Macroeconomics

Question 1

What the government hopes to achieve

Answer 1

Low and stable inflation
Steady and sustained growth
High and full employment
Balance of payments equilibrium - the difference between imports and exports
Redistribution of income
Concern for the environment

Question 2

Gross Domestic Product (GDP)

Answer 2

The monetary value of all goods and services produced within the Uk in a given time period

Question 3

Economic Growth

Answer 3

• Economic growth refers to an increase in the production of goods and services within an economy over a period of time.
• It is typically measured by the increase in a country’s Gross Domestic Product (GDP), which is the total value of all goods and services produced within a country’s borders.
• Economic growth is important because it allows for higher standards of living, increased consumption and investment, and improved living conditions. It also creates job opportunities and reduces poverty. However, economic growth can also have negative impacts such as income inequality, environmental degradation, and resource depletion.

Question 4

Inflation

Answer 4

An increase in the general price level of goods and services

Question 5

Real GDP

Answer 5

is a measure of a country’s economic output that adjusts for changes in prices over time
- real GDP can help to distinguish between price changes and actual changes in the quantity of goods and services produced.

Question 6

The circular flow

Answer 6

describes the flow of money between different sectors and how they are interconnected.

Question 7

Injections

Answer 7

in the circular flow of income, spending which is not generated by households including investment, government spending and exports

Question 8

Withdrawals or leakages

Answer 8

in the circular flow of income, spending by households which does not flow back to domestic firms. It includes savings, taxes and imports.

Question 9

Macro policies

Answer 9

Macroeconomics includes looking at the effects of policies such as a change in taxation or higher/lower interest rates

Question 10

Monetary policy

Answer 10

Monetary policy refers to the actions taken by a central bank to influence the money supply, interest rates, and credit conditions in an economy. The goal of monetary policy is to manage demand, inflation, and stability in the economy.

Question 11

Fiscal policy

Answer 11

is the use of government spending and taxation to influence the economy. Governments typically use fiscal policy to promote strong and sustainable growth and reduce poverty.

Question 12

Key objectives of macroeconomic policy

Answer 12

Price stability (CPI inflation of 2%)
Growth of Real GDP (national output)
Falling unemployment/raising employment
Higher average living standards (national income per capital)
The stable balance of payments on the current account
Equitable distribution of income and wealth

Question 13

3 ways of measuring national income

Answer 13

• National output (o) - this is the value of the flow of goods and services from firms to households
• National Expenditure (E) - this is the value of spending on goods and services
• National income (Y) - this is the value of the income paid by firms to households
  O=E=Y

Question 14

Nominal & Real GDP

Answer 14

• The value of goods and services measured at current prices is NOMINAL GAP.
• A better measure is called real GDP, it is the value of goods and services at constant prices- its adjusted for inflation

Question 15

Limitations of GDP statistics

Answer 15

• There are likely to be inaccuracies in the published figures
  – Does not account for the distribution of wealth: GDP only measures the total value of goods and services produced in a country, but not how the wealth generated is distributed among its citizens.
• Does not measure non-monetary transactions: GDP does not include activities that are not traded in markets, such as household work or volunteer work, making it an incomplete measure of economic activity.
• Does not measure environmental impact: GDP does not account for the negative environmental impact of economic activity, leading to over-estimation of economic growth in countries that exploit their natural resources.
• Does not capture changes in quality of life: GDP only measures economic output and not the changes in the quality of life of its citizens, such as changes in life expectancy, educational attainment, or happiness.
• Does not account for inflation: GDP figures are often adjusted for inflation, but this process can be imprecise, leading to over- or under-estimation of economic growth.
• May not reflect economic well-being: GDP only measures economic activity and may not reflect the overall well-being of society. For example, a rise in GDP may be accompanied by an increase in income inequality or environmental degradation

Question 16

Aggregate Demand

Answer 16

the total amount of demand for all finished goods and services produced in an economy.

Question 17

The components of aggregate demand are

Answer 17

• Household spending on goods and services (C)
• Gross Fixed Capital Investment Spending (I)
• Value of the Change in Stocks (Inventories)
• Government Consumption (G) (Public services)
• Exports of Goods and Services (X)
• (minus) Imports of Goods and Services (M)

Question 18

Understanding why the AD curve slopes downwards

Answer 18

• Falling real incomes = As the price level rises, the real value of income falls and consumers are less able to buy what they want or need – this is known as the real balance effect
• Balance of trade = A persistent rise in the price of level of Country X could make foreign-produced goods and services cheaper, causing a fall in exports and a rise in imports
  Interest rate effect - If the price level rises, this causes inflation and an increase in demand for money and a possible rise in interest rates on loans which then has a deflationary effect on consumer and business demand

Question 19

Key shifts in Aggregate Demand

Answer 19

Changes to Monetary Policy
= Changes in official monetary policy interest rates
= Changes in the supply of money and credit
= Changes in the value of a country’s exchange rate

Changes to Government Fiscal Spending
=Changes in the level of direct/ indirect taxes
=Changes in government (state) spending
=Changes in Government (fiscal) borrowing
Business and consumer confidence
=Planned capital investment spending by businesses
=Consumer confidence and retail spending

Question 20

External shocks to aggregate demand

Answer 20

• A large rise to fall in the value of the exchange rate
• A recession, slowdown or boom in one or more of a nation’s key trading partner countries
• A slump in the housing market/ construction sector of a country
• An event such as the global financial crisis which caused a fall in the supply of credit available to businesses and households
• A large change in commodity prices for a country that is a commodity exporter

Question 21

Disposable income

Answer 21

Household income after the deduction of taxes and the addition of welfare benefits.

Question 22

Value added tax (VAT)

Answer 22

A tax on consumption, which is paid to the tax authorities by the seller on behalf of the consumer

Question 23

Marginal Propensity to save - MPS
Some key factors affecting consumer spending

Answer 23

• Real Disposable income
• Employment and Job security
• Household wealth
• Expectations and sentiment
• Market interest rates

Question 24

Importance of saving

Answer 24

Business survival
- Corporate savings provide a cushion during a recession
- Business savings can be used as finance for takeovers and for capital investment projects

Funding investment
- Banks need deposits from which they can lend
- Savings flow into pension funds – these can be reinvested in stock markets providing investment funds
Buffer for consumers
- Savings can smooth consumption during tough times
- They allow people to reduce their debts
- Saving are a key source of retirement income

Question 25

Consumer confidence

Answer 25

consumer confidence is an economic indicator that measures the degree of optimism that consumers have regarding the overall state of a country’s economy and their own financial situation.

Question 26

Business Capital Investment

Answer 26

• Investment is a component of AD, and is a factor affecting competitiveness
  Gross investment spending is total spending on new capital
• If the gross investment is higher than depreciation, then the net investment is positive and the size of the capital stock will grow
• Gross investment – capital depreciation = net investment

Question 27

The difference between Gross and Net Investment

Answer 27

Gross Investment - Gross investment spending is a total investment in new capital inputs
It is the total amount that the economy spends on new capital

Net Investment = Gross Investment adjusted for capital consumption
If gross investment in a given year is higher than capital consumption, then net investment will be positive and the economy’s capital stock will grow.

Question 28

Key factors determining business investment

Answer 28

Actual and expected demand
Expected profits and business taxes
Interest rates + the availability of business finance
Business confidence
= A higher level of investment can raise both actual and potential GDP growth and help to control inflationary pressures

Question 29

The Accelerator Effect (Consumption and Investment)

Answer 29

The accelerator effect is a relationship between planned capital investment and the rate of change in national income
- Consider an industry where demand is rising quickly
- Firms may respond initially by using their existing productive capacity more intensively or running down stocks of finished products
- If they expect high demand will be sustained – they may increase spending on plant and machinery, factories and new technology in order to increase their supply capacity
- This causes an accelerator effect – where a given change in demand for consumer goods and services will cause a bigger percentage change in demand for capital goods

Question 30

Examples of the Accelerator Effect in Action

Answer 30

• Investment to create extra capacity in cloud computing storage services
• Investment in 4G mobile networks to meet rising household and business demand
• Expanding the fleet sizes of growing airlines, especially for low-cost short destinations
• Capital investment in renewable energy as the balance of energy supply shifts towards renewables

Question 31

The Negative Accelerator Effect

Answer 31

When the rate of growth of demand in an industry slows then net investment spending by businesses often falls. E.g. declining investment in steel plants in a recession or a drop in investment demand when government subsidies for renewable energy are cut

Question 32

The Net Trade Balance (X-M) and Aggregate Demand

Answer 32

The net trade balance has measured the value of exported goods and services minus the value of imported products
A trade surplus means that X>M – aggregate demand will increase
A trade deficit means that M>X – aggregate demand will fall
If X=M, then the trade balance is zero, and external trade will have a neutral effect on AD

Question 33

Public and Private Sector Debt

Answer 33

• Public sector debt is owed by central and local government and by public (state-owned) corporations
• Debts owed by state-owned banks are included in the national debt
• Private sector debt is owed by private businesses and households.
• Companies may have borrowed to finance investment (corporate sector debt)
• Households have loans for example credit card debt and mortgages on properties.
• Financial debt is also part of the private sector – this is the outstanding (unpaid) debts of banks and financial corporations - for example, the level of bad debts on loans to businesses and to the housing market

Question 34

Aggregate supply

Answer 34

Aggregate supply is the number of goods and services that producers in an economy are willing and able to supply at a given level of price.

Question 35

Short-run aggregate supply

Answer 35

• Short-run aggregate supply is the relationship between planned national output and the general price level
  SRAS shows how much output the economy can generate in the short term at each price level
• A rise in the general price level should stimulate an expansion of the supply
• When prices are falling, production may contract
  The main factor causing a shift in SRAS is the resource cost of producing goods and services e.g. unit wage costs

Question 36

Shifts in the short-run aggregate supply

Answer 36

Changes in resource (input) prices
- Wage costs per unit of output
- Labour productivity (higher efficiency ceteris paribus lowers unit costs)
- Raw material and component prices such as glass, cement, rubber
- Energy costs such the world price of oil, gas and electricity

Business taxes, subsidies, regulations and imported costs
- VAT, environmental charges/employment taxes
- Changes in the scale and size of government subsidies to certain industries
- Business rates + costs of meeting business regulations and other laws
- Cost of imported components (affected by the exchange rate + fluctuations in world commodity prices)
Supply shocks
- E.g. A hurricane, a tsunami or the effects of drought, flooding or a political crisis / civil war which can have an effect on a country’s national output

Question 37

External factors affecting aggregate supply

Answer 37

World oil and gas prices
Energy prices/ Costs
Other minerals/ Metal prices
Foodstuff prices
Import tariffs/quotas

Question 38

Long Run aggregate supply

Answer 38

In the long run, the ability of an economy to produce goods and services to meet demand is based on the state of production, technology and the availability the quality of factor inputs.

Question 39

Increasing LRAS - Lifting Productive Potential

Answer 39

• Changes in a nation’s potential GDP are brought about by:
• Changes in labour supply available for production (i.e. more people joining the labour force)
• Changes in the stock of capital inputs – affected by the level of gross capital investment
• Changes in the efficiency of allocation of factor inputs e.g. shifting resources from rural to urban areas
• Improvements in the quality of factor inputs/productivity of inputs
• Advances in the state of technology
• Improvements in institutions such as the banking system
• An outward shift of LRAS signifies an increase in long-run potential output and employment
• A higher level of LRAS signifies real economic growth

Question 40

Productivity

Answer 40

It measures the efficiency of the production process
In the long run, productivity is a major determinant of economic growth and of inflation.
A fall in labour productivity leads to a rise in firms’ (unit) costs of production (assuming that the level of wages remains the same)
Higher productivity allows businesses to pay higher wages and achieve increased profits at the same time.

Question 41

the non-linear SRAS curve

Answer 41

When spare capacity is high then SRAS will be elastic
=A rise in AD can be met easily by increased output
=There is little threat of rising prices (inflation)
The elasticity of SRAS curve falls as output increases
=The amount of spare capacity declines
=Possibility of diminishing returns in production
=Bottlenecks in supply of inputs and components
=Resource shortages as the economy approaches full employment e.g. Skilled labour becomes more scarce
=When SRAS becomes perfectly inelastic the economy is at full capacity (equivalent to being on the PPF boundary)
=Further increases in AD at this point are purely inflationary in the short run with little extra real output

Question 42

The Multiplier effect

Answer 42

The multiplier effect occurs when an initial injection into the circular flow causes a bigger final increase in real national income. This injection of demand might come for example from a rise in exports, investment or government spending.

Question 43

Positive Multiplier

Answer 43

when an initial increase in an injection ( or a decrease in a leakage) leads to a greater final increase in real GDP.

Question 44

Negative Multiplier

Answer 44

When an initial decrease in an injection (or an increase in a leakage) leads to a greater final decrease in real GDP.

Question 45

Marginal propensity to consume (MPC)

Answer 45

MPC = change in consumption following a change in income
= change in total consumption/change in gross income

Question 46

Marginal propensity to save (MPS)

Answer 46

MPS = change in savings following a change in income
= change in total savings/change in gross income

Question 47

How does the Multiplier effect help the economy

Answer 47

The multiplier effect arises because one agent’s spending is another agent’s income. When a spending project creates new jobs, for example, this creates extra injections of income and demand into a country’s circular flow.
This leads to a bigger final effect on the level of national output and also total employment in the labour market

Question 48

the calculation for the value of the multiplier is:

Answer 48

Multiplier = 1 / (sum of the propensity to save + tax + import)

Question 49

High Multiplier effect

Answer 49

• The economy has plenty of spare capacity (negative output gap) to meet higher demand
• Marginal propensity to import and tax is low
• High propensity to consume any extra income (i.e. a low propensity to save)

Question 50

Low Multiplier effect

Answer 50

• The economy is close to its capacity limits e.g. during a boom phase
• Propensity to import goods & services is high – extra demand leaks from the circular flow
• Higher inflation causes rising interest rates which then dampens other components of AD

Question 51

Boom

Answer 51

A period when the rate of growth of real GDP is fast and higher than the long-term trend

Question 52

Business cycle

Answer 52

Short-run fluctuations of national output (real GDP) around its long-term trend.

Question 53

National income

Answer 53

Everything produced, earned and spent in a country.

Question 54

Slowdown

Answer 54

A weakening of the rate of growth, real GDP is still rising but increasing at a slower rate

Question 55

Recession

Answer 55

A period of at least six months when an economy suffers a fall in output. Or a broadly-based contraction in output, employment, investment and confidence

Question 56

Recovery

Answer 56

A phase of the cycle, after a recession, during which real GDP starts to increase and unemployment begins to fall

Question 57

Depression

Answer 57

A prolonged downturn in the economy and where a nation’s GDP falls by at least 10 per cent

Question 58

The economic cycle definition

Answer 58

There are national fluctuations around the trend which is to be expected. But large or frequent fluctuations are not good for an economy. It’s better for the economy’s short-run growth to mimic the trend rate.

Question 59

ECONOMIC CYCLE

Answer 59

The economic cycle represents how an economy grows over time. We divide growth into two forms, actual and trend growth.

When actual growth is sloping upwards, it means short-run economic growth is occurring. The economy’s GDP growth is positive.

The economy is in a recession when actual growth slows downwards and continues for two successive quarters.

Question 60

The output gap

Answer 60

The output gap is a measure of the difference between the actual output of an economy and its potential output.

Question 61

Problems in estimating the output gap include:

Answer 61

1. Inaccurate data on the labour force for example difficulties in measuring the scale of net inward labour migration
2. Problems in accurately measuring productivity
3. Surveys of producers about spare capacity may be inaccurate
4. Gaps in knowledge about how much businesses are investing and the potential output from new capital e.g. in digital sectors
5. Uncertainties about the number of people who may have left the labour market as “discouraged workers”
6. Hard to measure the amount of under-employment in the labour market at different stages of the economic cycle

Question 62

Negative and Positive output gaps

Answer 62

Negative
- The level of actual GDP is less than potential GDP.
- factor resources are underutilized eg. demand deficient unemployment
- The main problem is likely to be higher unemployment and possible deflation risk

Positive
- Actual GDP is greater than the estimated potential GDP
- Some resources working beyond usual capacity (shift work & overtime)
- Main problem is rising demand-pull and cost-push inflationary pressures

Question 63

Demand-side shocks are things that cause AD to shift left or right. Some examples include:

Answer 63

1. Global recession -> will cause your country’s exports to decrease due to less demand from abroad
2. Housing market boom -> could cause the wealth effect. Can cause increases in spending and confidence
   examples include -
   - Economic downturn in a trading partner
   - Unexpected tax increases
   - financial crisis causing bank lending to fall
   - bigger than expected rise in unemployment

Question 64

Supply-side shocks are things that cause AS to change. Some examples include:

Answer 64

1. War -> wars can cause wreckage and destruction everywhere which inhibits the economy’s ability to output goods/services
2. Discovery of new resources -> if we discover new resources it means our potential to supply goes up
   - steep rise in oil and gas prices or other commodities
   - political turmoil/strikes
   - natural disasters causing a sharp fall in. production
   - unexpected breakthroughs in production technology

Question 65

Possible Causes of a Recession

Answer 65

External events
- A recession in a trading partner e.g. the European Union or the USA
- A sharp rise in global commodity prices e.g. rising oil and gas prices

Tightening of macro policy
- Higher interest rates lead to more expensive loans
- A rise in taxation or a cut in government spending

Fall in asset prices or supply of credit
- Steep decline in the level of share or house prices
- A collapse in the supply of credit (e.g. Global financial crisis)

Drop in business and consumer confidence
- Lower business confidence cuts investment and may lead to job losses
- Declining consumer confidence leads to less spending and more saving

Question 66

Short Term Economic Effects of a Recession

Answer 66

Business Profits and capital investment
- Falling demand can cause more businesses to fail and profits fall
- Planned investment declines – hitting industries that make the capital goods

Unemployment
- A steep decline in aggregate demand causes a fall in the demand for labour
- This causes a contraction in employment and a rise in cyclical unemployment

Government Finances
- Recession causes a decline in tax revenues and more welfare spending
- The result is usually an increase in the budget deficit and a rising national debt

Inflation
- Many business offer price discounts to off-load excess unsold stocks
A deep recession risks causing a period of sustained deflation (negative inflation)

Question 67

longer Term Economic & Social Effects of a Recession

Answer 67

Long-Term Economic Effects
- Rising structural long-term unemployment and regional decline
- Low rates of investment can reduce the size of the capital stock
- Persistent budget (fiscal) deficits and a rising national debt leads to austerity (cut in public services)

Long-Term Social Effects
- Falling real wages hits average living standards and reduces demand
- Widening inequality of income and wealth leading to rising poverty
- Social costs such as loss of social cohesion and threats to democracy

Question 68

Hysteresis v Creative Destruction

Answer 68

Hysteresis refers to the idea in economics that the effects of past events can continue to influence current and future economic outcomes. For example, a recession may cause some workers to lose their jobs permanently, which can lead to a long-term increase in the unemployment rate even after the economy has recovered.

Creative destruction, on the other hand, is the process by which new technologies and innovations lead to the replacement of older, less efficient technologies and industries. This process is seen as a key driver of economic growth and progress, as it allows for the development of new and better products and services, and can lead to increased productivity and higher living standards.

Both hysteresis and creative destruction can have important implications for economic policy, with hysteresis suggesting the need for policies to address the long-term effects of economic shocks, and creative destruction highlighting the importance of fostering innovation and entrepreneurship.

Question 69

CHARACTERISTICS OF BOOM/RECESSION PERIODS

Answer 69

In a boom, spending is high, therefore inflationary pressure is high. Employment will be higher because the demand for labour is a derived demand. GDP growth will be positive and will be growing quickly.

In a boom, there is a positive output gap, when the actual GDP exceeds the trend (potential) GDP.

In a recession, spending is low, therefore inflationary pressure is low. There may even be a risk of deflation. Employment will be lower so unemployment will be high. There will be cyclical unemployment. GDP growth will be negative.

In a recession, there is a negative output gap, when the actual GDP is smaller than the trend (potential) GDP.

Question 70

Inflation

Answer 70

A sustained rise in the general price level leading to a fall in the purchasing power of money

Question 71

hyperinflation.

Answer 71

A period of very high rates of inflation, usually leading to
a loss of confidence in an economy’s currency.

Question 72

Deflation

Answer 72

• A decline in the general price level in an economy,
• Deflation is a persistent fall in the general price level of goods and services. The rate of inflation becomes negative.

Question 73

Usage of all this in the Real World?

Answer 73

= We have an inflation target in the UK of 2% per annum CPI inflation.

= Inflation measurements can be used when negotiating higher wages. The government also uses these measures to decide pensions and other benefits. Also, the government uses inflation when considering the National Minimum Wage.

= International Competitiveness - comparing our inflation rate with that of the world. We can easily track our price competitiveness which is important for our exports and imports. The lower our inflation over time, the more likely we are competitive - this should help exports increase, and imports should decrease.

Question 74

Limitations of the CPI as a measure of inflation

Answer 74

• The CPI is not fully representative - it will be inaccurate for the
  ‘non-typical’ household,
• CPI excludes mortgage interest payments and council tax.
• Information was given by households in the Living Costs and Food Survey can be inaccurate.
• The basket of goods is infrequently updated (once a year). So short-term changes in spending are not accounted for.

Question 75

2 main causes of Inflation
Demand-Pull

Answer 75

occurs when there is an increase in the general price level due to demand-side factors.
An increase in AD is responsible for this. It could occur when government spending increases for example, or any of the AD components.
- Economy close to full capacity (inelastic AS)
- Positive output gap (AD > potential GDP)

Question 76

Demand-pull diagram explanation

Answer 76

If you notice from the diagram , demand-pull inflation is occurring from point A. It is most problematic when the economy is already operating on the LRAS curve. This is because the economy is already operating at maximum capacity, Yfc. If the economy is at full capacity, and demand continues to grow, then demand is likely to be growing faster than supply. If supply cannot keep up, then there will be shortages in the economy and prices will have to rise to reestablish long-run equilibrium.

Question 77

2) Cost-Push

Answer 77

occurs when there is an increase in firms’ cost of production. An increase in the costs of production will lead to them increasing the prices of their products. Ceteris paribus, the general price level will rise and the SRAS curve will shift to the left.
- Increasing raw material and component costs from domestic and overseas suppliers
- Rising import prices due to a falling exchange rate – increases in import costs
- An increase in business taxes eg. VAT

For example, an increase in the price of oil would lead to an increase in production costs for the majority of firms. These costs being passed onto the consumer is reflected in the SRAS curve shifting to the left

Question 78

Benefits of Inflation

Answer 78

1) Good for existing borrowers
Inflation decreases the purchasing power of money. Over time, money will essentially be worth less. If you have an existing loan, then the value of your loan is worth less and less over time too. In theory, it should get easier to pay back over time (as long as incomes have been increasing).

2) Stable inflation is a good sign for businesses
Low, sustained inflation is actually a healthy sign. It gives a business more certainty about future prices. It shows businesses that the economy is growing at a steady level and that prices are going up. Businesses are in business to make a profit and prices going up is a good sign.

3) Reduces risk of deflation
Deflation is actually worse than inflation in many cases. An economy with a steady rate of inflation (for example, 2%) reduces its risk of being caught in the deflationary trap.

Question 79

Costs of Inflation Part 1

Answer 79

1) An increase in the cost of living

This leads to a reduction in living standards for households, particularly if the economy has a severe inequality problem. The poorest in society will be the most affected, which could mean an increase in relative poverty.

2) A decrease in real income

If income does not go up at the same rate as inflation, then real income will decrease over time. This means that the average person will be able to buy less than before. It could mean incomes have to be renegotiated with employers which could lead to…

3) Wage-price spiral

Employers are likely to receive increased demands for higher wages. Employers are likely to respond by meeting worker demands but at the same time also increase their prices further to compensate. It could also lead to an increase in lay-offs by firms to cut costs.

4) Reduction in confidence levels
Firms and households are likely to experience a reduction in confidence, particularly if the inflation rate is high and unstable. Households are more likely to reduce their spending and ‘save for a rainy day’, while businesses are likely to hold back investment projects due to the uncertain economic environment.

5)Menu Costs
An increasing rate of inflation means that businesses are more likely to need to increase the rate at which they increase their prices. This means changing prices more often, updating labels and menus etc. All this comes at a cost - businesses must pay workers to do this extra work

Question 80

Costs of inflation part 2

Answer 80

6) Shoe leather costs
Inflation also brings about what is known as shoe leather costs. These are costs incurred by the shopper, going from shop to shop to get the best deal. Prices increasing at a faster rate means that consumers are likely to become more price sensitive and hunt for the best prices. This comes at a cost to the consumer in terms of time spent.

7) Decreased international competitiveness
Prices increasing at faster rates, particularly compared to other countries, will mean that your country becomes less internationally competitive over time.

8) Decreased willingness to save
As inflation reduces the purchasing power of money, people are less likely to leave their savings in the bank. For example, if the bank pays 2% interest per annum, and inflation is 3% per annum, what does this mean? It means your savings are losing real value over time. So people will be more reluctant to save in banks.

9) Shortage of funds in banks
Fewer savers mean that banks are less willing and able to lend to people who want to borrow, particularly businesses looking to invest.

10) Risk of hyperinflation
This is a severe case and is generally unlikely if the economy is being managed well. It generally happens when the government (or central bank) is creating too much money. Inflation can be well over 100% in this case.

Question 81

Macroeconomic Policies to Control Inflation. Inflation can be reduced by policies that
(i) slow down the growth of AD or
(ii) boost the rate of growth of aggregate supply (AS)

Answer 81

= Fiscal policy: A tightening fiscal policy would include less spending on public and merit goods or welfare payments or raising direct taxes

= Monetary policy:
- A ‘tightening of monetary policy via higher interest rates or a reversal of quantitative easing or tougher controls on bank lending
- Higher interest rates may cause the exchange rate to appreciate bringing cheaper imported goods and services

= Supply-side policies to increase productivity, competition and innovation
= Direct controls
Public sector pay controls e.g. Limiting pay rises for NHS workers
Capping or other regulation of prices of utilities such as water bills

Question 82

The Causes of Price Deflation

Answer 82

Demand-side causes of deflation
= Deep fall in AD causing a persistent recession/depression
= Large negative output gap – i.e. high level of spare capacity

Supply-side causes of deflation
- Improved productivity
- Technological advances
- Significant fall in wage rates
- High exchange rates cause import prices to fall

Question 83

Consequences of Price Deflation

Answer 83

1. Holding back on spending: Consumers may postpone demand if they expect prices to fall in the future
   Debts increase: The real value of debt rises with deflation and higher real debts can be a big drag on consumer confidence
2. The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices.
3. Lower profit margins: Lower prices can mean reduced revenues & profits for businesses - this can then lead to higher unemployment as firms seek to reduce costs by shedding labour.
4. Confidence and saving: Falling asset prices such as price deflation in the housing market hit personal sector wealth and confidence
5. Income distribution: Deflation leads to a redistribution of income from debtors to creditors – but debtors may default on loans
   Deflation can make exporters more competitive eventually – but this often comes at a cost i.e. higher unemployment in the short term

Question 84

Unemployment

Answer 84

The unemployed are those people able, available and willing to work but cannot find a job despite an active search for work

Question 85

WHY IS UNEMPLOYMENT A PROBLEM FOR THE COUNTRY?

Answer 85

It restricts the output and income that the economy can produce.
It leads to less spending because less is being earned.
It means there is unused capacity making us productively inefficient.
Unemployment benefits that arise will cost the taxpayer money

Question 86

Claimant Count

Answer 86

This unemployment figure is calculated by tracking the number of those in the country who are claiming job seekers’ benefits.

Question 87

Labour Force Survey

Answer 87

A survey is sent around to a proportion of households in the country which asks people if they are currently employed and actively seeking work.

Question 88

unemployment rate

Answer 88

the percentage of the labour force that is currently unemployed.

Question 89

Frictional

Answer 89

Transitional unemployment due to people moving between jobs eg. The person is waiting for the new job to start.

Question 90

Seasonal

Answer 90

= this type of unemployment occurs when certain industries experience spikes in demand at different times of the year.
= For instance, the holiday industry. The holiday industry is booming in school holidays and in the summer months. Throughout the rest of the year, there is less demand for labour in those industries. Another example would be the temporary increase in the demand for labour during the Christmas holidays.

Question 91

Structural

Answer 91

this is when the demand for skills and the supply of skills are not matched. When industries go into decline, the workers in those industries can have very specific skill sets that are non-transferable.

If you are a coal miner, for instance, you cannot transfer your skills to the financial markets because your skills are not a match for the requirements of those jobs. This is a serious type of unemployment and the government can try to get around this by setting up training schemes for those who need specific skill sets. If a person is structurally unemployed for too long, it can even lead to long-term unemployment.

Question 92

Cyclical

Answer 92

This is when fluctuations in the economic cycle lead to periods of higher unemployment and periods of excess employment.

Question 93

High unemployment has economic effects

Answer 93

1. Reduced GDP: When people are out of work, they have less money to spend, which decreases demand for goods and services and lowers economic growth.
2. Increased poverty: High unemployment often leads to poverty, as people struggle to meet their basic needs without a steady income.
3. Inequality: Unemployment can worsen income inequality, as those who are employed and have stable incomes may benefit while those who are unemployed struggle.

Question 94

High unemployment has social effects

Answer 94

1. Decreased morale and self-esteem: Unemployment can lead to feelings of worthlessness and hopelessness, as individuals are unable to find work and provide for themselves and their families.
2. Increased crime: High unemployment can lead to increased crime as individuals turn to illegal activities to support themselves.
3. Strained family relationships: Unemployment can lead to financial stress and other related issues, which can strain relationships within families.

Question 95

There are a few potential beneficial effects of unemployment, including

Answer 95

1. Reallocation of labour: Unemployment can lead to a reallocation of labour as workers leave declining industries and find employment in growing industries.
2. Increased productivity: During periods of unemployment, workers may use the time to acquire new skills and knowledge, which can increase their productivity and competitiveness in the job market.
3. Lower inflation: High levels of unemployment can reduce wage pressures and slow the growth of prices, helping to keep inflation in check.
4. Improved job matching: Unemployment can lead to a better match between workers and jobs, as workers have the time to search for positions that better align with their skills and interests.

Question 96

Labor scarring refers to the long-term negative impacts of unemployment on an individual’s future employment prospects and earning potential. The main effects are:

Answer 96

1. Skill depreciation: When workers are unemployed for an extended period, they risk losing their skills and abilities, making it harder for them to find work when the economy improves.
2. Decreased earning potential: Unemployed workers may be forced to accept lower-paying jobs than they previously held, leading to a reduction in their earning potential over the long term.
3. Stigma: The stigma attached to unemployment can make it harder for individuals to find work, as employers may view them as less desirable candidates due to their time out of the workforce.

Question 97

Policies to Reduce Unemployment – Labour Demand

Answer 97

Macro Stimulus Policies (+ Multiplier Effects)
1. Monetary policy: This involves actions taken by central banks to influence the money supply and interest rates, such as reducing interest rates to encourage borrowing and spending.
2. Fiscal policy: This involves government spending and taxation changes, such as increasing government spending on infrastructure projects or cutting taxes to increase consumer spending.
- Cutting the cost of employing workers
Competitiveness Policies
- Reductions in corporation tax (to increase investment)
- Enterprise policies to lift the rate of new business start-ups

Question 98

WHAT CAN THE GOVERNMENT DO ABOUT UNEMPLOYMENT?

Answer 98

Remember, low unemployment is one of the key macroeconomic objectives. It is in the government’s interest to keep unemployment low as it is one of the areas the public assesses them by. People are directly affected by unemployment, and to most people it is the economic objective that matters most. Having a way of earning money is the way people survive and make their way.

So, we have established that the government needs to do something about it. The benefit of lowering unemployment is that GDP will also be positively affected. If there are more people producing things, then national output will go up won’t it?

Take for example, cyclical unemployment. Why is this unemployment occurring? It is because of a period of low aggregate demand. So what sort of policies do we use to reduce this unemployment? Surely, the best way to combat this problem is by increasing aggregate demand. Think of how the government can do that (think AD = C + I + G + (X-M).

Question 99

EXAMPLE POLICIES

Answer 99

Expansionary Demand-Side Policy: This would be put in place to reduce cyclical unemployment. This would especially be needed in severe recessionary periods to keep firms employing people. So expansionary fiscal or monetary policy would work.

Job Training Schemes: This would try to improve the skills of the current labour force. It will mean that over time, our labour force becomes more productive and can therefore produce more. This will have an effect on reducing structural unemployment especially. It will give people the skills they need to sell themselves in the labour market. Employers will be more willing to take on labour because they will see them as more productive.

Reforms to the tax and welfare system: If you reduce taxes and make claiming welfare benefits less attractive, then you incentivise people to supply their labour. Some people who previously did not want to work (so, they were not in the labour force), will now be incentivised to go to work. This should increase the number of those employed.

Reducing geographical immobility: In the UK, there is a regional divide between the north and the south (in other countries, I expect that there will also be some sort of regional divide). Those who are working in the south in the UK generally have better job opportunities than those in the north because of the City of London. Many people will not move to the south to seek more job opportunities because of family ties etc, so policies that improve transport to help more people get to work in less time will increase the number of those employed.

Apprenticeship Schemes: This will especially help the younger generation. It will provide them a specific skill set in which they can specialize and hence market themselves. At the end of their apprenticeship, they will be rewarded with a qualification of some sort, to certify that they are qualified to do a specific job. These schemes are starting to become more popular in the UK, especially after the huge rise in university fees.

Education: Reforms to the education system, making public money go further, building more schools, reducing classroom sizes, better teaching standards etc. All of these things lead to better-educated people. Generally speaking, the more educated you are, the more skilled you are or the more skilled you can be

Question 100

Balance of Payments

Answer 100

measures the international flows of money between a country and the rest of the world

So, the value of all money going in and value of all money going out of a country.

Question 101

THE CURRENT ACCOUNT

Answer 101

1. The trade (or visible) balance – refers to the trade in physical goods. It comprises exports (+) and imports(-) of raw materials, semi-processed and finished manufactured goods. The U.K. has had a persistent __deficit __on visible trade since the 1970s. In other words visible imports exceed in value visible exports
2. The invisible trade balance – refers to the trade in services, such as financial services (banking and insurance), tourism, business services (i.e. legal advice, management consultancy, accountancy, advertising & marketing). The U.K. has a strong and persistent surplus on invisible trade, reflecting the economy’s internationally competitive service industries
3. International Income Flows - Any money classified as income that comes here (inflow) or money that goes out (outflow). So if you earn an income that is paid from abroad, it would be an inflow of money to our income. Incomes could be interest payments from abroad or a salary.
4. Net Transfers - a transfer of money to or from a foreign government or from a person. So, for example government aid or transfers from one person to a family member in another country.

Question 102

current account deficit

Answer 102

If the money going out to foreign countries is larger than the money coming in from foreign countries

Question 103

current account surplus

Answer 103

If the money coming in is larger than that money going out in the current account

The point is that our government’s aim is to try and maintain a sustainable level on our current account, be it a deficit or a surplus.

Question 104

A current account deficit can be caused

Answer 104

1. Increased imports: When a country imports more goods and services than it exports, it can result in a current account deficit.
2. Declining competitiveness: If a country’s products become less competitive in the international market, it may lead to a decline in exports and an increase in imports.
3. Investment inflows: Foreign investment in a country can lead to an increase in imports, which can result in a current account deficit.
4. Low savings rate: If a country has a low savings rate, it may result in increased borrowing from abroad, which can increase the current account deficit.
5. Government spending: High government spending can lead to increased imports, which can result in a current account deficit.
6. Demographic changes: An aging population and declining birth rate can lead to reduced savings, increased consumption, and a larger current account deficit.

Question 105

A current account surplus

Answer 105

1. Increased exports: When a country exports more goods and services than it imports, it can result in a current account surplus.
2. Competitiveness: If a country’s products become more competitive in the international market, it can lead to an increase in exports and a decrease in imports, resulting in a current account surplus.
3. Low domestic demand: If domestic demand is weak, it can reduce imports and increase exports, leading to a current account surplus.
4. Savings rate: If a country has a high savings rate, it can reduce the need for borrowing from abroad, resulting in a current account surplus.
5. Favorable terms of trade: If a country experiences an improvement in the prices it receives for its exports relative to the prices it pays for its imports, it can result in a current account surplus.
6. Capital inflows: Inflow of capital into a country can result in a current account surplus, as foreign investment increases the country’s assets.

Question 106

The UK Current Account Balance

Answer 106

Since the 1980s the U.K.’s current account has been in deficit. This has been mainly due to a widening deficit in visible trade, as U.K. manufacturing has been in long-term decline. Although the U.K. has a healthy surplus on invisible trade, this is considerably smaller than the trade deficit. The negative balance on secondary income also contributes to an overall current account deficit.

Question 107

the U.K. has a chronic current account deficit, it is not widely seen as a problem because:

Answer 107

1. The deficit is a small % of GDP. Just as an individual can manage higher borrowing and debt as income rises, (rich people can afford bigger mortgages, for instance) the same is true of a country. Provided the deficit does not grow faster than the economy, it should not be a problem to finance it
2. The current account is not the main determinant of the U.K. net overseas debt. The value of UK net assets abroad (the value of UK-owned assets abroad minus the value of foreign-owned assets in the U.K) is many times greater than the current account deficit
3. The U.K. has been very successful in attracting foreign direct investment. This results in credit items on the __capital and financial account __of the balance of payments, and so helps to finance the current account deficit.

Question 108

Economic policies that can be used to reduce a trade deficit

Answer 108

Fiscal policy: Raising interest rates can make a country’s currency more attractive to foreign investors, increasing demand for the currency and reducing the trade deficit this reduces purchasing power.

Exchange rate policy: A devaluation of a country’s currency can make its exports cheaper and imports more expensive, reducing the trade deficit since this causes changes in demand.

Trade policy: The government can implement tariffs or quotas on imports to reduce the trade deficit by making foreign goods more expensive.

Investment policy: Encouraging foreign investment in the country can increase the inflow of capital and boost production capacity and competitiveness in high-value industries reducing the trade deficit.

Fiscal policies: Encouraging savings and reducing government spending can improve a country’s current account balance and reduce the trade deficit.

Industrial policy: The government can promote and support domestic industries, making them more competitive and reducing the trade deficit.

Innovation policy: Encouraging innovation and research and development can improve a country’s competitiveness and reduce the trade deficit.

Question 109

The United Kingdom (UK) has been facing challenges in terms of its international competitiveness in recent years.

Answer 109

Brexit: The UK’s exit from the European Union has resulted in increased uncertainty and trade barriers, affecting the competitiveness of UK businesses.

Skilled labor shortage: The UK is facing a shortage of skilled workers in certain sectors, which can make it difficult for businesses to remain competitive.

Productivity gap: The UK’s productivity lags behind other developed economies, making it less competitive in the international market.

High levels of debt: High levels of household and government debt can reduce consumer spending and investment, affecting the competitiveness of the UK economy.

Infrastructure: The UK’s outdated infrastructure can make it difficult for businesses to remain competitive, especially in comparison to other developed economies.

Question 110

The Phillips Curve shows a trade-off between inflation and unemployment. A demand-side policy to reduce unemployment could conflict with price stability

Answer 110

• As the rate of unemployment falls, labour shortages may cause an increase in wage inflation and higher unit labour costs
• When an economy is booming, so does the derived demand for and prices of components and raw materials – leading to higher costs
• Rising demand and falling unemployment can lead to suppliers raising their prices to increase their profit margins

Question 111

rapid economic growth

Answer 111

POSITIVE EFFECTS
- Increased income: Rapid economic growth often leads to higher wages and increased consumer spending, which can improve the standard of living for individuals and families.
- Job creation: Economic growth often results in new job opportunities, which can reduce unemployment and increase consumer confidence.
- Improved infrastructure: Rapid economic growth can lead to increased government spending on infrastructure, such as roads, airports, and communication networks.

NEGATIVE EFFECTS
- Environmental degradation: The pursuit of economic growth can result in increased pollution, deforestation, and other environmental degradation.
- Income inequality: Rapid economic growth may benefit some individuals and companies more than others, leading to increased income inequality.
- Overheating: Rapid economic growth can lead to inflation and overheating of the economy, which can cause a downturn in the future.

Question 112

Policies to Improve Growth and the Trade Balance

Answer 112

Supply-Side Policies
- Reforms to improve labour productivity
- Incentives to boost research & development & innovation
- Measures to increase investment in export sectors

Exchange Rate Depreciation
- A depreciation of the currency (in theory) makes exports more price competitive and imports are more expensive
- But the effects are dependent on price elasticity of demand

Effective Macro Economic Policies
- Monetary policy to help keep inflation low relative to the inflation of major trading competitors
- Infrastructural investment to increase export competitiveness

Question 113

Possible Conflicts between Macro Policies

Answer 113

1. Policies designed to meet environmental goals might damage the competitiveness of domestic businesses in international markets. E.g. A carbon tax or a minimum price on C02 emission permit
2. Measures to reduce inequality such as higher top rate income taxes or increased VAT on luxury consumer products may have consequences for inflation, trade and jobs
3. Expansionary fiscal policies involving higher government borrowing that have the effect – in the medium term – of driving inflation and interest rates higher (this is known as crowding out)
4. The effects of changes in interest rates on the distribution of income e.g. the effects on millions of savers of the period of exceptionally low interest rates in the UK over recent years

Question 114

Short-run Philips Curve

Answer 114

This curve shows the basic trade-off between unemployment and inflation. The basic correlation is that when inflation is high, unemployment is low. It is a negative correlation. An example of how this works is that when there is greater demand in the economy there will be less unemployment as labour is a derived demand. However, at the same time, the extra demand will result in some demand-pull inflation occurring.

It was initially considered to be correct until it was disproven. It misses out on one vital factor which is the expected rate of inflation. This is remedied in the Long-Run Phillips Curve diagram.

Question 115

Monetary policy is mainly used as a demand-side policy.

Answer 115

• Monetary policy is the use of interest rates and money supply to achieve macroeconomic objectives such as economic growth and inflation.’
• This means that its use influences the spending/aggregate demand level. In reality, it is used all the time to avoid a big boom-bust cycle.

Question 116

Expansionary Monetary Policy:

Answer 116

If the interest rate is lowered this will tend to increase the level of spending and thus, aggregate demand. Why? Because with a lower rate of interest there is less incentive to save, more incentive for consumers to borrow (mortgages, loans and credit cards) and more incentive for firms to borrow (capital investment).

Question 117

Contractionary Monetary Policy:

Answer 117

If the interest rate is increased, this will disincentivise spending. This is because there is a greater reward for saving and an increase cost of borrowing.

Question 118

HOW DO WE CONTROL THE MONEY SUPPLY?

Answer 118

The central bank also has control over the supply of money in the economy. When they want to try and make the economy grow they can inject more money into the economy by raising the money supply. This is called quantitative easing.
It involves the creation of new money which the central bank then uses to buy financial assets such as bonds from commercial banks. Commercial banks then get hold of this money and this is how it enters the circular flow of income. The central bank can also take its money back from commercial banks by selling its financial assets. Once the central bank receives the money back, the money is then destroyed.

Answer 119

• They argue that any manipulation of aggregate demand should be via monetary policy, and focused on keeping inflation to the target rate, and not on other macroeconomic objectives. They do not believe that demand side-policies can make any difference to growth or employment in the long run; instead, it produces only short-term gains in output and employment, but at the cost of higher inflation. They believe economies will return to full employment quickly if the appropriate supply-side policies are being followed_._
• Keynesian economists believe that demand-side policies have an essential role in maintaining growth and employment. They point out that governments throughout the developed world gave massive fiscal and monetary expansionary boosts to their economies after the banking crisis. Without this, they argue that recovery from the recession could have taken many years longer, with high unemployment and a large negative output gap. They also point out that in the 1930s, the Great Depression ended sooner in the USA and Germany, as a result of big increases in government spending, compared to Britain, where the government was more concerned to keep a balanced budget.

Question 120

What is meant by an expansionary fiscal policy?

Answer 120

An expansionary fiscal policy involves the government aiming to increase aggregate demand – through deliberately increasing real government spending and/or lowering direct and indirect taxes, which is financed by an increase in the size of the budget (fiscal) deficit.

The main aim of an expansionary fiscal policy is usually to stimulate real output and employment and perhaps reduce the risk of a persistent deflationary recession. The impact takes time to feed through the circular flow – but the time lags are also variable – contrast higher welfare payments with long-term infrastructure spending.

Question 121

Evaluating the Arguments for a Low Tax Economy

Answer 121

• Those in favor of a low tax economy claim that it boosts economic growth. When the government imposes low taxes on businesses, they have more money to invest in their operations. This, in turn, leads to increased production and job creation, which ultimately boosts the economy.
  When the government imposes low taxes on investments, more people are willing to invest their money, knowing that they will pay fewer taxes. This, in turn, leads to more capital accumulation, which ultimately boosts economic growth.
• Additionally, when people have more disposable income, they are more likely to save or invest, which can lead to long-term economic growth.
• low taxes can lead to a decrease in government revenue, which can make it difficult for the government to fund important programs like education and healthcare.
• Taxes are needed to fund high quality public services

Question 122

contractionary fiscal policy

Answer 122

involves reducing government spending and/or increasing taxes to slow down economic growth. This type of policy is used during times of inflation or high economic growth.