AS MACRO

REVISION

PACK

COLOUR CODE TO REVISION GUIDE

GREENHEADING/SUB HEADING

BLUEDEFINITIONORANGE

EXPLAINING A CONCEPT

AGGREGATE DEMAND The total demand for a country’s goods and

services at a given price and in a given time

period

This planned expenditure on domestic output

comes from firms, households, the government

and foreigners

There are five components to aggregate

demand and the formula is

AD=Consumer expenditure + Investment +

Government Spending + (Exports –

Imports)

AD = C + I + G (X – M)

PRICES

The average each of the prices of all the products

produced in an economy

CONSUMER EXPENDITURE

Spending by households on consumer products

INVESTMENT

Spending on capital goods

GOVERNMENT SPENDING

Spending by central government and local government

on goods and services

NET EXPORTS

The value of exports minus the value of imports

TRANSFER OF PAYMENTS

Money transferred from one person or group not in

return for any goods or services

COMPONENTS OF AGGREGATE DEMAND

CONSUMER EXPENDITURE

Consumer expenditure is also know as

consumption

This is usually the largest component in most

countries

It is the spending by households on clothes, foods

and insurance.

INVESTMENT

Is the most volatile of the components of

aggregate demand

It is the spending on capital goods such as

delivery vehicles

This fluctuates highly depending on the economy

GOVERNMENT SPENDING

It is the spending from the local and central government

They spend on things such as education, healthcare and

police services

This does not include transfer of payments such as benefits

NET EXPORTS

This is calculated by the exports of foreigners spending on

a country’s goods and services and then deducts spending

by any imports by the country's population

This can create a positive or a negative effect on aggregate

demand but this is highly reliant if the country has a trade

surplus or a deficit.

TRADE SURPLUS

the value of exports exceeds the value of imports

TRADE DEFICIENT

The value of imports exceeds the value of imports

CONSUMER EXPENDITURE

There is a range of influences on how much a household

spends:

Real disposable income

Richer households and economies tend to spend more in total

to the poorer, as they have more money to spend.

The proportion of income or the APC, will fall as the income

rises. A banker would have a smaller APC because they are a

larger income.

AVERAGE PROPENSITY TO INCOME

the proportion of disposable income spent. It is the consumer

expenditure divided by the disposable income

Wealth

The more wealth there is the more people have to spend, this is

in form of their houses, shares and saving account. This is a clear

result in greater consumer confidence, because if the market

prices for houses were to go up, people tend to spend more

because, house prices are a crucial indication of how the

economy is doing.

WEALTH

A stock of assets, e.g. Property, shares and money held in a

saving account

CONSUMER EXPECTATION AND CONFIDENCE

This is a significant influence on consumer expenditure

When consumers are feeling optimistic about the future,

expecting their job prospects to be good they spend more.

The proportion of income spent can rise at income rises

THE RATE OF INTEREST

Change in the rate of interest are another important influence

A fall in rate of interest will stimulate a rise in consumer

expenditure. It becomes cheaper for consumers to borrow, it

reduces the incentive for people save as they would get less in

return. Also mortgages and loans are easier to pay off, leaving

extra money for consumption.

Net savers will lose out if the rate of interest falls.

NET SAVERS

People who save more than they borrow

THE AGE STRUCTURE OF THE POPULATION

It is generally thought that the young and the elderly spend a

large amount of their disposable income.

So the government measures that to redistribute the income of

the rich to the poor, so that it can likely cause an increase in the

consumer spending

DISTRIBUTION OF INCOME

How income is shared out between households in a country

INFLATION

A sustained rise in the price level

This is difficult to determine as to what impacts the effects of

spending

If you expect a high inflation in the future, the spending now

may increase rapidly

However at times there as a high amount of saving during a

time of inflation, as they were trying to maintain the real value of

their money

SAVING

Real disposable income minus spending

This is not a component of aggregate demand, but influences the

spending undertakes by governments, foreigners, firms and

households

INFLUENCES OF SAVINGREAL DISPOSABLE OF INCOME

If the real disposable income increases, household will not only save

more but will also save a larger proportion of income

Their average propensity to save increases

AVERAGE PROPENSITY TO SAVE

The proportion of disposable income saved. It is saving divided by

disposable income

THE RATE OF INTEREST

A rise in the rate of interest would increase the rewards of saving

and then therefore would encourage people to save more.

These are some target savers who would have to put less money in

the account as the interest would be reduce the amount to save

TARGET SAVERS

People who save with a target figure in mind

CONFIDENCE AND EXPECTATIONS

Households and firms tend to save more when they are uncertain or

concerned about the future

For example, if people were worried of losing their jobs there would

be this sudden precaution to save, as there may be a drop in income

SAVING SCHEMES

If there is a range of saving scheme this should lead to more saving

as there is more variety

RANGE OF FINANCIAL INSTITUTIONS

Saving can be affected by the well respected institutions, as there are

many highly established institutions in the country, which would lead

to confidence.

However in practise it has been found that financial systems have

become more sophisticated and developed, causing a fall in saving

rates

GOVERNMENT POLICIES

A decision by the government to introduce a tax free saving scheme

will encourage people to save more

In contrast, if there is a raise in the state pension scheme then there

would be a decrease in the incentive of people saving for a pension

THE AGE STRUCTURE OF THE POPULATION

It has been found that people save little

when they are young, but when having

reached middle ages the saving increases

It is also known that the elderly dissave,

drawing in their saving to maintain their

living standards when they retire

DISSAVE

Spending more than disposable income

SAVING RATIO

Saving as a proportions of disposable income

INVESTMENT

Firms invest when they expect returns from the capital goods that they

buy to be greater than their cost

INFLUENCES INCLUDE CHANGES IN DISPOSABLE INCOME

If the real disposable income increases, demand for the goods and

services would increase. This would then encourage firms to invest so

that they can expand their capacity.

Firms would also have to believe that the increases in demand would

be sufficient and will last so that they can produce the extra output

EXPECTATIONS

Firms are more likely to invest more if they are optimistic about the

future and future prospects.

The extent and speed of changes in expectations are the main

reasons for the volatility of investment

CURRENT PROFIT LEVELS

High profits can encourage investments in two ways. They provide

the finance to invest and they would also contribute to the firms

optimism about the future

CAPACITY UTILISATION

The extent of which firms are using their capital goods

Firms are more likely to invest if they are operating close to full

production

In contrast, if they have considerable space of capacity, they may be

able to increase the output without having to buy new capital goods

CORPORATION TAX

A tax on the firm’s profit

A cut in corporation tax would lead to an increase in the amount of

profit that the firm is likely to keep, which would be mean more money to

invest.

Government can stimulate investment by providing investment subsidy

ADVANCES IN TECHNOLOGY

A firm may invest in new capital goods if they think that the equipment

would produce at a much faster rate or better quality, so it return they

would expect higher profit because of an increase in demand or a fall in

unit price

PRICE OF CAPITAL EQUIPMENT

A reduction in the price of capital equipment may also increase

investment. Such a fall may make it available for more firms to use the

equipment so that it can expand their capacity

THE RATE OF INTEREST

As with consumer expenditure, investment is influenced by

the rate of interest

A rise in the interest would reduce the chances of

investment for four reasons:

It will increase the opportunity cost of the investment,

they can use the profit on something else, although

most investment is made from the retained profits

A higher interest rate would make it more expensive

to borrow and may discourage an investment projects

A change in the interest would affect the return of the

investment, a higher rate would reduce the chances of

investment; firms will anticipate the demand to fall

Also a rise in interest rates causes a decrease in the

interest of shares. Lower demand for shares would

cause a reduction in the price level and decrease the

funds for the investment

GOVERNMENT SPENDING

The decisions for government spending are influenced by a number of

factors:

GOVERNMENT VIEW ON THE MARKET

The governments view on the extent of the market failure and the ability to

correct it

Economies where the government plays a large part usually has a high

government spending and this would form a larger proportion of aggregate

demand

THE LEVEL OF ECONOMIC ACTIVITY

If there is a high unemployment rate, government may increase the

spending in a bid to increase the aggregate demand and the output of the

economy.

In contrast if there is high inflation the government may reduce the amount

of spending

THE DESIRE TO PLEASE ELECTORATE

Voters can add pressure on the government to spend money on education,

healthcare and safety, so that there can they can attempt to increase the

political support

WAR

If there is war, terrorism and rising crime, this can also increase the

government spending

NET EXPORTS

The influences on export revenue and import expenditure

REAL DISPOSABLE INCOME ABROAD

A rise in income abroad would mean more exports abroad, they

will but more goods and services from the UK

REAL DISPOSABLE INCOME AT HOME

An increase in income at home would result in a fall in exports

and an increase in imports. Or the export market would divert some

of the goods to the population of the country

THE DOMESTIC PRICE LEVEL

If domestically produced products are to become expensive, firms

and households at home and abroad will switch from them to

products made by other countries

THE EXCHANGE RATE

A fall in the exchange rate would result in more exports but fewer

imports as it would be more expensive to buy from them

GOVERNMENT RESTRICTIONS ON TRADE

A country’s exports may rise if the government were to remove

any restrictions

THE RELATIONSHIP BETWEEN AGGREGATE DEMAND

AND THE PRICE LEVEL

Three effects as to why the AD curve slopes downward

THE WEALTH EFFECT

This relates to the changes in households and firms

wealth when there is a change in price

When there is an increase in the price level then it

reduces the purchasing power of wealth and causing the

AD to contract fall in rate

THE INTERNATIONAL TRADE EFFECT

A rise in price level, assuming no change in the exchange

rate will make the country’s goods less competitive

This would cause an increase in the foreign goods, or

imports

Net exports would fall and AD would contract

THE RATE OF INTEREST

A rise in the price would result in high number of selling as they

would get more in return such as government bonds

This leads to an increase in supply of the government bonds which

would lead to a fall in price, such changes could raise the percentage

of interest

This is because the interest rate changes in proportion with the

change in price level

For example a bond pays £5 interest, if initially sold for £100, the

interest rate in 5%. When the price fall to £50 then the interest rate

would be 10%

A higher interest rates like this would result in a decrease in

investment and consumption

In contrast a fall in price leads to a so AD slopes from left to right

because a rise in the price level would reduce the monetary wealth,

raise the interest rate and reduce the international competiveness

GOVERNMENT BOND

A financial asset issued by the central or local government as a means

of borrowing money

SHIFTS IN AD

A price change will only cause a

movement along the curve

The influences for a shift are:

Expectations

Changes in government policy

Changes in the exchange rate

Change in the population size

If households become more optimistic

about the future, increases the consumer

expenditure and investment

A cut in the restrictions and taxation

AGGREGATE SUPPLY

The total amount that producers in an

economy are willing and able to supply at

a given price and at a given time period

the shape of the AS curve is determined

by the capacity existing in the economy

When the output is low and there is high

unemployment, this is shown at the

beginning of the AS curve

AS is perfectly elastic , meaning that more

can be supplied without raising the price

SHIFTS IN AS

A change in AS means that the total

output that producers are willingly and

able to supply at any given price level alters

The influences for a shift on the short run

are:

Changes in the cost of production

Changes in the cost of raw material

Shifts on the long run

Changes in the quality or the quantity of

resources

Such as labour and efficiency

MACROECONOMIC EQUILIBRIUM

A situation where AD equals the same as AS and the real GDP is

not changing

AD

When AD is higher than AS, there would be a shortage of

goods and services

Firms would find their stocks declining

The excess demand would encourage firms to expand their

output

The surplus in AD would push the price higher, depending on

the level of capacity

AS

When AS is exceeding AD, would lead to pressure that would

move the economy back to equilibrium

The existence eon the unsold of goods and services would

cause the AS to contract

The price level would fall but depending on the level of

capacity

THE CIRCULAR FLOW ON INCOME

2 SECTOR MODEL

THE CIRCULAR FLOW ON INCOME

5 SECTOR MODEL

LEAKAGES

Withdrawals of possible spending from the

circular flow of income

Taxes, saving, spending on imports

Leakages reduces the aggregate demand

INJECTIONS

additional of extra spending into the circular

flow of income

Investment, government spending, exports

Increases the aggregate demand

When the injections and leakages are equal

the output will not be changing

THE MULTIPLIER EFFECT

The process by which any change in a component of

aggregate demand results in a greater final change in

real GDP

When injections exceeds leakages, aggregate

demand will increase

The rise in AD will have a greater final effect on the

economy, this occurs when people spend money, that

expenditure becomes the income for those who sell

them

They will in return spend that money that they

receive, so there is a knock on effect, with AD rising by

more than the initial amount

Spending will continue to rise until leakages match

the initial injection

At AD1, it is the post injection , at

AD2, is the rise of the injection.

After this there should be a final

change in AD which should be the

final rise in AD. This should result in

a great change in GDP and little

change in price

CHANGES IN AD

Three key influences on the effect of a

change in AD on the

Output of an economy

Unemployment rate

Inflation

They all depend on the

Size of the initial change

The size of the multiplier

Original level of economic activity

If the economy is initially operating with

a considerable spare capacity, an increase

in AD is likely to effect the output of the

economy, reduce the unemployment, and

leave the price level unchanged

AD1

AD

An increase in AD

and increasing the

output without

changing the price

level

A rise in AD may increase both output

and price level.

This output will occur if either economy

moves from a position of significant spare

capacity to one where there is a shortage

of resources

AD1

AD

AD1

AD

Finally if the economy is already

operating at full employment, with no

spare capacity an increase in Ad will be

purely inflationary

There would be no change in GDP but

only in price

CHANGES IN AS

The effects on the changes in AS will depend on the

Size of the change

Initial level of economic activity

An increase in AS would result in a increase in GDP

and price falling down

There is a possibility, however when the increase

in AS may have no impact on the economy. This

would only occur when the economy is initially

operating at a low level and there is high level of

unemployment

In this case it would result in no change in GDP or

price as they are working elastic part of the curve

if there is increase is AS as much as AD,

then the economy can enjoy higher output

without encountering any inflationary

pressure

An increase in output but no change in the

price level

However AD does occur rapidly and could

result in inflation or result in overheating

OVERHEATING

The growth of aggregate demand

outstripping the growth of aggregate

supply, resulting in inflation

OUTPUT GAP

The difference between an economy’s

actual and potential real GDP

Occurs when the economy is not

producing to the full capacity

A negative output gap occurs when the

economy’s actual output is below its

potential output

A positive output gap arises when the

economy’s actual output is above the

potential

ECONOMIC GROWTH

In the short run, an increase in real GDP, and in the long run an

increase in the productive capacity that is, in the maximum output that

the economy can produce

REAL GDP

The country’s output measured in constant prices and is adjusted with

inflation

NOMINAL GDP

Output measured in current prices and no adjusted to inflation

REAL GDP = GDP figure x base year price index

current price index

Calculating the percentage change in nominal GDP

Difference in GDP

Original

SUSTAINABLE GROWTH

Economic growth that can continue over time and does not endanger

future generations’ ability to expand productive capacity

TREND GROWTH

The expected increase in potential output over time. It is a measure of

how fast the economy can grow without generating inflation

X 100

MEASURING ECONOMIC GROWTH

Economic growth is usually measured by the annual percentage

change in real GDP, or the country’s output

The circular flow of income shows that the country’s income is equal

to the country’s output and its expenditure

So real GDP can be calculated by total of output, income and

expenditure, without the inclusion of leakages and injections

Care must be taken when doing this for output, you may calculate the

raw material but the price of the finished product, so avoid double

counting

Income, only income which have been earned in return for providing

goods and services, not the transfer of payments such as benefits

Expenditure, to include exports as they are made by the producers of

the country and to exclude the exports, as the money goes to foreign

country

PRODUCTION AND PRODUCTIVITY

Production is what is produced, so if there is an increase in GDP then

the output has increased

If a productivity rises more than the wages, then labour costs will fall

resulting for the country to become more price competitive

WHAT CAUSES ECONOMIC GROWTH

In the short run, an economy with spare capacity

can experience economic growth as a result of an

increase in aggregate demand

There can be consumption led growth, which is

based on the cut of income tax or the rise in

consumer confidence

In the long run an increase in the quantity or the

quality of the resources increases

The increase in the labour force, such as more

women entering the labour force

The ability to produce the products

The advances in technology

Improvements in training and education

THE BENEFITS OF ECONOMIC GROWTH

A likely rise in the standard of living, if the GDP

increases then the population can enjoys the

increased in goods and services

enable poverty to be low, higher output increases

the tax revenue so that it can be used to finance the

poor

Reducing poverty by increasing the rate of

employment, however the risk of this is that there is

not an increase in aggregate demand in line with the

increase in the labour force

Increases the output level of the country and

thereby increases the status and power in the

international organisations and in international

organisations

UNEMPLOYMENT

a situation where people are out of work but are willing and

able to work

The unemployed X 100

Labour force

UNEMPLOYMENT RATE

The percentage of the labour force who are out of work

There are two methods of measuring unemployment

LABOUR FORCE SURVEY

A measure of unemployment based on a survey using the ILO

definition of unemployment

INTERNATIONAL LABOUR ORGANISATIONAL (ILO)

A member organisation of the United Nations that collects

statistics on the labour market conditions and seeks to improve

the working conditions, they use the claimant count

CLAIMANT COUNT

A measure of unemployment that includes those receiving

unemployment related benefits

CAUSES OF UNEMPLOYMENT

This can be examined from the demand and the supply side

There are three causes of this

CYCLICAL UNEMPLOYMENT

Unemployment arising from a lack of aggregate demand, in

this case demand for products would be low and resulting in

a high unemployment

STRUCTURAL UNEMPLOYMENT

Unemployment caused by a decline of certain industries and

occupations due to changes in demand and supply. People

may loose there jobs because of technological advances or

when firms produce abroad because of cheaper labour force

FRICTIONAL UNEMPLOYMENT

Short term unemployment occurring when workers are in

between jobs. It is less serious than cyclical and structural

unemployment as they are for short periods

DIFFICULTIES IN INTERPRETING REAL GDP

On the surface an increase in real GDP suggests that living standards

are improving, as more goods and services are being produced

However, it eliminates the rise in output may be the case of an

increase in population, the solution to this is to asses the real GDP by

per capita

Real GDP takes inflation into account, so a raise in income may not

necessarily mean an increase in the standard of living

Another problem which can occur is the existence of an informal

economy, this is when there is unrecorded economic activity

The existence of this causes the GDP to be lower as the informal

economy is not taken into account it also understates the rate of

unemployment. Also the inflation rate is usually lower in this type of

economy which also overstates the rate of inflation

INFORMAL ECONOMY

Economic activity which is not recorded or registered with the

authorities

Tax revenue is lower than would be possible if all economies where

taxed. Firms tend to stay small in an informal economy as they want to

avoid the attention of authorities

MEASURING INFLATION

INFLATION

A steady rise in price as measured by a change in

cost overtime by a standard basket of goods and

There are two methods which are used to measure

inflation

CONSUMER PRICE INDEX (CPI)

Excluded all housing costs, such as mortgages

interest payments, council tax and television license

Includes university accommodation fees

Based on spending in private households

Geometric means in contrasting the index

The basket is then compared with a sample from

the month before and the inflation is calculated

RPI (RETAIL PRICE INDEX)

The basket is referred as the basket of which a typical

customer would buy products so that they can

calculate the product index

RPIX

Minus the interest rates of mortgages

Arithmetic means of methodology

The exclude the mortgagees rates because when

there is an increase in the interest rates it would take a

up large proportion of income, resulting in a decrease

in demand

RPIY

Mortgages interest payments plus any indirect taxes

such as VAT.

Excludes food prices and energy prices

DEMAND PULL INFLATION

Occurs when there is excess demand

Businesses respond to high demand by raising prices to increase

their profit margins

Demand-pull inflation is associated with the boom phase of the

cycle

The main causes of demand pull inflation

Very fast growth of demand for credit / borrowing

High levels of consumer spending

CAUSES OF PULL INFLATION A depreciation of the exchange rate increases the price of imports and reduces the foreign price of UK exportsA reduction in direct or indirect taxation - consumers will have more disposable income causing demand to riseRapid growth of the money supply as a consequence of increased bank and building society borrowingRising consumer confidence and an increase in the rate of growth of house pricesFaster rates of economic growth in other countries – providing a boost to UK exports overseas (an injection of AD)

COST PUSH INFLATION

Occurs when costs of production are increasing

Causes:

External shocks (e.g. commodity price rises)

A depreciation in the exchange rate

Rises in labour costs (wages)

Higher indirect taxes on goods(e.g. VAT)

Leads supply falling

Firms raise prices to protect their profit margins –

better able to do this when market demand is price

inelastic

“Wages often follow prices”

A rise in inflation can lead to rising inflationary

expectations

CONSEQUENCE OF INFLATION

Fall in the value of money

Menu costs

The costs of changing prices due to

inflation

Shoe leather costs

Costs in terms of the extra time and effort

involved in reducing money holdings

Admin costs

adjusting accounts, negotiating with

unions about wage rises, assessing raw

materials costs

Inflationary noise

The distortion of price signals caused by

Inflation

CONSEQUENCE OF INFLATION

Random redistribution of income

Some workers will get a rise in income in line with

inflation whilst others don’t

Fiscal Drag

People’s incomes being dragged into

higher tax bands as a result of tax brackets

not being adjusted in line with inflation

Uncertainty

Inflation causing inflation

People thinking that inflation will go up and would

stock up causing an increase in demand, pushing

prices higher

Loss of international competitiveness

Often seen as fewer exports

BENEFITS

If low and steady, higher prices from D-pull

inflation may encourage firms to increase output

Workers like rises in their pay, even if nominal

Allows flexibility for firms to alter wages.

Most would resist a cut in nominal (money) wage

but accept a small rise smaller than inflation

SIGNIFICANCE DEPENDS ON

The rate of inflation

Cost push vs Demand pull

Its cause

Fluctuating or stable?

Correctly anticipated?

Relative rate (compared to other countries)

CAUSES OF INFLATION

The exchange rates

If the exchange rate is low then there would be little

inflation as there would be high exports and high

demand

Government restrictions on free trade

This would add to the cost of exports which would

change the price level resulting in inflation

The domestic price level

If the price is rational with the cost of production

and there is high demand this may cause inflation

Real disposable income at home

If there is high income at home, this would increase

the demand and would then increase the price

BALANCE OF PAYMENTS

A record of all the money which is flowing in and out of the country

INFLUENCE ON THE BOP

REAL DISPOSABLE INCOME AT HOME

A rise in income at home may result in a fall in exports as firms divert

some products from the export market to the domestic market. Also,

consumers can afford to import more.

REAL DISPOSABLE INCOME ABROAD

More money people have abroad, the more they are likely to import

UK goods.

THE EXCHANGE RATE

If the exchange rate lowers, it will make UK goods more competitive

and drive up exports. It also makes imports more expensive

THE DOMESTIC PRICE LEVEL

If inflation rises it makes UK goods less competitive, therefore exports

are likely to fall

GOVERNMENT RESTRICTIONS ON FREE TRADE

The more restrictive governments are of foreign imports, the greater

the net exports. Such as tariffs and quotas

There are three parts of BOP

CURRENT ACCOUNT

Trade in goods and services

Income, money which flows in as wage, dividends

and interest

Current transfers, money from the government or

international transfers money form individuals

CAPITAL ACCOUNT

Patens, buying foreign land for embassies

Big transfers to invest in capital parts

FINANCIAL ACCOUNT

Covers all investment into and out of the economy

Foreign Direct Investment is when companies are

moving out to operate in another country

CONSEQUENCES OF DEFICIT IN THE CURRENT ACCOUNT

Results in an increase in the deficit

Lowers the economy's output

Raises the unemployment

Put a downward pressure on the price

A fall in the exchange rate

Increase in the country's debt

A SURPLUS IN CONTRAST

Experiencing a inflow of money in the economy

An increase into he money would result in the banks

having more to lend

Increase in the number of entrepreneurs as they would

be invested by the banks because of the increase in money

This would lead to an increase in employment and

growth may result hence

The cause of a defect or a surplus is the same for the Balance of

Payments

STRUCTURAL ISSUES

Poor quality products

Products being too expensive

Products not in line with changing demand

SIGNIFICANCE

Its size

E.g. what percentage of GDP.

Duration

If it lasts a short time it is unlikely to be significant.

Cause

Price and income fluctuation are not always a major

cause for concern, but structural problems are more

serious. E.g. high inflation and low productivity are

structural problems that may persist.

What’s happening in the capital and financial account.

EXCHANGE RATES

the price of one currency in terms of another

currency

FIXED EXCHANGE RATE

when the government intervene in the currency

market so that, that can stay close to the exchange

rate target

ADVANTAGES

Provides a greater certainty for exporters as there is

less speculative activity

Can exert a strong discipline on firms to control the

costs as it would make them internally competitive

Helps maintain low inflation eventually bringing the

interest rates down

FLOATING RATES

Changes in the market of demand and supply of

the currency to cause a change

ADVANTAGES

Fluctuations acts a price signals when the

economy is not doing goods

Countries with a large deficit would be able to

reduce it as the rates change dues to the demand

and supply of the currency

This should reduce the deficit in the current

account, only if the price elasticity of demand for

imports and exports are high

Allows the government and authorities to have

flexibility in determining interest rates

INFLUENCE ON DEMAND AND SUPPLY OF

CURRENCIES

International competiveness (especially

labour productivity, investment and relative

inflation rises

Change in income abroad

Change in income at home

Domestic interest rates, demand and supply

would cause a change in exchange rate

For investment reasons, such as foreign

direct investment

Speculation

Interest rates and exchange rates follow in the same

direction

Hot money is injected into the economy when the

interest rates are high as they would be getting more

in return, this would lead to an increase in demand

for that currency

There are time when this is not true, when the there

is an interest rate cut and the foreigners confidence

increases and causes the exchange rate to do up

When talking about the exchange rate follow this

sequence

Rate (change) – Price (change) – Demand (change) –

AD (change) – Inflation (change) – potential (change)

– interest rates (change) – exchange rate (change)

FISCAL POLICIES

The taxation and spending decisions of the

government

The aim of the fiscal policy is to influence AD

The government can either increase or decrease the

use of the fiscal policy

They do this by:

Changing the government spending

Changing consumption through the use of taxes

G and C are both components of AD

If the government increases spending then this

would increase AD and vice versa

If the government were to raise the taxes then this

would reduce the AD and vice versa

Higher spending will often have a multiplier effect

and this will further increase AD

REFLATIONARY POLICIES

Designed to increase AD

For example increase in government spending

and decrease in taxes

This is also known as the expansionary or loose

fiscal policy

Reducing taxes and increasing government

spending has the same effect, greater spending in

the economy

Government will do this if they want to reduce

unemployment, the extra spending will increase the

demand for products which firms will meet by

hiring workers

Firms profit will increase, this will lead to inflation

DEFLATIONARY POLICIES

Policies designed to reduce AD

Reduced government spending and increase in

taxes

Also known as the contractionary or tight fiscal

policy

The government may wish to reduce inflation by

increasing the taxes and reducing the government

spending

There will be less spending in the economy and

firms will make less profit

This prevents the economy from growing too fast

A problem is that the unemployment might

increase as firms are can not expand

OTHER REASONS FOR CHANGES IN THE

FISCAL POLICY

Encouraging consumption of merit goods

Discouraging consumption or demerit

goods

Altering distribution of income

Altering incentives, changing the aims of

people

Simplifying systems

DISCRETIONARY FISCAL POLICIES

The government actively influences AD by

changing tax or expenditure

AUTOMATIC STABILISERS

Forms of government spending that changes

automatically to offset fluctuations in economic activity

When GDP rises government receives more tax

VAT

Income tax

Inheritance tax

Road tax

Co operation tax

PROGRESSIVE TAX

To tax that takes a higher percentage from the rich to

the poor. Such as income tax, the Robin Hood tax

REGRESSIVE TAX

A tax that takes a higher percentage from the income

of the poor. VAT takes a higher proportion of income

to the poor

GOVERNMENT SPENDING

this can be broken into

CAPITAL EXPENDITURE

New hospitals

Schools

Roads

The government only borrows for this

CURRENT SPENDING

Running public services

Teachers wages

Medicines used for NHS

TRANSFER PAYMENTS

Money transferred from taxpayers to benefit

recipients

DEBT INTEREST PAYMENTS

Payments made to the holders of government debts

DEFICITS AND SURPLUSES (BUDGET)

If government spends more than the it

gains in tax revenue then gain a budget

deficit

if the opposite occurs then it is known as

a budget surplus

They raise the tax to raise the revenue to

discourage consumption of the products

EFFECTIVENESS OF THE FISCAL POLICY

Takes time to have an effect- time lag

Takes time to gather information

A lot of government spending is inflexible

Needs to be based on accurate information

Households and firms are not always

rational, they are not predictable

There maybe adverse effects on incentives

and the macroeconomic objectives

The changes in offset they may change in

circumstances with other countries

MONEY SUPPLY

Government increases money supply – easy for banks to lend so

they lend more- people have more money to spend- AD increases

MONETARY POLICY

The main aim of the monetary policy is to help to keep

macroeconomic stability in the economy and also maintain the

value of money

It is also known as demand side policy

Monetary policy involves the use of interest rates and other

instruments of policy to control

The growth of AD relative to the economy’s productive

potential

The demand for the supply of money and credit

Occasionally influence the value of the exchange rate

Currently the monetary policy concerns changes in short term

base interest rates

Monetary policy seeks to influence AD, it has little impact on

LRAS

The government sets the inflation target

IF THE INTEREST RATES INCREASE THEN

Commercial banks will increase rates

Consumption will reduce and lower firms

investment plans

More foreigners want to place money in the UK

Rise in demand for the pound will increase the

exchange rate

Net exports will decrease

Decrease in AD as there is a decrease in exports

DOES IT ALWAYS WORK

There is a chance that C+I will not change

Fixed rate interests will not be effected

High profits so firms may invest anyway

Confidence and expectations may change

LIMITS TO THE RATE OF CHANGE

Mortgage interest rates do not always follow

base rates changes

Many home owners are in fixed rate mortgages

People in rented property have no direct

change if businesses are operating with spare

capacity , a fall in rates will not necessarily lead to

higher planned capital investment

Many sources of funding for capital spending

Lower interest rates causes a fall in in effective

disposable income of millions of people with net

savings

EFFECTIVENESS OF MONETARY POLICY

Time lags- takes 2 years for the full effect of

the interest rate to show

It is difficult to control, banks have profit

motives to increase profits

Speculations working against government

such as the Black Wednesday

Optimism vs. government signals

In relation with other governments, hot

money

Side effects on the Balance of Payments

Interest rates below 0 would lead to no

profits

GOVERNMENT SPENDING

Not all cash would contribute to

increasing AD

Some could be saved and some could

spent on imports

MONETARY POLICIES

Decrease interest rates or increase money

supply – stimulates consumption and

investment-exchange rate falls increasing

net exports- increase AD

SIDE EFFECTS ON POLICIES

Higher AD increases price level

Increases deficit on the current account of the

balance of payments

SUPPLY POLICIES TO REDUCE UNEMPLOYMENT

Time is taken to find job- quality of information

Improved education and training

Better low cost child care

Make work place more accessible for disable

workers

Widening the gap between income from work

and benefits

Reduce employment legislations

EFFECTIVENESS OF SUPPLY SIDE POLICY

They are selected and targeted at particular

markets, and are designed to raise efficiency

AS should increase AD without any

inflationary pressures

Higher quality of resources would make

domestic firms more price and quality

competitive

Improves the country’s current account

position

Some policies such as education and trainining

will take a long time to have an effect

Can be expensive to operate and there is no

grantee that it will work

POLICIES ON INFLATION, ECONOMIC GROWTH AND

BALANCE OF PAYMENTS

POLICIES TO CONTROL INFLATION

If a country is experiencing inflation then measures it

implements will be influenced by what is the cause

In the long run, instruments will be used to main the

price stability

COST PUSH INFLATION

Restriction of wage rates

Main disadvantage of this is that it creates an

inflexibility in the labour force

Reduce the firms cost by reducing cooperation tax

Provide subsidies to cover rising cost

Danger of this is that people will become reliant on

the government subsidies

DEMAND PULL INFLATION

Raise in income tax

Some people may suffer severely such as the poor

Changes in interest rates

People will be uncertain of future prospects

Imports may change due to speculations and

would importers would be uncertain

INFLATION TARGETING

Can reduce demand pull and cost push inflation

by reducing the expectations of inflation

It also makes the monetary policy more

transparent and the central bank more accountable

LONG RUN

A government reduces inflation by

increasing AS

Rightward shifts in AD would result in

shifts equal to AS

SYMMETRIC

deviations above and below the target are given equal

weighting

ASYMMETRIC

deviations below inflation target and seen as less important

that deviations above target

POLICIES TO PROMOTE ECONOMIC GROWTH

SHORT RUN POLICIES

Achieved by increasing AD through either expansionary

fiscal or monetary policy

Some fiscal and monetary instruments have the advantage

that that have the potential to increase both AS and AD

Lowering interest rates will stimulate not only consumption

but investment, higher investment increases AS

Increasing the government spending will shift AS to the

right

LONG RUN POLICIES

Increase output, will continue if

productive capacity steadily rises

For long run economic growth the

quantity or quality has to increase

Reduction in policies

SUPPLY SIDE POLICIES

Most government seek stable growth so

that the growth can match the trend

growth patterns

CHANGES IN UK’S PATTERN OF

INTERNATIONAL TRADE SINCE 2000

The UK was a oil exporter up until 2000

but then turned into a oil importer by 2005

The UK has a surplus in most services

category such as education, insurance and

finance

ADVANTAGES

Exchange of goods and services across national

borders, allows the country to specialise in the

goods and services that they do

Lower prices and higher quality from the

competition

Enjoy a variety of products internationally

There is a larger market to sell their products

DISADVANTAGES

Firms with in the country would lose demand

as everything is price competitive

Competition increased

Become self reliant

POLICIES TO IMPROVE BOP

SHORT RUN

Exchange rate adjustment

Deflationary demand management

The government may want to adopt deflationary

fiscal and monetary policy

Import restrictions

LONG RUN

Giving subsidies to suppliers to become more

internationally competitive

Improve the education and training

Improve the quantity and quality of materials

Work more efficiently

Invest in technology to work effieicenty

PROTECTIONISM

The protection of domestic industries from

foreign competition

TARIFFS

The tax on imported products, the effect of

imposing the tariff is that it should raise the

prices and then should decrease the demand for

it

VOLUNTARY EXPORT RESTRAINT

A limit placed on imports from a country with

the agreement of that country’s government,

this protect the specialised goods made by both

countries

QUOTAS

this is the limit of the supply for importing

goods and services

It can be imposed on exports such as, the

country is experiencing a food shortage

and would prefer to keep the food for their

country

The effect of the quota is to reduce the

supply, which is inelastic

FOREIGN EXCHANGE RESTRICTIONS

By limiting the amount of the foreign

exchange made available to those wishing to

buy imported goods and services or invest

EMBARGOES

Is a total ban on the export or the import for a

product

RED TAPE

Time deploying customs such as legislations, to

make it expensive and time consuming to import

the product

QUALITY MEASURES

Setting high and complex measures to raise

the cost of importing