Economics Unit 2 Edexcel

Breif overview of U2

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  • Created on: 14-05-12 14:03

Economic growth

Definition: An expansion in the productive capacity of an economy/an increase in real GDP. Drawn as a shift in the LRAS/movement outwards of PPF.

Importance:  Standards of living INC (developing countires ease off poverty). Incomes INC (households, firms profits INC, gov tax rev INC >improved public goods) 

Nomial GDP does not take account of fluctuations in price. Real GDP takes into account the impact of inflation/deflation(value at constant prices). Limitations of GDP: Polpualtion size and age distibution, Income inequality, Externalities, Quality of life, Exchange rate changes (not represent PPP)

Capacity output is reached when all factors of production are fully utilised:
Capital- Investment(an increase in capital stock) but some will offset depriciation; Net investment=Gross investment-depriciation(technology)  Labour- size(difficult to control, migration), increase producutity(increase in output keeping inputs constant, educ/train,health) Entreprendurship(specialist form of labour input, innovation)

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Fiscal Policy

Defi: Demand side policy, decisions made by the gov. concerning expenditure, taxation and borrowing. 

Government budget may change alone due to automatic stabilisers(income tax rev./benefits adjust without need for gov intervention)

 Defecit= G>T(Expansionary/recssion) Expansionary fiscal policy acts as an injection into the circular flow of income and benefits from the multiplier(Impact is dependant on withdrawals, eg level of import) Only effective if cuts sloping part of LRAS(or just causes inflation) Defecit must be financed by PSNCR may accumulate and INC net debt. May be bad for BOP, INC Imports.

Surplus= T>G(Tight/boom). Good for BOP DEC imports and DEC inflation.

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Fiscal policy evaluation

  • Disincentives of Tax Cuts. 
  • Side Effects on Public Spending, causing market failure and social inefficiency. 
  • Government needs correct knowledge of business cycle
  • Time Lags budget only set annually, time to filter though to spending
  • Budget Deficit 
  • Other Components of AD,if consumer confidence is very low, reducing taxes may not lead to an increase in consumer spending.
  • Depends on Multiplier,
  • size is effected by the size of withdrawals e.g. imports.
  • Crowding Out occurs when increased government  spending results in decreasing the size of the private sector
  • illusionary used by gov. to influence business cycle before run up to an election.
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Monetary policy

Def: Decisions made to influence the money supply or interest rates(controlled by MPC independent of the gov.)

Interest rates(the price of money) are used to achieve target of inflation 2%(+/-1%).Interest rates influence(INC interest rates, DEC AD)

  • The housing market: INC mortgage repayments, DEC disposable income DEC consumption also DEC demand for housing(fall in house prices)
  • Demand for credit: cost of borrowing INC > DEC demand for retail/durables
  • Saving rate: INC rate of return, INC savings
  • Business capital investment: DEC planned invest, other factors influence decisions
  • Confidence/Speculation: DEC interest rates indicate a recession DEC business confidence(BOE aware/or they are worried about a recession)
  • Exchange rate: Pound appreciates, may also attract "hot money" into British financial system. Stronger exchange rate DEC competitiveness of UK exports internationally > DEC exports and market share but makes imports cheaper > INC. 
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Evaluation of Monetary policy

  •  It is independent. They are not subject to political pressures.
  •  Monetary Policy is pre-emptive. They try to prevent inflation before it occurs. 
  •  MPC have reduced inflation expectations. Given people/businesses confidence.
  • Interests rates have a powerful effect in influencing UK consumer spending. This is because many people have mortgages or other types of loans.   

Limitations of the MPC’s Effectiveness

  •  Interest rates have a time lag. It is estimated it takes 18 months for interest rates to have an effect.
  • Not all sectors respond to interest rates changes. Eg. INC IR not affect housing, older people have a small mortgage therefore changes in interest rates have little effect.
  •  It depends upon other components of AD. E.g. if consumer confidence is high then INC interest rates may little effect on DEC consumer spending.
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Supply side policies

Def: Directly impact AS(increase productive capacity of economy) PPF curve/AS

Labour market: DEC wages + INC labour competitiveness/flexibility

  • Reduce income tax Impr incentive to work eg cut of 50% tax to 45% (progressive taxation is used to redistribute income, DEC inequality)
  • Reduce unemployment benefits INC labour supply, need to still provide protection for those unable to work.
  • Economic stability price signals work effectively > allocative efficiency
  • Reduce trade union power Pressure to increase wages removed
  • Education/training Increase productivity, retraining as economy develops.

Product market: INC competition + INC productivity

  • Deregulation Opening up of markets(reduce barriers to entry) more contestable. INC competitors>INC competition>DEC prices eg. gas/electricity
  • Privitisation  gov ownership to private. (profit motive) eg British airways, British gas

Problems: Effective in LR but do not have an immediate impact, can lead to unequal distribution of income eg, benefit cuts and high end tax cuts. Measures to increase AS will be ineffective if AS level is low.

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Gov objective conflicts

Economic growth and sustainability: INC growth INC evi degradation, inadequate legislation>exploitation of environment. DC devote resources to developing renewable resources, LDC need to devote resources current issues such as poverty whilst west enjoy higher standards of living.

Unemployment and inflation: (Philips curve) the lower the unemployment in an economy, the higher the rate of inflation, demand for Labour is high>firms willing to INC wages> passed onto prices.

Economic growth and current account: INC real income may INC demand for imports(dependent on MPI)

Expansionary FP and supply side: Together to policies reduce the pressure on price(INC AD and INC AS)

Monetary policy and supply side: INC interest rates> INC business costs >cost push inflation

Inflation and BOP: to control inflation gov will INC interest rates(attracting hot money) strong £ makes exports less competitive internationally and imports cheaper> Worsening BOP

Growth and inequality: (Kuznets theory) first to benefit from economic growth will be entrepreneurs(risk takers), at someone elses expense, widening the income gap, but low skilled workers may be emplyed(likelihood of immigrants filling these jobs)

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Balance of payments

Def: Account of all the transactions with an economy and the rest of the world. =0

Current:(UK defecit) recording of exports and imports of goods and services and transfer payments

  • Goods(tangible products) UK big pharmaceutical exporter, car importer.
  •  Services(intangible products) UK big banking exporter, holiday importer.
  • Transfer, investment income, dividends, wages paid to personal overseas.

Financial: (UK surplus) recording of all international transactions for assets. eg. bonds, treasury bills, bank deposits, stocks, currency, real estate, etc.

Imbalances causes: Country overspending, not producing wanted goods, strength of currency, different stages of business cycle, increased net incomes leaving economy, uk economy has high production costs

Deficit only becomes a problem when it becomes unsustainable(compromising the needs of future generations to meet our needs now).

Surplus=Exports>Imports(eg Germany/China) Defecit=Imports>Exports(eg USA/UK)

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Aggregate demand

Def: AD=C+I+G+(X-M) 

Consumption: As peoples real incomes INC consumption tends to INC but some would save(MPC, proportion of additional income devoted to consumption), this money whether spent or saved is called disposable income(influ. savings, assets). Consumption might INC due to: DEC unemployment, DEC income tax, DEC interest rates, INC confidence, INC asset prices.

Investment: Spending by firms to increase/replace capital stock. If increasing can cause shift in PPF/AS. Influenced by:

  • Taxation, DEC corporation tax > deter investment
  • Interest rates, INC > higher cost of borrowing
  • Inflation, INC > uncertainty of demand

Government expenditure: Mostly autonomous but some is automatic.

Imports and exports: 

  • Exchange rate ~ INC > DEC X + INC M
  • Inflation, ~ INC > DEC competitiveness > DEC X
  • Demand(incl, non price factors) dependant on state of rest of world economy, quality of goods
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Aggregate supply

Def: It is the total amount of goods and services that firms are willing to sell at a given price level in an economy.

Shifts to AS in short run caused byWage ratesPrice of imported raw materials, Interest rates, taxation, subsidies. When to AS curve reaches vertical it indicates it has reached its PPF operate below this and it indicates unemployed resources.

Shifts to LRAS: Expanding labour sector(increased incentive to work, migrants/emigration), productivity(labour and capital), Occupational mobility of labour, expanding of capital stock(R&D), Increased business efficiency(increased competition), Innovation/invention. EXTERNAL SHOCKS, rise in oil prices, invention of new technology.

Multiplier: shifts in AS or AD benefits from the multiplier, size depends on circular flow. Eg. Savings, imports, investment, exports, taxation.

Wealth effect: If asset prices INC consumers feel more wealthy> likely to INC confidence > INC C. Equity release: take out loans based on house value > finances consumption.

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Def: a sustained rise in general price level

  • Redistribute income from savers to spenders(money looses value)

CPI: -Survey of 7000 households on most popular 650 goods(basket of goods) these are assigned a weighting as proportion of income. The price changes of the basket of goods are recorded(civil servants) x weightings to produce an index. Inflation is calculated from the % change in these index.

Problems: 1. No account of housing costs 2. only 57% of people respond to survey 3. Inaccuracy of data they receive 4. Doesn't represent atypical spenders(e.g. veggie) 5. Fashions change faster than basket of goods 6. no account for BOGOF

RPI Takes account of housing costs BUT unique statistical method to uk.

Demand pull: AD exceeds AS. INC MPC, INC I

Cost push: INC production costs > INC prices.  INC price raw materials, INC corporation tax, DEC value of currency.

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Very useful. Thank You.

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