Edexcel A Level Economics A

Revision Notes
UNIT 2 – The UK Economy – Performance & Policies
2.1.1 Economic Growth
Economic Growth

Gross Domestic Product (GDP)

• National income accounting measures the economic activity within a country and provides insights
into how a country is performing
• One of the main methods to determine economic activity is to measure the rate of change of
output in an economy
• The output of an economy is called gross domestic product (GDP)
• GDP is the value of all goods/services produced in an economy in a one-year period
• It can be measured using the following approaches
o The expenditure approach: adds up the value of all the expenditure in the economy
▪ This includes consumption, government spending, investment by firms and net
exports (exports - imports)
o The income approach: adds up the rewards for the factors of production used
▪ Wages from labour, rent from land, interest from capital and profit from
entrepreneurship
• Both approaches should provide the same figure as one party's expenditure is another
party's income
• The value of GDP is different to the volume of GDP
o The value is the monetary worth
o The volume is the physical number

The Distinction Between Real, Nominal & Per Capita GDP

• In economics, the use of the word nominal refers to the fact that the metric has not been adjusted
for inflation
• Nominal GDP i s the actual value of all goods/services produced in an economy in a one-
year period
o There has been no adjustment to the amount based on the increase in general price
levels (inflation)
• Real GDP is the value of all goods/services produced in an economy in a one-year period -
and adjusted for inflation
o For example, if nominal GDP is £100bn and inflation is 10% then real GDP is £90bn
• GDP per capita = GDP / the population
o It shows the mean wealth of each citizen in a country
o This makes it easier to compare standards of living between countries:
▪ For example, Switzerland has a much higher GDP/capita than Burundi

When an exam question uses the phrase 'at constant prices' it is referring to real GDP. For example,
a question may read, 'Explain what is meant by a rise in GDP at constant prices'. This requires you
to define real GDP and then explain the rise.

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Gross National Income
• GDP may not be the best metric to measure a country's output or wealth
• GDP measures the value of production within a country's borders
o It does not consider the income earned by its citizens while operating outside of the
country
• Gross national income (GNI) measures the income earned by citizens operating outside of the
country + the GDP
o Many citizens employ their resources outside of a country's borders - and then send the
income home
• Gross national product (GNP) takes it one step further
o GDP + income from abroad - income sent by non-residents to their home countries
• GNP/capita provides a much more realistic view of a country's wealth than GDP/capita

Growth Comparisons Between Countries

• National income statistics are useful for making comparisons between countries
o They provide insights on the effectiveness of government policies
o They allow judgments to be made about the relative wealth and standard of living within
each country
o They allow comparisons to be made over the same or different time periods
▪ For example, the growth of the Asian Economies in the last 15 years can be
compared to the growth of the European Economies in the 1990s
• Using real GDP is a better comparison than nominal GDP
o One country may have a much higher rate of economic growth, but also a much higher rate
of inflation. Real GDP provides a better comparison
• Using real GDP/Capita provides better information than real GDP as it takes population
differences into account
• Using real GNI/capita is a more realistic metric for analysing the income available per person
than GDP/capita
• Using real GNP/capita provides information on the income that is actually within a country's
borders
o This value can be significantly different from GDP/Capita

When studying national income data that has been provided for data response questions, you will
often see a generalised pattern emerge
• Developed countries will have a smaller gap between their GNP and GDP
• Developing countries often have a higher GDP than GNP - as much as 6%
The reason for this is usually linked to multinational companies involved in resource extraction,
who then send income/profits home

Purchasing Power Parities (PPP)

• Purchasing power parity (PPP) is a conversion factor that can be applied to GDP, GNI and GNP
• It calculates the relative purchasing power of different currencies
o It shows the number of units of a country's currency that are required to buy a product in
the local economy, as $1 would buy of the same product in the USA
• The aim of PPP is to help make a more accurate standard of living comparison between
countries where goods/services cost different amounts
• If a basket of goods cost $150 in Vietnam (once the currency has been converted) and the same
basket of goods cost $450 in the USA, the purchasing power parity would be 1:3
o It seems like the cost of living is much higher in the USA

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 o However, if the USA GNP/capita is more than three times higher than the GNP/capita of
Vietnam, it could be argued the USA has better standards of living
o Conversely, if the GNP/capita in the USA was less than three times that of Vietnam, it
could be argued that Vietnamese citizens enjoy a higher standard of living as they
spend less income to acquire the same goods/services

Limitations of Using GDP for Comparisons

A Table Which Explains the Limitations of Using GDP Data to Compare Living Standards
Between Countries & Over Time
• The distribution of income in an economy is provided as
Lack of information provided an average (GDP/capita)
on inequality • The differences in the standard of living within the same
country can be significant
• GDP provides no information on the increase/decrease in
the quality of goods/services over time
• If quality worsens but prices are lower, then the standard of living is
Quality of goods/services
judged to have increased
• The poor quality may actually have decreased the standard of
living
• If it included voluntary/unpaid work, then GDP/capita would
be higher
Does not include
• E.g. some economies have a high amount of family child care
unpaid/voluntary work
provision. This increases standards of living but is not recorded
in any way
• GDP data does not capture the amount of time taken to produce
the GDP/capita
Differences in hours worked
• In one country, where it takes less time to generate the income than
in a similar country, the standard of living would actually be higher
• GDP does not capture the environmental and health impacts of
generating the income within a country (externalities)
Environmental factors
• In one country, where there are fewer externalities in generating
the income the standard of living would be higher

National Happiness
• National happiness and societal well-being are measured in the UK by the Office for National
Statistics (ONS)
• While GDP focusses on production, happiness focuses on health, relationships, the environment,
education, satisfaction at work and living conditions
• National incomes statistics tend to present more positive data while national happiness surveys
yield more normative data
• There is a link between income and happiness and the Easterlin Paradox is often used to explain it
o Happiness and increases in income have a direct relationship up to a point
o Beyond that point, the relationship is less evident

When studying national income data that has been provided for data response questions, you will
often see a generalised pattern emerge
• Developed countries will have a smaller gap between their GNP and GDP
• Developing countries often have a higher GDP than GNP - as much as 6%
The reason for this is usually linked to multinational companies involved in resource extraction,
who then send income/profits home

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2.1.2 Inflation
Inflation, Deflation & Disinflation
• Inflation is the sustained increase in the average price level of goods/services in an economy
o The average price level is measured by checking the prices of a 'basket' of goods/services
that an average household will purchase each month
o This basket of goods is turned into an index and it is called the consumer price index
(CPI)
o The UK has an inflation target of 2% per annum
▪ Low inflation is better than no inflation as it is a sign of economic growth
• Deflation occurs when there is a fall in the average price level of goods/services in an economy
o Deflation only occurs when the percentage change in prices falls below zero %
• Disinflation occurs when the average price level is still rising, but at a lower rate than before
o These figures demonstrate disinflation: Y1 = 5% Y2 = 4% Y3 = 2%
▪ Inflation is increasing but at a decreasing rate

Worked example
How would you characterise the fall in the CPI from 2018 to 2021? Explain your answer

Step 1: Study the time period and decide if you are witnessing inflation, disinflation or
deflation
Disinflation
Step 2: Explain your answer
According to the CPI data, prices are still rising but at a decreasing rate. For example, in 2018 prices were
rising at around 3%. In 2019 this increase fell to roughly 1.8%. In 2021, they were still rising but by a much
lower 0.5%

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Calculating Inflation Using the Consumer Price Index (CPI)

• Inflation is the sustained increase in the average price level of goods/services in an economy

• The inflation rate is the change in average price levels in a given time period
o The inflation rate is calculated using an index with 100 as the base year
o If the index is 100 in year 1 and 107 in year 2 then the inflation rate is 7%

• The UK uses two inflation indices - the consumer price index (CPI) and the retail price index
(RPI)
o Each is calculated slightly differently

The Consumer Price Index (CPI)

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

• Goods/services in the basket are weighted based on the proportion of household spending
o E.g. More money is spent on food than shoes, so shoes have a lower weight in the basket

• Each month, prices for these goods/services are gathered from 150 locations across the UK
o These prices are averaged out

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

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

Worked example
Using the information in the table, calculate the inflation rate for 2021 if the price of the basket in the base
year (2019) was $400

Good Price 2020 Price 2021 Weight Basket 2020 Basket 2021
(Price x weight) (Price x weight)
Housing, water,
950 1200 34% 323.00 408.00
electricity, gas

Transport 250 325 11% 27.50 35.75

Food 500 620 9% 45.00 55.80

Recreation &
300 340 10% 30.00 34.00
culture

Clothing &
190 210 5% 9.50 10.50
footwear

$435.00 $544.05

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Step 1: Calculate the CPI for 2020

Step 2: Calculate the CPI for 2021

Step 3: Calculate the percentage difference between the CPI for 2021 and 2020

The Limitations of Using the CPI

• The CPI provides a level of inflation for the average basket and the basket of many households is
not the average basket
o Depending on what households buy the level of inflation for each one can vary
significantly
o As an average, it also ignores regional differences in inflation e.g. London inflation may be
much higher than Harrogate inflation
• The CPI is one of several methods used by countries in determining inflation - another is
the retail price index (RPI)
o This can make comparisons between countries less meaningful as one may use the RPI
& another the CPI
• The CPI does not capture the quality of the products in the basket
o Product quality changes over time and so the comparison with different time periods is
less useful
• The CPI only measures changes in consumption on an annual basis
o Changes in consumption can occur more frequently and the index is always behind these
changes
• The CPI is prone to errors in data collection
o It is based on a survey that goes to thousands of households each year, yet it is still a small
sample
o The respondents have no incentive to fill in the survey carefully and accurately

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The Retail Prices Index (RPI)
• The retail price index (RPI) is calculated in exactly the same way as the CPI
o Certain goods/services that are excluded from the CPI are included with the RPI
▪ These include council tax, mortgage interest payments, house depreciation,
and other house purchasing costs such as estate agents fees
• Due to the extra inclusions, inflation measured using the RPI is usually higher than the CPI
o This is mainly due to its sensitivity to interest rate changes which affect mortgage interest
o It's argued that the RPI is a more accurate indication of a households inflation

The Causes of Inflation

• An increase in the average prices in an economy can be caused by demand pull inflation, cost
push inflation, an increase in the money supply, & an increase in wages

Demand Pull Inflation

• Demand pull inflation is caused by excess demand in the economy
• Aggregate demand (AD) is the sum of all expenditure in the economy
o AD = Consumption (C) + Investment (I) + Government spending (G) + Net Exports (X-M)
• Short run aggregate supply (SRAS) is the total supply provided in the economy at a given
average price level

A diagram that shows how an increase in aggregate demand raises the average price level in an
economy

Diagram Analysis
• If any of the four components of AD increase, there will be a shift to the right of the AD curve
from AD1 → AD2
• At the original price (AP1), there is now a condition of excess demand in the economy
• As prices rise, there is a contraction of AD and an extension of SRAS
• Prices for goods/services are bid up from AP1 → AP2
• Demand pull inflation has occurred

Cost Push Inflation

• Cost push inflation is caused by increases in the costs of production in an economy

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 A diagram that shows how an increase in the costs of production raises the average price level in
an economy

Diagram Analysis
• If any of the costs of production increase (labour, raw materials etc.), or if there is a fall
in productivity, there will be a shift to the left of the SRAS curve from SRAS1→SRAS2
• At the original price (AP1), there is now a condition of excess demand in the economy
• As prices rise, there is a contraction of AD and an extension of SRAS
• Prices for goods/services are bid up from AP1→AP2
• Cost push inflation has occurred
Changes to the Money Supply
• If the Central Bank lowers the base rate, there is likely to be increased borrowing by firms and
consumers
o This will result in an increase in consumption and investment
o It is likely to lead to a form of demand-pull inflation
• The Central Bank can also increase the money supply through quantitative easing
o This will result in increased liquidity and lower interest rates
o It is likely to lead to a form of demand-pull inflation

Changes to Wages
• Increased aggregate demand in an economy causes demand-pull inflation
• Workers now feel less well off as their wages no longer have the same purchasing power
• Workers may demand wage increases to compensate for the higher prices
• Those wage increases are now a form of cost push inflation (increased costs of
production) and drive prices even higher
• This economic phenomenon is called a wage-price spiral

The Effects of Inflation

The Impact Of Inflation On Different Stakeholders
Firms Consumers Government Workers

• Uncertainty. Rapid • Decrease in purchasing • Inflation erodes • Demand higher

price changes create power international wages to
uncertainty and delay • Decrease in the real competitiveness of export compensate for
investment value of savings (as industries reduced
• Menu change costs. money will be worth less in • Trade-offs involved in purchasing power
Price changes force real terms) tackling inflation e.g • If wage increases
firms to change their • Fall in real income for reducing inflation may ≠ inflation,
menu prices too and those on fixed increase unemployment motivation &
this can be expensive incomes/pension and/or reduce economic productivity may
growth fall

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2.1.3 Employment & Unemployment

Measures of Unemployment
• Someone is considered to be unemployed if they are not working but actively seeking work
o They are part of the labour force
• A country's population is divided into the labour force - and non labour force
o The labour force consists of all workers actively working and the unemployed (who are
seeking work)
▪ Usually between the ages of 16-65
o The non labour force includes all those not seeking work e.g. stay at home parents,
pensioners, school children
▪ Economically inactive are those people who are between 16-65 and not working or
not seeking work
• Unemployment in the UK is measured using two different approaches
o The International Labour Organisation (ILO) Survey
o The Claimant Count

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

The ILO & UK Labour Force Survey The Claimant Count

• An extensive survey is sent to a random • Counts the number of people claiming job
sample of ≈ 60,000 UK households every seekers allowance (JSA) in the UK
quarter • More stringent requirement to be considered
• Respondents self-determine if they unemployed than with the ILO survey
are unemployed based on the ILO criteria • Requires claimants to meet regularly with
o Ready to work within the next two a 'work coach'
weeks
o Have actively looked for work in the
past one month
• The same survey is used globally so
it's useful for making international
comparisons

The Distinction Between Unemployment & Underemployment

• Unlike the unemployed, people who are underemployed are working
• Someone is underemployed when:
o They want to work more hours than they currently work
o They are working in a job that requires lower skills than they have e.g. an architect
working as a gym instructor
• Underemployment is often a response to cyclical unemployment
o Workers who have lost their jobs in a weak economy are willing to take part-time jobs or
accept roles outside of their main skill base
• Underemployment is also a consequence of structural unemployment
o Unless workers retrain and gain new skills, it will be hard for them to gain full
employment

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The Significance of Changes to Employment, Unemployment & Inactivity Rates
Four Metrics Are Commonly Used When Analysing the Labour Market in an Economy

Unemployment rate Employment rate

Labor force participation rate Inactivity rate

• The employment rate could be increasing even as the unemployment rate is increasing:
o May be caused by increased immigration which causes working age population to
increase
o May be caused by a decrease in the inactivity rate as people move from inactive to
employed
• Unemployment rates do not capture the hidden unemployment that occurs in the long term
o Workers look for a job but may eventually give up and become economically inactive
o This actually improves the unemployment rate as fewer people are actively seeking
work

The Causes of Unemployment

• Structural unemployment occurs when there is a mismatch between jobs and skills in the
economy
o It usually happens as the structure of an economy changes e.g. the secondary sector is
declining and the tertiary sector is growing
o There is no longer a need for a specific type of worker e.g. ship builders in Glasgow
o Many Western industries have relocated production to China causing structural
unemployment in their economies
o Unless workers receive help to retrain, they are often left unemployed or under-employed
• Cyclical or demand deficient unemployment is caused by a fall in AD in an economy
o This typically happens during a slow down or recession
o The demand for labour is a demand derived from the demand for goods/services
o As output falls in the economy, firms lay off workers
• Seasonal unemployment occurs as certain seasons come to an end and labour is not
required until the next season
o E.g. fruit pickers; summer seaside resort workers; ski instructors
• Frictional unemployment occurs when workers are between jobs
o This is usually short-term unemployment
o Workers have voluntarily left their previous job to search for another
• Real wage unemployment occurs when wages are inflexible at a point higher than the free-
market equilibrium wage
o Usually caused by the existence of minimum wage laws
o The higher wage creates an excess supply of labour
o This excess supply represents real wage unemployment

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The Significance of Migration On Employment/Unemployment
• Labour is a key factor of production and one way to expand output in an economy is to increase
the amount of labour available
o This is often achieved through easing the inward migration policies (immigration)
• The UK has experienced significant immigration since the 1990's, especially from Eastern Europe
• Net migration is the difference between inward migration and outward migration (emigration)
o Less developed economies generally have net outward migration
o More developed economies generally have net inward migration
o More developed economies usually have skilled workers emigrating

Significance On Employment
• The immigrants usually fill vacancies that the local citizens cannot (or will not) fill
o These tend to be manual labour, dangerous, and low skilled jobs
• The increased supply of labour may push down wages in the economy, especially for low skilled
jobs
o Lower average wages are an incentive for employers to hire more workers
o Employment may increase as a result
• Immigration results in an increased population which increases consumption in the economy
o Greater output requires more labour so it creates more jobs
Significance On Unemployment
• Immigrants may displace some local workers increasing the level of unemployment
• Dependents of immigrants may be unable to find work and register as unemployed
The Effects of Unemployment
• The effects of unemployment, especially long-term unemployment, are extremely damaging
o There are impacts on the individual, the economy, the government, and firms

Long term unemployment affects individuals, the economy, government, and firms

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2.1.4 Balance of Payments
Components of the Balance of Payments
• The Balance of Payments (BoP) for a country is a record of all the financial transactions that occur
between it and the rest of the world
• The BoP has two main sections:
o The current account: all transactions related to goods/services along with payments related
to the transfer of income
o The financial & capital account: all transactions related to savings, investment
and currency stabilisation
• It is called the BoP as the current account should balance with the capital/financial
account and be equal to zero
o If the current account balance is positive, then the capital/financial account balance
is negative (and vice versa)
• Money flowing into the country is recorded in the relevant account as a credit (+) and money
flowing out as a debit (-)
The Current Account of the Balance of Payments
• The Current Account is often considered to be the most important account in the BoP
o It records the net income that an economy gains from international transactions

An Example of the UK Current Account Balance For 2017

Component 2017
Net trade in goods (exports - imports) £-32.9bn
Net trade in services (exports - imports) £27.9bn
Sub-total trade in goods/services £-5bn
Net income (interest, profits & dividends) £-2.1bn
Current transfers £-3.6bn
Total Current Account Balance £-10.7bn
Current Account as a % of GDP 3.7%
• Goods are also referred to as visible exports/imports
• Services are also referred to as invisible exports/imports
• Net income consists of income transfers by citizens and corporations
o Credits are received from UK citizens who are abroad and send remittances home
o Debits are sent by foreigners working in the UK back to their countries
• Current transfers are typically payments at government level between countries e.g. contributions
to the World Bank
• The Current Account balance is often expressed as a % of GDP
o This allows for easy international comparisons

Current Account Deficits and Surpluses

• A Current Account deficit occurs when the value of the outflows is greater than the value of the
inflows
o Usually occurs when the imports > exports
• A Current Account surplus occurs when the value of the inflows is greater than the value of the
outflows
o Usually occurs when imports < exports

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 • The UK government has a macroeconomic aim to get their Current Account balance as close
to equilibrium as possible
o Most years it tends to run a small deficit
o Export led economic growth would help it become positive
o However, with increasing income and wealth in an economy, the value of imports rises
▪ Consumers enjoy the variety of goods/services abroad
▪ Rising imports push the balance towards a deficit

Students sometimes confuse a UK Government Budget deficit with a Current Account

deficit. Ensure that your understanding of the distinction between these two concepts is clear.
The Budget deficit occurs when: UK Government spending > UK Government revenue (tax
receipts).
The Current Account deficit refers to the BOP.

The Relationship Between the Current Account Imbalances & Macroeconomic Objectives
• The UK government has a range of macroeconomic objectives which they attempt to achieve
• Setting policies to target one objective may complicate the possibility of achieving other
objectives
o There is a trade-off
• If the Current Account is running a deficit, this has a negative impact on aggregate demand
(AD)
o Net exports are a component of AD
o If net exports are negative then AD decreases
• To correct the current account deficit, the government could raise tariffs
o This would likely decrease imports bought by households
o Firms who rely on imports for raw materials used in production, would now face higher
costs of production
o These higher costs are likely to be passed on to consumers in the form of higher prices
o Reducing the current account deficit has come at the expense of increased inflation in the
economy - there has been a trade-off

The Interconnectedness of Economies Through Trade

• The world is more connected than ever and there is a high level of interdependence between
economies
o Covid 19 and the Ukraine War demonstrated how disruptions in one part of the world
cause widespread problems in others
• One country's imports are another country's exports
• Theoretically, the global value of exports will be equal to the global value of imports
• Producers all over the world are often highly dependent on imported raw materials used in
production e.g. a motor car has around 30,000 individual parts
o Building a car is a global effort and requires a high level of interconnectedness between
multiple economies

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2.2 Aggregate Demand (AD)

2.2.1 The Characteristics of AD

The Components of AD
• Aggregate demand (AD) is the total demand for all goods/services in an economy at any
given average price level
• Its value is often calculated using the expenditure approach
o AD = Consumption (C) + Investment (I) + Government spending (G) + (Exports-Imports) (X-
M)
o AD = C + I + G + (X-M)
• If AD increases then economic growth has occurred and vice versa
• Consumption is the total spending on goods/services by consumers (households) in an economy
• Investment is the total spending on capital goods by firms
• Government spending is the total spending by the government in the economy:
o Includes public sector salaries, payments for provision of merit and public goods etc.
o It does not include transfer payments
• Net exports are the difference between the revenue gained from selling goods/services abroad
and the expenditure on goods/services from abroad
o Individuals, firms and governments export/import

The relative importance of the components of AD

• Depending on the country, the value of each component and its contribution to AD can vary
significantly:
o Government spending in Sweden is 53% of AD and in the UK, it is 25% of AD
• The % that each component contributes to AD in the UK is approximately
o Consumption: 60%
o Investment: 14%
o Government spending: 25%
o Net Exports: 1%
• A 1 % increase in consumption or government spending will have a much larger impact on
economic growth than a 1% increase on net exports

The AD Curve
• The relationship between the average price level and the total output in an economy is shown
with an aggregate demand (AD) curve

A diagram showing the aggregate demand (AD) curve for an economy with Average Price Level on
the Y axis and Real GDP on the X axis

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 • The AD curve is downward sloping due to three reasons:
1. The interest rate effect: At higher average price (AP) levels, there are likely to be higher
interest rates. Higher interest rates reduce investment and are an incentive for households to
save - and vice versa
2. The wealth effect: As AP increases, the purchasing power of households decreases and the AD
falls - and vice versa
3. The exchange rate effect: As AP falls, interest rates are likely to fall too. Lower interest rates
lower the exchange rate. With a lower exchange rate, the economy's goods/services are more
attractive abroad and exports increase, thereby increasing real GDP

A Movement Along The AD Curve

• Whenever there is a change in the average price level (AP) in an economy, there is a movement
along the aggregate demand (AD) curve

A diagram showing an increase and decrease in the average price level (AP) which causes a
movement along the aggregate demand (AD) curve leading to a contraction/expansion of AD
Diagram Analysis

• An increase in the AP (ceteris paribus) from AP1 → AP2 leads to a movement along the AD
curve from A → B
o There is a contraction of real GDP from Y1 → Y2
• A decrease in the AP (ceteris paribus) from AP1 → AP3 leads to a movement along the AD curve
from A → C
o There is an expansion of real GDP (output) from Y1 → Y3
A Shift of the Entire AD Curve
• Whenever there is a change in any of the determinants of aggregate demand (AD) in an
economy, there is a shift of the entire AD curve

A diagram showing a shift in the entire aggregate demand (AD) curve due to a change in one of the
determinants of AD

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Diagram Analysis
• An increase in any one of the determinants of aggregate demand (AD) results in a shift right of
the entire curve from AD1 → AD2
o At every price level, real GDP has increased from Y1 → Y2
• A decrease in any one of the determinants of AD results in a shift left of the entire curve
from AD1 → AD3
o At every price level, real GDP has decreased from Y1 → Y3

2.2.2 Consumption (C)

The Influence of Disposable Income On Consumption

• Disposable income is the money that households have left from their salary/wages after they
have paid their taxes and have received any transfer payments/benefits
o If taxes increase, then disposable income decreases - and vice versa
o If wages fall, then disposable income decreases - and vice versa
o If transfer payments to a household increase (e.g. Unemployment benefits),
then disposable income increases - and vice versa
• Consumption increases as disposable income increases
• Consumption decreases as disposable income decreases

The Relationship Between Savings & Consumption

• Disposable income can either be saved or spent on goods/services (consumption)
o When savings decrease, consumption usually increases
o When savings increase, consumption usually decreases
• The household savings ratio calculates household savings as a proportion of household income
o This percentage is often low when an economy is booming and full of confidence - and vice
versa
o During lockdown in 2020 this ratio reached a record high in the UK of around 25%

Other Influences on Consumer Spending

Changes to Interest Rates

• Interest rates are set by the government's Central Bank

o Changes to the base rate cause commercial banks to change the lending and saving
rates they offer customers

• A change in interest rates will change the level of consumer spending and savings
o If interest rates increase there is a greater incentive to save
▪ More saving = less consumption
o If interest rates increase, the monthly repayment on any loan or mortgage increases
▪ Higher loan repayments = less consumption

Changes to Consumer Confidence

• The stronger the economy, the higher consumer confidence
o Consumers feel secure in their jobs and are confident of receiving regular salary
payments
▪ Consumption increases and saving decreases
• In a weakening or recessionary economy, consumer confidence falls
o Consumers feel less secure in their jobs
▪ Consumption decreases and saving increases

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Changes to Wealth
• If consumer wealth increases, then consumption usually increases
o Rising property prices or share prices give consumers confidence to borrow more
money
▪ Increased borrowing = increased consumption

2.2.3 Investment (I)

Gross & Net Investment
• Investment is the total spending on capital goods by firms
o Investment helps to increase the capacity (production possibilities) of an economy
o Increased capacity = increased potential economic growth
• Depreciation is the decrease in monetary value of a capital good (asset) over time
o Replacing old capital goods does not necessarily increase capacity
▪ It can, if the replacement technology means an increase in capacity is possible
• A distinction can be drawn between gross and net investment
o Gross investment is the total amount of spending on capital goods
▪ This spending includes replacing old capital goods and purchasing new capital
goods
o Net investment is the gross investment - depreciation
▪ This metric provides information on the addition of new capital goods to an
economy
▪ It gives a better indication of the extra production possibilities that have been
created through investment by firms
Influences on Investment
• Investment by firms is influenced by multiple factors in an economy
• Firms will choose to invest if they feel confident that they will make a good return on their
investment
o The decision to invest is linked to the business objective of profit maximisation

A Table That Shows Four Key Influences on the Decision by Firms to Invest
Rate of economic Influence of government &
Interest rates Demand for exports
growth regulations
• Increasing • Most investment by • If demand • Government intervention
growth sends firms is financed for exports increa can increase investment
a signal through business ses, firms will e.g. subsidies
that higher loans likely invest to • Government regulation ca
output will • Decreasing interes meet the global n decrease investment (it
generate high t rates encourage demand raises costs of
er profits investment • Demand for production for firms and
• The faster the • There is a exports can can lower profits)
economic mostly inverse increase if
growth, the relationship betwe the exchange
greater en investment and rate depreciates
the urgency interest rates • Goods/services
to invest now seem
cheaper to
foreigners

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Other Influences on Investment
• In addition to the points above, the following three influences also influence investment
decisions by firms:
1. Business expectations & confidence: the longer a period of economic growth, the higher the
business confidence will be. If growth slows, future expectations of profits will decrease
and investment decisions become harder
2. Keynes & animal spirits: John Maynard Keynes believed firms exhibit too much optimism in
the good times and take too many risks. They run with the mood of the economy and make less
rational investment decisions
3. Access to credit: The easier the access to loanable funds, the higher the levels of investment.
Some developing economies have low access to credit and this holds back investment

2.2.4 Government Expenditure (G)

Influences on Government Expenditure
• Government expenditure is influenced by the trade/business cycle and spending linked to
achieving policy aims
o Government expenditure can happen on a local level (e.g., Kent County Council) or
a national level (central government)

A Table Explaining the Influence of The Trade Cycle and Policy Aims on Government
Expenditure
Influence of The Trade/Business Cycle Influence of Policy Aims

• Unemployment decreases with a booming • Fiscal Policy is set once a year and
economy leading to a lower level of means announced during the presentation of the
tested benefit payments - and vice versa Government's budget
• Tax revenue increases with a booming • Expenditure is directly related to the
economy and can be used to pay Government's objectives and policy aims
back government debt or increase • E.g., A policy aimed at upgrading Britain's
expenditure on public/merit goods - and Navy requires increased expenditure
vice versa

2.2.5 Net Trade (X-M)

Influences on the Net Trade Balance
• The net trade balance is the difference between the value of the exports and imports (X-M)
• The net trade balance is influenced by changes to real income, exchange rates, state of the world
economy, and the degree of protectionism

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 A Table Showing How Changes to Each of the Influencing Factors Effects Exports & Imports

Effect on Exports Effect on Imports (X-M)

Change in Condition
UK real income Consumers purchase
Little effect Trade balance weakens
increases more
Real income increases Foreigners purchase
Trade balance
abroad more UK products - Little effect
strengthens
exports increase
Exports more Consumers' money goes
expensive for foreigners - further abroad - imports Trade balance weakens
UK £ appreciates
exports decrease increase
Exports less Consumers' money
Trade balance
expensive for foreigners - is worth less abroad -
UK £ depreciates strengthens
exports increase imports decrease
Increased demand for UK Little effect Trade balance
World economy booms exports strengthens
Decreased demand for Little effect Trade balance weakens
World economy slows UK exports
Depends on retaliation Decreased demand for
Trade balance
measures from other imports as they are more
Protectionism increases strengthens
countries expensive
Increased demand for
Likely to increase imports as they are less Trade balance weakens
Protectionism decreases
expensive

When evaluating the extent to which the trade balance strengthens or weakens as a result of
exchange rate changes, remember that it is dependent on the price elasticity of demand (PED)
of the exports and imports.
This is explained by the Marshall Lerner Condition and the J Curve.
The Marshall-Lerner Condition states that the depreciation/devaluation of a country's currency will
lead to an improvement in its net trade balance only if the sum of the price elasticities of its
exports and imports is greater than one
The J Curve argues that a net trade balance will worsen in the short term after a currency
devaluation, but then improve in the medium to longer term.

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2.3 Aggregate Supply

2.3.1 Characteristics of AS

The Aggregate Supply (AS) Curve

• Aggregate supply is the total supply of goods/services produced within an economy at a specific
price level at a given time

A diagram showing the upward sloping short run aggregate supply (SRAS) curve for an economy

• The AS curve is upward sloping due to two reasons

o The aggregate supply is the combined supply of all individual supply curves in an
economy which are also upward sloping
o As real output increases, firms have to spend more to increase production e.g. wage bills
will increase
▪ Increased costs result in higher average prices

A Movement Along the SRAS Curve

• Whenever there is a change in the average price level (AP) in an economy, there is a movement
along the short run aggregate supply (SRAS) curve

A diagram showing an increase and decrease in the average price level (AP) which causes a movement along
the short run aggregate supply (SRAS) curve leading to a contraction/expansion of SRAS

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Diagram Analysis
• An increase in the AP (ceteris paribus) from AP1 → AP2 leads to a movement along the SRAS
curve from A → B
o There is an expansion of real GDP from Y1 → Y2
• A decrease in the AP (ceteris paribus) from AP1 → AP3 leads to a movement along the SRAS
curve from A → C
o There is a contraction of real GDP (output) from Y1→Y3

A Shift of the Entire SRAS Curve

• Whenever there is a change in the conditions of supply in an economy (e.g. costs of production or
productivity changes), there is a shift of the entire SRAS curve

A diagram showing a shift in the entire short run aggregate supply (SRAS) curve due to a change in
one of the conditions of supply in an economy

Diagram Analysis
• A decrease in costs or increase in productivity results in a shift right of the entire curve
from SRAS1 → SRAS2
o At every price level, output and real GDP has increased from Y1 → Y2
• An increase in costs or decrease in productivity results in a shift left of the entire curve
from SRAS1 → SRAS3
o At every price level, output and real GDP has decreased from Y1 → Y3

The Relationship Between Short-run & Long-run AS

• Short run aggregate supply (SRAS) is influenced by changes in the costs of production or
productivity
o Short run refers to the time period where at least one factor of production is fixed
• Long run aggregate supply (LRAS) is influenced by a change in the productive capacity of the
economy
o Productive capacity is changed by changes to the quantity or quality of the factors of
production
▪ When production capacity changes, it is equivalent to a shift inwards/outwards of
the production possibilities frontier (PPF)
• Long term economic growth requires the productive capacity to increase

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2.3.2 Short-run AS

Factors Influencing Short-run AS

• There are multiple factors that can influence the short-run aggregate supply (SRAS). These
include:
o Changes in costs of raw materials and energy
o Changes in exchange rates (E/R)
o Changes in tax rates

A Table That Explains The Influences On Short-run Aggregate Supply (SRAS)

Change in Condition Explanation Impact on SRAS

As the price of input costs rise, fewer

Increase in costs of raw goods/services can be produced with the SRAS decreases - shifts left
materials/energy same amount of money
As the price of input costs decrease, more
Decrease in costs of raw goods/services can be produced with the SRAS increases - shifts right
materials/energy same amount of money
Producers often import raw materials
Stronger currency = cheaper imports SRAS increases - shifts right
Appreciation of E/R Cheaper imports = decrease in input costs
Lower costs = more output
Producers often import raw materials
Weaker currency = more expensive imports
More expensive imports = increase in input SRAS decreases - shifts left
Depreciation of E/R
costs
Higher costs = less output
Taxes represent an additional cost for firms
Decrease in tax rates Decreasing taxes = decrease in costs SRAS increases - shifts right
Lower costs = more output
Taxes represent an additional cost for firms
Increasing taxes = increase in costs SRAS decreases - shifts left
Increase in tax rates
Higher costs = less output

2.3.3 Long-run AS

Keynesian Versus Classical Long-run AS

• Long run aggregate supply (LRAS) is influenced by a change in the productive capacity of the
economy
o Productive capacity is changed by changes to the quantity or quality of the factors of
production
• Economists have two opposing views on how LRAS works in an economy
o The original view is called the classical view
o The insights developed by John Meynard Keynes in 1936 are called the Keynesian view

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The Classical LRAS View
• The classical view believes that the LRAS is perfectly inelastic (vertical) at a point of full
employment of all available resources
o This point corresponds to the maximum possible output on a production possibilities
frontier (PPF)
• The classical view believes that in the long-run an economy will always return to this full
employment level of output
• There may be short-run output gaps in the economy
o During extreme periods of economic growth there can be an inflationary gap that
develops
▪ In the long run this will self-correct and return to the long-run level of output, but at
a higher average price level
o During slowdowns or recessions there can be a recessionary gap that develops
▪ In the long-run this will self-correct and return to the long-run level of output, but at
a lower average price level

A diagram that shows the Classical View of long-run aggregate supply (LRAS) with a vertical
aggregate supply curve at the full employment level of output (YFE)

Diagram Analysis

• Using all available factors of production, the long-term output of this economy (LRAS) occurs at
YFE
• The economy is initially in equilibrium at the intersection of AD1 and LRAS (P1, YFE)
• A slowdown reduces output from AD1→AD2 and creates a short term recessionary gap
• This self corrects in the long term and returns the economy to the long-run equilibrium at the
intersection of AD2 and LRAS (P2, YFE)

The Keynesian LRAS View

• Keynes believed that the long-run aggregate supply curve (LRAS) was more L shaped
o Supply is elastic at lower levels of output as there is a lot of spare production capacity in
the economy
▪ Struggling firms will increase output without raising prices
o Supply is perfectly inelastic (vertical) at a point of full employment (YFE) of all
available resources
▪ The closer the economy gets to this point the more price inflation will occur as firms
compete for scarce resources

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 • The Keynesian view believes that an economy will not always self-correct and return to the full
employment level of output (YFE)
o It can get stuck at an equilibrium well below the full employment level of output e.g. Great
Depression
• The Keynesian view believes that there is role for the government to increase its
expenditure so as to shift aggregate demand and change the negative 'animal spirits' in the
economy

A diagram that shows the Keynesian View of long-run aggregate supply (LRAS) with a vertical aggregate
supply curve at the full employment level of output (YFE) becoming more elastic at lower levels of output

Diagram Analysis
• Using all available factors of production, the long-term output of this economy (LRAS) occurs at
YFE
• The economy is initially in equilibrium at the intersection of AD1 and LRAS (P1, YFE)
• A slowdown reduces output from AD1→AD2 and creates a recessionary gap Y1-YFE
o The economy may reach a point where average prices stop falling (P2), but output
continues to fall
o This economy may not self-correct to YFE for years
o The low output leads to high unemployment and low confidence in the economy
▪ This stops further investment and further reduces consumption
• Keynes argued that this was where governments needed to intervene with
significant expenditure e.g. Roosevelt's New Deal; response to financial crisis of 2008

Factors Influencing Long-run AS

• Any factor that changes the quantity or quality of a factor of production will impact the long-run
aggregate supply (LRAS) of an economy:
o This corresponds to an outward or inward shift of the potential output of an economy on
the production possibilities frontier
• The following factors will shift the entire LRAS curve outwards and increase the potential output of
the economy:
1. Technological advances: these often improve the quality of the factors of production e.g.
development of metal alloys
2. Changes in relative productivity: process innovation often results in productivity
improvement e.g. moving from labour intensive car production to automated car production
3. Changes in education and skills: over time this increases the quality of labour in an economy
4. Changes in government regulations: these can improve the quantity of the factors of
production. e.g. deregulation of fracking (extracting oil from shale deposits) increased oil reserves
5. Demographic changes and migration: a positive net birth rate or positive net migration rate will
increase the quantity of labour available
6. Competition policy: regulating industries so as to prevent monopoly power results in more firms
supplying goods/services in an economy and this increases the potential output of an economy

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 You will frequently be examined on your understanding of factors that shift the short-run aggregate
supply (SRAS) curve and long-run aggregate supply (LRAS) curve.
Make sure you know the difference and remember that LRAS factors will shift the entire LRAS
curve to the right, representing an increase in the potential output of the economy. Changes to
SRAS do not change the potential output of the economy.
This is the impact a long-run shift will have:

A diagram illustrating long-run economic growth through a change in one of the factors that shift
the long-run aggregate supply (LRAS) of the economy

2.4 National Income

2.4.1 National Income
The Circular Flow of Income
• The circular flow of income is an economic model that illustrates money flows in an economy
o There is a simple model which shows the money flows between households and firms
o There is a more complex model which adds in other economic agents including
the government, financial sector and foreign trade (net exports)

A diagram showing the simplified Circular Flow of Income between households and firms

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Diagram Analysis

• Households own the wealth in the economy

o These are the factors of production
• Households supply their factors of production to firms and receive income as a reward
o They receive rent for land, wages for labour, interest for capital, and profit for enterprise
o With this income, they purchase goods/services from firms
• Firms purchase factors of production from households
o They use these resources to produce goods/services
o They sell the goods/services to households and receive sales revenue
• National income is the value of the output of an economy over a period of time
o It can be calculated using the income approach or expenditure approach
o Expenditure = income
• Income is a flow in the economy, whereas wealth is a stock of assets that can be used
to generate income

2.4.2 Injections & Withdrawals

Injections & Withdrawals
• Money can enter or leave the circular flow of income in an economy
• Injections add money into the circular flow of income and increase its size
o Increased government spending (G)
o Increased investment (I)
o Increased exports (X)
• Withdrawals or leakages remove money from the circular flow of income and reduce its size
o Increased savings by households (S)
o Increased taxation by the government (T)
o Increased import purchases (M)

A diagram that shows the injections and withdrawals that influence the relative size of the circular
flow of income

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Diagram Analysis

• The relative size of the injections and withdrawals impacts the size of the economy:
o Injections > withdrawals = economic growth
o Withdrawals > injections = fall in real GDP

• Injections represent new income in the economy

• The multiplier effect can cause the economy to grow by a greater amount than the size of the
injection
o E.g. If government spending increases, the money becomes income for households who
then spend it purchasing goods/services from firms, who then spend some of it on
purchasing raw materials

• Changes to any of the factors that influence government spending, investment, consumption and
net exports will increase/decrease the relative size of the circular flow of income
o E.g. An increase in interest rates will increase savings (withdrawal), and reduce
consumption and investment

Remember to consider the net effect and proportionality of the injections and withdrawals. For
example if the size of the government spending is large, it is likely to completely outweigh the
combined withdrawals of savings and imports.
The size of the multiplier is dependent on the marginal propensity to consume (MPC), the
marginal propensity to save (MPS), the marginal propensity to import (MPM) and the marginal
propensity to be taxed (MPT).

2.4.3 Equilibrium Levels of Real National Output

Real National Output Equilibrium
Short-run Equilibrium

• Real national output equilibrium occurs where aggregate demand intersects with aggregate
supply

A diagram showing the Classical short-run equilibrium in an economy resulting in an equilibrium

price of AP1 and real output of Y1

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 • According to classical theory, this economy is in short run equilibrium at AP1Y1
• Any changes to the components of AD will cause the AD curve to shift left or right creating a new
short-run equilibrium
• Any changes to the determinants of SRAS will shift the SRAS curve left or right creating a new
short-run equilibrium
Long-run Equilibrium

• Classical and Keynesian economists have different views on the long-run equilibrium of real
national output
o Classical economists believe that the economy will always return to its full potential
level of output and all that will change in the long-run, is the average price level
o Keynesian economists believe that the economy can be in long-run equilibrium at any
level of output

A diagram that shows the Classical view of long-run equilibrium which occurs at the intersection of
long-run aggregate supply (LRAS), short-run aggregate supply (SRAS) & aggregate demand (AD)

Diagram Analysis

• The LRAS curve demonstrates the maximum possible output of an economy using all of
its scarce resources
• The SRAS intersects with AD at the LRAS curve
• This economy is producing at the full employment level of output (YFE)
• The average price level at YFE is AP1

A diagram that shows the Keynesian view of long-run equilibrium which occurs at the intersection
of long-run aggregate supply (LRAS) & aggregate demand (AD)

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Diagram Analysis
• The vertical portion of the LRAS curve corresponds to the classical view of LRAS
o The Keynesian view believes there is a maximum level of possible output
• The LRAS curve becomes elastic at a certain price level as prices cannot fall further
o Possibly due to minimum wage laws, the existence of trade unions, or long-
term employment contracts preventing wage decreases
• Real output national equilibrium can occur at any level of output
o In this case equilibrium is at the intersection of LRAS and AD (AP1Y1)

Changes in the Equilibrium Price Level & Real National Output

Changes Using the Classical Approach
1. An Increase in Aggregate Demand (AD)

A diagram showing the Classical re presentation of an increase in aggregate demand (AD)

Diagram Analysis
• The initial equilibrium level of output was at AP1Y1
• An increase in one of the components of AD (e.g. consumption) causes the AD to increase
AD1→AD2
• Average prices in the economy rise to AP2 and the real level of output increases to Y2
• The new short-run equilibrium is at AP2Y2

2. An increase in short run aggregate supply (SRAS)

A diagram showing the Classical representation of an increase in the short-run aggregate supply
(SRAS)

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Diagram Analysis

• The initial equilibrium level of output was at AP1Y1

o This equilibrium represents a recessionary or negative output gap equal to Y1YFE
• An increase in one of the determinants of SRAS (e.g. productivity) causes the SRAS to increase
SRAS1→SRAS2
• Average prices in the economy fall to AP2 and the real level of output increases to Y2
• The new short-run equilibrium is at AP2Y2
• There is still a negative output gap but it is smaller (Y2YFE)

Changes Using the Keynesian Approach

1. Changes to Aggregate Demand (AD)

A diagram that illustrates the Keynesian view of how changes to aggregate demand (AD) have
different impacts on the average price level (AP)

Diagram Analysis

• The economy is initially in equilibrium at the intersection of AD1 and LRAS

o The price level is AP1 and the output is at Y1
• An increase in any component of AD (e.g. government spending) causes AD to shift from
AD1→AD2
o As this increase occurs close to the full employment level of output, there is a large
increase in the average price level (AP1→AP2), but a relatively small increase in real
output (Y1→Y2)
• A decrease in any component of AD (e.g. net exports) causes AD to decrease from AD1→AD3
o As this decrease occurs close to the elastic portion of the LRAS curve, there is a
relatively larger decrease in the real output (Y1→Y3) than the decrease in the average
price level (AP1→AP3)
• If a further decrease in AD were to take place from AD3→AD4, there would be virtually no impact
on the average price level, but the real output would fall from Y3→Y4

One of the key differences that you are examined on with regard to the Classical and Keynesian
models, is the understanding that a change to aggregate demand (AD) potentially has a different
impact on the economy under the Keynesian model. A change to AD in the Classical model will
always increase or decrease the average price level. A change to AD in the Keynesian model may
not change the price level at all. This is due to the elastic portion of the LRAS curve in the
Keynesian model.

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Changes to Long-run Aggregate Supply (LRAS)
1. Changes to LRAS in the Classical Model

• Changes to any of the determinants of LRAS will change the long-run productive potential of the
economy

A diagram showing the Classical view of an increase in the long-run aggregate supply (LRAS) of an
economy and how it lowers average price levels

Diagram Analysis
• The initial potential output of this economy is seen at YFE
o The economy is in equilibrium at AP1YFE
• A change to the education level in the economy can increase the quality of labour and shift the
LRAS to the right from LRAS1→LRAS2
o There is now an increased level of possible output in the economy YFE1
• The extra supply in the economy allows prices to fall and output to increase resulting in a new
equilibrium at AP2YFE1

2. Changes to LRAS in the Keynesian Model

• As with the Classical model, changes to any of the determinants of LRAS will change the long-
run productive potential of the economy

A diagram showing the Keynesian view of an increase in the long-run aggregate supply (LRAS) of
an economy and how it changes output without necessarily changing average price levels

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Diagram Analysis
• The initial potential output of this economy is seen at YFE
o The economy is in equilibrium at the intersection of AD1 and LRAS (AP1YFE)
• A change to the immigration policy can increase the quantity of labour and shift the LRAS to
the right from LRAS1→LRAS2
o There is now an increased level of possible output in the economy YFE1
o AD is in the vertical portion of the LRAS curve so output will increase
(YFE→YFE1) and average prices will fall (AP1→AP3)
• If the starting point of this economy had been the equilibrium at AD2Y2, then according to
Keynesian thinking, an increase in LRAS would not impact the economy as it is stuck in a
depression & requires AD to increase in order to change national output

2.4.4 The Multiplier

The Multiplier
• The multiplier ratio is the ratio of change in real income to the injection that created the
change
o E.g. If the UK government injected an additional £5m into the economy through government
spending and it resulted in an increase in real income of £15m, the value of the multiplier
would be 3
• The multiplier process is based on the idea that one individual's spending is another
individual's income
o An increase in consumption immediately increases AD
▪ Store owners who have benefitted from the extra consumption now have extra
income
▪ They spend some of that income on goods/services
▪ Their expenditure on goods/services is now income for the next tier of individuals
o Due to the successive rounds of spending, the final increase in national income is much
larger than the initial injection
o The size of the multiplier is entirely dependent on the size of leakages that occur during the
process
▪ The higher the leakages the smaller the multiplier
• The initial injection shifts AD to the right
o The result of the multiplier process is that there is then a secondary movement of AD to
the right which (if the multiplier were 2) may be double the initial movement
• The multiplier can also work in reverse when injections are reduced (downward multiplier effect)

The Effects of Marginal Propensities on the Multiplier

• The 'marginal propensities' refer to the proportion of the next $ earned that a consumer saves,
consumes, is taxed, or purchases imports with
• Marginal propensities are calculated for economies and provide insights into how each additional
$ of income is allocated
o Sweden has a higher tendency to save than the USA
▪ Their marginal propensity to save is higher
▪ The USA, therefore, has a greater multiplier on any injections into the Circular Flow

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 An Explanation of The Marginal Propensities

Marginal Propensity to Marginal Propensity to Marginal Propensity Marginal Propensity

Consume (MPC) Save (MPS) to Tax (MPT) to Import (MPM)
The proportion of The proportion of The proportion of The proportion of
additional income that additional income that additional income that additional income that
is spent is saved is paid in tax is spent on imports

Calculating the Multiplier

• The value of the multiplier can be calculated one of two ways

o By focusing on the marginal propensity to consume (MPC)
o By focusing on the withdrawals that occur on each additional $ of income (MPS + MPT +
MPM)

1. Focussing on the MPC

2. Focusing on the Withdrawals

Worked example
An economy has the marginal propensity to save of 0.15, marginal propensity to tax of 0.20 and a marginal
propensity to import of 0.15.
a) Calculate the size of the multiplier.
b) If the Government increases their infrastructure spending by £60m, calculate the total increase in GDP,
assuming all other things remain equal.

Step 1: Insert the values into the withdrawal formula

Step 2: Multiply the injection by the multiplier

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Significance of the Multiplier in Shifting AD

• The greater the withdrawals, the smaller the value of the multiplier - and vice versa
• The greater the MPC, the greater the value of the multiplier - and vice versa
• Any change in one of the factors that impacts on disposable income, will change the multiplier
o If taxes increase the value of the multiplier reduces
o If interest rates increase, savings increase and consumption decreases and the multiplier
reduces
o If exchange rates appreciate the level of imports will increase and the multiplier
decreases
o If confidence in the economy increases consumption increases and the multiplier
increases
• It is extremely useful for the Government to know the value of the multiplier
o They can use it to judge the likely economic growth caused by increased spending
• There is a time lag as it takes time for the successive rounds of income to work through the
economy

The final bullet point above mentions time lags. This is an excellent point to include in
any evaluation on the effectiveness of the multiplier. It may take up to 18 months for the full
multiplier effect to be seen & any change to consumer confidence during this period will impact
the final outcome.

2.5 Economic Growth

2.5.1 Causes of Growth
Causes of Economic Growth

• Economic growth can occur in the short-run or long-run and each is explained differently

Short-run Economic Growth

• Changes to any of the components of aggregate demand (AD) will cause short-run economic
growth to occur
o This is illustrated on an AD/AS diagram by a rightward shift in AD
o It can also be illustrated by using the production possibilities frontier model by moving
from a point inside the curve to a point closer to the curve
1. Short-run Economic Growth on AD/AS Diagram

A diagram illustrating short-run economic growth through a shift of aggregate demand from
AD→AD1

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Diagram Analysis
• An increase in consumption, investment, government spending or net exports has caused a shift in
AD from AD→AD1
• The current real output has increased from Y1→Y2 which represents an increase in real GDP
o An increase in real GDP = economic growth
• This short-run growth has led to an increase in average prices from AP1→AP2

2. Short-run Economic Growth on Production Possibilities Frontier (PPF)

A diagram illustrating short-run economic growth on a production possibilities frontier (PPF) model

Diagram Analysis

• An increase in production has caused a shift in production combinations from X→Y

• The current real output has increased moving closer to the maximum possible output of the
economy
o This represents an increase in real GDP
o An increase in real GDP = economic growth

Long-run Economic Growth

• Long-run economic growth is caused by any improvements to the quality or quantity of the factors
of production
o These factors include all of the determinants of long-run aggregate supply

A diagram illustrating long-run economic growth through an increase in the long-run aggregate
supply (LRAS) of the economy

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Diagram Analysis

• A change to the quantity/quality of the factors of production has increased potential output of the
economy from YFE→YFE1
o E.g. More rigorous competition policy creates a higher number of firms in each industry
leading to greater aggregate supply in the economy
▪ This shifts the long-run aggregate supply curve to the right
LRAS1→LRAS2 resulting in economic growth
• The final impact on price levels depends on the shape of the long-run aggregate supply curve
(Keynesian or Classical)

Actual & Potential Growth

• Actual economic growth occurs when there is an increase in the quantity of
goods/services produced in an economy in a given period of time
o This is often measured by the percentage change in real gross domestic product (GDP)
• Potential growth is the increase in the productive potential of an economy as demonstrated by
a shift outward of the production possibilities frontier (PPF) or the long-run aggregate supply
(LRAS) curve
• At any given point in time, the actual economic growth may be less than the potential
growth available to the economy

International Trade & Export-led Economic Growth

• International trade is an important source of income for many countries
• Export-led economic growth refers to growth that occurs as a result of an increase in the sale of
goods/services to foreign countries
o Net exports is a component of aggregate demand (AD)
o For many developing countries, the exports represent a high percentage of the annual AD
and gross domestic product (GDP)
▪ When the value of the exports rise, the real GDP rises significantly - and vice versa
• E.g. China experienced significant export-led economic growth from 1988 to the global financial
crisis of 2008

2.5.2 Output Gaps

• Actual growth can be differentiated from the idea of long-term trends in growth rates
• A long-term growth trend is the underlying trend rate of economic growth over a longer period of
time
o This is determined by the constant increases in the productive capacity of an economy
(aggregate supply)
▪ The increase in productive capacity is illustrated by a rightward shift of the long-run
aggregate supply curve (LRAS)
o Use of long-term growth trends can reduce the impact of outliers in the data

Positive & Negative Output Gaps

• An output gap is the difference between the actual level of output (real GDP) and the maximum
potential level of output
o A positive output gap occurs when real GDP is greater than the potential real GDP
o A negative output gap occurs when the real GDP is less than the potential real GDP

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 ▪ There is spare capacity in the economy to produce more goods/services than are
being produced

• It is difficult to measure output gaps accurately

o This is because it is hard to know exactly what the maximum productive potential of an
economy is
o Rapidly rising prices can indicate a positive gap is developing
o Rising unemployment and slowdown in economic growth can indicate that a negative
gap is increasing

A Negative Output Gap

An Keynesian (top) and Classical (bottom) diagram illustrating an economy that has a negative
output gap (Y1- YFE) and is currently producing less than its potential output

Diagram Analysis

• The potential output of this economy is at YFE

• The economy is in a short-run equilibrium at AP1Y1
o A negative output gap exists at Y1 - YFE
▪ This effectively gives the economy sparer capacity in the short-term
o One cause of this may be that the AD has recently decreased due to a fall in consumption
o The Classical view is that the output will return to YFE in the long-run, but at a lower
average price level
o The Keynesian view is that an economy may be stuck in a negative output gap for a long
period of time

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 A Positive Output Gap

An AD/AS diagram illustrating an economy that has a positive output gap (YFE - Y1) and is currently
producing more than its potential output

Diagram Analysis

• The potential output of this economy is at YFE

• The economy is in a short-run equilibrium at AP1Y1
o A positive output gap exists at YFE - Y1
▪ This effectively gives the economy more productive capacity in the short-term
o One cause of this may be that workers are willing to work overtime once full capacity is
reached
▪ It is not sustainable and the Classical view is that the output will return to YFE, but
at a higher price level

2.5.3 Trade (Business) Cycle

Trade (Business) Cycle

• A trade (business) cycle refers to the changes in real GDP that occur in an economy over time
o This is the actual growth
• The real GDP will fluctuate above and below the long-term trend rate of growth
• There are four recognisable points in the cycle
o Peak/boom; slowdown/downturn; recession, recovery

A Trade Cycle Diagram that illustrates the fluctuations of real GDP (actual growth) around long-term
trend growth

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Diagram Analysis

• A positive output gap is identified as growth of real GDP that is above the trend
• A negative output gap is identified as growth of GDP that is below the trend
• There is often a natural flow through the different stages from boom to slowdown to recession to
recovery
• This flow of real GDP can be moderated by government intervention
o E.g. increasing taxes in a boom period or increasing spending in a recession

A Table Explaining the Characteristics of a Boom & Recession

Characteristics of a Recession Characteristics of a Boom

Two consecutive quarters (6 months) or more
Increasing/high rates of economic growth
of negative economic growth
Decreasing unemployment and increasing job
Increasing/high unemployment
vacancies
Reduction of negative output gap or creation of a
Increasing negative output gap and spare
positive gap. Spare capacity is reduced or
production capacity
eliminated
Low confidence for firms/households High confidence and more risky decisions taken
Low inflation Increasing rate of inflation - usually demand pull
Increase in government expenditure perhaps An improvement in the government budget as tax
leading to a great budget deficit revenues rise and expenditure falls

You will often be examined on the characteristics of the trade cycle. Remember to
demonstrate critical thinking around the assumptions of the model. For example, some firms
may thrive during a recession as consumers switch to purchasing inferior goods (Poundland).
Additionally, the components of aggregate demand do not rise/fall at the same rate. For example,
during recovery, consumption may increase well ahead of investment by firms.
An economy may also experience some fundamental restructuring during a prolonged recession
and the composition of real GDP growth may be significantly different to what is was before the
recession.

2.5.4 The Impact of Economic Growth

Benefits & Costs of Economic Growth

• Economic growth is considered to be the main contributor to an improvement in the standards of

living
• Due to the negative aspects of economic growth, there is much controversy about maintaining it as
a central macroeconomic aim
o Instead, arguments for a focus on societal well-being are gaining traction

A Table Summarising the Benefits & Costs of Economic Growth

Benefits of Economic Growth Costs of Economic Growth

Rising aggregate demand causes demand pull
Increased incomes lead to better standards of living inflation; purchasing power of people on fixed
incomes may fall

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 Lack of equity in the distribution of income - the
Decreased levels of absolute poverty
rich may get richer and the poor poorer

Improvement in the quality/quantity Environmental damage caused by negative

of environmentally friendly technologies externalities of production

Higher sales revenue for firms and greater profits Increased inflation can harm export sales
Increased investment by firms increases the Decreased export sales may lead to a delay in
potential output of the economy investment by firms
Increased income usually leads to greater
Reduced expenditure by governments on benefits
consumption of demerit goods
Greater output often requires more time from
Higher government tax revenue due to rising
workers and can decrease leisure time and well-
incomes and surging corporate profits
being
Increased employment resolves some of the
negative social impacts of unemployment

2.6.1 Possible Macroeconomic Objectives

Economic Growth
• Economic growth is a central macroeconomic aim of most governments
• Many developed nations (UK included) have an annual target rate of 2-3%
o This is considered to be sustainable growth
o Growth at this rate is less likely to cause excessive demand pull inflation
• Politicians often use it as a metric of the effectiveness of their policies and leadership
• Economic growth has positive impacts on confidence, consumption, investment, employment,
incomes, living standards and government budgets

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

Source: Macrotrends

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 A Table Highlighting Some of the Economic Growth Trends in the UK Since 1998

1998-2007 2008-2015 2016-2019 2020 -

Supply chain issues

due to
Global financial
Gradual disinflation possibly Brexit. Decreased cons
Steady crisis followed by rapid
due to future expectations umption due to the
growth fluctuating bounce back due
regarding the impact of impact of Covid 19.
between 2-4% to government
the Brexit vote These created
intervention - and then
a deep recession (short
steady growth
-lived due to government
intervention)

Low Unemployment
• The target unemployment rate for the UK is 4-5%
• This is close to the full employment level of labour (YFE)
o There will always be a level of frictional unemployment
o This makes it impossible to achieve 100% employment
• Different economies have different rates that are considered to be close to the full employment
level of labour e.g. Japan's level is about 2.5%
• Within the broader unemployment rate, there is an increased emphasis on the unemployment
rate within different sections of the population
o E.g. youth unemployment, ethnic/racial unemployment by group
▪ In 2021, black unemployment in the UK was 11% and white unemployment was 4.%

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

Source: Macrotrends

• Unemployment tends to be inversely proportional to real GDP growth

o When real GDP increases, unemployment falls
o When real GDP decreases, unemployment rises
• Unemployment in the UK remained relatively high for the six years following the global financial
crisis of 2007

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Low & Stable Rate of Inflation
• The UK has a target inflation rate of 2% using the Consumer Price Index (CPI)
• A low rate of inflation is desirable as it is a symptom of economic growth
• The different causes of inflation (cost push or demand pull) require different policy responses from
the Government
o Demand-side policies ease demand pull inflation
o Supply-side policies ease cost push inflation

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

• In the UK, a continual deviation from the target of 2% would not be considered as stable
o An inflation rate in April 2022 of 4-5% was considered to be unstable, eroding
household purchasing power
• A low & stable rate of inflation is important as it
o Allows firms to confidently plan for future investment
o Offers price stability to consumers

Balance of Payments Equilibrium On The Current Account

• The Balance of Payments (BoP) for a country is a record of all the financial transactions that occur
between it and the rest of the world
o The current account focuses mainly on the financial transactions related to exports and
imports of goods/services
• Governments aim for Balance of Payments equilibrium on the Current Account
o If exports > imports it will create a current account surplus
o If imports > exports, it will create a current account deficit
▪ Each one of these conditions has advantages/disadvantages associated with it
▪ However, a current account deficit is more problematic in the long-run
• The UK has traditionally run a small deficit
o As a % of GDP the UK current account deficit is insignificant so has not been problematic

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 A diagram showing the UK Trade Deficit from 1998 to 2020. The bottom graph illustrates the trade
deficit as a % of GDP and the top one illustrates the absolute value expressed in US$
Source: Macrotrends

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

Balanced Government Budget

• The Government Budget is presented annually and includes the forecasted revenue and
expenditure
o Revenue comes from the sale of assets, taxes, sales revenue from goods/services e.g. train
tickets
o Expenditure includes all government spending such as public sector salaries;
unemployment benefits; spending on public & merit goods
• The UK Government aims to run a balanced budget
o If expenditure > revenue, there is a budget deficit
o Any deficit has to be financed through public sector borrowing
o Any borrowing is added to the public sector debt (Government debt)
• If the UK Government debt becomes too high (expressed as a % of GDP), then lenders begin
to lose confidence in the Government's ability to repay the debt
o The Government then has to raise the interest rate it offers to lenders, which
makes borrowing more expensive
• The UK Government has worked extremely hard recently to reduce the budget deficit and run a
balanced budget
o Covid 19 expenditure has eroded the progress they made

Government deficit (net borrowing) as a percentage of GDP - 1973 to 2021

Source: ONS

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 • Reducing the deficit can mean tough choices for the economy
o E.g. cutting public sector pay; raising taxes; reducing unemployment benefits; reducing
spending on merit goods
• The significant deficit increase in the 2020/21 budget due to Covid 19 will need to be repaid
o The short-term help offered through the crisis may generate long-term pain as the
Government seeks to cut future spending so as to repay the debt

Environmental Protection
• In April 2021, the UK Government stated that their environmental aim was to reduce emissions
by 78% by 2035
o This reduction is based on the emission levels of 1990
o It is one of the most ambitious climate change targets globally
o It includes the UK’s share of international aviation and shipping emissions
• Broader environmental aims include
o A focus on sustainability
o The reduction of negative externalities of production
o 100% energy from renewable sources by 2035

Greater Income Equality

• The reduction of income inequality remains a high priority
• High levels of income inequality create social unrest and can ultimately lead to revolutions
• Income inequality is measured using the Gini Coefficient
o Most developed economies have a Gini target of 0.3-0.4
• Perfect income equality is not desirable as it removes the incentive to work and study
• Unchecked capitalism has a natural outcome of high income inequality
o The wealthy are able to keep buying factors of production
o The concentration of ownership becomes more and more narrow with fewer individuals
owning the bulk of the world's wealth
• There is a need for the UK government to intervene to maintain acceptable levels of income
inequality

A diagram showing the general increase in income inequality in the Uk since 1977
Source: ONS
• In the diagram above, the Gini coefficient has been multiplied by 100 to create percentage
o 34% would equate to a coefficient of 0.34

• Absolute poverty is worse in developing countries. However, In a developed economy such as the
UK, a 1% increase in income inequality can push a lot more households into absolute poverty

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2.6.2 Demand-side Policies
Demand-side Policies

• Demand-side policies aim to shift aggregate demand (AD) in an economy

• There are two categories of demand-side policies
o Fiscal policy and monetary policy
• Fiscal policy involves the use of government spending and taxation to influence AD
o The government is responsible for setting fiscal policy
o The UK Government presents their fiscal policies to the country each year when it delivers
the Government budget
• Monetary policy involves adjusting interest rates and the money supply so as to influence AD
o The Bank of England (UK central bank) is responsible for setting monetary policy
o The Bank's Monetary Policy Committee meets 8 times a year to set policy

Monetary Policy Instruments

• The two main instruments of monetary policy include
o Incremental adjustments to the interest rate (usually not more than 0.25%)
o Quantitative easing which increases the supply of money in the economy
▪ The Central Bank creates new money and uses it to buy open-market assets
• When a policy decision is made, it creates a ripple effect through the economy and this effect is
known as a transmission mechanism

Incremental Changes to Interest Rates

The transmission mechanisms of changes to the interest rate

Before Explaining a Mechanism from the Diagram Above, Key Terminology Can Be
Reviewed Below

Official Rate Market Rates Asset Prices

Exchange Rate Net External Demand Inflation

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Example 1
• Official rate decreases by 0.25% → market rates decrease → loans are cheaper → consumers
borrow more → consumption increases → AD increases → inflation increases
Example 2
• Official rate decreases by 0.25% → market rates decrease → mortgages are cheaper → property
buyers borrow more → demand for houses increases → asset prices increase
Example 3
• Official rate decreases by 0.25% → market rates decrease → buyers borrow more → asset prices
increase → households with assets feel wealthier → consumption increases → AD increases →
inflation increases
Example 4
• Official rate increases by 0.25% → hot money flows increase → the exchange rate appreciates →
exports more expensive and imports cheaper → net exports reduce → AD decreases → inflation
decreases
Example 5
• Official rate increases by 0.25% → market rates increase → existing loan repayments now more
expensive to repay → discretionary income falls → consumption decreases → AD decreases →
inflation decreases

Quantitative Easing Transmission Mechanism

• The Bank of England commits to buy £60bn of gilts a month → commercial banks receive cash for
their gilts → liquidity in the market increases → commercial banks lower lending rates →
consumers and firms borrow more → consumption and investment increase → AD increases →
inflation increases

Fiscal Policy Instruments

• Fiscal Policy involves the use of government spending and taxation to influence aggregate
demand in the economy
• Government spending includes direct expenditure, but not transfer payments
o Transfer payments are part of fiscal policy, but are not counted as government spending in
the AD formula
▪ Transfer payments enter the circular flow when the recipients spend them
Fiscal Policy Impacts
Example 1
• The Government increases VAT from 20% to 22% → consumers pay more tax → discretionary
income reduces → consumption reduces → AD reduces → inflation eases

Example 2
• The Government decreases corporation tax → firms net profits increase → investment by firms
increases → AD increases → inflation increases
Example 3
• The Government freezes/reduces public sector pay → consumer confidence falls → consumption
decreases → AD decreases → inflation decreases

Example 4
• The Government increases the allowances in the Universal Credit (unemployment benefits) →
household income increases → consumption increases → AD increases → inflation increases

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Government Budget (Fiscal) Deficit & Surplus
• The Government Budget (Fiscal policy) is presented each year as a balanced budget, a budget
deficit, or a budget surplus
o A balanced budget means that government revenue = government expenditure
o A budget deficit means that government revenue < government expenditure
o A budget surplus means that government revenue > government expenditure
• A budget deficit has to be financed through public sector borrowing
o This borrowing gets added to the public debt

Government Budget (Fiscal) Deficit & Surplus

• The Government Budget (Fiscal policy) is presented each year as a balanced budget, a budget
deficit, or a budget surplus
o A balanced budget means that government revenue = government expenditure
o A budget deficit means that government revenue < government expenditure
o A budget surplus means that government revenue > government expenditure
• A budget deficit has to be financed through public sector borrowing
o This borrowing gets added to the public debt

Direct & Indirect Taxation

• The main source of government revenue is taxation
• Direct taxes are taxes imposed on income and profits
o They are paid directly to the government by the individual or firm
▪ E.g. Income tax, corporation tax, capital gains tax, national insurance contributions,
inheritance tax
• Indirect taxes are imposed on spending
o The supplier is responsible for sending payment to the government
▪ Depending on the PED and PES producers are able to pass on a proportion of the
indirect tax to the consumer
▪ The lower a consumer spends the less indirect tax they pay
▪ E.g Value Added Tax (20% VAT rate in the UK in 2022), taxes on demerit goods,
excise duties on fuel etc.
Diagrams to Illustrate Demand-side Policies
Expansionary Demand-side Policies

• Demand-side policies that aim to increase aggregate demand are called expansionary policies
• Expansionary monetary or fiscal policy will shift aggregate demand to the right

Classical diagram illustrating expansionary demand-side policies which increase real GDP (Y1 →Y2)
and average price levels (AP1 →AP2)

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Expansionary Policies Include

• Reducing taxes; decreasing interest rates; increasing government spending; increasing quantitative
easing

Contractionary Demand-side Policies

• Demand-side policies that aim to decrease aggregate demand are called contractionary
policies
• Contractionary monetary or fiscal policy will shift aggregate demand to the left

Keynesian diagram illustrating contractionary demand-side policies which decrease real GDP
(YFE →Y1) and average price levels (AP1 →AP2)

Contractionary Policies Include

• Increasing taxes; increasing interest rates; decreasing government spending; decreasing/stopping

quantitative easing

The Role of the Bank of England

• The Bank of England's Monetary Policy Committee (MPC) consists of nine members
• They meet 8 times a year to set the monetary policy
o At this meeting they set the Bank Rate and discuss if quantitative easing is required (or
should continue)
o Policy is decided by majority vote
o It can take up to two years for the full effects of decisions to be seen in the economy
• The single most important consideration in their deliberations is the inflation target of 2% CPI

A Table That Explains Some of the Factors That Influence the Decision Made by The MPC

Without further intervention, the

Rate of real GDP growth
likely state of the economy a few Current level of CPI Inflation
(output gaps?)
months ahead

Interest rate elasticity

(low confidence = inelastic
State of the property market Unemployment figures
(Overheating?)
response)
Business & consumer confidence Global outlook The exchange rates

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Demand-side Policies During the Great Depression & 2008 Global Financial Crisis
• The Great Depression started in the USA in October 1929 and continued until the late 1930's
o By 1932 the USA unemployment rate was around 25%
o More than 9,000 banks closed during this decade
▪ The flow of money in the economy was weak (poor liquidity)
• The Great Depression created a global slump
o In the UK, unemployment doubled and exports halved leading to a major recession
• The 2008 Global Financial Crisis started in the USA in September 2008 with the collapse of the
investment bank, Lehman Brothers
o The crisis was inextricably linked to interest rates and risky lending in the property market
o In total, about 10 million households lost their homes (roughly 1 in every 20 homes)
o Unemployment doubled from around 5% to 10%
o 489 Banks failed in the five-year period following the crisis - most were bailed out by central
governments
• The 2008 Global Financial Crisis created a global slump
o UK unemployment rose from 5.2% to 7.8%
A Summary of the Demand-side Policies Used During the Great Depression & 2008
Financial Crisis

Fiscal Policy Monetary Policy

• Roosevelt's New Deal (1933-1939) • There is disagreement over
provided large government the effectiveness of monetary
spending on infrastructure and policy
conservation projects (Keynesian • In February 1930 the Federal
approach which increases AD) Reserve Bank cut the Bank
• The government employed many Rate from 6% to 4%
people. Construction projects • In late 1930 they raised the rate
Great Depression included The Edgar Hoover Dam & again to help strengthen
Policy Responses USA The Golden Gate Bridge the exchange rate as investors
• Protectionism increased to increase were selling dollars to buy gold
domestic production • Raising the rate was
and consumption (the Smoot–Hawley a contractionary policy that
Tariff Act in 1930) further weakened the flow of money
• Entry into the 2nd World War further
boosted government spending and
recovery
• The Government prioritised • In 1931 the, the UK stopped using
a balanced budget with contractionary the gold standard which had
policies as they wanted to appreciated the currency
avoid crowding out significantly since 1919
• In 1931, they cut public sector • The Pound (£) depreciated by
wages and unemployment nearly
benefits by 10% - which 25%; exports immediately increas
further reduced consumption and ed and so did AD
Great Depression
confidence in the economy • The Bank Rate was lowered from
Policy Responses UK
• In 1931 they raised income tax from 6% to 2% in late 1931 and this
22.5% to 25% which helped AD increase
decreased disposable income and
consumption
• In 1932, they introduced a 10%
tariff on all imports (except from British
Colonies) so as to increase production
and consumption within the UK

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 • Keynesian approach involving • The Federal Reserve cut Bank
significant government spending Rates eight times between October
and expansionary fiscal policy from 2007 & the end of 2008 from 5.25%
2008 to 2012 to 0.25%
• The banks were not allowed to fail and • Three rounds of quantitative
supported by the Government easing known as QE1, QE2 and
• The Economic Stimulus Act of QE3 injected over $3tn. into
2008 Financial Crisis
2008 injected $152bn. in fiscal the money supply
Policy Responses USA
stimulus
• The American Recovery and
Reinvestment Act of 2009 injected
another $787bn. over the next few
years
• Both of these increased AD and
helped the economy to quickly recover
• Keynesian approach involving • The Bank of England cut the Bank
significant government Rate nine times between December
spending and expansionary fiscal 2007 & March 2009 dropping from
policy from 2008 to 2010 5.75% to 0.5%
• The banks were not allowed to fail and • Several rounds of quantitative
were supported by the Government easing worth £375bn. took place
• Policies included income tax cuts, VAT between March 2009 & July 2012
reduction of 2.5%, £20bn. small
business loan guarantee scheme, a
2008 Financial Crisis
car scrappage scheme to support the
Policy Responses UK
car industry
• A major injection by the government
was £3bn. investment spending on
infrastructure and defence
• The new Conservative
Government switched from
expansionary fiscal policy to Austerity
• Cutting government spending and
raising taxes delayed the recovery

Strengths & Weaknesses of Demand-side Policies

Strengths of Monetary Policy

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

Weaknesses of Monetary Policy

• Conflicting goals e.g economic growth puts upward pressure on inflation

• Time lags between policy and the desired impact (up to 2 years)
• Expansionary policy is less effective in negative output gaps than when used with positive output
gaps
o Consumers may not respond to lower interest rates when confidence is low
• Cheaper credit can inflate asset prices in the long term
• The interest rate has limitations on downward adjustment

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Strengths of Fiscal Policy

• Spending can be targeted on specific industries

• Short time lag as compared with monetary policy
• Redistributes income through taxation
• Reduces negative externalities through taxation
• Increased consumption of merit/public goods
• Short term government spending can lead to an increase in the long-run aggregate supply
o E.g. Building a new airport immediately increases government spending and AD, but when
it is built, the potential output will have increased

Weaknesses of Fiscal Policy

• Policies can fluctuate significantly as governing parties' change

o Long term infrastructure projects may lack follow-through
• Increased government spending can create budget deficits

o Repaying this debt may lead to austerity on future generations

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

When evaluating any demand-side policy, avoid generalisations and focus on the effects of the
specific policy mentioned. To strengthen any response, fully develop each transmission mechanism
as this is part of your 'chain of analysis'. Always conclude by explaining the likely impact on the real
GDP and average price levels.

2.6.3 Supply-side Policies

Supply-side Policies
• Supply-side policies aim to shift the long-run aggregate supply (LRAS)
• There are two categories of supply-side policies
o Interventionist and market-based
• Interventionist supply-side policies require government intervention in order to increase the full
employment level of output
o These are mainly used to correct market failure
• Market-based supply-side policies aim to remove obstructions in the free market that are holding
back improvements to the long-run potential
o E.g. Setting up a regulator to prevent monopolies forming

Aims of Supply-side Policies

• Broadly speaking, there are five aims of supply-side policies
o The overall aim is to increase the quantity/quality of the factors of production

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 Market Based & Interventionist Strategies to Meet the Aims of Supply-side Policies

Aim of Supply-side Policy Market Based Approach Interventionist Approach

• Reducing income/corporation
tax rates
• Restructuring
To increase incentives the unemployment
benefits system to incentivise
the unemployed to seek work
• Increased government
spending on innovation
• Privatisation & deregulation • Direct support to firms
To promote competition • Trade liberalisation (subsidies)
promotes international
competitiveness
• Decreasing trade union
power so wages can be • Increased government
decreased spending on
To reform the labour market • Decreasing minimum improving occupational
wages to lower costs of mobility
production
• Increasing government
spending
on education and
retraining
To improve the skills and
• Increasing government
quality of the labour force
spending
on healthcare so that
productivity improves
• Increased government
spending
To improve infrastructure
on infrastructure

MCQ will test your ability to differentiate between market-based and interventionist supply-side
policies.
When evaluating supply-side polices in essay responses, demonstrate critical thinking by
acknowledging that privatisation has been used for so long that there is little left to privatise and
perhaps a better way forward is to improve competition policy & regulation.
Remember, the private sector will also be increasing supply in an economy (it is not only up to the
government) as they are incentivised to increase their profits.

Diagrams to Illustrate Supply-side Policies

• Successful supply-side policies will increase the long-run aggregate supply (LRAS)
o This equates to an increase in the production possibilities of an economy

• The successful implementation can be illustrated on either a Classical or Keynesian diagram

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 A Classical diagram that illustrates the implementation of successful supply-side policy

A Keynesian diagram that illustrates the implementation of successful supply-side policy

Diagram Analysis

• E.g. Efforts to reduce trade union power have been successful

o There is now less protection on wage levels
▪ Wage levels fall
• Firms will now hire more workers & the quantity of productive labour in the economy has
increased
o This causes LRAS1 to increase to LRAS2
▪ Output increases from YFE to YFE1
▪ Average price levels fall from AP1→AP2

Strengths & Weaknesses of Supply-side Policies

Strengths of Supply-side Policies

• They increase the rate of growth of an economy

• They reduce average price levels
• They reduce unemployment
• They often increase the value of net exports
• Improvements in Infrastructure can raise the quality of life for all citizens

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Weaknesses of Supply-side Policy
• The distribution of income worsens as labour market reforms and wage policies lower worker's
wages
• They are expensive to implement
• There are significant time lags between expenditure & seeing the benefits
• Due to the long-term nature, changes in government often result in changes to budgets & scope
of projects
o The end result may be less effective than it could have been
• Vested interests can result in less effective outcomes e.g. There are many examples of
privatisation occurring in such a way that the government's preferred bidders obtained an asset at a
knock down price
o Often the preferred bidders were not necessarily the most efficient firms
2.6.4 Conflicts & Trade-offs Between Objectives & Policies

Trade-offs Between Macroeconomic Objectives

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

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

Objectives
Trade-off Explanation

Increasing economic growth causes the economy to move closer

Economic Growth & Inflation to full employment. Prices for remaining resources are bid up
leading to inflation which may outpace the target inflation rate of
2%

Economic growth often increases pollution, negative

Economic Growth &
externalities and the depletion of non-renewable resources. The
Environmental Sustainability
higher the growth, the faster the depletion

During periods of high economic growth, the profits the owners of

Economic Growth & Inequality the factors of production receive are disproportionate to any
increase in workers' wages leading to greater inequality

Economic Growth & Balanced Economic growth driven by expansionary fiscal policy often
Budget requires a budget deficit
Economic growth usually leads to higher incomes which leads to an
Economic Growth & Balancing increase in imports by households thereby worsening the current
the Current Account account balance

The closer an economy moves to full employment the less workers

Low Unemployment & Low
will be available for hire and wage inflation will help
Inflation
increase overall inflation

You are usually examined on trade-offs and conflicts in longer essay questions. In your
responses, be more precise than general. For example do not speak about contractionary
monetary policy, but focus on a specific contractionary monetary policy tool (e.g. increasing
interest rates) - and then logically explain the conflicts or trade-offs that will develop.

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Short-run Phillips Curve
• The Short-run Phillips Curve (SRPC) observes that there may be a trade-off between
unemployment and inflation
o Rising inflation is accompanied by falling unemployment
o Rising unemployment is accompanied by falling inflation
o This trade-off makes it difficult for the government to achieve both low unemployment and
low inflation

The Short-run Phillips Curve illustrates the relationship between changes to aggregate demand
(AD), inflation & unemployment

Diagram Analysis

• The economy is initially in equilibrium at AP1YFE

• At this point, unemployment is at 4% and inflation is at 3% and this is considered to be full
employment (YFE)
o There is always some unemployment due to the frictional and structural unemployment
that exists
• An increase in AD from AD1→AD2 causes a positive output gap (YFE-Y2)
o With an increase in output the demand for labour rises & unemployment falls from
4%→3%
o The remaining labour in the market is scarcer & workers are able to negotiate higher wages
▪ This causes wage inflation in the economy
o Wage inflation leads to an increase in inflation from 3%→4%
• A decrease in AD from AD1→AD3 causes a negative output gap (YFE-Y3)
o With a decrease in output the demand for labour falls & unemployment rises from 4%→5%
o Labour is more abundant & to get hired workers have to accept lower wages
▪ This causes wage deflation in the economy
o Wage deflation leads to a decrease in inflation from 3%→2%

Policy Conflicts & Trade-offs

• Similarly to the trade-offs that exist in achieving the different macroeconomic objectives, there
are trade-offs & conflicts that occur with the use of demand-side & supply-side policies
Example 1
• Raising interest rates (contractionary monetary policy), eases demand-side inflationary pressure
but raises the cost of borrowing for firms and slows down supply-side investment
o Tackling short term inflation, delays long term supply-side growth
Example 2
• An increase in government spending (expansionary fiscal policy) can bring about improvements
on the supply-side of the economy in the long-run (LRAS)

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 o Conversely, it may cause a shortage in short-run aggregate supply (SRAS) as
government spending causes excess demand in the economy, leading to inflation
Example 3
• Increased environmental policies may lead to a fall in economic growth and lower LRAS
o Fossil fuel industries have traditionally enabled increases in LRAS

When assessing demand-side and supply-side policies, it's important to consider them
in totality. Government and central banks will use a combination of policies to address
economic issues. So, even if the question asks you to evaluate the use of an individual
policy (e.g. fiscal policy), you should include alternative policies in your answer.

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