Economics- How the economy works

Overview of all the basics for the exam.

  • Created by: White
  • Created on: 30-05-11 17:18

Objectives of government policy

Main objectives: 

  • Maintaining full employment- Full employment is where everyone who is able and willing to work has a job. This does not mean everyone has a job as many choose not to, for example some choose to stay at home and look after their children.
  • Economic growth- This refers to growth of output in the economy. The value of the output will be equal to the value of the incomes for the workers and owners of factors of production which produce that output. The government are aiming for a more affluent economy.
  • Achieving price stability- This means keeping inflation low. Inflation is the general rise in price. The government aims for 2% per annum.
  • Balancing imports and exports- This means that the government wants a blance between exports and imports over time. This does not mean every year they want exports and imports to be the same but that a deficit in some years can be matched by surpluses in other years.
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The governments main policies

The main policies:

  • Fiscal Policy- It is aimed at changing the level of total (aggregate) demand in the economy through changes in taxation and government spending. 
  • Interest rate policy- This is also aimed at changing the level of total (aggregate) demand in the economy, but through changes in interest rates. This policy is not operated directly by the government, but by the Bank of England. 
  • Supply-side policy- This s aimed to increase the economy's capacity. An example would be educationa and training to improve the quality of the workforce.
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Economic Growth

Economic growth- growth in output of economy over time- a growth of real GDP over time.

Gross domestic product (GDP)- the total value of goods and services produced in the country in a year.

GDP per capita- GDP divided by the total population (GDP per head).

Economic growth is the growth of the country's output over time. Output is measured as GDP, the value of all the goods and services produced within the country in a year. This is the same as the total income of the people of that country in a year. The total value of output becomes incomes for those who produce it- incomes in the form of wages, profits, interest and rent.

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The causes of economic growth

The causes: 

  • Investment- spending on capital goods, more being spent on capital goods means the economy has the capacity to produce more goods and services in the future.
  • Changes in technology- When technical improves the quality and quantity of capital goods increases.
  • A larger workforce- The more workers the more can be produced with them.
  • Education and training- this affects the quality of the workforce. The more educated, trained and skilled the worker the higher the output of the country is likely to be.
  • Government policies- the government takes responsibility for the macro-economic management of the economy.
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Benefits of economic growth

The benefits:

  • A rise in material living standards- If GDP rises faster than the population rises, GDP per capita increases. This means everyone, on average, has more output available to consume than before. They are materially better off.
  • A rise in the welfare of the population- As the capacity of the economy to produce more grows, the government is able to devote more resources to services such as education and health. This can improve the general welfare of the country.
  • A rise in employment and a fall in unemployment- As output rises, more workers will be required to produce it, therefore unemployment falls.
  • A reduction in poverty- As output and incomes rise , the government is able to take more in taxes from the higher-income groups and use the revenue to raise the living standards of those with lower incomes, for example by providing benefits.
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Costs of economic growth

The costs:

  • Environmental costs- Greater output and consumption can lead to more pollution of the land, air, sea and fresh water. For example as output increases so does the transportation of these goods, which means more pollution being created. (Note: Quality of life does not depend on material possessions and consumption. It includes leisure time and quality of the environment in which we work and live.)
  • Congestion- Economic growth is often concentrated in certain urban areas, which can become overcrowded and congested. There may be more pressure on on services and roads tend to become more congested and travelling times increased.
  • Loss of non-renewable resources- Economic growth uses resources that can't be replaced, including oil, natural gas,metals and other minerals. As some of these resources are home to animals they may find themselves becoming endangered and some may face extinction.
  • Inequalities of income and wealth- The benefits of growth are unevenly spread. This means some become better off while others stay the same.
  • Inflation- Sometimes the economic growth is too fast to respond without a rise in the general price level.
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Employment and unemployment

Full employment is where all those able and willing to work are in paid employment.

Unemployment is where those able and willing to work are unable to find employment.

Measuring unemployment: 

  • Claimant count- measures unemployment according to the number of people claiming unemployment related benefits.
  • Labour Force Survey- a survey of a sample of households, counting people as unemployed if they are actively seeking work but do not have a job.
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Types of unemployment

Voluntary unemployment- This is caused by people choosing not to work.

Seasonal unemployment- This is caused by seasonal workers not being employed at other times of the year. (Coastal resorts will employ more workers in the summer period).

Frictional unemployment- This is caused by workers moving between jobs. There are time lags between workers leaving their job and starting a new one.

Structural unemployment- This is caused by long-term changes in the structure of industry when some industries decline. This is a serious, long-term type of unemployment. The workers are often occupationally immobile, which means they have the wrong skills and qualifications for other jobs.

Technological unemployment- This is caused by capital taking the place of labour. Automation means that workers lose their jobs. This has been common in manufacturing industries, for example increased use of robots on car assembly lines.

Cyclical unemployment- This is caused by a fall in total (aggregate) demand in the economy. If the demand for goods and services falls, then fewer workers are needed to produce output and some will be laid off. These unemployed now have lower incomes and in turn will spend less lowering total (aggregate) demand, which will lead to more unemployed. It can continue in a vicious cycle and lead to a very high level of unemployment.

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Consequences of unemployment

The consequences: 

  • Labour resources are wasted- The economy is it not using all of its resources that are available, therefore wasting them.
  • Lower living standards- Workers and their families suffer a lower standard of living as unemployment causes their income to fall.
  • Excluded workers- Some people are unemployed for so long they become excluded from the workforce. They become unemployable.
  • Costs to taxpayers- The unemployed are entitled to Jobseeker's Allowance or other benefits. The more unemployed people there are the greater the cost to taxpayers. A raise in taxes is likely.
  • A budget deficit- As well as the rise in spending , the government will lose tax revenue from workers that become unemployed, for example income tax will have a much smaller revenue than from before.
  • Regional problems- Unemployment is unlikely to spread evenly throughout the country. In times of high unemployment some locations tend to suffer much more than others, and may become 'depressed areas'.
  • Social problems- As well as lowering living standards, the unemployment may suffer from a loss of status and self-esteem. It can lead to an increase in crime.
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Inflation is a sustained rise in the general price level over time.

Price stability is where the general level of prices is kept constant or grows at an acceptably low rate over time.The government aim to keep inflation low to obtain this, 2% per annum.

Rate of inflation is the rate at which the general price level rises over time.

Inflation is measured mainly by Consumer Prices Index (CPI). This is the official measure of the rate of inflation for the UK government and governments of other European Union countries. 
The government find out the spending pattern of average families in the country. It records the prices of everything the families buy each month. This is done across the country. So if prices rise from one month to the next it is recorded in the CPI. Goods and services that usually take a higher proportion of the spending are more important when measuring inflation.

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Causes of inflation

The causes:

  • Demand-pull inflation- This is caused when the total (aggregate) demand in the economy rises. The supply of the goods and services cannot compete without the amount demanded, therefore stimulating a rise in price or causes the prices to be pulled up to reduce to demand.Demand-pull inflation usually occurs when the economy is near to full employment.
  • Cost-push inflation- This is caused when costs of production rise and cause the price level to rise. This is because if production increases the producer will need to make more money in order to afford the production and sustain the same level of profit.
  • Wage-price spiral- As the price level rises workers aim for wage rises. When these are given, this results in prices rising even more and leads to more inflation. This may continue in a cycle were inflation can become very high.
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Consequences of inflation

The costs: 

  • Shoe leather costs- If prices are not stable , consumers and firms spend more time 'shopping around' to find a reasonable price. This extra time and effort is known as 'shoe leather costs'.
  • Menu costs- Firms have to adjust their price lists more often when there is inflation, for example restaurants increasing the prices on their menus.
  • Income redistribution problems- Some people (especially debtors) may gain from inflation. Workers with a strong trade union may be able to achieve wage rises that keep up with inflation. But many people on low, fixed incomes may face hardship as their income fails to keep up with the prices.
  • Labour market problems- Workers will want wage rises to keep up with inflation and cause the employer to struggle with the increase in labour costs, this can lead to conflict between employers and employees and this can cause strikes.
  • Balance of payments problems- This will happen when a country which we trade with has a higher inflation rate than our own. Their competitive will decrease and prices drop so more consumers and firms will import goods and so will lead to a trade deficit.
  • Unemployment- High inflation reduces the confidence of businesses and so they invest less leading to unemployment as total (aggregate) demand falls.
  • Hyper inflation.
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Indirect and direct tax

Indirect taxes:

  • Excise duties- Taxes on specific range of goods (tobacco, alcohol).
  • VAT- 20% tax on all goods apart from food and children's clothes.

Direct taxes:

  • Income tax- Any income you make you pay an amount of it to the government, the more you earn the more you pay.
  • National insurance contributions- Like income tax.
  • Corporation tax- A tax on the profits of companies.
  • Inheritance tax- A tax on inheritance.
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Government policies

Fiscal policy- It uses taxation and government spending to achieve the government's objectives. If the government wishes to reflate or expand the economy it will aim for a budget deficit. This aims at achieving economic growth and more employment. If they wish to do the opposite they will aim for a budget surplus. A budget surplus aims at reducing both inflation and a balance of payments deficit.

Monetary policy- This uses interest rate policy to achieve government objectives. It uses the base bank rates, set by the Bank of England, to keep inflation between 1 and 3%. If they need to reduce inflation they raise interest rates to stop spending and increase saving. To increase inflation and economic growth they reduce interest rates to increase spending and raise total (aggregate) demand.

Supply-side policy- This is focused on increasing the ability of the economy to supply more goods and services, for example increasing education and training leads to a much more effective workforce that can produce more.

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Supply-side policies

The supply-side policies:

  • Educating and training- More qualified workforce to produce more output.
  • Reducing direct taxes- Decrease in direct taxes can cause a incentive to work harder.
  • Reducing benefits- Reduced benefits encourages people to look for work to earn more money.
  • Encouraging enterprise- New businesses are encouraged to start by making allowances for them not to pay certain taxes.
  • Encouraging new technology and innovation- The government puts up schemes to increase investment into technology.
  • Reducing monopoly power- Monopolies restrict output so by putting laws on them and stopping merges that may lead to monopolies the output of the economy increases.
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