Theme 2 - ECONOMICS

Economic growth occurs when there is a rise in the value of Gross Domestic Product (GDP).

GDP measures the number of goods and services produced in an economy. In other words, a rise in economic growth means there has been an increase in national output.

• Real GDP is the value of GDP adjusted for inflation. For example, if the economy grew by 4% since last year, but inflation was 2%, real economic growth was 2%.
• Nominal GDP is the value of GDP without being adjusted for inflation. In the above example, nominal economic growth is 4%. This is misleading because it can make GDP appear higher than it really is.
• Total GDP is the combined monetary value of all goods and services produced within a country’s borders during a specific time period.
• GDP per capita is the value of total GDP divided by the population of the country. Capita is another word for ‘head’, so it essentially measures the average output per person in an economy. This is useful for comparing the relative performance of countries.
• The volume of GDP is GDP adjusted for inflation. It is the size of the basket of goods and the real level of GDP.
• Value of GDP is the monetary value of GDP at prices of the day. It is the nominal figure and can be calculated by volume times current price level. 

National income can also be measured by:

Gross National Product (GNP) is the market value of all products produced in an annum by the labour and property supplied by the citizens of one country. It includes GDP plus income earned from overseas assets minus income earned by overseas residents. GDP is within a country’s borders, whilst GNP includes products produced by citizens of a country, whether inside the border or not.

Gross National Income (GNI) is the sum of value added by all producers who reside in a nation, plus net overseas interest payments and dividends. It includes what a country earns from overseas and removes any money that is sent back home by foreigners in that country.

This is a theory that estimates how much the exchange rate needs adjusting so that an exchange between countries is equivalent, according to each currency’s purchasing power.

For example, if a car cost £15,000 and the exchange rate between the UK and the US is 1.5 £ per $, then in the US, the car should cost $10,000. This means both cars cost the same number of US dollars and the same number of pounds Sterling.

This helps to minimise misleading comparisons between countries.
 

GDP does not give any indication of the distribution of income. Therefore, two countries with similar GDPs per capita may have different distributions which lead to different living standards in the country.

GDP may need to be recalculated in terms of purchasing power, so that it can account for international price differences. The purchasing power is determined by the cost of living in each country, and the inflation rate.

There are also large hidden economies, such as the black market, which are not accounted for in GDP. This can make GDP comparisons misleading and difficult to compare.

GDP gives no indication of welfare. 

UK national well-being

The Office for National Statistics is trying to develop more ways of measuring national well-being. It should give a wider picture of society and the standard of living within the UK. The UN happiness report found that the six factors which affect national wellbeing are: real GDP per capita, health, life-expectancy, having someone to count on, perceived freedom to make life choices, freedom from corruption and generosity. The UK 'Measuring National Wellbeing' report includes questions about life satisfaction, anxiety, happiness and worthwhileness. 

The relationship between real incomes and subjective happiness

The UK economy grew by 5% in GDP per capita between 2007 and 2014, but showed no change in life satisfaction. However, generally, the higher the GDP per capita, the higher the average life satisfaction score. One finding is that happiness and income tend to be positively related at low levels of income but, once basic needs are met, higher income does not lead to increased happiness. 

Inflation is the sustained rise in the general price level over time. This means that the cost of living increases and the purchasing power of money decreases.

Deflation is the opposite, where the average price level in the economy falls. There is a negative inflation rate.

Disinflation is the falling rate of inflation. This is when the average price level is still rising but to a lower extent. This means goods and services are relatively cheaper now than a year ago, and the purchasing power of money has increased.

For example, a 4% increase in the price level between 2014 and 2015 would be inflation. A change from 4% to 2% is still inflation, but there has been disinflation where the price rise has slowed. If the change in the price level is now -3%, there is deflation. 

This is done using the Consumer Prices Index (CPI).

It measures household purchasing power with the Family Expenditure Survey. The survey finds out what consumers spend their income on. From this, a basket of goods is created. The goods are weighted according to how much income is spent on each item. Petrol has a higher weighting than tea, for example. Each year, the basket is updated to account for changes in spending patterns.

In the UK, it is a government macroeconomic objective for inflation to be at 2%, or 1% either side of this. They want to maintain price stability.

The key points when answering an exam question on CPI are:

• A survey is used
• Weighted basket of goods
• Measures average price change of the goods
• Updated annually

• The basket of goods is only representative of the average household, so it is not accurate for households who do not own cars, for example, and therefore do not spend 14% of their income on motoring.
• Different demographics have different spending patterns. 
• CPI is slow to respond to new goods and services, even though it is updated regularly.
• Moreover, it is hard to make historical comparisons, since technology twenty years ago was of a vastly different quality, and arguably a different product altogether, than now. 

This is an alternative measure of inflation.

Unlike CPI, RPI includes housing costs, such as payments on mortgage interest and council tax. This is why RPI tends to have a higher value than CPI.

It excludes the top 4% of earners and low income pensioners.

However, CPI takes into account the fact that when prices rise people will switch to product that has gone up by less, whilst RPI does not. 

Demand-pull: This is from the demand side of the economy. When aggregate demand is growing unsustainably, there is pressure on resources. Producers increase their prices and earn more profits. It usually occurs when resources are fully employed.

The main triggers for demand-pull inflation are:

• A depreciation in the exchange rate, which causes imports to become more expensive, whilst exports become cheaper. This causes AD to rise.
• Fiscal stimulus in the form of lower taxes or more government spending. This means consumers have more disposable income, so consumer spending increases.
• Lower interest rates make saving less attractive and borrowing more attractive, so consumer spending increases.
• High growth in UK export markets means UK exports increase and AD increases.

Cost-push: This is from the supply side of the economy, and occurs when firms face rising costs.

This occurs when:

• Raw materials become more expensive, such as when oil prices rise.
• Labour becomes more expensive. This could be through trade unions.
• Expectations of inflation
• If consumers expect prices to rise, they may ask for higher wages to make up for this, and this could trigger more inflation. 
• Indirect taxes could increase the cost of goods such as cigarettes if producers choose to pass the costs onto the consumer.
• Depreciation in the exchange rate, which causes imports to become more expensive, which pushes up the price of raw materials.
• Monopolies, using their dominant market position to exploit consumers with high prices.

Growth of the money supply: If, for instance, the Bank of England printed more money, there would be more money flowing in the economy.

Extreme increases in the money supply usually cause hyperinflation, when the rate of inflation is incredibly high and uncontrollable.

It is only inflationary if the money supply increases at a faster rate than real output.

Consumers

• Those on low and fixed incomes are hit hardest by inflation, due to its regressive effect, because the cost of necessities such as food and water becomes expensive. The purchasing power of money falls, which affects those with high incomes the least.
• If consumers have loans, the value of the repayment will be lower, because the amount owed does not increase with inflation, so the real value of debt decreases.

Firms

• Low interest rates mean borrowing and investing is more attractive than saving profits. With high inflation, interest rates are likely to be higher, so the cost of investing will be higher and firms are less likely to invest.
• Workers might demand higher wages, which could increase the costs of production for firms. Firms may be less price competitive on a global scale if inflation is high. This depends on what happens in other countries, though.
• Unpredictable inflation will reduce business confidence since they are not aware of what their costs will be. This could mean there is less investment.

The government

• The government will have to increase the value of the state pension and welfare payments because the cost of living is increasing

Workers

• Real incomes fall with inflation, so workers will have less disposable income.
• If firms face higher costs, there could be more redundancies when firms try and cut their costs.

Extra Notes: The effects on individuals, such as firms, consumers or workers, are microeconomic impacts whilst the inflation figure itself is a macroeconomic impact- this shows how the macro-economy has microeconomic effects.

It is usually difficult to accurately measure unemployment. Some of those in employment might claim unemployment-related benefits, whilst some of the unemployed might not reveal this in a survey.

 The two main measures of unemployment in the UK are:

• The Claimant Count
  
• The International Labour Organisation (ILO) and the UK Labour Force Survey (LFS) 

This counts the number of people claiming unemployment-related benefits, such as Job Seeker’s Allowance (JSA). They have to prove they are actively looking for work.

Evaluating the Claimant Count:

Not every unemployed person is eligible for or bothers claiming JSA. Those with partners on high incomes will not be eligible for the benefit, even if they are unemployed.

Although there may be instances of people claiming the benefit whilst they are employed, the method generally underestimated the level of unemployment. 

ILO - The International Labour Organisation 

LFS - UK Labour Force Survey 

The LFS is taken on by the ILO.

It directly asks people if they meet the following criteria:

• Been out of work for 4 weeks
• Able and willing to start working within 2 weeks
• Workers should be available for 1 hour per week. Part-time unemployment is included.

Since the part-time unemployed are less likely to claim unemployment benefit, this method gives a higher unemployment figure than the Claimant Count. 

The unemployed are those able and willing to work, but are not employed. They are actively seeking work and usually looking to start within the next two weeks.

The underemployed are those who have a job, but their labour is not used to its full productive potential. Those who are in part-time work, but are looking for a full-time jobs are underemployed. 

Consumers

• If consumers are unemployed, they have less disposable income and their standard of living may fall as a result. There are also psychological consequences of losing a job, which could affect the mental health of workers.

Firms

• With a higher rate of unemployment, firms have a larger supply of labour to employ from. This causes wages to fall, which would help firms reduce their costs. However, with higher rates of unemployment, since consumers have less disposable income, consumer spending falls so firms may lose profits. Producers who sell inferior goods might see a rise in sales. It might cost firms to retrain workers, especially if they have been out of work for a long time. 

Workers

• With unemployment, there is a waste of workers’ resources. They could also lose their existing skills if they are not fully utilized. Those in jobs are likely to see a fall in their wages as supply of labour increases

The government

• If the unemployment rate increases, the government may have to spend more on JSA, which incurs an opportunity cost because of the money could have been invested elsewhere. The government would also receive less revenue from income tax, and from indirect taxes on expenditure, since the unemployed have less disposable income to spend.

Society

• There is an opportunity cost to society since workers could have produced goods and services if they were employed. There could be negative externalities in the form of crime and vandalism, if the unemployment rate increases.

Inactivity: The economically inactive are those who are not actively looking for jobs. These could include carers for the elderly, disabled or children, or those who have retired. Some workers are discouraged from the labour market, since they have been out of work for so long that they have stopped looking for work. If the number of the economically inactive increases, the size of the labour force may decrease, which means the productive potential of the economy could fall. 

Structural

• This occurs with a long term decline in demand for the goods and services in an industry, which costs jobs. 
• This type of unemployment is worsened by the geographical and occupational immobility of labour. If workers do not have the transferable skills to move to another industry, or if it is not easy to move somewhere jobs are available, then those facing structural unemployment are likely to remain unemployed in the long run.
• Globalisation contributes to structural unemployment since production in the manufacturing sectors moves abroad to countries with lower labour costs. 

Cyclical

• This is caused by a lack of demand for goods and services, and it usually occurs during periods of economic decline or recessions. Firms are either forced to close or make workers redundant, because their profits are falling due to decreased consumer spending, and they need to reduce their costs. This then causes the output to fall in several industries.
• This type of unemployment could actually be caused by increases in productivity, which means each worker can produce a higher output, and therefore fewer workers are needed to produce the same quantity of goods and services. 

Frictional

This is the time between leaving a job and looking for another job. It is common for there to always be some frictional unemployment, and it is not particularly damaging since it is only temporary. For example, it could be the time between graduating from university and finding a job.

This is why it is rare to get 100% employment: there will always be people moving between jobs.

Seasonal

This occurs during certain points in the year, usually around summer and winter. During the summer, more people will be employed in the tourist industry, when demand increases. 

Real Wage

Wages above the market equilibrium may cause unemployment. Classical economists argue that by letting wages fall to the equilibrium level, there would be no unemployment. 

Migrants are usually of working age and many are looking for a job, so the supply of labour at all wage rates tends to increase with more migration.

Migrants tend to bring high-quality skills to the domestic workforce, which can increase productivity and increase the skillset of the labour market. This could increase global competitiveness.

Migrant labour affects the wages of the lowest paid in the domestic labour market, by bringing them down. This is because migrants are usually from economies with lower average wages than the UK NMW. However, this impact is only small. For the medium and higher income households, it is hard to find evidence of worker displacement or depressed wages.

In general, a higher skilled workforce is more employable. Economies progress over time and so higher skills are needed to work in them. This means that the skills of the workforce need to continuously improve in order to maintain employment. Structural unemployment occurs if individuals don't have the right skills. 

This is a record of all financial transactions made between consumers, firms and the government from one country with other countries.

It states how much is spent on imports, and what the value of exports is.

Exports are goods and services sold to foreign countries and are positive in the balance of payments. This is because they are an inflow of money.

Imports are goods and services bought from foreign countries, and they are negative on the balance of payments. They are an outflow of money.

The balance of payments is made up of:

• The current account
• The capital account
• The official financing account

The current account on the balance of payments is the balance of trade in goods and services

A current account surplus means there is a net inflow of money into the circular flow of income. The UK has a surplus with services, but a deficit with goods.

The UK has a current account deficit. This means the UK spends more on imports from foreign countries than they earn from exports to foreign countries. If the deficit is large and runs for a long time, there could be financial difficulties with financing the deficit. 

The UK government’s macroeconomic objectives are to have:

• Full employment
• Low, stable inflation
• A sustainable current account on the balance of payments
• Sustainable economic growth

By selling more exports to foreign countries, the UK will have a greater inflow of money into the circular flow of income. This will increase AD and improve the rate of economic growth.

In the UK, during periods of economic decline or recessions, the current account deficit falls. This is because consumer spending falls.

During periods of economic growth, when consumers have higher incomes and they can afford to consume more, there is a larger deficit on the current account.

If imported raw materials are expensive, there could be cost-push inflation in the UK, since firms face higher production costs. 

In theory, the sum of all countries’ trade balances should be zero, since what one country exports will be imported by another country.

If the UK’s main export market, such as the EU, faces an economic downturn then demand for UK goods and services will fall, since consumers in the EU are less able to afford imports.

International trade has meant countries have become interdependent. Therefore, the economic conditions in one country affect another country, since the quantity they export or import will change. 

Aggregate demand is the total demand in the economy. It measures spending on goods and services by consumers, firms, the government and overseas consumers and firms.

It is made up of the following components, which make up the equation: C + I + G +(X-M)

• Consumer spending: This is how much consumers spend on goods and services. This is the largest component of AD and is therefore most significant to economic growth. o Investment: This is business spending on capital goods. It accounts for around 15-20% of GDP in the UK per annum, and about ¾ of this comes from private sector firms. The other ¼ is spent by the government on, for example, new schools.
• Government spending: This is how much the government spends on state goods and services, such as schools and the NHS. It accounts for 18-20% of GDP. Transfer payments are not included in this figure, because no output is derived from them, and it is simply a transfer of money from one group of people to another.
• Exports minus imports: This is the value of the current account on the balance of payments. A positive value indicates a surplus, whilst a negative value indicates a deficit. The UK has a relatively large trade deficit, which reduces the value of AD. This is the most insignificant part of AD.

• A fall in the price level from P1 to P2 causes an expansion in demand from Y1 to Y2.
• A rise in the price level from P2 to P1 causes a contraction in demand from Y2 to Y1.
• Changes in the price level cause movements along the demand curve.

The downward slope of the AD curve can be explained by:

• Higher prices lead to a fall in the value of real incomes, so goods and services become less affordable in real terms.
• If there was high inflation in the UK so that the average price level was high, foreign goods would seem relatively cheaper. Therefore, there would be more imports, so the deficit on the current account might increase, and AD would fall.
• High inflation generally means the interest rates will be higher. This will discourage spending since saving becomes more attractive and borrowing becomes expensive.

The AD curve is shifted by changes in the components of AD (C, I, G or X-M):

• A rise in AD is shown by a shift to the right in the demand curve (AD1 -> AD2).
• This rise in economic growth occurs when any of the components of AD increase.

Consumer spending: This is how much consumers spend on goods and services. This is the largest component of AD and is, therefore, most significant to economic growth. It makes up just over 60% of GDP.

Disposable income: is the amount of income consumers have left over after taxes and social security charges have been removed. It is what consumers can choose to spend.

Consumer income might come from wages, savings, pensions, benefits and investments, such as dividend payments.

A consumer’s marginal propensity to consume is how much a consumer changes their spending following a change in income. Consumers on low incomes are more likely to spend. 

A consumer’s marginal propensity to save is the proportion of each additional pound of household income that is used for saving.

A consumer’s marginal propensity to consume added to the marginal propensity to save is equal to 1. Consumer income which is not spent is saved. 

Interest rates: If the Monetary Policy Committee lowers interest rates, it is cheaper to borrow and reduces the incentive to save, so spending increases. There are time lags between the change in interest rates and the rise in consumption. Lower interest rates also lower the cost of debt, such as mortgages. This increases the effective disposable income of households.

Consumer confidence: If consumers have higher confidence levels, they spend more because they are less concerned about needing to save for future difficulties. This is affected by anticipated income and inflation.                                                                                                          If consumers fear unemployment or higher taxes, consumers may feel less confident about the economy, so they are likely to spend less and save more. This delays large purchases, such as houses or cars.

Wealth effects: In the UK, most people own their houses. This means that a rise in the price of houses makes people feel wealthier, so they are likely to spend more. This is the wealth effect.      A consumer’s housing equity is the difference between the market value of a property and how much loan is remaining to be paid. If house prices increase, consumers experience a rise in equity, so they might be paying less on their mortgage than the house is worth on the market. This makes consumers feel wealthier, so they are more willing to spend. This can also occur with other assets, such as shares.

Gross investment: This is the amount that a firm invests in business assets that do not account for depreciation.                                                                                Depreciation is when something starts to lose value, such as how a car loses value the older it gets. If the depreciation in the value of the capital is greater than the growth in gross investment, there is a decrease in the value of capital in the economy and there is no economic growth.

Net investment: This is the actual addition to the capital stock of an economy after depreciations have been considered. Net investment= gross investment – depreciation. 

The rate of economic growth

• If growth is high, firms will be making more revenue due to higher rates of consumer spending. This means they have more profits available to invest.

Business expectations and confidence

• If firms expect a high rate of return, they will invest more. Firms need to be certain about the future, otherwise, they will postpone their investments.
• Also, expectations about society and politics could affect investment. For example, if a change in government might happen, or if commodity prices are due to rise, businesses may postpone their investment decisions.
• Keynes coined the term animal spirits when describing instincts and emotions of human behaviour, which drives the level of confidence in an economy.

Demand for exports

• This is related to the rate of market demand. The higher demand is, the more likely it is that firms will invest. This is because they expect higher sales, so they might direct capital goods into the markets where consumer demand is increasing.

Interest rates

• Investment increases as interest rates falls. This means that the cost of borrowing is less and the return to lending is higher.
• The higher interest rates are, the greater the opportunity cost of not saving the money. 

Access to credit

• If banks and lenders are unwilling to lend, such as shortly after the financial crisis when banks became more risk averse, firms will find it harder to gain access to credit, so it is either more expensive or not possible to gain the funds for investment.
• The availability of funds is dependent on the level of saving in the economy. The more consumers are saving, the more available fund are for lending, and therefore for investing.

The influence of government and regulations

• The rate of corporation tax could affect investment. Lower taxes means firms keep more profits, which could encourage investment.
• High levels of regulation would discourage investment 

The trade cycle

• This is another term for the business cycle, which refers to the stage of economic growth that the economy is in.
• The economy goes through periods of booms and busts.
• Real output increases when there are periods of economic growth. This is the recovery stage. o The boom is when economic growth is fast, and it could be inflationary or unsustainable.
• During recessions, real output in the economy falls, and there is negative economic growth.
• During recessions, governments might increase spending to try and stimulate the economy. This could involve spending on welfare payments to help people who have lost their jobs, or cutting taxes.
• This will increase the government deficit, and they may have to finance this. o During periods of economic growth, governments may receive more tax revenue since consumers will be spending more and earning more. They may decide to spend less, since the economy does not need stimulating, and fewer people will be claiming benefits.

Fiscal policy

• Governments use fiscal policy to influence the economy. It involves changing government spending and taxation
• Governments might spend on public goods and merit goods, as well as welfare payments.
• Fiscal policy is a demand-side policy, so it works by influencing the level or composition of AD.
• Discretionary fiscal policy is a policy which is implemented through one-off policy changes.
• Automatic stabilisers are policies which offset fluctuations in the economy. These include transfer payments and taxes. They are triggered without government intervention.
• The government might use expansionary fiscal policy during periods of economic decline. This involves increasing spending on transfer payments or on boosting AD, or by reducing taxes.
• During periods of economic growth, governments might use contractionary fiscal policy by decreasing expenditure on purchases and transfer payments. Additionally, tax rates might increase. This reduces the size of the government budget deficit.

Real income

• During periods of economic growth, consumers have higher incomes and they can afford to consume more. This means they are likely to import more so there is a larger deficit on the current account.
• During periods of economic decline, real incomes fall and historically, this has led to improvements in the UK’s current account due to fewer imports.
• Incomes have little impact on exports.

Exchange rates

• A depreciation of the pound means imports are more expensive and exports are cheaper, so the current account trade deficit narrows as people are less likely to buy imports and more likely to buy exports. (SPICED- strong pound, imports cheap, exports dear)
• Depreciations make the currency relatively more competitive against other currencies.
• However, it depends on which currency the pound depreciates against. 
• Moreover, the demand for UK exports has to be price elastic to lead to an increase in exports. If demand is price inelastic, exports will not increase significantly, and the value of exports will decrease.

State of the world economy

• A decline in economic growth in one of the UK’s export markets means there will be a fall in exports. This is because consumer spending in those economies will fall, due to falling real incomes.
• For example, the UK’s largest export market is the EU. If they face an economic downturn then demand for UK goods and services will fall, since consumers in the EU are less able to afford imports.

Degree of protectionism 

• Protectionism is the act of guarding a country’s industries from foreign competition. It can take the form of tariffs, quotas, regulation or embargoes.
• If the UK employed several protectionist measures, then the trade deficit will reduce. This is because the UK will be importing less due to tariffs and quotas on imports to the UK.
• However, since protectionism leads to retaliation, exports might decrease too, which undoes the effect of reduced imports.

Non-price factors

• The competitiveness of a country’s goods and services, which is influenced by supply-side policies, impacts how many exports the country has.
• A country can become more competitive by being innovative, having higher quality goods and services, good advertising and marketing, strong customer service and operating in a niche market, having lower labour costs, being more productive or by having better infrastructure. These increase exports.
• Moreover, trade deals and being part of trading blocs can influence how much a country exports. This either opens up a country to or closes a country from, significant export opportunities

Aggregate supply shows the quantity of real GDP which is supplied at difference price levels in the economy.

The SRAS curve is upward sloping because at a higher price level, producers are willing to supply more because they can earn more profits

Moving along the AS curve

Only changes in the price level, which occur due to changes in AD, lead to movements along the AS curve

If AD increases, there is an expansion in the SRAS, from Y1 to Y2. If AD falls, there is a contraction in SRAS, from Y1 to Y3

Shifting the AS curve

The SRAS curve shifts when there are changes in the conditions of supply, any of the factors which affect SRAS. 

• The short run is the period of time when at least one factor of production is fixed, whilst in the long-run, all factors of production are variable.
• The short-run aggregate supply curve (SRAS) only covers the period immediately after a change in the price level. It shows the planned output of an economy when prices change, whilst the cost of production and productivity of the factor inputs are kept constant. A change in one of these will result in the shift of the curve.
• The curve is upward sloping because supply is assumed to be responsive to a change in AD, which is reflected in the price level. 
• The long-run aggregate supply curve (LRAS) shows the potential supply of an economy in the long run. This is when prices, and the costs and productivity of factor inputs, can change. Similarly to the PPF, it can show the economy’s productive potential.
• The curve is vertical in the classical model because supply is assumed not to change as the price level changes. 

The SRAS curve shifts when there are changes in the conditions of supply.

This is usually in the form of costs to businesses:

The cost of raw materials and energy may change. A rise in their costs would increase costs for businesses and thus decrease SRAS from SRAS1 to SRAS3.

A stronger currency reduces the price of imports, so imported products will be cheaper. This would reduce business costs. The AS curve would shift outwards, from SRAS1 to SRAS2.

Increased tax rates would increase business costs and therefore decrease SRAS from SRAS1 to SRAS3.

• The Keynesian view suggests that the price level in the economy is fixed until resources are fully employed.
• The horizontal section shows the output and price level when resources are not fully employed; there is spare capacity in the economy. The vertical section is when resources are fully employed.
• Over the spare capacity section, the output can be increased (AD1 to AD2) without affecting the price level (stays at P1). In other words, output changes are not inflationary.
• Once resources are fully employed, an increase in output (AD3 to AD4) will be inflationary (price level increases from P2 to P3)

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• The classical view suggests that output is fixed at each level. All factors of production in the economy are fully employed in the long run.
• This means that changing AD, such as from AD1 to AD2, only makes a change in the price level (P1 to P2), and it will not change national output (real GDP).

The LRAS curve is influenced by changes which affect the quantity or quality of the factors of production. This is equivalent to shifting the PPF curve i.e. when the economy is operating at full capacity. An increase in the number of goods/services produced would mean that LRAS would shift outwards.

Technological advances: If more money is spent on improving technology, the economy can produce goods in larger volumes or improve the quality of goods and services produced.

Changes in relative productivity: A more productive labour and capital input will produce a larger quantity of output with the same quantity of input.

Changes in education and skills: This improves the quality of human capital, so it is more productive and more able to produce a wider variety of goods and services. They may become more innovative and able to contribute to technological advances.

Changes in government regulations: Government regulation could limit how productive and efficient a firm can be if it is excessive. This is sometimes referred to as ‘red-tape’. 

• Firms and households interact and exchange resources in an economy. Households supply firms with the factors of production, such as labour, land, capital and enterprise, and in return, they receive wages, rent, dividends and profit.
• Firms supply goods and services to households. Consumers pay firms for these.
• This spending and income circulate around the economy in the circular flow of income, which is represented in the diagram above. Therefore, national income= national output=national expenditure.
• Saving income removes it from the circular flow. This is a withdrawal of income. Investing money into the economy is an injection.
• Taxes are also a withdrawal of income, whilst government spending on public and merit goods and welfare payments are injections into the economy.
• International trade is also included in the circular flow of income. Exports are an injection into the economy since goods and services are sold to foreign countries and revenue in earned from the sale. Imports are a withdrawal from the economy since money leaves the country when goods and services are bought from abroad.
• The economy reaches a state of equilibrium when the rate of withdrawals = the rate of injections. 

An injection into the circular flow of income is money which enters the economy. This is in the form of government spending, investment and exports.

Withdrawal from the circular flow of income is money which leaves the economy. This can be from taxes, saving and imports.

The economy reaches a state of equilibrium when the rate of withdrawals = the rate of injections.

If there are net injections into the economy, there will be an expansion of national output.

If there are net withdrawals from the economy, there will be a contraction of production, so output decreases. 

The economy reaches a state of equilibrium when the rate of withdrawals = the rate of injections. This is equivalent to the point where AD = AS. 

At a price above equilibrium, there will be excess supply. At a price below equilibrium, there will be excess aggregate demand, in the short run.

Shift in AS

• If the economy becomes more productive, or if there is an increase in efficiency, supply will shift to the right. This lowers the average price level (Pe to P1) and increases national output (Ye to Y1). The economy is no longer producing at long-run equilibrium, as they producing beyond the LRAS.
• If AS shifts inwards, price increases and national output decreases.

Shift in AD

• If firms have less confidence or there is a recession, AD might shift inwards. This causes the price level to fall from Pe to P1, and national output to fall from Ye to Y1.
• If AD increases, the price level and level of national output both increase. 

The multiplier ratio

This is the ratio of the rise in national income to the initial rise in AD. In other words, it is the number of times a rise in national income is larger than the rise in the initial injection of AD, which led to the rise in national income.

The multiplier process

The multiplier effect occurs when there is a new demand in an economy. This leads to an injection of more income into the circular flow of income, which leads to economic growth. This leads to more jobs being created, higher average incomes, more spending, and eventually, more income is created.

The multiplier effect refers to how an initial increase in AD leads to an even bigger increase in national income.

It occurs since ‘one person’s spending is another person’s income’.

Marginal propensity to consume (MPC): A consumer’s marginal propensity to consume is the proportion of each additional pound of household income that is spent. The higher the MPC, the bigger the size of the multiplier. The government could influence the MPC by changing the rate of direct tax. If consumers have more disposable income due to lower income tax rates, their propensity to consume might increase.

Marginal propensity to save (MPS): A consumer’s marginal propensity to save plus the marginal propensity to consume is equal to 1. If consumers save more than they spend, the size of the multiplier will be small.

Marginal propensity to tax (MPT): This is defined as the proportion of each pound taxed by the government. The higher the rate of tax, the less disposable income each consumer has, and the smaller the size of the multiplier.

Marginal propensity to import (MPM): If consumers spend income on imports rather than domestic goods and services, income is withdrawn from the circular flow of income. This reduces the size of the multiplier.

- One formula that can be used to calculate the multiplier is 1/(1-MPC).

Example: If consumers spend 0.6 of every £1 they earn, they save 0/4. Therefore, the multiplier will be: 1/(1-0.6) = 1/0.4 = 2.5. This means that every £1 of income generates £2.50 of new income.

- An open economy has three areas of withdrawals: taxes, imports and savings.

- The marginal propensity to withdraw is calculated by MPW = MPS + MPT + MPM

- This gives another formula for calculating the multiplier: 1/MPW

If an economy has a lot of spare capacity, extra output can be produced quickly and at little extra cost. This makes AS elastic and it means the size of the multiplier will be larger. A small increase in AD will lead to a large increase in national income.This is perhaps best shown on the Keynesian curve. The vertical section is perfectly inelastic, with no spare capacity, whilst the horizontal section is perfectly elastic, with lots of spare capacity.

If AS is inelastic, the multiplier effect is likely to be smaller than its potential. This is because if AD increases, prices will increase. The increase in output will not be as significant.

It is also possible to have a ‘reverse’ multiplier. This means that a withdrawal of income form the circular flow of income could lead to an even larger decrease in income for the economy. This could decrease economic growth and potentially lead to a decline in the economy. 

Economic growth is defined as the expansion of the productive potential of the economy. It can be depicted by an outward shift in the PPF or an outward shift in a country’s LRAS curve. It is measured by the annual change in real GDP.                                                                            Economic growth occurs due to an improvement in the quantity or quality of one of the factors of production, or an increase in the efficiency of the way they are used. For example:

• Improving the labour force, with better quality due to higher education.
• A larger labour force. This may be due to migration, birth rates or improved participation rates.
• Improved technology, which is more productive. This means resources are used more efficiently.
• More investment, to fuel economic growth. 
• Discovering new resources, such as oil.
• Incentives for enterprise, such as tax breaks or subsidies.

Actual growth is the percentage increase in a country’s real GDP and it is usually measured annually. It is caused by increases in AD.                                                                                    Potential growth is the long run expansion of the productive potential of an economy. It is caused by increases in AS. The potential output of an economy is what the economy could produce if resources were fully employed. 

• Export-led growth occurs when countries open up their economies to the international market. One of the most famous examples of this is China, which has had export-led growth for many years.
• International trade is important for this. Countries can specialise where they have a comparative advantage, which increases world output and lowers average costs.
• A country has a comparative advantage when it can produce goods and services at a lower opportunity cost than another.
• It will initially increase AD, so will only bring about short term growth. However, it will encourage firms to invest and therefore bring about long term growth by improving the supply-side of the economy.
• It allows the government to bring about economic growth and high employment without seeing a current account deficit.
• Export-led growth means the economy is unbalanced since there is a surplus on the current account on the balance of payments. Whilst this means there are net injections into the economy, it is not necessarily sustainable. However, the growth in the economy may lead to an increase in imports which will balance the current account.
• Moreover, it means the country relies on the economic state of other countries since these are the consumers of their goods and services. If there is a recession in a major export market, exports will fall and so will economic growth. 

• Actual growth is the percentage increase in a country’s real GDP and it is usually measured annually. It is caused by increases in AD.
• The long-term trend in growth rates is the long run expansion of the productive potential of an economy. It is caused by increases in AS.
• The potential output of an economy is what the economy could produce if resources were fully employed. 

An output gap occurs when there is a difference between the actual level of output and the potential level of output. It is measured as a percentage of national output.

A negative output gap occurs when the actual level of output is less than the potential level of output. This puts downward pressure on inflation. It usually means there is the unemployment of resources in an economy, so labour and capital are not used to their full productive potential. This means there is a lot of spare capacity in the economy. 

A positive output gap occurs when the actual level of output is greater than the potential level of output. It could be due to resources being used beyond the normal capacity, such as if labour works overtime. If productivity is growing, the output gap becomes positive. It puts upward pressure on inflation. 

It is difficult to estimate the trend in a series of data.

The structure of the economy often changes, which means estimates may not always be accurate. For example, immediately after a recession, the level of spare capacity might fall below the level anticipated, since some workers might become economically inactive, firms might close and some banks might be unwilling to lend.

Changes in the exchange rate might offset some inflationary effects of a positive output gap.

Data is not always reliable, especially from emerging markets, and extrapolating data from past trends might lead to uncertainties. 

This refers to the stage of economic growth that the economy is in.

• The economy goes through periods of booms and busts.
• Real output increases when there are periods of economic growth. This is the recovery stage.
• The boom is when economic growth is fast, and it could be inflationary or unsustainable.
• During recessions, the real output in the economy falls, and there is negative economic growth.
• During recessions, governments might increase spending to try and stimulate the economy. This could involve spending on welfare payments to help people who have lost their jobs, or cutting taxes.
• During periods of economic growth, governments may receive more tax revenue since consumers will be spending more and earning more. They may decide to spend less, since the economy does not need stimulating, and fewer people will be claiming benefits.

Boom

• High rates of economic growth
• Near full capacity or positive output gaps
• (Near) full employment Demand-pull inflation 
• Consumers and firms have a lot of confidence, which leads to high rates of investment
• Government budgets improve, due to higher tax revenues and less spending on welfare payments 

Recession

• In the UK, a recession is defined as negative economic growth over two consecutive quarters. 
• Negative economic growth
• Lots of spare capacity and negative output gaps
• Demand-deficient unemployment
• Low inflation rates
• Government budgets worsen due to more spending on welfare payments and lower tax revenues
• Less confidence amongst consumers and firms, which leads to less spending and investment 

Costs

• Economic growth does not benefit everyone equally. Those on low and fixed incomes might feel worse off if there is high inflation and inequality could increase.
• There is likely to be higher demand-pull inflation, due to higher levels of consumer spending.
• Consumers could face more shoe leather costs, which means they have to spend more time and effort finding the best deal while prices are rising.
• The benefits of more consumption might not last after the first few units, due to the law of diminishing returns, which states that the utility consumers derive from consuming a good diminishes as more of the good is consumed.

Benefits

• The average consumer income increases as more people are in employment and wages increase.
• Consumers feel more confident in the economy, which increases consumption and leads to higher living standards.

Costs

• Firms could face more menu costs as a result of higher inflation. This means they have to keep changing their prices to meet inflation.

Benefits

• Firms might make more profits, which might in turn increase investment. This is also driven by higher levels of business confidence.
• Higher levels of investment could develop new technologies to improve productivity and lower average costs in the long run.
• As firms grow, they can take advantages of the benefits of economies of scale.
• If there is more economic growth in export markets, firms might face more competition, which will make them more productive and efficient, but it will also give them more sales opportunities

Cost: Governments might increase their spending on healthcare, if the consumption of demerit goods increases.

Benefit: The government budget might improve, since fewer people require welfare payments and more people will be paying tax.                                                                                                       ________________________________________________________________________________

Costs

• High levels of growth could lead to damage to the environment in the long run, due to increase negative externalities from the consumption and production of some goods and services.

Benefits

• As consumer incomes increase, some people might show more concern about the environment.
• Higher average wages mean consumers can enjoy more goods and services of a higher quality.
• Public services improve, since governments have higher tax revenues, so they can afford to spend on improving services. 

Cost: Governments might increase their spending on healthcare, if the consumption of demerit goods increases.

Benefit: The government budget might improve, since fewer people require welfare payments and more people will be paying tax.                                                                                                       ________________________________________________________________________________

Costs

• High levels of growth could lead to damage to the environment in the long run, due to increase negative externalities from the consumption and production of some goods and services.

Benefits

• As consumer incomes increase, some people might show more concern about the environment.
• Higher average wages mean consumers can enjoy more goods and services of a higher quality.
• Public services improve, since governments have higher tax revenues, so they can afford to spend on improving services. 

Economic growth: In the UK, the long run trend of economic growth is about 2.5%. Governments aim to have sustainable economic growth for the long run. In emerging markets and developing economies, governments might aim to increase economic development before economic growth, which will improve living standards, increase life expectancy and improve literacy rates.

Low unemployment: Governments aim to have as near to full employment as possible. They account for frictional unemployment by aiming for an unemployment rate of around 3%. The labour force should also be employed in productive work.

A low and stable rate of inflation: In the UK, the government inflation target is 2%, measured with CPI. This aims to provide price stability for firms and consumers and will help them make decisions for the long run. 

Balance of payments equilibrium on current account: Governments aim for the current account to be satisfactory, so there is not a large deficit. This is usually near to equilibrium. A balance of payments equilibrium on the current account means the country can sustainably finance the current account, which is important for long term growth

Balanced government budget: This ensures the government keeps control of state borrowing, so the national debt does not escalate. This allows governments to borrow cheaply in the future should they need to, and makes repayment easier.

Protection of the environment: This aims to provide long run environmental stability. It ensures resources used are not exploited, such as oil and natural gas, and that they are used sustainably, so future generations can access them too. Moreover, it means there is not excessive pollution.

Greater income equality: Income and wealth should be distributed equitably, so the gap between the rich and poor is not extreme. It is generally associated with a fairer society. 

Demand-side policies are policies designed to increase consumer demand, so that total production in the economy increases. 

Monetary policy is used by the government to control the money flow of the economy. This is done with interest rates and quantitative easing. This is conducted by the Bank of England, which is independent from the government.

Fiscal policy uses government spending and revenues from taxation to influence AD. This is conducted by the government. 

Interest rates

In the UK, the Monetary Policy Committee (MPC) alters interest rates to control the supply of money. They are independent of the government, and the nine members meet each month to discuss what the rate of interest should be. Interest rates are used to help meet the government target of price stability since it alters the cost of borrowing and reward for saving.

The bank controls the base rate, which ultimately controls the interest rates across the economy. A reduction in the base rate will lead to a rise in AD.  This happens through a number of transmission mechanisms:

• Consumption and investment increase due to lower costs of borrowing
• Higher consumption, due to lower borrowing, will mean that asset prices increase. This will lead to a positive wealth effect.
• Saving becomes less attractive, as a lower rate of return is offered, so consumption and investment both increase. Mortgage interest repayments are lower and so, therefore, consumers have more income left to spend, which also increases consumption.
• Lower interest rates reduce the incentive for investors to hold their money in British banks, so the demand for the pound will fall. The pound will be weaker, so exports will be cheaper and imports more expensive. Net trade will therefore increase.

Asset purchases to increase the money supply: Quantitative Easing (QE)

This is used by banks to help to stimulate the economy when standard monetary policy is no longer effective. This has inflationary effects since it increases the money supply, and it can reduce the value of the currency.

QE is usually used where inflation is low and it is not possible to lower interest rates further.

QE is a method to pump money directly into the economy. It has been used by the European Central Bank to help stimulate the economy. Since the interest rates are already very low, it is not possible to lower them much more. The bank bought assets in the form of government bonds using the money they have created. This is then used to buy bonds from investors, which increases the amount of cash flowing in the financial system. This encourages more lending to firms and individuals, since it makes the cost of borrowing lower. The theory is that this encourages more investment, more spending, and hopefully higher growth. A possible effect of this is that there could be higher inflation.

If inflation gets high, the Bank of England can reduce the supply of money in the economy by selling their assets. This reduces the amount of spending in the economy. 

• Banks might not pass the base rate onto consumers, which means that even if the central bank changes the interest rate, it might not have the intended effect.
• Even if the cost of borrowing is low, consumers might be unable to borrow because banks are unwilling to lend. After the 2008 financial crisis, banks became more risk-averse.
• Interest rates will be more effective at stimulating spending and investment when consumer and firm confidence is high. If consumers think the economy is still risky, they are less likely to spend, even if interest rates are low.

Government spending and taxation

• Governments can change the amount of spending and taxation to stimulate the economy. The government could influence the size of the circular flow by changing the government budget, and spending and taxes can be targeted in areas which need stimulating.
• Fiscal policy aims to stimulate economic growth and stabilise the economy.
• In the UK, the government spends most of its budget on pensions and welfare benefits, followed by health and education. Income tax is the biggest source of tax revenue in the UK.

Expansionary fiscal policy

This aims to increase AD. Governments increase spending or reduce taxes to do this. It leads to a worsening of the government budget deficit, and it may mean governments have to borrow more to finance this. 

Deflationary fiscal policy

This aims to decrease AD. Governments cut spending or raise taxes, which reduces consumer spending. It leads to an improvement in the government budget deficit. 

A government has a budget deficit when expenditure exceeds tax receipts in a financial year.

A government has a budget surplus when tax receipts exceed expenditure.

Direct taxes are imposed on income and are paid directly to the government from the taxpayer. Examples include income tax, corporation tax, NICs and inheritance tax. Consumers and firms are responsible for paying the whole tax to the government.

Indirect taxes are imposed on expenditure on goods and services, and they increase production costs for producers. This increases the market price and demand contracts. 

• Governments might have imperfect information about the economy. It could lead to inefficient spending.
• There is a significant time lag involved with employing fiscal policy. It could take months or years to have an effect.
• If the government borrows from the private sector, there are fewer funds available for the private sector, which could lead to crowding out.
• The bigger the size of the multiplier, the bigger the effect on AD and the more effective the policy.
• If interest rates are high, fiscal policy might not be effective for increasing demand.
• If the government spends too much, there could be difficulties paying back the debt, which could make it difficult to borrow in the future.

• The Great Depression initiated in 1929, and by 1933 real GDP had fallen by 30% and the unemployment rate increased to 25%. In the 75 years prior to this, economic declines lasted about 2 years; The Great Depression lasted over a decade.
• Keynes shifted macroeconomic thought from a focus on AS to AD. Keynesian economists emphasis the use of demand-side policies to close gaps between actual and potential output.

Causes:

• It was set off by the Wall Street Crash of 1929
• This led to a huge loss in consumer and business confidence, decreasing consumption and investment
• The 1920s had been a period of unsustainable boom and the banking system was unstable; the government allowed the banks to crash
• The USA had introduced protectionism whilst the UK was committed to the gold standard, where its currency was fixed to gold and was overvalued.

Responses in the UK:

• The government thought to balance the budget was essential so they cut public sector wages and unemployment benefits and raised income tax
• Interest rates were high to help maintain the pound, which came under attack from speculators
• Eventually, they left the gold standard and cut interest rates.

Responses in the USA:

• Roosevelt's New Deal used public sector investment, work schemes for the unemployed and fiscal stimulus to increase AD and bring about a recovery
• Some argue that not enough spending was undertaken for it to be effective; it was the war which eventually ended the Depression
• They also tried to increase the money supply, but it is unclear how effective this was.

The Global Financial Crisis is sometimes called The Great Recession, and it refers to the decline in world GDP in 2008-2009

Causes: Before the crash, asset prices were high and rising, and there was a boom in economic demand. There were risky bank loans and mortgages, especially in the US where government securities were backed by subprime mortgages. This means the borrowers had poor credit histories, and after house prices crashed in the US in 2006, several homeowners defaulted on their mortgages in 2007. Banks had lost huge funds and required assistance from the government in the form of bailouts.

Policy responses in the UK and USA:

• Both governments were forced to nationalise banks and building societies. They guaranteed savers their money in order to prevent the chaos of a collapsed system.
• They used expansionary monetary policies, including record low interest rates and quantitative easing.
• The UK cut VAT from 17.5% to 15% and saw a huge increase in government borrowing.
• The USA used more expansionary fiscal policy, and this is perhaps why it recovered faster. In 2010, the UK prioritised reducing National Debt but the USA did not make this decision until 2013.

Market-based policies limit the intervention of the government and allow the free market to eliminate imbalances. The forces of supply and demand are used.

To increase incentives

Reducing income and corporation tax to encourage spending and investment. - Reducing benefits to increase the opportunity cost of being out of work

To promote competition

By deregulating or privatising the public sector, firms can compete in a competitive market, which should also help improve economic efficiency.

To reform the labour market

• Reducing the NMW (or abolishing it altogether) will allow free market forces to allocate wages and the labour market should clear.
• Reducing trade union power makes employing workers less restrictive and it increases the mobility of labour. This makes the labour market more efficient. 

Interventionist policies rely on the government intervening in the market.

To promote competition

• A stricter government competition policy could help reduce the the monopoly power of some firms and ensure smaller firms can compete, too.

To reform the labour market

• Governments could try and improve the geographical mobility of labour by subsidising the relocation of workers and improving the availability of job vacancy information.

To improve the skills and quality of the labour force

• The government could subsidise training. This also lowers costs for firms, since they will have to train fewer workers.
• They may spend more on education
• Spending more on healthcare helps improve the quality of the labour force, and contributes towards higher productivity.
• This may help to reduce occupational immobility.

Both diagrams show the effects of employing a supply-side policy. The LRAS curve shifts to the right, to show the increase in the productive potential of the economy. In other words, the maximum output of the economy at full employment has increased. This leads to a fall in the average price level, from P1 to P2, and an increase in national output, from Y1 to Y2. 

• Supply-side policies are the only policies which can deal with structural unemployment, because the labour market can be directly improved with education and training.
• Demand-side policies are better at dealing with cyclical unemployment since they can reduce the size of a negative output gap and shift the AD curve to the right.
• There are significant time lags associated with supply-side policies and not all policies will be successful.
• Market-based supply-side policies, such as reducing the rate of tax, could lead to a more unequal distribution of wealth.
• There may be negative impacts on the government budget due to higher government expenditure or lower taxes.
• Policies may impact AD before they impact AS and so they could have inflationary effects.
• If there is a lot of spare capacity in the economy, then supply-side policies will have no impact. On the Keynesian curve, if the economy is producing on the elastic part of the curve, there will be no change in output following the policy

Economic growth vs inflation

A growing economy is likely to experience inflationary pressures on the average price level. This is especially true when there is a positive output gap and AD increases faster than AS.

Economic growth vs the current account

During periods of economic growth, consumers have high levels of spending. In the UK, consumers have a high marginal propensity to import, so there is likely to be more spending on imports. This leads to a worsening of the current account deficit. However, export-led growth, such as that of China and Germany, means a country can run a current account surplus and have high levels of economic growth.

Economic growth vs the government budget deficit

Reducing a budget deficit requires less expenditure and more tax revenue. This would lead to a fall in AD, however, and as a result, there will be less economic growth.

Economic growth vs inflation

A growing economy is likely to experience inflationary pressures on the average price level. This is especially true when there is a positive output gap and AD increases faster than AS.

Economic growth vs the current account

During periods of economic growth, consumers have high levels of spending. In the UK, consumers have a high marginal propensity to import, so there is likely to be more spending on imports. This leads to a worsening of the current account deficit. However, export-led growth, such as that of China and Germany, means a country can run a current account surplus and have high levels of economic growth.

Economic growth vs the government budget deficit

Reducing a budget deficit requires less expenditure and more tax revenue. This would lead to a fall in AD, however, and as a result, there will be less economic growth.

Economic growth vs the environment

High rates of economic growth are likely to result in high levels of negative externalities, such as pollution and the usage of non-renewable resources. This is because of more manufacturing, which is associated with higher levels of carbon dioxide emissions.

Unemployment vs inflation

In the short run, there is a trade-off between the level of unemployment and the inflation rate. This is illustrated with a Phillips curve. As economic growth increases, unemployment falls due to more jobs being created. However, this causes wages to increase, which can lead to more consumer spending and an increase in the average price level. The extent of this tradeoff can be limited if supply-side policies are used to reduce structural unemployment, which will not increase average wages.

This occurs when one macroeconomic policy has a larger impact than another, which conflicts with the other policy or reduces its effectiveness. Every policy is likely to have unintended consequences; these are some examples:

Environment vs competitiveness: If ‘green taxes’ are implemented, such as carbon taxes, or if there are minimum prices on pollution permits, the competitiveness of domestic firms could be compromised. This is because they are limited in their production.

Fiscal vs monetary policy: Expansionary fiscal policies involve more government borrowing, which could cause interest rates and the inflation rate to rise.

Interest rate vs inequality: The low-interest rate could affect the distribution of income. Savers only receive a small return on their savings.