Theme 2 - The UK Economy, Performance and Policies Flashcards
Economic growth
The rate of change of output, so an increase in the long term
productive potential of the country, meaning there is an increase in the amount of goods and services that a country produces
Gross Domestic Product
The total value of goods and services produced in a country within a year
Total Gross Domestic Product
The combined monetary value of all goods and services produced within a country’s borders during a specific time period
Gross Domestic Product per capita
The value of total gross domestic product divided by the population of the country
Real Gross Domestic Product
The value of gross domestic product adjusted for inflation
Nominal Gross Domestic Product
The value of gross domestic product without being adjusted for inflation
Gross National Income
The value of goods and services produced by a country over a period of time plus net overseas interest payments and dividends
Gross National Product
The value of goods and services over a period of time through labour or property supplied by citizens of a country both domestically and overseas
Purchasing Power Parity
An exchange rate of one currency for another, which compares how much a typical basket of goods in the country costs compared to one in another country
Problems of using Gross Domestic Product to compare standards of living
- Inaccuracy of data
- Inequalities
- Quality of goods and services
- Comparing different currencies
- Spending
Gross National Happiness
A measure of economic and social progress that prioritizes well-being and quality of life over GDP, considering factors like psychological well-being, health, education, and environmental sustainability
Inflation
A sustained increase in the general price level of goods and services in an economy over time
Deflation
A sustained decrease in the general price level of goods and services in an economy over time
Disinflation
A decrease in the rate of inflation, meaning prices are still rising but at a slower pace than before
Consumer Price Index
A measure of inflation that tracks the average change in the prices of a basket of goods and services commonly purchased by households over time
Limitations of the Consumer Price Index
- Not totally representative as different households spend different amounts on each good
- Does not include the price of housing
- Difficult to make comparisons with historical data. It was only used since 1996
Retail Price Index
A measure of inflation that tracks changes in the cost of a fixed basket of goods and services, including housing costs such as mortgage interest payments
Demand pull inflation
Inflation caused by excessive aggregate demand exceeding aggregate supply, leading to rising prices
Cost push inflation
Inflation caused by rising production costs like wages or raw materials, which lead firms to increase prices to maintain profitability
Growth of money supply as a cause of inflation
Inflation occurs when the money supply increases faster than the economy’s ability to produce goods and services, leading to higher demand and rising prices
Effects of inflation on consumers
- If people’s incomes do not rise with inflation then they will have less to spend , which could cause a fall in living standards
- Those who are in debt will be able to pay it off at a price which is of cheaper value, but those who are owed money lose because the money they get back is of cheaper value
Effects of inflation on firms
- If inflation in Britain is higher than other countries, British goods will be more expensive making them less competitive and making them more difficult to export, which will also affect the balance of payments
- Deflation isn’t good as it encourages people to postpone their purchases as they wait for the price to fall further
- Workers might demand higher wages, which could increase the costs of production for firms
Effects of inflation on governments
- If the government fails to change excise taxes in line with inflation then real government revenue will fall
- The government will have to increase the value of the state pension and welfare payments because the cost of living is increasing
Effects of inflation on workers
- Real incomes fall with inflation, so workers will have less disposable income
- Deflation could cause some staff to lose their jobs as there is a lack of demand meaning firms see a fall in profit and have to decrease staff to cut costs
Unemployment
Those of working age who are without work, able to work and
seeking work and have actively sought work in the last 4 weeks and are available to start work in the next 2 weeks
Measures of unemployment
- Claimant count
- Labour Force Survey
Claimant count
The number of people receiving benefits for being unemployed, such as Job Seeker’s Allowance
Labour force survey
A survey conducted to measure unemployment by assessing the number of people actively seeking work and available to start within two weeks
Inactive
Those who are neither employed nor unemployed; they are people of working age not seeking employment as well as those seeking employment but not able to start work e.g. those in study and those who do not want or need a job
Underemployment
A situation where workers are employed but in jobs that do not fully utilise their skills, qualifications or available working hours
Types of unemployment
- Structural unemployment
- Frictional unemployment
- Seasonal unemployment
- Cyclical unemployment
- Real wage inflexibility
Structural unemployment
Long-term unemployment caused by changes in the economy, such as technological advancements or industry decline, leading to a mismatch between workers’ skills and available jobs
Frictional unemployment
Short-term unemployment that occurs when workers are between jobs or entering the workforce, often due to job search time and career transitions
Seasonal unemployment
Unemployment that occurs due to predictable changes in demand for labor at different times of the year, affecting industries like tourism, agriculture, and retail
Cyclical unemployment
Unemployment caused by a lack of demand during economic downturns, where businesses reduce output and lay off workers
Real wage inflexibility
Unemployment caused when wages are kept above the market equilibrium (e.g., due to minimum wages or trade unions), leading to excess supply of labor and job shortages
Geographical mobility
The ability of workers to move between different locations to find employment, including factors like housing costs, family ties and regional economic conditions
Occupational mobility
The ability of workers to change jobs or industries based on their skills, training, and qualifications, which can be limited by factors like education requirements and industry-specific expertise
Impacts of unemployment on workers
- Those who are made unemployed normally have a loss of income which usually results in a decline in their living standards
- The long-term unemployed (those unemployed for more than 12 months) often find it more difficult to get another job as they lose skills
- Those who are in jobs will suffer from lower job security and will fear being made redundant
Impact of unemployment on firms
- If disposable incomes decrease there will be a decrease in demand for their goods
- Long term unemployment can lead to loss of skills and reduce employability of workers, so firms have a smaller pool of skilled people to employ
- They can offer low wages as people will take the job anyway because they know there is a lack of jobs so have few options
Impact of unemployment on consumers
- Consumers in areas of high unemployment lose out because local shopping centres tend to be run down and don’t offer the range of shops available to those in areas of low unemployment so they suffer from less choice
- Firms may lower prices and put on sales in order to increase demand for their product
Impact of unemployment on the government
- Reduced income will result in a fall in tax revenues and higher spending on welfare payments for families with people out of work, incurring an opportunity cost as the money could be better spent elsewhere
- Will result in an increase in the budget deficit likely causing the government to raise taxation or scale back plans for public spending on public and merit goods, such as the NHS or education
Balance of payments
Record of all financial dealings over a period of time between economic agents of one country and all other countries
Imports
Goods and services purchased from foreign countries, leading to an outflow of money from the domestic economy
Exports
Goods and services sold to foreign countries, generating an inflow of money into the domestic economy
Components of the balance of payments
- Current account
- Capital account
- Financial account
Current account
Records trade in goods and services, primary income (e.g., investment income), and secondary income (e.g., foreign aid, remittances)
Capital account
Records transfers of assets, such as debt forgiveness and migrant asset transfers
Financial account
Records investment flows, including foreign direct investment, portfolio investment, and reserve assets
Current account surplus
When a country’s total exports of goods, services, and income receipts exceed its total imports and income payments, leading to a net inflow of money into the economy
Current account deficit
When a country’s total imports of goods, services, and income payments exceed its total exports and income receipts, leading to a net outflow of money from the economy
UK government’s macroeconomic objectives
- Low unemployment
- Low and stable inflation
- Sustainable economic growth
- Balance of payment equilibrium, including current account balance
Aggregate Demand
The total demand for goods and services in an economy at a given price level over a period of time
Formula for Aggregate Demand
AD = C + I + G + (X - M)
Components of Aggregate Demand
- Consumption
- Investment
- Government spending
- Net exports
Axis for an Aggregate Demand curve
- Price level (Y-Axis)
- Real Gross Domestic Product (X-Axis)
Income effect
As a rise in prices is not matched straight away by a rise in income, people have lower real incomes so can afford to buy less, leading to a contraction demand
Substitution effect
If prices in the UK rise, less foreigners will want to buy British
exports and more UK residents will want to buy imported foreign goods because they are cheaper. The rise in imports and fall of exports will decrease net exports so Aggregate Demand will contract
Real balance effect
A rise in prices will mean that the amount people have saved
up will no longer be worth as much and so will offer less security. As a result, they will want to save more and so reduce their spending, causing a contraction in Aggregate Demand
Interest rate effect
Rising prices mean firms have to pay their workers more and so
there is higher demand for money. If supply stays the same, then the ‘price of money’ i.e. interest rates will rise because of this higher demand. Higher interest rates mean that more people will save and less will borrow and will also mean that businesses invest less, so Aggregate Demand will contract
Disposable income
The amount of income left for individuals or households after paying taxes and receiving government transfers, available for spending or saving, reflecting the real purchasing power of consumers
Marginal Propensity to Consume
The proportion of an additional unit of income that a consumer is likely to spend on goods and services, rather than saving
Formula for Marginal Propensity to Consume
Change in consumption / Change in income
Average Propensity to Consume
The proportion of total income that is spent on consumption
Formula for Average Propensity to Consume
Total consumption / Total income
Marginal Propensity to Save
The proportion of an additional unit of income that a consumer saves rather than spends
Formula for Marginal Propensity to Save
Change in savings / Change in income
Average Propensity to Save
The proportion of total income that is saved rather than consumed
Formula for Average Propensity to Save
Total savings / Total income
Influences on consumer spending
- Interest rates
- Consumer confidence
- Wealth effects
- Distribution of income
- Tastes and attitudes
Gross investment
The total amount spent on new capital goods, such as machinery, buildings, and equipment, in a given period, without accounting for depreciation
Net investment
The total amount spent on new capital goods, after accounting for depreciation
Formula for net investment
Gross investment - Depreciation
Influences on investment
- Rate of economic growth
- Business expectations and confidence (Animal spirits)
- Demand for exports
- Interest rates
- Influence of government and regulations
- Access to credit
- Technological change
- Costs
Influences on government expenditure
- The trade cycle
- Fiscal policy
- Age distribution of the population
How the trade cycle influences government expenditure
In a recession, the government may increase spending in order to increase demand to reduce unemployment. Government spending also automatically rises during a recession as they have to spend more on unemployment benefits. During booms, the government may decrease spending to decrease demand and reduce inflation
How fiscal policy influences government expenditure
Fiscal policy is the decisions about government spending and taxes and it will depend on the priorities of the government. The level of government spending depends on what they lay out in
their fiscal policy
How age distribution of the population influences government expenditure
An ageing population leads to increased government expenditure on pensions, social care etc. whilst a young population leads to increased spending on education. The more dependents in the economy (the young and old), the higher government spending tends to be
Net trade
The difference between a country’s exports and imports, so if exports exceed imports there is a trade surplus but if imports exceed exports there is a trade deficit
Formula for net trade
Exports - Imports
Influences on net trade balance
- Real income
- Exchange rates
- State of the world economy
- Degree of protectionism
- Non-price factors
- Prices
How real income influences net trade balance
When real income in the UK is high, there tends to be increased
imports as people demand more goods and services and the UK is unable to meet their needs. This will mean that net trade decreases. However, if an increase in real income is due to export-led growth then net trade will increase
How exchange rates influence net trade balance
A strong pound makes imports cheap and exports dear because it costs foreigners more to buy pounds with their local currency. As a result, imports will increase and exports will decrease so net trade will decrease, but this depends on the elasticity of imports and exports
How the state of the world economy influences net trade balance
If the UK’s main export country is doing well, then UK exports are likely to rise and so net trade is likely to rise
How the degree of protectionism influences net trade balance
If there is high protectionism on UK exports in other countries, exports will decrease as it will be harder for UK firms to sell their goods in other countries. If there is high protectionism on imports into the UK, imports will decrease. If the UK imposes protectionist measures, other countries are likely to retaliate and therefore exports are likely to decrease
How non-price factors influence net trade balance
Two non-price factors which affect net trade are quality and
design and marketing. If UK goods are of a higher quality and design, exports will be high as foreign demand for UK goods will increase and imports will decrease as people will buy the British goods instead of foreign goods, meaning net trade will increase
How prices influence net trade balance
High prices of UK goods will mean that the goods are less competitive compared to international goods since people make decisions partly based on price. This means the volume of exports will decrease and the volume of imports will increase
Aggregate supply
The total quantity of goods and services that firms in an economy are willing and able to produce at a given price level over a period of time
Short run
A period in which at least one factor of production is fixed, meaning firms can adjust output by changing variable inputs (e.g., labor) but cannot expand capacity (e.g., capital or land)
Long run
A period in which all factors of production are variable, allowing firms to adjust capacity, invest in capital, and respond fully to changes in market conditions
Factors influencing short run aggregate supply
- Changes in costs of raw materials and energy
- Changes in exchange rates
- Changes in tax rates
How changes in costs of raw materials influence short run aggregate supply
An increase in the cost of raw materials and energy increases the cost of production. This means the SRAS curve will shift left as it will cost more to make the same amount of goods and therefore
businesses will only produce this amount of goods if prices rise
How changes in exchange rates influence short run aggregate supply
A weaker pound will lead to an increase in the price of imports and this will cause SRAS to decrease as production becomes more expensive. If the pound becomes stronger, imports will be cheaper and so SRAS will increase
How changes in tax rates influence short run aggregate supply
Taxes increase the cost of production and thus they cause a fall in SRAS, shifting it to the left. Subsidies shift it the curve right as they decrease costs
The two types of long run aggregate supply curve
- Classical
- Keynesian
Factors influencing long run aggregate supply
- Technological advances
- Changes in relative productivity
- Changes in education and skills
- Changes in government regulations
- Demographic changes and migration
- Competition policy
How technological advances influence long run aggregate supply
Improvements in technology shift the LRAS curve to the right, meaning more can be produced. This is because it will speed up
production, so more goods can be produced with the same amount of resources
How changes in relative productivity influence long run aggregate supply
The more productive the economy is, the more that will be produced with the given resources. Productivity depends on a range of factors, such as efficiency, skill of labour and technology. Additionally, if the UK is more productive than other countries it will encourage production of that good in the UK, so investment will be increased, and this will increase LRAS
How changes in education and skills influence long run aggregate supply
A more skilled workforce will be more employable and work quicker and more efficiently within their jobs, so the output per
worker will increase, which will shift the LRAS to the right. Education could also be used to improve the occupational mobility of labour which decreases structural unemployment as people are able to switch to new jobs
How changes in government regulations influence long run aggregate supply
Government regulations are able to impact LRAS through a number of different ways, such as by increasing the size of the workforce or they could make it easier to set up businesses and increase incentives to be entrepreneurial (i.e. lower corporation tax) which would increase companies, jobs and output so increase LRAS.
How demographic changes and migration influence long run aggregate supply
If immigration is higher than emigration, the population will grow and so therefore there will be more workers which will increase the LRAS
How competition policy influences long run aggregate supply
The government can promote competition between businesses and markets which will force them to improve the quality of their goods or lower prices. In order for businesses to do this and still make a profit, they have to improve their efficiency and this efficiency will mean that more goods and services can be produced, so LRAS will increase
Circular flow of income
A model that illustrates how money, goods, and services move between households and firms in an economy
Households in the circular flow of income
Households provide factors of production (labor, land, capital) to firms and receive income (wages, rent, profit)
Firms in the circular flow of income
Firms produce goods and services, which households buy, creating expenditure
Income
The money received by individuals, households, or businesses from various sources, such as wages, rent, interest, and profits, over a period of time, meaning it is a flow concept
Wealth
The total value of an individual’s or economy’s assets, including property, savings, investments, and other valuables, minus any liabilities (debts), meaning it is a stock concept
Injections
Additional spending that enters the circular flow of income, increasing aggregate demand, which includes investment, government spending and exports
Withdrawals
Money that leaves the circular flow of income, reducing aggregate demand, which includes savings, taxes and imports
Multiplier process
Idea that an increase in AD because of an increased injection (exports, government spending or investment) can lead to a further increase in national income
Multiplier ratio
The factor by which a change in an injection (investment, government spending, or exports) leads to a larger change in national income
Marginal Propensity to Tax
The proportion of an additional unit of income that is paid as tax
Formula for Marginal Propensity to Tax
Change in taxes / Change in income
Marginal Propensity to Import
The proportion of an additional unit of income that is spent on imports
Formula for Marginal Propensity to Import
Change in imports / Change in income
Formula for the multiplier
- 1 / 1 - Marginal Propensity to Consume
- 1 / Marginal Propensity to Withdraw (Marginal Propensity to Save + Marginal Propensity to Tax + Marginal Propensity to Import)
Economic growth
An increase in the real output of goods and services in an economy over time, measured by the rise in real GDP
Causes of economic growth
There needs to be an increase in quality or quantity of one of the four factors of production, land, labour, capital or enterprise or these being used more efficiently
Land as a cause of economic growth
The discovery of new resources e.g. oil will increase economic growth
Labour as a cause of economic growth
An increase in the quality or quantity of labour will improve economic growth, such as through a larger workforce or higher skilled workers making them more efficient
Capital as a cause of economic growth
If a country receives sustained investment, they will be able to access or develop new technology which will enable the country to improve productivity. It will also mean more machines can be bought and used, even if these are not a technological advancement, so more goods can be produced
Enterprise as a cause of economic growth
If the government offers tax benefits and grants, they will encourage the development of business, creating jobs and meaning more goods and services are produced, which will increase economic growth
Technological progress as a cause of economic growth
Improved technologies mean that the average cost of production is lower, whether this is because it is quicker to produce or less labour or equipment is needed
Efficiency as a cause of economic growth
Efficiency is important in bringing about economic growth as it means less resources are needed to produce each good, so more goods can be produced
Actual growth
The percentage change in GDP, which is when the economy has actually produced more goods and services, reflecting short-term economic expansion within an economy’s current capacity
Potential growth
The increase in an economy’s productive capacity over time, leading to a higher long-term sustainable output level, represented by an outward shift of the long-run aggregate supply curve or the production possibility frontier
Actual growth rates
The actual change (i.e. the change in real GDP) over time and its changes are what make up the business cycle
Long-term trends in growth rates
The average sustainable rate of economic growth over a period of time
Output gap
The difference between an economy’s actual output (real GDP) and its potential output (full capacity GDP)
Positive output gap
When actual Gross Domestic Product is above potential Gross Domestic Product, meaning the economy is producing beyond its sustainable capacity
Negative output gap
When actual Gross Domestic Product is below potential Gross Domestic Product, meaning the economy is underperforming with unused resources
Trade cycle
The recurring fluctuations in economic activity over time, characterized by periods of expansion and contraction in real GDP
Phases of the trade cycle
- Boom
- Recession
- Slump
- Recovery
Characteristics of a boom
High economic growth, low unemployment, rising inflation, strong consumer and business confidence
Characteristics of a recession
Two consecutive quarters of negative GDP growth, rising unemployment, falling demand and lower inflation
Characteristics of a slump
Severe and prolonged economic decline with high unemployment and low confidence
Characteristics of a recovery
Gross Domestic Product starts to rise, employment increases and confidence improves, leading back to expansion
Benefits of economic growth on consumers
- The average consumer income increases as more people are in employment and wages increase
- Consumers feel more confident in the economy, which increases consumption and leads to higher living standards
- Improved productive efficiency due to better technology could lead to lower prices or higher quality goods
Drawbacks of economic growth on consumers
- Economic growth does not benefit everyone equally. Those on low and fixed incomes might feel worse off if there is high inflation and inequality could increase
- Consumers could face more shoe leather costs, which means they have to spend more time and effort finding the best deal while prices are rising
- The benefits of more consumption might not last after the first few units, due to the law of diminishing returns
Benefits of economic growth on firms
- Investment will increase since businesses are more successful. They will have more money to invest and more incentive to invest as they will know they can make money from their investments
- Business confidence will improve as there are potential demand increases for businesses’ products and this confidence will also lead to increased investment
- There will be more research and development done to invent more technology and more firms will be able to have the best technology, which is likely to increase productive efficiency and lead to lower costs
Drawbacks of economic growth on firms
- Firms could face more menu costs as a result of higher inflation. This means they have to keep changing their prices to meet inflation
- Firms who sell inferior goods (with negative income elasticities)
may lose out - Changing technologies and globalisation also mean that some firms find their markets disappearing e.g. DVD rental stores
Benefits of economic growth on the government
- Tax revenues will rise as more goods and services are being bought, more income is being earnt and more profits being made. This means the government has more money to put into the NHS, education, benefits etc.; the quality of these systems will be improved, and this will help to improve living standards
- Can help to reduce the budget deficit, perhaps even bringing about a budget surplus which would allow money to be saved for future recessions
Drawbacks of economic growth on the government
- Governments might have to increase their spending on healthcare if the consumption of demerit goods increases
- Economic growth tends to mean people expect more from the
government, which may cause conflict
Benefits of economic growth on current and future living standards
- Economic growth will result in lower poverty levels . An increase in the production of goods and services will increase jobs so there will be less unemployment and less people on benefits. Wages are also likely to increase
- Housing standards and the quality of food increases due to economic growth
- Increased government spending will lead to improved living standards both now and in the future, as better educated people usually have higher living standards
Drawbacks of economic growth on current and future living standards
- High levels of growth could lead to damage to the environment in the long run, due to increase negative externalities from the consumption and production of some goods and services
- Economic growth may result in increased inequalities between rich and poor. The rich may be the only ones that have gained from the economic growth and they may even lower the living standards of the poor by exploiting the poor
Possible macroeconomic objectives
- Economic growth
- Low unemployment
- Low and stable inflation
- Balance of payment equilibrium on the current account
- Balance government budget
- Protection of the environment
- Greater income equality
Demand-side policies
Government policies aimed at influencing aggregate demand to achieve macroeconomic objectives like growth, low unemployment, and stable inflation
Expansionary policy
A demand-side policy used to boost aggregate demand and stimulate economic growth, typically during a recession or negative output gap
Contractionary policy
A demand-side policy used to reduce aggregate demand and control inflation, typically during a boom or positive output gap
Monetary policy
The use of interest rates, money supply, and exchange rates by a central bank (e.g., the Bank of England) to influence aggregate demand and achieve macroeconomic objectives
Fiscal policy
The use of government spending and taxation to influence aggregate demand and achieve macroeconomic objectives like economic growth, low unemployment, and price stability
Expansionary monetary policy
- Lower interest rates, encourages borrowing and spending
- Increase money supply, more liquidity in the economy
- Weaker exchange rate, boosts exports and reduces imports
Contractionary monetary policy
- Raise interest rates, discourages borrowing and spending
- Reduce money supply, limits excess liquidity
- Stronger exchange rate, reduces inflation but makes exports less competitive
Expansionary fiscal policy
- Increase government spending on infrastructure, healthcare, and education
- Cut taxes to raise disposable income and encourage consumption and investment
Contractionary fiscal policy
- Decrease government spending, to cool down an overheating economy
- Increase taxes, to reduce disposable income and limit inflation
Limitations of monetary policy
- Liquidity trap, if interest rates are already very low, further cuts may not encourage borrowing or spending
- Time Lags, changes in interest rates take 12-24 months to fully impact the economy
- Interest rate insensitivity, consumers and businesses may not respond to lower rates if confidence is low (e.g., during a recession)
- Conflict with other policies, fiscal policy (government spending & taxation) may counteract monetary policy effects (e.g., government austerity could limit Aggregate Demand growth despite low interest rates)
Limitations of fiscal policy
- Budget deficits and national debt, expansionary fiscal policy (higher spending or tax cuts) can lead to higher government debt, which may require future tax increases or spending cuts
- Inflationary pressure, excessive government spending can cause demand-pull inflation, reducing purchasing power
- Political constraints, governments may make decisions based on political popularity rather than economic necessity (e.g., avoiding tax increases before elections)
- Effectiveness depends on multiplier, if the fiscal multiplier is low (e.g., due to high imports or low confidence), the impact of fiscal policy may be weaker than expected
Quantitative Easing
A form of expansionary monetary policy where a central bank (e.g., the Bank of England) creates new money electronically to buy financial assets, such as government and corporate bonds
Positive effects of Quantitative Easing
- Lower Interest Rates, Quantitative Easing increases the money supply, reducing interest rates and making borrowing cheaper for consumers and businesses
- Weaker exchange rate, more money in the economy can depreciate the currency, making exports more competitive
- Higher asset prices, Quantitative Easing raises demand for financial assets (e.g., bonds, stocks), increasing their prices and creating a wealth effect that encourages spending
Negative effects of Quantitative Easing
- Inflation risk, excessive Quantitative Easing can overstimulate demand, leading to demand-pull inflation
- Inequality, wealthier individuals benefit more from rising asset prices, increasing income inequality
- Asset bubbles, Quantitative Easing boosts financial markets, potentially leading to overvaluation of assets (e.g., stocks, real estate)
Budget surplus
When government revenue (taxes) exceeds government spending over a specific period, leading to a positive fiscal balance
Budget deficit
When government spending exceeds government revenue (taxes) over a specific period, leading to increased borrowing
Direct taxes
Taxes levied directly on individuals or businesses based on income, profits, or wealth, such as income tax, corporation tax, and inheritance tax
Indirect taxes
Taxes levied on goods and services, such as VAT, excise duties, and sales tax, which are paid by consumers through higher prices
Great Depression
In the 1930s, the world experienced a severe depression known as the Great Depression, in the UK unemployment was over 15% and in the US it was almost 25%. The areas most affected in the UK were the primary industry and the manufacturing industry which relied on exports and so were impacted by the collapse of world trade
Causes of the Great Depression
- Stock market crash (1929), a major collapse in share prices led to panic selling and a loss of wealth and confidence
- Bank failures, many banks collapsed due to loan defaults, reducing money supply and causing a credit crunch
- Protectionism and trade barriers, policies like the Smoot-Hawley Tariff (1930) reduced international trade, worsening the downturn
Policy responses to the Great Depression in the UK
- Abandoning the Gold Standard (1931), the UK left the gold standard, allowing the pound to depreciate, making exports more competitive and boosting economic growth
- Fiscal austerity, the government cut public sector wages and unemployment benefits to reduce the budget deficit, but this worsened unemployment in the short run
- Interest rate cuts, the Bank of England lowered interest rates to 2%, reducing borrowing costs and encouraging investment
Policy responses to the Great Depression in the USA
- The New Deal, introduced by President Franklin D. Roosevelt, the New Deal aimed to provide relief, recovery, and reform through government intervention
- Monetary policy, the US left the gold standard, allowing the dollar to depreciate, making exports more competitive and increasing the money supply
Global Financial Crisis
A severe worldwide economic crisis triggered by the collapse of the US housing market and banking system, leading to a credit crunch, recession, and government bailouts
Causes of the Global Financial Crisis
- Subprime mortgage collapse, banks issued high-risk subprime loans in the US, leading to massive defaults
- Housing market bubble, easy credit and speculation caused housing prices to soar, followed by a sharp crash
- Bank failures and credit crunch, major banks collapsed (e.g., Lehman Brothers, 2008), leading to a loss of confidence and reduced lending
Policy responses to the Global Financial Crisis in the UK and the USA
- Both governments were forced to nationalise banks and building societies and guarantee savers their money in order to prevent the chaos of a collapsed banking system. For example, the British government bought Northern Rock and most of Royal Bank of Scotland and Lloyds Bank
- They used expansionary monetary policies with record low interest rates and quantitative easing. The Bank of England said the QE led to lower unemployment and higher growth than would otherwise have been the case
Supply-side policies
Policies aimed at increasing the productive capacity of the economy by improving efficiency, competition, and incentives in markets. These policies shift the long-run aggregate supply (LRAS) curve to the right, leading to sustainable economic growth
Market based policies
Policies that aim to increase efficiency and economic growth by reducing government intervention and allowing free market forces to operate more effectively
Interventionist policies
Policies where the government actively intervenes in the economy to improve productivity, infrastructure, and human capital, leading to long-term economic growth
Examples of market based policies
- Increase incentives, reducing income and corporation tax to encourage spending and investment and/or reducing benefits to increase the opportunity cost of being out of work
- Promote competition, privatisation (selling nationalised companies to private sectors) or deregulation (reducing restriction on businesses which restrict entry to the market) makes firms
more competitive - Reform the labour market, reducing trade union power makes employing workers less restrictive and it increases the mobility of labour, making the labour market more efficient
Interventionist policies
- Promote competition, a stricter government competition policy could help reduce the monopoly power of some firms and ensure smaller firms can compete
- Reform the labour market, governments could try and improve the geographical mobility of labour by subsidising the relocation of workers and improving the availability of job vacancy information
- Improve skills and quality of the labour force, the government could subsidise training, lowering costs for firms, since they will have to train fewer workers or spend more on healthcare to help improve the quality of the labour force and contributes towards higher productivity
- Improve infrastructure, governments could spend more on infrastructure, such as improving roads and schools
Strengths of of supply-side policies
- Unlike demand-side policies, supply side policies are able to both increase output and decrease prices
- More long-term policies and lead to long term economic growth, rather than small changes in economic growth following changes in Aggregate Demand
- Can be directed at increasing exports which will also improve the balance of payments
Weaknesses of supply-side policies
- The Keynesian Long Run Aggregate Supply curve shows that they have no impact when Long Run Aggregate Supply is elastic, and so demand-side policies are needed to fix the problem in the short run
- Not all supply side policies work at actually increasing supply, whilst others cause conflicts and both these issues vary depending on which policies are used
- Often the government has to spend more money (for example on education) or decrease taxes, which will decrease their revenue and lead to a budget deficit
Conflicts and trade-offs between objectives
- Economic growth vs. Protection of the environment
- Economic growth vs. Balance of Payments
- Unemployment vs Inflation
Conflicts and trade-offs between economic growth and protection of the environment
As the economy grows, we expect more resources to be used. As we use resources and produce goods, we produce pollution and noise and destroy habitats. Economic growth in China has been rapid but it has led to serious levels of pollution
Conflicts and trade-offs between economic growth and Balance of Payments
Some countries such as India have seen rapid economic growth leading to balance of payments problems. The country is so large that its industry is largely producing goods for its own people and the wealth of the people has led to increased demand for imported goods
Conflicts and trade-offs between unemployment and inflation
In the short run, there is a trade-off between the level of unemployment and the inflation rate, illustrated with a Phillips curve. As economic growth increases, unemployment falls due to more jobs being created. However, this causes wages to increase, which can lead to more consumer spending and an increase in the average price level
Conflict and trade-offs between policies
- Expansionary and deflationary fiscal and monetary policies
- Changes in interest rates
- Supply-side policies
- Fiscal deficits
Conflict and trade-offs between expansionary and deflationary fiscal and monetary policies
Expansionary policies will increase AD, to increase output, employment and economic growth but will lead to increased inflation and may worsen the balance of payments as some of the increased demand for goods and services will be met by imports. On the other hand, deflationary policies will decrease AD to improve inflation but will decrease employment and economic
growth
Conflict and trade-offs with changes in interest rates
An increase in interest rates will be used to decrease inflation. However, continuously high rates will damage long-term investment as less businesses will want to invest, and this will decrease long-term growth. Moreover, they will raise the value of the pound which will decrease exports and increase imports, worsening the balance of payments. Whereas, low interest rates tend to increase income inequality, as the richest people hold a
larger proportion of their wealth in non-money assets, such as stocks, shares and belongings and so aren’t affected much by interest rates
Conflict and trade-offs with supply-side policies
Supply side policies intend to increase aggregate supply, and
therefore improve long term economic growth. They are also able to decrease long term inflation but may increase it in the short term if they encourage investment as this will increase Aggregate Demand. Moreover, policies which decrease trade union power, reduce wages, lower benefits, change taxation etc. may increase income inequality as these will negatively affect the poorest in the country
Conflict and trade-offs with fiscal deficits
In order to reduce fiscal deficits, the government may decide to reduce government spending and increase taxes. Firstly, this will reduce Aggregate Demand and decrease short term economic growth and higher unemployment. Also, the higher the fall in output as a result of these measures, the higher the fall in tax revenues will be and so therefore the more ineffective the policy
