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Explain how changes in the exchange rate can affect the balance of payments and
how this in turn can affect the level of domestic economic activity.
The exchange rate is the rate at which one currency can be exchanged for another
A falling exchange rate increases exports as UK goods become cheaper and reduces
imports as foreign products appear more expensive. The increase in exports leads to
an increase in AD for domestically produced goods/services which will increase
national output, employment but also prices.
An increasing exchange rate will lead to a reduction in inflation, a reduction in
employment and output too. Exports would decrease as our products would appear
expensive, and imports would increase as the value of the sterling does, because
foreign goods appear cheaper.
Distinguish between fiscal and monetary policy (Demand-side Policies).
Fiscal policy makes use of changes in government spending and/or taxation to
influence aggregate demand. For example, increasing government spending and
cutting taxes increases AD as it will help boost output and create jobs. People will
have more money to spend.
Monetary policy makes use of interest rates to try and control the supply of money in
the economy and the price of it. For example, by lowering interest rates, firms and
people will find it cheaper to borrow money and will opt out of saving and into
consumption instead. People will spend more as they have more money to do so
with. Firms will increase their investment and consumption increases too. This
increase in AD will create jobs and contribute to economic growth.
Explain why governments collect taxes and how government spending can affect the
- raise money for the government
- used to reduce the consumption of demerit goods like tobacco.
- to reduce differences in income, giving the gov't more money to provide for the
less well off
- used to make foreign goods more expensive, encouraging consumers to buy UK,
-Reduce the amount of money consumer have to spend.
- Can be used to protect the environment.
During recession, gov't spending will increase in order to increase AD and create
more jobs - help recover from recession.
During a boom period, expenditure will fall and taxes will be raised to order to
Explain how the interest rate is used by the Bank of England to influence AD in the
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Interest rates are the cost of borrowing money, or the benefit of lending or saving
money expressed as a percentage. The Bank of England, the Monetary Policy
Committee set the interest rate in order to achieve the inflation target of 2%.
When interest rates decrease, it is easier for households and firms to borrow money
and so AD will increase creating jobs, increasing output and contributing to economic