenues which could be spent on enhancing public services
or infrastructure of the country which will help to attract more FDI’s and thus, increasing the economic
growth rates.
• Prevent entry of harmful or unwanted products: barriers may be used to prevent the selling of unwanted or
harmful products by overseas producers such as Tobacco.
• Reducing the current account deficits: by imposing tariffs, the imports will become expensive and therefore,
consumers would prefer purchasing the domestic products. Hence, imports fall which will help to
improve/strengthen the current account.
• Retaliation: this is when the trade barriers will be imposed on countries that impose trade barriers just to
take revenge. Hence, both countries will find trading difficulties and have current account impacts.

Methods of protection
Tariffs or custom duties
• They are the taxes on imports to make them more expensive. This reduces the demand for foreign goods
and increases the demand for cheaper domestic products. As a result, foreign firms will be protected and
current account deficits can be avoided.
o Advantages
▪ They raise revenues for the government
▪ Lower current account deficits
▪ Protect the domestic producers from facing overseas competition.
o Disadvantages
 ▪ If the tariff is set too high, government revenues will be zero due to no imports.
▪ Less choices for consumers
▪ Retaliation would reduce the export earnings

Quotas
• They are the physical limits of the quantity of imports allowed into the country. This would reduce the
competition that domestic producers may face. And also, increase the prices of these products hence,
discouraging citizens and resident from purchasing these imported goods.
o Advantages
▪ They physically limit the number of imports entering the country
▪ In the short-term, the prices may be stable, therefore, people may purchase the imports.
This will provide the domestic producers the opportunity to build up stocks which will be
needed when the prices of imports start to rise.
▪ They are used to protect certain industries such as Agriculture
o Disadvantages
▪ Domestic producers may be over protected and thus, fail to improve efficiency
▪ Restricted choices

Subsidies
• This involves giving financial supports such as money, tax breaks or grants. This helps to lower the costs of
domestic producers and therefore, they lower their prices. As a result, they are able to easily compete with
the foreign products as they may seem to be much cheaper. They can also easily break into the international
market and increase the exports.
o Advantages
▪ More domestic firms are encouraged to enter the market
▪ This helps to increase the employment, export and strengthen the current account
o Disadvantages
▪ Costs to the government
▪ Opportunity costs: the money spent on export subsidies could be used for education and so
on.

Governments are encouraged to promote free trade instead of restricting. This is because they increase the
choices for consumers and reduce the prices for goods and services. If domestic producers are exposed to
competition they may be more competitive, innovative and produce better quality products.

Diagrams to show Tariffs, quotas and subsidies

Tariffs and Quotas

These barriers restrict the amount of supply. Hence, the supply curve moves
upwards and increases the prices.

Subsidies
This barrier increases the supply. Hence, the supply curve moves downwards and
reduces the prices

Chapter 39: Trading Blocs

• Trading blocs are formed when group of countries situated in the same region join together and enjoy trade
with no barriers such as tariffs or quotas. This is where free trade is encouraged as there is no any form of
trade barriers among members. But there may common tariffs or quotas set when importing from non –
members.
They are of different sizes:
• Preferential trading areas (PTA’s)
o This where members agree to remove trade barriers on various goods and services although some of
the goods are not covered in this free trade policy.
• Free trade areas (FTA’s)
o Completely free of all trade barriers
o Members can impose trade restrictions of non-member countries
• Customs unions
o Same like FTA’s
o But they impose a common set of trade barriers for non-member countries
o Goods imported from non-member countries can be transported to member countries
• Common markets
o Same like customs unions
o Allow free flow of capital and labour between member countries
o Member countries have the same regulations and standards
• Economic unions
o Same like common markets and custom unions
o Aims for more integrations

Impact of Trading Blocs on member states

• Advantages
o Goods will be cheaper
o More consumer choice
o Higher economic growth
o Increase in quality of goods
o Innovative products
o Larger consumer base
o Attracts FDI
o Closer cooperation between members
o Reduction in cross border conflicts

• Disadvantages
o Trading blocs only encourage regional free trade and not world free trade
o There is a higher financial cost and therefore, the tax payer bears the burden
o Regional monopolies may form which may exploit the consumers
o Members may become too vulnerable to trade within the bloc and may be highly affected with
changes in demand patterns in the bloc.
o New practice, laws and regulations may be implemented to the member country after joining the
trading bloc.

Impact of Trading Blocs on Non-member countries

• Non-member states may find it difficult to trade among other countries due to the barriers and common
tariffs imposed.

Examples of Trading Blocs

• NAFTA (North America Free Trade Agreement) - joining of USA, Canada and Mexico
• ASEAN (Association of Southeast Asia nations) - joining of 10 members including Thailand, Malaysia,
Singapore and others
• SACU (South African custom unions) - joining of Botswana, Namibia and others.

Chapter 40: World Trade Organization (WTO) and World Trade patterns
• Trade liberalization: moving to greater free trade with the removal of free trade barriers
• World trade organization (WTO) is an internationally recognized body that persuades countries to abolish
trade barriers and promote free trade around the globe.
Roles of WTO
• Trade negotiations: This is where WTO bring different countries together and negotiate for a free trade
agreement towards the trade liberalization. They draw trading agreements which addresses various issues
such as dumping, unfair subsidies and quality of the products.
• Implementation and Monitoring: A committee is being appointed by the WTO to monitor the trade in
goods, services and intellectual property rights. Countries must submit reports to WTO as a part of the
monitoring process.
• Settling disputes: Countries bring about their disputes faced while trading with the other countries to the
WTO. WTO will act as a judge and implement rules and regulation to ensure that trade flows smoothly
between countries.
• Building membership: WTO helps and encourages new members to join up.

Criticisms of WTO
• These come from some bodies who don’t support globalization:
• It is undemocratic: As the rules and regulations are written by the WTO for the corporations, the rights of
consumers, environmentalist and others are not taken into consideration.
• It Favors the rights of corporations over those of workers: They focus more on the businesses and least on
the workers. E.g.: Child Labor is allowed as per the regulations of WTO.
• Destroying the environment: some acts that protect the environment are made illegal by WTO.
• It favours wealthy nations over the poor ones: Most of WTO meetings are conducted with the wealthy
nations and sometimes the representatives of the poorer nations are not even invited.
• It is causing hardships for poorer nations: the present policies that harm poor farmer’s income and cause
various other hardships.

World trade patterns

• Reasons for an increase in the international trade
o Travel and consumer awareness: due to trend of travelling, people consume more goods from other
countries. Also, consumers are now aware of the better quality, cheaper and variety of products in
the outside world.
o Trade agreements: this is when countries for trading blocs and agree on free trade helping to import
products from all countries in a particular region which exposes customers to a wider variety of
choices and alternatives.

Trade in developed countries

• Loss of trade in manufacturing: this is when developed countries are slowly moving to the provision of
services in the tertiary sector due to the De-industrialization (Discussed previously)
• More Air Travel: due to the development of budget airlines who offer cheaper flights to different
destinations, people are increasing travelling to various places around the globe.
• Widening of the development gap: despite the fact that developed countries are growing from the
international trade, the income inequality gap continues to rise sue to the disparity in the way the income is
redistributed.

Trade in Developing countries

• Increase in net migration: Increased amount of people leaving the country to find work in developed
countries.
• Increase FDI in Africa: This country has been benefiting a lot from the FDI’s. This is because FDI’s improve
the living standards of workers in the country by providing more job opportunities, training and other
facilities.
• Rise in commodity dependence: Developing are now focusing on raw materials sales (Commodity sales) for
their international trade as they are experts in producing these products. Hence, this helps to increase their
exports.
• Debt cancellation: this is when developing countries benefit from cancelation of debt repayment by
developed countries which allows them to send money on their nation’s infrastructure and people and find
ways to improve their performance economically.
 • Reduction in barriers: Removal trade barriers for developing countries through the WTO will help them to
enjoy free trade. This assists in strengthening their current account, increasing profits for exporters, creating
more job opportunities and wider choices for people, which helps to improve their living standards.

Chapter 41: Exchange rates and their determination

• Currency speculators: they are firms, individual or institutions that buy and sell currencies in the
• expectation of higher returns. (Capital gains)
• Foreign exchange market: this is where currencies are bought and sold
• Exchange rate is the value of a currency in terms of another.

Factors affecting the demand for a currency

• Interest rates: When the saving interest rates are high, foreigners may want to save their money in the
banks of those high interest countries. Hence, they may have to purchase more of that currency, which will
consequently result in higher demand for the currency. As a result, Exchange rates would rise. (Vice Versa)
• Currency Speculators: If currency speculators expect an increase in the prices of a currency, for instance the
dollar, they may demand more of the currency as the make a profit in the future by selling them.
• The demand for exports: when export earnings increases, the demand for the currency would rise and the
importers from other countries may have to purchase more the currency. Hence, exchange rates may rise.
• Movement of Capital: this is when the MNC’s set-up their operations in other countries such as the UK, they
may demand for more of the Pounds as to purchases resources to set-up their operations.

Factors affecting the supply of a currency

• Interest rates in other countries: For instance, when the interest rates in the USA are higher than the
interest rates of UK, UK citizens may decide to save money in the US banks. Therefore, they may purchase
more dollars, this may increase the flow of pounds the foreign exchange, which will reduce the exchange
rate.
• Currency Speculators: if speculators believe that the price of pounds is going to fall, they will sell the
pounds, this may increase the supply of pounds and thus, reduce the exchange rates.
• The demand for imports: when the demand for imports is high, the supply of pounds in the foreign
exchange market will rise causing the currency exchange rates to fall.

Determination of Exchange rates

The exchange rates are determined by the market forces, supply and demand
of a currency. They are same like any other products.

Effect of changes in supply and demand on the exchange rates

When the supply of a pound increases, the exchange rate would fall.
This may be caused by an increase in the imports resulting in higher
levels of the currency in the foreign exchange market.
 When the demand for currency increases, this can result in a higher
exchange rate. This may be caused by
higher exports.

Chapter 42: Impact of changing Exchange rates

• Appreciation is when the value of a currency increases due to changes in market forces.
• Depreciation is the fall in the value of a currency due to changes in market forces.
• Revaluation is when the currency of a country is deliberately increased by the government.
• Devaluation is the when the currency of a country is deliberately reduced by the government.

Fall in exchange rates (Depreciation)

• Changes in the exchange rates could have impacts on the demand for exports and imports and the current
account balance (balance of trade). When the exchange rate falls from £1 = $1.50 to £1=$1.20
o Changes in exports: exports become cheaper in UK as the prices fall and demand increases.
o Changes in imports: imports become more expensive because the prices increase.
o Impact on current accounts: current account balance improves.

Rise in exchange rates (Appreciation)

• When the exchange rate rises from £1 = $1.50 to £1=$1.20,
o Changes in exports: exports decrease as now they become more expensive for US.
o Changes in imports: imports increases as they become cheaper as prices are lowered
o Impact on current accounts: current account balance worsens.

Exchange rates and Government policy

• The government can influence the exchange rates to strengthen the current account by reducing the deficits.
They can do this by making changes to interest rates as the interest rates have a directly proportional
relationship with the Exchange rates. Therefore, the interest rates can be reduced which will depreciate the
currency and thus, make imports expensive which will reduce the deficit.

However, this may be ineffective due to the following reasons:

• The government might not have complete control over the interest rates.
• Reducing the interest rates will conflict with other policies
• Devaluation will only work if demand for exports and imports are responsive to price change

Exchange rates and Price elasticity

• The effectiveness of the exchange rates will depend on the PED. For instance, fall in interest rates will reduce
the exchange rates, which may cause a deficit in the current account only if the demand for exports and
imports are elastic.