Economics Theme 2 Revision

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  • Created by: remybray
  • Created on: 01-06-17 11:36

Measures of economic performance: economic growth

  • Nominal value - the value of an economic variable based on current prices, taking no account of changing prices through time
  • Real value - the value of an economic variable, taking account of changing prices through time
  • To convert nominal measurements to real: 100 x Nominal GDP/ Real GDP is a price index
  • To create an index number: Current value / Base value x 100
  • Potential economic growth - an expansion in the productive capacity of the economy.
  • This type of economic growth can be thought of as an expansion in the productive capacity of an economy, enabling a society to produce more goods and services in any given period as a result of an expansion in its resources.
  • This economic growth can be demonstrated by shifting LRAS to the right or by shifting the PPF curve outwards.
  • Actual economic growth - whereby an increase in aggregate demand can lead to a higher level of real GDP/output, if the initial AD/AS equilibrium is below full capacity. 
  • This does not lead to an increase in the productive capacity of the economy, but is equivalent to a move towards the PPF. 
  • The output gap is the difference between wehere the economy is currently operating and where it normally operates.
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Measures of economic performance: economic growth

  • Gross Domestic Product (GDP) - a measure of the economic activity carried out in the domestic economy over a period.
  • Gross National Income (GNI) - GDP plus net income from abroad
  • If the intention is to monitor the standard of living in a country, GNI is to be preferred to GDP, as it more closely reflects the incomes of the residents, including net flows of income between countries. 
  • GNI per capita - the average level of GNI per head of population. This makes it possible to compare across countries.
  • There are several problems with using GDP or GNI data to make international comparisons:
  • Inequality in income distribution - looking at the average level of income per person may be misleading if there are wide differences in the way in which income is distributed within countries.
  • The informal sector and the accuracy of data - it is never absolutely certain that the accuracy with which data are collected is consistent across countries. Some data collection agencies may be more reliable than others. One particular area where this is pertinent is the informal sector. In every economy there are some transactions that go unrecorded. In most economies, there are economic activities that take place that cannot be closely monitored because of their informal nature. This is especially the case in developing countries.
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Measures of economic performance: economic growth

  • Exchange rate problems - GNI is initially calculated in terms of local currencies and then converted into US dollars using official exchange rates. However, this doesn't necessarily provide information about the relative purchasing power of incomes. There is now an alternative set of international estimates of GNI based on purchasing power parity (PPP) exchange rates, which are designed to reflect the relative purchasing power of incomes in different societies more accurately.
  • Social indicators - it is questionable whether GNI can be regarded as a reasonable indicator of a country's standard of living. It focuses on summing the transactions that take place in an economy over a period of time, which can be seen as a narrow view of what constitutes the 'standard of living'. It may be that the quality of people's lives depends on more things than simply the material resources that are available.  
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Measures of economic performance: economic growth

The importance of economic growth:

  • More jobs
  • The accelerator effect of growth on capital investment: rising AD and real output encourages investment in capital 
  • Greater business confidence: further encouraging investment and consumption
  • Greater choice and lower prices: greater investment and confidence by businesses means more R&D (research and development) by firms and so the choice of goods available increases. Higher consumer spending also leads to more firms - they therefore compete against each other and prices for goods fall. 
  • Fiscal policy: a growing economy boosts tax revenues and generates the money to finance spending on public and merit goods and services without having to raise taxes - which avoids a budget deficit and having to borrow money.
  • Potential environmental benefits: more investment in cleaner technologies
  • Improvements in living standards: increased tax revenues means life expectancies will increase, as the government spends more on healthcare. Expanding the availabilty or quality of resources in an economy (quantity and quality increase in any of the factors of production causes LRAS to shift right) enables the standard of living of the country to increase.
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Measures of economic performance: economic growth

Drawbacks of economic growth

  • Not all of the benefits of growth are evenly distributed. 
  • A rise in real GDP can often be accompanied by widening income and wealth inequality in society that is reflected in an increase in relative poverty.
  • Environmental concerns: fast growth can create negative externalities (noise and air pollution), increase in household and industrial waste, deforestation, over-exploitation of fish stocks, loss of natural habitat and bio-diversity created through the construction of new roads, buildings, etc.
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Measures of economic performance: inflation, unemp

Inflation

  • Inflation - the rate of increase in the average price level in an economy
  • The consumer price index (CPI) has been the price index used by the government in the UK in setting its inflation rate since the beginning of 2004.
  • This index is based on the prices of a bundle of goods and services measured at different points in time. A total of 180,000 individual price quotes on 680 different products are collected by the ONS each month, by visits to shops, telephone and using the internet. Data on spending from the Household Final Monetary Consumption Expenditure survey is used to compile the weights for the items included in the index. These weights are updated each year, as changes in the consumption patterns of households need to be accommodated if the index is to remain representative. 
  • A criticism of the index has been that it excludes housing costs of owner-occupiers, and a new index was launched in March 2013 to remedy this. The index is known as CPIH and is published alongside the CPI.
  • The CPI sets out to measure the way that inflation affects the 'average' or representative family, but individual households whose consumption pattern differs from the norm may experience inflation in different ways.
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Measures of economic performance: inflation, unemp

  • The traditional measure of inflation in the UK for many years was the retail price index (RPI). 
  • When the Blair government first set an explicit inflation target, it chose the RPIX, which is the RPI excluding mortgage interest repayments. This was felt to be a better measure of the effectiveness of macroeconomic policy. It was argued that if interest rates are used to curb inflation, then including mortgage interest repayments in the inflation measure will be misleading. 
  • The CPI replaced RPIX partly because it is believed to be a more appropriate indicator for evaluating policy effectiveness. In addition, it has the advantage of being calculated using the same methodology as is used in other countries in the European Union, so is more useful for making international comparisons.
  • CPI and RPI differ because the contents of the basket of goods differ and also in the population of people who are covered by the index, e.g. RPI excludes pensioner households and the highest income households, whereas the CPI does not.
  • There is an important statistical difference in how the RPI and CPI are calculated; the CPI uses a geometric mean, while the RPI uses an arithmetic mean.
  • The CPI excludes some vital housing costs that are included in the RPI, e.g. council tax, mortgage interest repayments, house depreciation, etc.
  • The RPI index excludes some items included in the CPI measure, such as university tuition fees and stockbroker fees.
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Measures of economic performance: inflation, unemp

  • The weightings given in the CPI index are based on the spending patterns of all households in the UK, tourists visiting the UK and those living in institutional accommodation e.g. unviersity halls of residence. CPI weightings are based on household spending in the National Accounts. In contrast, RPI weightings are based on the Expenditure and Food Survey.
  • Deflation - a fall in the average level of prices
  • Disinflation - a fall in the rate of inflation
  • Deflation is sometimes perceived to be bad for the economy on the grounds that economic agents will see this as a sign that the economy is in terminal decline. If people expect prices to continue to fall, they may postpone purchases in the expectation of being able to buy at a lower price in the future. This would then mean a fall in demand in the economy, perpetuating the recession.
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Measures of economic performance: inflation, unemp

Unemployment

  • In employment - people who are either working for firms or other organisations, or self-employed
  • Economically inactive - those people of working age who are not looking for work, for a variety of reasons
  • Discouraged workers - people who have been unable to find unemployment and who are no longer looking for work
  • Workforce - people who are economically active - either in employment or unemployed
  • Unemployed - people who are economically active but are not in employment
  • Full employment - a situation where people who are economically active in the workforce and are willing and able to work are able to find employment.
  • Full employment is seen as one of the core macroeconomic policy objectives. Having large numbers of people without jobs means that the economy is not making the best use of its labour resources, and is thus sacrificing potential output that could be produced. It is also undesirable from the perspective of individuals who find themselves unemployed.
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Measures of economic performance: inflation, unemp

  • Setting aside those who are economically inactive, there will always be some unemployment in a society, if only because there will be some people between jobs, or engaging in job search. 
  • Furthermore, if the economy were to be operating very close to full capacity, this would be likely to put upward pressure on wages and thus prices. Therefore, there may be a conflict between achieving full employment and maintaining the stability of prices.
  • Historically, unemployment was measured by the number of people registered as unemployed and claiming unemployment benefit (JSA). This measure of unemployment is known as the claimant count of unemployment. 
  • People claiming the JSA must delcare that they are out of work, and capable of, available for and actively seeking work, during the week in which their claim is made.
  • However, although people claiming the JSA must declare that they are available for work, it nonetheless includes some people who are claiming benefit, but are not actually available or prepared to work.
  • Also, the claimant count figure had come under increasing criticism because it was felt to be open to government manipulation. In the 1980s and 1990s, the UK government introduced over 30 different changes to the way in which the claimant count was calculated, in order to reduce the numbers officially unemployed.
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Measures of economic performance: inflation, unemp

  • It can be argued that the claimant count understates unemployment, as some people may be out of work but not claiming benefits for reasons such as:
  • The individual's savings are too high to make them eligible for JSA
  • Household income may be relatively high if a partner or family member is economically active
  • Some people are ineligible for JSA, e.g. those who have not built up sufficient National Insurance contributions, or those who are not EU citizens
  • Some people may be too embarrassed to claim benefit, or do not understand that they may do so. 
  • Because of these problems, the claimant count has been superseded by the ILO unemployment rate, a measure based on the Labour Force Survey. 
  • ILO unemployment rate: a measure of the percentage of the workforce who are without jobs, but are available for work, willing to work and looking for work.
  • It defines as being unemployed those people who are:
  • without a job, want a job, have actively sought work in the last 4 weeks and are available to start work in the next two weeks; or
  • out of work, have found a job and are waiting to start it in the next 2 weeks
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Measures of economic performance: inflation, unemp

  • The Labour Force Survey (LFS) measures unemployment by conducting a sample survey of over 60,000 households every three months. This is the government's official preferred measure of unemployment and compares directly to data collected from all countries according to the International Labour Force Organisation (ILO). 
  • It is important to be aware of the difficulties in measuring unemployment accurately. Both measures do not include part time workers who are actively seeking full time work or those on government training and work schemes who would prefer to be in proper employment (young workers especially).
  • The ILO unemployment data are based on sample evidence, and extrapolated up to give the picture for the UK as a whole. The sample cannot be guaranteed to be fully representative. 
  • There may be people who cannot find jobs for which they are qualified, and who take jobs in second-choice occupations. This is a form of underemployment.
  • Underemployment - where an individual is employed in a second-choice occupation or is only able to work part-time but would like to work full-time.
  • Reasons for underemployment include: an employer may only be able to offer limited hours, a worker may be in a job that lends itself to certain hours of the day, e.g. bar staff, self-employed workers may have low hours of work as a result of low demand for their skills or services, poor economic conditions may result in more people looking for jobs but fewer jobs being created.
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Measures of economic performance: inflation, unemp

  • There will always be some unemployment in a dynamic economy. At any point in time, there will be workers transferring between jobs. This needs to happen if the pattern of production is to keep up with changing patterns of consumer demand and relative opportunity cost. 
  • In a typical period of time there will be some sectors of an economy that are expanding and others that are in decline. It is crucial that workers are able to transfer from those activities that are in decline to those that are booming.  Accordingly, there will be some unemployment while this transfer takes place, and this is known as frictional unemployment - unemployment associated with job search.
  • There may be some longer-term unemployment while workers retrain for new occupations and new sectors of activity. There may be workers who are at a late stage in their career and for whom retraining is not worthwhile, or who cannot find firms that are prepared to train them for a relatively short payback time. Such unemployment is known as structural unemployment - it arises because of the mismatch between the skills of workers leaving contracting sectors and the skills required by expanding sectors in the economy. 
  • Cyclical unemployment - unemployment that arises during the downturn of the economic cycle, such as a recession.
  • Demand-deficient unemployment - unemployment that arises because of a deficiency of AD in the economy, so that the equilibrium level of output is below full employment
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Measures of economic performance: inflation, unemp

  • Seasonal unemployment - unemployment that arises in seasons of the year when demand is relatively low.
  • If unemployment benefits are set at a relatively high level compared with wages in low-paid occupations, some people may choose not to work, thereby creating voluntary unemployment.
  • If the economy is operating below full capacity, then it is operating within the PPF, and is therefore not making the best possible use of society's resources. If those unemployed workers were in employment, society would be producing more aggregate output; the economy would be operating more efficiently overall.
  • There may be costs from the perspective of prospective workers, in the sense that involuntary unemployment carries a cost to each such individual in terms of forgone earnings and the need to rely on social security support.
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Measures of economic performance: inflation, unemp

The balance of payments

  • Balance of payments - a set of accounts showing the transactions between the residents of a country and the rest of the world.
  • Three main items appear on the current account:
  • The balance of trade in goods and services - the balance between UK exports and imports of such goods and services. The trade in goods is normally negative overall. However, this is partly balanced by a normally positive flow in trade in services, where the UK earns strong credits from its financial services.
  • Profits and income payments - part of this represents employment income from abroad, but the major item of income is made up of profits, dividends and interest receipts arising from UK ownership of overseas assets.
  • International transfer payments - either transfers through central government or transfers made or received by private individuals. This includes transactions and grants with international organisations or with the EU. 
  • A persitent deficit on the current account may pose long-term problems that need to be addressed, as it may not be desirable to continue selling UK assets indefinitely.
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Measures of economic performance: inflation, unemp

  • Suppose the Bank of England holds interest rates high compared with other countries, in order to try to control inflation. High UK interest rates will tend to attract financial inflows from abroad, as investors find the UK attractive as a home for their funds. These flows are sometimes known as 'hot money'. This implies a deficit on the current account. The downside of such a structure is that UK assets are being sold abroad, which might not be in the best interest of the economy in the long run. 
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Aggregate Supply

  • Aggregate supply the output of all goods and services that are produced within an economy during a period of time.
  • The total quantity of output supplied in an economy over a period of time depends on the quantities of inputs of factors of production employed: that is, the total amounts of labour, capital and other factors used. The ability of firms to vary output in the short run will be influenced by the degree of flexibility the firms have in varying inputs. 
  • In the short run, firms may have relatively little flexibility to vary their inputs, e.g. they cannot buy bigger machinery, employ more people or move to a bigger factory.
  • If firms wish to vary their output, they may need to do so by varying the intensity of utilisation of existing inputs, e.g. pay existing workers overtime or turn machines up.
  • Short-run aggregate supply curve - a curve showing how much output firms would be willing to supply in the short run at any given price level.
  • If the overall price level changes, this will induce a movement ALONG the curve, but if something changes to affect the position of the curve, it will SHIFT.
  • In the short run, the strongest influence on AS is likely to be the costs faced by firms, as these can change quite rapidly in the short run, whereas other factors such as technological change are more significant in the long run. So, a change in the costs faced by firms may induce them to supply more (or less) output, resulting in a SHIFT.
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Aggregate Supply

  • A shift in SRAS will happen (exogenous shock) when any of 3 circumstances occur:
  • The cost of inputs - e.g. a change in the cost of raw materials. If a key raw material becomes more limited in supply, perhaps because reserves are exhausted, then prices will tend to rise, thus raising firms' costs of production. They may then choose to supply less output at any given price and the AS curve would shift to the left.
  • The exchange rate - where firms rely on imported inputs of raw materials, energy or component parts used in production, then a change in the exchange rate could affect AS, by affecting the domestic price of imported inputs. If the exchange rate appreciates, this would reduce the cost of any raw materials (and production costs) so AS would increase. The exchange rate can change in the short run for a variety of different reasons, so firms may face some quite sudden changes in their costs. One way that firms can guard against this is through the nature of the contracts drawn up with their foreign suppliers, if future prices can be specified in a way that hedges against possible exchange rate fluctuations.
  • Government intervention - an increase in regulation that forced firms to spend more on health and safety measures would raise costs, and result in a leftward shift of the AS curve in the short run. An increase in the rate of corporation tax would have similar effects.
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Aggregate Supply

  • An influential school of macroeconomists, known as the Monetarist School, argued that the economy would always converge on an equilibrium level of output they they referred to as the national rate of output. If this were the case, then the long-run relationship between AS and the price level would be vertical. A change in the overall price level does not affect aggregate output, because the economy always readjusts rapidly back to full employment - a position in which the aggregate economy is operating at its potential full capacity level.
  • An opposing school of thought (known as the Keynesian School) held that the macroeconomy was not sufficiently flexible to enable continuous full employment. They argued that the economy could settle at an equilibrium position below full employment, at least in the medium term. 
  • In particular, inflexibilities in labour markets would prevent adjustment. E.g. if firms had pessimistic expectations about AD, and thus reduced their supply of output, this would lead to lower incomes because of the workers being laid off. This would then mean that AD was indeed deficient, so firms' pessimism was self-fulfilling. 
  • If AD increases when the economy is not operating at full capacity then the output change is large but the price level change is proportionally small.
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Aggregate Supply

  • LRAS represents the productive capacity/potential GDP of the economy - this means the maximum amount that can be produced by an economy in the long run.
  • Changes in potential GDP are brought about by:
  • The quantity of inputs - the first obvious way in which aggregate output could be increased is if there is an increase in the availability of the factors of production. In particular, an increase in labour and/or capital inputs would lead to an increase in the amount of output that can be produced. An increase in the size of the workforce (perhaps due to migration) can lead to an increase in potential output. An increase in the quantity of capital will also have the effect of increasing the capacity of the economy to produce. However, such an increase requires firms to undertake investment activity. 
  • The effective use of inputs - the effectiveness with which inputs are utilised is another important influence on the position of the aggregate supply curve. Advances in technology are one way in which inputs can be more effectively utilised - new machinery can improve the efficiency with which other inputs are used, and the development of new materials can also have an impact. Such developments can reduce firms' costs and increase the amount of aggregate output that can be produced, leading to a shift in the LRAS curve. Labour as a factor of production can also become more effective and productive, and can be seen as a form of human capital.
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Aggregate Supply

  • Improvements to education and the provision of skills training can improve the productivity of labour, again leading to a rightward shift of LRAS. 
  • Improvements to infrastructure, e.g. roads, railways, would reduce the costs faced by firms, which could then lead to a rightward shift of LRAS.
  • Measures to encourage new business start ups - increasing competition means that competing businesses strive to reduce their costs and improve the quality of their products (in order to beat their rivals). In doing so, this should mean increased investment in capital (both quantity and quality) and also improvements in terms of labour (increasing productivity reduces costs). 
  • Higher spending on research and development (increased quality of capital)
  • Net inward migration of skilled labour (increased quantity and quality of labour)
  • Changes in school-leaving and retirement ages (increases quantity of labour)
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The Multiplier Effect

  • Multiplier - the ratio of a change in equilibrium real income to the autonomous change that brought it about; it is defined as 1 divided by the marginal propensity to withdraw
  • Following an increase in government spending, investment or export revenue, there will be an injection into the economy. This injection will prompt further income generation and spending, causing the multiplier effect.
  • In effect, equilibrium output may change by more than the original increase in expenditure.
  • The size of this multiplier effect depends on a number of factors. 
  • Most importantly, it depends on the size of withdrawals or leakages from the system. In particular, it depends on how much of the additional income is saved by households, how much is spent on imported goods, and how much is returned to the government in the form of direct taxes. These items constitute withdrawals from the system, in the sense that they detract from the multiplier effect.
  • E.g. if households save a high proportion of their additional income (low MPC), then this clearly reduces the multiplier effect, as the next round of spending will be that much lower. 
  • Marginal propensity to import - the proportion of additional income that is spent on imports of goods and services. 
  • Marginal propensity to tax - the proportion of additional income that is taxed
  • Marginal propensity to consume - the proportion of additional income devoted to consumer expenditure.
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The Multiplier Effect

  • Marginal propensity to withdraw - the proportion of additional income that is withdrawn from the circular flow - the sum of the marginal propensities to save, import and tax.
  • You can calculate the multiplier using : 1/MPW  or 1/1-MPC
  • The multiplier is the idea that an increase in autonomous expenditure, such as government expenditure or investment expenditure by firms, will have multiplier effects through successive rounds of additional expenditure. 
  • In the context of the AD/AS model, this will affect the extent to which the AD curve shifts to the right following an increase in autonomous expenditure. In other words, the initial shift of AD will be augmented in following periods by further shifts as the successive rounds of additional expenditure work themselves through the system.
  • However, the effect on equilibrium and price level will depend on how close the economy is to the full employment level. The AS curve becomes steeper as output and price level increase. The closer the economy is to the full employment level, the smaller the elasticity of supply, so an increase in AD close to full employment will have more of an effect on the price level (and hence potentially on inflation) than on the level of real output.
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Economic growth

  • Potential economic growth can be thought of as an expansion in the productive capacity of an economy, e.g. a shift in the production possibility frontier (PPF): economic growth enables a society to produce more goods and services in any given period of time as a result of an expansion in its resources.
  • Actual economic growth (measured by the rate of growth of GDP) may also reflect a movement towards the frontier: e.g when an economy is recovering from a period of recession.
  • A second way of thinking about economic growth is to use the AD/AS model. E.g. an increase in the skills of the workforce will enable firms to produce more output at any given price, so that the LRAS curve will shift rightwards. This entails an increase in full employment output, which can be characterised as economic growth.
  • Business cycle - a phenomenon whereby GDP fluctuates around its underlying trend, following a regular pattern.
  • Output gap - the difference between actual real GDP and potential real GDP. If actual GDP is below potential GDP, then the gap is negative; if actual GDP is above the trend level, the gap is positive.
  • Actual GDP is something that we observe, whereas potential GDP represents the level of GDP that could be achieved if the economy were using all its resources effectively.
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Economic growth

  • The output gap can be illustrated using an AD/AS diagram. E.g. where Y1 is the actual GDP and Y* is the potential level that could be achieved at full employment. The output gap in this case is the difference between them.
  • boom occurs when real GDP is rising at a faster rate than the trend rate of growth. Some of the characteristics of a boom include:
  • A fast growth of consumption helped by rising real incomes, strong confidence and a surge in house prices and share prices
  • A pick up in demand for capital goods as businesses invest in extra capacity to meet strong demand to make higher profits
  • More jobs created and falling unemployment and higher real wages
  • High demand for imports which may cause the economy to run a larger trade deficit because it cannot supply all of the goods and services that consumers are buying
  • Government tax revenues will be rising as people earn and spend more and companies are making larger profits - the government has more money to spend in education, environment, health and transport
  • An increase in inflationary pressures if the economy overheats and has a positive output gap.
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Economic growth

  • slowdown occurs when the rate of growth decelerates - but national output is still rising
  • Recession - occurs when GDP falls for two or more consecutive quarters.
  • There are many symptoms of a recession:
  • A fall in purchases of components and raw materials
  • Rising unemployment 
  • A rise in the number of business failures and businesses announcing lower profits and investment
  • A decline in consumer and business confidence
  • A contraction in consumer spending and rise in the percentage of income saved
  • A drop in the value of exports and imports of goods and services
  • Government tax revenues are falling and welfare benefit spending is rising
  • The budget deficit is rising quickly
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Economic growth

  • An increase in capacity output can come either from an increase in the quantity of the factors of production, or from an improvement in their efficiency or productivity. 
  • Productivity is a measure of the efficiency of a factor of production.
  • Labour productivity - a measure of output per worker, or output per hour worked
  • Capital productivity - a measure of output per unit of capital
  • Total factor productivity - the average productivity of all factors, measured as the total output divided by the total amount of inputs used
  • An increase in productivity raises aggregate supply and the potential capacity output of an economy (LRAS shifts right), and thus contributes to economic growth.
  • High productivity also may lead to increased profit, generating funds for investment into even more efficient production techniques. High levels of productivity mean that each worker can produce a higher output, which ultimately means less workers need to be employed – reducing overall costs.
  • An increase in capital input is one source of economic growth. 
  • Investment - expenditure undertaken by firms to add to the capital stock, e.g. buying machinery or factory buildings
  • The choice that any society makes here is between using resources for current consumption and using resources for investment. The opportunity cost of capital investment is the current consumption forgone.
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Economic growth

  • An increase in capacity output can come either from an increase in the quantity of the factors of production, or from an improvement in their efficiency or productivity. 
  • Productivity is a measure of the efficiency of a factor of production.
  • Labour productivity - a measure of output per worker, or output per hour worked
  • Capital productivity - a measure of output per unit of capital
  • Total factor productivity - the average productivity of all factors, measured as the total output divided by the total amount of inputs used
  • An increase in productivity raises aggregate supply and the potential capacity output of an economy (LRAS shifts right), and thus contributes to economic growth.
  • High productivity also may lead to increased profit, generating funds for investment into even more efficient production techniques. High levels of productivity mean that each worker can produce a higher output, which ultimately means less workers need to be employed – reducing overall costs.
  • An increase in capital input is one source of economic growth. 
  • Investment - expenditure undertaken by firms to add to the capital stock, e.g. buying machinery or factory buildings
  • The choice that any society makes here is between using resources for current consumption and using resources for investment. The opportunity cost of capital investment is the current consumption forgone.
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Economic growth

  • The level of investment and the quality of investment will directly affect the level of economic growth. The efficiency of the labour force and and the other factors of production will depend upon the amount and quality of capital they have.
  • The contribution of capital to growth is reinforced by technological progress, as the productivity of new capital is greater than that of old capital that is being phased out. This means that technology is increasing the contribution that investment can make towards enlarging capacity output in an economy. 
  • Innovation can also contribute, through the invention of new forms of capital and new ways of using existing capital, both of which can aid economic growth.
  • Labour also contributes to economic growth.
  • There is little scope for increasing the size of the labour force in a country, except through international migration. Nonetheless, the size of the workforce does contribute to the size of capacity output.
  • The quality of labour input is more amenable to policy action. Education and training can improve the productivity of workers, and can be regarded as a form of investment in human capital.
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Economic growth

  • Human capital - the stock of skills and expertise that contribute to a worker's productivity
  • For many developing countries, the provision of healthcare and improved nutrition can be seen as additional forms of investment in human capital, since such investment can lead to future improvements in productivity.
  • International trade can contribute to economic growth. For many relatively small countries, international trade is a key part of achieving economic growth. If the domestic market is not sufficiently large, effective demand may not allow economies of scale to be reaped. By engaging in international trade, a country is able to specialise, and thus produce goods more efficiently, reaping the gains from large-scale production.
  • For many less developed countries, this is especially important, as not only is it crucial to be able to reach a large market, but also it is important to be able to earn the foreign exchange needed to import physical capital that cannot be produced domestically.
  • The countries that have been most successful in achieving economic growth in the last few decades are all countries that have relied on being able to expand rapidly through promoting exports (export-led growth). E.g. Korea, Singapore, Hong Kong and Taiwan
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Economic growth

  • An increase in AD can lead to higher real output in the economy if the initial equilibrium is below full capacity output, but this is equivalent to a move towards the PPF so it does not affect overall productive capacity in the economy.
  • The only exception to this is where the increase in AD is due to an increase in investment expenditure that will later enable an increase in productive capacity. 
  • If the economy is in equilibrium below full employment, then an increase in AD can also result in actual economic growth as the economy moves closer to full capacity. 
  • In some situations it may be vital that there is an increase in AD in order to accommodate the increase in AS.
  • Expanding the availability of resources in an economy enables the standard of living of the country to increase. For developing countries this may facilitate the easing of poverty, and may allow investment in human capital that will improve standards of living further in the future.
  • For households in industrial economies, growth may bring higher incomes, for firms it may bring higher profits, for governments it may bring higher tax revenue and an improved capacity to provide public goods.
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Economic growth

  • It may be argued that other policy objectives should be regarded as subsidiary to the growth target. In other words, the control of inflation, the maintenance of full employment and the achievement of stability in the current account of the balance of payments are seen as important short-run objectives, because their achievement facilitates long-run economic growth.
  • In some less developed countries there has been a long-running debate about whether a society in its early stages of development should devote its resources to achieving the growth objective or to catering for basic needs.
  • By making economic growth the prime target of policy, it may be necessary in the short run to allow inequality of incomes to continue, in order to provide the incentives for entrepreneurs to pursue growth, 
  • With such a 'growth-first' approach it is argued that eventually, as growth takes place, the benefits will trickle down: growth is necessary in order to tackle poverty and provide for basic needs.
  • However, others have argued that the first priority should be to deal with basic needs, so that people gain in human capital and become better able to contribute to the growth process. 
  • It is also important to realise that economic growth does not neccessarily translate into improvements in living standards: e.g where the benefits from growth are concentrated in certain groups within a society, rather than being spread widely.
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Economic growth

  • For the industrial countries, the importance of economic growth has been brought into sharp focus through the crisis of the late 2000s, which is still affecting many economies. The consequences of such a recession are significant.
  • If output is falling, and firms are reducing their production, it is likely that they are laying off workers, so that unemployment rises. This then leads to falling incomes, which reduces AD and may lead to further drops in output, prolonging the recession.
  • Economic growth also brings costs, perhaps most obviously in terms of pollution and degradation of the environment. In designing long-term policy for economic growth, governments need to be aware of the need to maintain a good balance between enabling resources to increase and safeguarding the environment. Pollution reduces the quality of life, so pursuing economic growth without consideration to this may be damaging.
  • These costs have been highlighted in recent years by the growing concerns that have been expressed about global climate change and the pressures on non-renewable resources.
  • The need to bring so many people out of extreme poverty lends urgency to the drive for economic growth. However, this needs to be balanced against the need to ensure sustainable development.
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Economic growth

  • Sustainable development - 'development that meets the needs of the present without comprimising the ability of future generations to meet their own needs'
  • Sustainable development also entails taking account of the depletion rates of non-renewable resources., and ensuring that renewable resources are renewed in the process of economic growth.
  • Another aspect of environmental degradation concerns biodiversity. This refers to the way in which misuse of the environment is contributing to the loss of plant and animal species, which are becoming extinct as their natural habitat is destroyed.
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Macroeconomic policy objectives

Economic growth

  • If the ultimate aim of a society is to improve the well-being of its citizens, then in economic terms this means that the resources available within the economy need to expand through time in order to widen's people's choices. This requires a process of economic growth, which is an increase in the productive capacity of the economy.
  • It may be argued that economic growth is regarded as the most fundamental of all macroeconomic policy objectives. E.g. one of the key reasons for maintaining low inflation is to encourage firms to undertake investment - because this enables economic growth. Maintaining full employment ensures the best possible use of a society's resources, enabling it to reach the PPF - and failure to do this may have indirect consequences for economic growth. Running a sustained current account deficit on the balance of payments that requires the sale of UK assets may limit the future growth prospects of the economy.
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Macroeconomic policy objectives

Full employment (low unemployment

  • For an economy to be operating on the PPF, the factors of production need to be fully employed. When the macroeconomic equilibrium ouput is below the potential full employment level, this may be seen as an unnecessary waste of potential output. In addition to this unfulfilled output, there may be a cost suffered by the people who are unemployed in this situation and who could have been productively employed.
  • Costs of unemployment:
  • Government tax revenue - workers who have found employment will be paying income tax and national insurance thus increasing the government's total tax revenue. However, not only will unemployed workers not be being into the system - they will be taking money out in the form of JSA. This could lead to a declining fiscal situation and a budget deficit, which would then have to be financed through borrowing.
  • Productive capacity - unemployment of workers implies that not all resources/factors of production (labour) are being fully utilised and so the economy would be operating within the PPF curve, below the full capacity of the economy. 
  • NOTE: if unemployed workers found a job this would NOT shift LRAS/SRAS to the right, this is because the overall quantity of workers hasn't increased - more are just simply being utilised, bringing the economy closer to full productive capacity.
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Macroeconomic policy objectives

  • Aggregate demand - if more people have jobs then this implies that their incomes will increase, causing an increase in the consumption component of AD - thus leading to actual economic growth. This would then have a multiplier effect, as somebody's spending is another person's income. Ultimately, increased spending within the economy could lead to higher sales and more profits for firms - who would then invest and increase the productive capacity of the economy (potential economic growth - shifting LRAS/SRAS to the right)
  • Economic welfare - often unemployment can lead to a reduction in a person's worth, happiness and dignity, possibly leading to social problems such as depression - improving wellbeing and welfare is the ultimate aim of society and employment is a huge factor in achieving this. Data has shown that sometimes increased unemployment can lead to increased levels of crime, creating a further cost to society.
  • Unemployment figures can sometimes be misleading, as although an economy may have low unemployment, it does not take into account whether or not those employed workers are fully utilising the skills in which they have to offer.
  • When highly trained immigrants arrive in a country, their foreign crudentials may not be recognised or accepted in their new country, or they could even be discriminated against. As a result, when doctors or engineers from other countries immigrate, they may be unable to find work in their profession, and they may have to seek unskilled work.
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Macroeconomic policy objectives

  • New graduates may also face underemployment, because even though they have completed the technical training for a given field which there is a good job market, they lack experience. 
  • Net migration is compatible with low unemployment. Migrants bring both increased supply of labour and higher demand (as they fuel consumption, which creates a demand for labour).
  • From one perspective an increase in the labour supply may push down wages. This is especially true, if migrants are keen to accept lower wages. However, net migration doesn't have to push down wages - increased migration will also have an effect on increasing demand for labour due to higher spending (consumption) in the economy. However, particular labour markets may notice lower wages if there is a concentration of immigrants willing to work. E.g. if wages are high in a particular agricultural market, migration from a low income country may lead to falling wages in these particular markets.
  • The impact of net migration depends on:
  • The skills and qualifications of migrants - the UK is increasingly strict on only allowing skilled workers - Non-EU immigrants now require greater skills to enter the UK.
  • How easy do migrants find it to integrate in the destination country- workers may find it more difficult to find work due to poor English or racial discrimination.
  • The age profile of migrants - if a high % are young workers, then this can help to reduce the dependency ratio - a crucial issue for government budget.
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Macroeconomic policy objectives

  • Current economic climate - in a recession, migrants will find it harder to gain employment (cyclical unemployment)
  • The type and skills of migrants - migrants from Eastern Europe may be more flexible and return home if the economic situation deteriorates. Low skilled migrants are more likely to be structurally unemployed.
  • Migrants can be a source of foreign income - e.g. tuition fees from foreign students. However, migrants may also send a substantial portion of their earnings to relatives abroad (remittance) - reducing the current account (balance of payments) of the UK.
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Macroeconomic policy objectives

Price stability

  • Inflation may be initiated on the supply side of the macroeconomy, arising from an increase in the costs faced by firms, perhaps through an increase in the price of oil, or increases in wage costs. This is called cost-push inflation, as the increase in the overall level of prices is cost driven.
  • In terms of the AD/AS model, an increase in production costs is an exogenous shock, so SRAS shifts to the left. 
  • An alternative explanation of a rise in the general price level could come from the demand side, where an increase in AD leads to a rise in prices, especially if the AS curve becomes so steep in the long run as to become vertical. In this case, inflation will be more impactful if the new equilibrium output is closer to the full employment level. 
  • An increase in AD could come, for example, from an expansion of money supply that causes interest rates to be lower than would have been the case, thus encouraging higher consumption and investment expenditure. An increase in the price level emanating from the demand side of the macroeconomy is called demand-pull inflation.
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Macroeconomic policy objectives

  • One-off movements in either AD or AS may lead to one-off changes in the overall price level, but unless the movements continue in subsequent periods there is no reason to suppose that inflation will continue. One explanation for continuing inflation is provided by changes in the supply of money circulating in an economy.
  • Persistent inflation can only take place when the money supply grows more rapdily than real output. This can be shown in terms of AD and AS. If the money supply increases, firms and households in the economy find they have excess cash balances: that is, for a given price level they have more purchasing power than they expected to have, and are holding more money than they intended. Their impulse will thus be to increase their spending, which will cause the AD curve to move to the right. They will probably also save some of the excess, which will tend to result in lower interest rates - which will then reinforce the increase in AD. However, as the AD curve moves to the right, the equilibrium price level will rise, returning the economy to equilibrium.
  • If the money supply continues to increase, the process repeats itself, with prices then rising persistently. One danger of this is that people will get so accustomed to the process that they speed up their spending decisions, which simply accelerates the whole process.
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Macroeconomic policy objectives

  • Very high inflation gives rise to a number of costs:
  • Menu costs - the fact that firms have to keep amending their price lists (printing labels, altering computer systems) raises the costs of production. 
  • Shoe-leather costs - high inflation discourages people from holding money because, at the very high nominal interest rates that occur when inflation is high, the opportunity cost of holding money becomes great. People therefore try to keep their money in interest-bearing accounts for as long as possible.
  • Distorts normal economic behaviour - this reluctance to use money for transactions may inhibit the effectiveness of markets. Markets will not work effectively when people do not use money (consumption grinds to a halt) and the economy begins to slip back towards a barter economy. The situation may be worsened if taxes or pensions are not properly indexed, so that they do not keep up with inflation. If pensions do not keep up with inflation, this means that pensioners lose out, and income inequality worsens. If tax revenue fails to keep up with government expenditure, then the authorities may be drawn into printing even more money in order to finance their spending plans.
  • Interest rates - low inflation may mean that the Bank of England can lower interest rates to stimulate the economy if they need to - lower interest rates will encourage consumption, investment and they will also make the value of the pound lower which makes UK exports cheaper and imports to the UK more expensive.
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Macroeconomic policy objectives

  • International competitiveness - high inflation would mean that UK goods/services are becoming more expensive (relative to other countries) and therefore less competitive, this would cause a fall in demand for UK goods and so the current account balance will deteriorate, exporting firms may lay off workers leading to an increase in unemployment and a fall in economic growth.
  • Business confidence - if the rate of change of prices cannot be confidently predicted by firms, the increase in uncertainty may be damaging, and firms may become reluctant to undertake the investment that would expand the economy's productive capacity.
  • Income in real terms - the impact of inflation can be worsened if wages and pensions fail to increase at the same time, meaning that people will receive a pay cut in real terms - which will cause a reduction in consumption. 
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Macroeconomic policy objectives

The balance of payments

  • A current account equilibrium is where all of the flows of money leaving the UK are equal to the flows of money entering the UK. They want to avoid a situation where there are more outflows of money than there are inflows (current account deficit). 
  • If the current account is in deficit, UK residents are purchasing more in imports of goods and services than the economy is exporting. 
  • Consequences of a current account deficit:
  • Impact of deficit upon AD - if the current account is in deficit, this implies that the UK is importing (outflow of money) more than it is exporting (inflow of money) - the effect would be a negative net exports, which is a component of AD, so AD would fall. Also mean less demand for domestic goods (fall in consumption). However this would depend upon the rest of the components of AD. Although (x-m) may be falling, this could be counteracted by other components - particularly consumption which makes up circa 65% of AD.
  • Evaluation: this would also depend upon the other 2 aspects of the current account (transfer payments and profits and income payments) as they may be causing the current account deficit, not the trade in goods/services aspect.
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Macroeconomic policy objectives

  • Impact of deficit upon the exchange rate - the value of the pound is determined by demand (residents and firms from other countries wanting to buy UK assets, goods and services) and supply (UK residents wanting to buy assets, goods and services from the rest of the world). If there is a current account deficit, then the value of imports exceeds the value of imports. Therefore the supply of the pound increases, causing the value of the pound to fall. This is negative because a weak pound means our imports are more expensive (SPICED), which could potentially make the BoP deficit and AD worse over time. However, a weaker pound would also make UK exports more competitive, so there is an argument that this would increase the demand for our exports and self-correct itself.
  • Evaluation: whether or not a low exchange rate would increase/decrease the value of imports/exports depends very much upon elasticity. If UK exports are generally inelastic, a low exchange rate would only increase the demand by a small amount.
  • Interest rates - the BofE may feel the need to respond to a weak pound by increasing interest rates, which would increase demand for the pound as investors seek to put their money into British banks (hot money). A by-product of this would be a reduction in spending by consumers and firms, which could reduce AD. However, given that some of this spending by firms/consumers will be imports, an increase in interest rates would arguably also improve the balance of payments situation.
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Macroeconomic policy objectives

  • Financing a BoP deficit - if an economy is experiencing a large and prolonged deficit on the current account (economists tend to define a deficit being large as anything more than 5% of GDP), then the government will have to finance this deficit; they can do this either by selling financial assets or most likely through borrowing, which would mean paying back interest and reduced government spending elsewhere in the economy. This could mean higher taxes and/or reduced government spending - impacting AD.
  • Causes of a deficit on the current account:
  • International non-price competitiveness - if UK goods/services are of a lower quality than the rest of the world, then the UK will sell fewer exports
  • International price competitiveness - UK goods can also be less competitive in terms of price, if goods are more expensive then foreign countries will purchase them from elsewhere. This could be caused by high UK inflation or by strict health and safety and minimum wage laws, which increase costs of production.
  • Exchange rate - if the value of the pound is strong, then foreign countries are less likely to purchase goods/services from the UK.
  • High propensity to import - UK firms and consumers may have a higher propensity to import goods from abroad.
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Macroeconomic policy objectives

Income redistribution

  • The final macroeconomic policy objective to be considered concerns attempts to influence the distribution of income within a society. Income redistribution may work through progressive taxation (whereby those on high incomes pay a higher proportion of their income in tax) or through a system of social security benefits such as JSA and Income Support.
  • Some degree of inequality in the income distribution within a society is inevitable. Market forces imply that different payments will be made to people in different sectors of economic activity and different occupations. Income inequality also arises because of inequality in the ownership of assets. 
  • One category of policy measures is designed to encourage horizontal equity (where people in identical circumstances and with identical skills and abilities receive identical income). Equal opportunities legislation tries to ensure that members of society do not suffer discrimination that might deny them equal pay for equal work, or equal access to employment. However, there remain significant differences in earnings and employment between ethnic groups and between men and women.
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Macroeconomic policy objectives

  • In a society where there is substantial inequality in the distribution of income, there are likely to be groups of people who are disadvantaged in various ways: e.g. they may find it more difficult to obtain education for themselves or for their children.
  • If this is so, it suggests that there are people in society who are inhibited from developing their productive potential - which in turn implies that economic growth in the future will be lower than it might be. This could provide a justification for redistributing income - or at least for trying to ensure that there is equality of opportunity for all members of society.
  • However, it might be argued that redistribution can be taken too far. If the higher-income groups in society face too high a marginal tax rate on their income, this could remove their incentive to exploit income-earning opportunities, which could have a damaging impact on economic growth. 
  • Too much inequality may also lead to high crime rates and social discontent, which in turn may lead to political instability in a society. 
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Conflicts between policy objectives

Unemployment and inflation

  • This relationship is shown on a diagram known as the Phillips curve. The core explanation behind this relationship is the idea that when demand for labour is high (and unemployment is low), firms will be prepared to bid up wages in order to attract labour. To the extent that higher wages are then passed on in the form of higher prices, this would imply a relationship between unemployment and inflation: when unemployment is low, inflation will tend to be higher, and vice versa.
  • If the Phillips curve relationship holds, attempts to reduce the rate of unemployment are likely to raise inflation. On the other hand, a reduction in inflation is likely to result in higher unemployment. This suggests that it might be difficult to maintain full employment and low inflation at the same time.
  • Evaluation: The 1970s provided something of a setback to this theory, when suddenly the UK economy started to experience both high unemployment and high inflation simultaneously, suggesting that the Phillips curve had disappeared. This combination of stagnation and inflation became known as stagflation. 
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Conflicts between policy objectives

Economic growth and sustainability

  • The link between economic growth and environmental degradation is a clear one. 
  • There is particularly evidence for this in terms of China which has experienced growth of >10% per annum for the past 20 years. Developing countries tend to go through a process of industrialisation, in which it is vital that energy supplies keep up with demand, as factories need to operate. China is the world's second biggest oil importer and is the world's largest producer of coal - accounting for 80% of its total energy use.
  • It is also possible that inadequate regulation can add to environmental degradation, as in the case of the explosion at a chemical plant that caused pollution in the Songhua river.
  • For economic growth to be sustainable, these environmental effects must be taken into account, or there is real danger that the improved living standards that flows from the growth process will be obtained only at the expense of the quality of life of future generations. This may require growth to be slowed in the short run in order to devote resources to the development of renewable and cleaner energy sources. 
  • However, it is politically and morally difficult to impose this on newly emerging societies in which there is widespread poverty, especially when the richer nations of the world continue to enjoy high standards of living while causig pollution of their own.
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Conflicts between policy objectives

Economic growth and the current account of the balance of payments

  • An increase in economic growth resulting in higher real incomes could lead to an increase in imports of goods and services, if UK residents spend a high proportion of their additional income abroad (the UK has a high propensity to import). 
  • Furthermore, if there is strong growth within the UK, then UK exporters may divert their attentions away from exporting goods and instead focus upon the buoyant domestic demand (as people have higher incomes now) within the UK market - which would reduce exports and make the current account head towards a deficit.
  • Evaluation: However, growth and the current account may not always be in conflict; as strong growth can be export-led. If exporting UK firms are selling lots of goods/services to foreign countries, then this will create jobs within the UK and increase AD. 
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Conflicts between policy objectives

Economic growth and inflation

  • An overheating economy (reaching full employment) may suffer high inflation as a result of AD continuing to rise which is of course demand-pull inflation. Furthermore, increasing output means that the demand for energy and raw materials will increase - causing cost-push inflation.
  • Attempts to control inflation through increased interest rates may cause the exchange rate to appreciate (inflow of hot money) and this can negatively impact upon AD (component of x-m would reduce as less exports are demanded). Consumption would also fall (borrowing is more expensive and saving is more appealing) and also investment will fall, as business investment is funded by borrowing.
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