OCR AS Economics

F582 The National and International Economy

Exam dates:

Mon 28 January 2013 pm (A2 resit only)

Mon 13th May 2013 am

Duration: 1 h 30 min

60 marks

Wish I’d

revised for

economics

1

Do you know?

Yes/No

The components of aggregate demand

The causes of changes in aggregate demand

The causes of changes in aggregate supply

The difference between injections and leakages

Government macroeconomic objectives and how they are measured

The difficulties of measuring and interpreting objectives

The causes and consequences of inflation

The causes and consequences of economic growth

The causes and consequences of unemployment

The causes and consequences of current account deficits and surpluses

Why exchange rates change

Fiscal, monetary and supply side policies

How Fiscal, monetary and supply side policies affect inflation, unemployment,

economic growth and the current account of the B of P

The effectiveness of different policies

The benefits of international trade

Possible conflicts between policy objectives (trade offs)

The methods of protectionism

2

What is the economy – models of it

The Circular Flow of Income

Money circulates through the economy as shown in the diagram below. Money can be

injected into the circular flow and it can leak out (aka withdrawals)

Injections Leakages

The economy is made up of households and firms, i.e. producers

and consumers. They interact and this is shown on an aggregate

demand and supply diagram. This is how it works:

This shows the equilibrium

price level in the economy and indicates output and unemployment of resources

Aggregate supply – why is it this shape?

Households

Firms

Investment

Exports

Govt.

Spending

Taxes

Imports

Saving

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Aggregate supply is the total output of goods and services that producers are willing

and able to supply at different price levels in a given time period.

The AS curve shows the POTENTIAL CAPACITY OF THE ECONOMY i.e. how much it could

possibly produce.

Aggregate demand – what is the formula

Aggregate demand = C + I + G + X - M

Any change in a component of aggregate demand will result

in a shift to the right

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AD AD1

AD2

AS

P

What happens when AD increases?

Aggregate demand is important. If aggregate demand increases then the economy can

grow in the short run, unemployment will decrease as more people will have to be

employed to meet the increased demand for goods and services and output will increase.

Increasing aggregate demand can result in a MULTIPLIER EFFECT. This means that any

change in aggregate demand or injection of spending into the economy will result in a

greater final change in Real GDP due to the amount of times it can circulate through the

economy between households and firms.

Price level

Real GDP

P1

Y Y1 Y2

When AD increase the economy grows.

(this is shown on the horizontal axis Y to Y1

to Y2.

Unemployment should DECREASE

The price level (inflation) could increase

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What affects aggregate demand?

Aggregate demand is the total demand for a country’s goods and services at a given price

level over a period of time. AD = C + I + G + (X – M)

Consumption

Spending by households on consumer products Affected by:

Real disposable income If it rises then more is spent

Wealth – property, savings accounts and shares. If this increases people feel more confident about spending

Consumer confidence and expectations – if consumers are optimistic i.e. in a boom then spending could increase. If they are not confident about their future or job security then spending could decrease.

Rate of interest – if it rises, people have to pay more back on their mortgages, borrowing becomes more expensive and savings are more attractive as more interest is received therefore consumption decreases. The opposite is true if interest rates fall

The age structure of the population. The young and the elderly usually spend a high proportion of their income. The elderly can disave i.e. draw on their savings however, they might still save in order to leave money to their relatives or pay for healthcare in the future.

Distribution of income – the poor spend a higher proportion of their income than the rich therefore if the govt. tries to redistribute income from rich to poor then spending is likely to increase

Inflation – if people expect prices to rise in the future they may spend their money now to avoid paying higher prices later, but another view says that they may save instead so that the value of their savings doesn’t decrease.

Investment Spending on capital goods (i.e. spending by businesses on production equipment) Affected by:

Changes in disposable income – if incomes are increasing then demand for a business’s goods may increase so they buy (invest in) more production equipment to expand productive capacity.

Expectations – if a firm expects demand for its products to be good in the future it will invest (buy) more capital goods (production equipment)

Capacity utilisation and profit levels – firms are more likely to invest in capital goods if they are producing/operating near to full capacity and if their profits are high as they believe they can make more profit and sell more goods (think of Manchester United expanding their stadium)

Corporation tax – (tax on profits). If this is reduced a firm can keep more of its profits and use the extra money to invest.

Interest rates - if they rise, firms find it more expensive to get loans (to spend on capital goods), they are more likely to want to save their money and gain interest on it in a bank, firms would assume that a higher rate of interest would reduce consumer spending which would affect the future profits of an investment not making it worthwhile.

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Government

Spending

Spending by central and local government on goods and services (but not benefits as these are transfer payments and affect consumption) ) Affected by

Desire to please the electorate – i.e. before a general election a govt. may increase or promise to increase spending as this pleases voters (can someone tell this to David Cameron)

War – terrorist attacks and rising crime can increase Govt. spending

The state of the economy – i.e. in a recession when there is high unemployment govt. spending may increase in order to increase AD, output and employment. If there is a boom and there is inflation they may try to reduce spending.

The govt’s view on whether there should be intervention in markets through spending or whether they think the market should be left alone.

Exports Products sold abroad (e.g. a British business selling its products to people in other countries

An increase in exports increases aggregate demand

Imports Products bought from abroad (e.g. a fridge from Comet will have come from China)

An increase in imports decreases aggregate demand

Net Exports

(X-M)

The value of exports minus the value of imports. An increase in net exports is good = exports increasing, imports decreasing. It is desirable to have more exports than imports. This is called a surplus Affected by:

Real disposable income abroad – if economies abroad grow and people abroad become better off they may demand more products some of which will come from the UK

Real disposable income at home – if income rises at home, there may be fewer goods exported as home firms may switch production into domestic markets as here is more demand. In a crisis firms may look abroad to sell their goods but in a boom they may try and sell at home instead. Additionally, if people increase their spending some of this will be spent on imports as the UK imports a large amount of its consumer goods.

The domestic price level – If prices at home are rising, exports become less competitive and demand may fall. Also if imports become relatively cheaper then people may choose them over domestic products leading to a decrease in net exports

The exchange rate – SPICED – strong pound imports cheaper exports dearer (and the opposite). If the exchange rate falls – export prices fall, import prices rise. If export prices fall, demand could increase = increase in net exports

Govt. restrictions on free trade – if tariffs and quotas and VERs are used import prices can be higher. If removed it can make it easier to export .

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What affects aggregate supply?

Shifts in aggregate supply

Changes in the

costs of

production ( in

the short run)

Costs of production such as raw material costs (oil),

wages, transportation, land.

An increase in costs will shift AS to the left

A decrease in costs will shift AS to the right

Changes in the

quality of

resources

Improvements in education and training increases the

quality of labour and their productivity (how much they

can produce)

Advances in technology i.e. better machinery can

increase production

Land can be improved with fertilisers

Changes in the

quantity of

resources

Resources can be increased through:

Increasing immigration

More women entering the labour force

Increasing the retirement age

Firms purchasing more capital goods can increase

production

Reducing regulations and rules on businesses and selling

off govt owned business to private individuals to run

them strictly for profit helps increase production.

Giving grants to small businesses to start up increases

the number of enterprises and therefore production.

The quantity of land as a resource can be increased e.g.

through discovering new oil fields

Macroeconomic equilibrium is a situation where AD equals AS (I.E. the lines

cross).

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What shifts both AS and AD?

Investment –

Shifts AD because business are buying capital goods (buying = demand)

Shifts AS because businesses are increasing the amount they can produce (their

productive capacity) by getting better machinery and equipment

Cuts in direct tax (tax on income, tax on firm’s profits) –

Shifts AD because businesses can keep more of their profits so can buy more capital

goods and consumers can keep more of their earnings so have more disposable income

and can spend more on goods

Shifts AS because workers can keep more of their wages and may be tempted to work

more hours or to not claim benefits and get a job instead. More workers = more

production. Also if firms spend money on capital goods (equipment and machinery)

they will be able to produce more = more supply

All this depends on the size of the tax cut or the amount invested.

9

Government macroeconomic objectives and how they

are measured

These are what the government wants to achieve in the economy to make us

better off:

There are 4 main macro-economic objectives

1. Economic growth

2. Low unemployment

3. Low and stable inflation

4. Balance of Payments equilibrium

There are also some minor objectives that are related to the main ones. These are

income redistribution (making sure that the rich are not too rich and the poor

are not too poor by e.g. using taxation to take more from the rich and less form the poor)

and economic stability (this means making sure economic growth is steady and

does not fluctuate through booms and slumps)

GDP and Real GDP

GDP (Gross domestic product) Output measured in current prices and so not adjusted

for inflation

Real GDP takes into account price rises during the year that it is being measured and

takes these off so that GDP can be compared to previous years to see if it has actually

gone up or down. Otherwise it would look like the economy is growing just because

process in general have gone up

How are these 4 objectives measured, what do they mean and what are the difficulties of measuring them

Objective How is it measured Difficulties of measuring

Economic growth in the short run an increase in aggregate demand, in the long run an increase in the productive capacity of the economy. Govt wants this to be stable. Around 3% growth per year is good. Higher or lower can cause other problems

Measured by the actual % change in real GDP. It shows the change in the country’s output. GDP can also be measured as income or expenditure and the circular flow of income shows that these figures should in theory be the same

Could be double counting e.g. raw materials may be counted as output and then the same raw materials could be counted as finished goods which would mean they had been included twice.

Some income and output is not declared to avoid paying tax – this is the informal economy

Unemployment A situation where people are out of work but willing and able to work. The unemployment rate is the % of the labour force who are out of work but willing and able to work

This is measured through 1. The labour force survey (a survey:

based on the ILO definition of unemployment

2. The claimant count – people claiming unemployment relate benefits in the UK.

The LFS survey includes more people who are without a job than the claimant count but is more difficult to collect than the claimant count.

Some people may be claiming benefit but not actively seeking work

Some people may not be claiming benefits but are unemployed NB. The claimant count is usually lower and more people are excluded.

Inflation A sustained rise in the price level. The % increase in the price level over a period of time* Some inflation is desirable – Bank of England controls inflation and sets a target of 2%

Measured by choosing a basket of goods and seeing if on average the price of buying a basket of goods has rise, CPI – consumer price index. it is a measure of the changes in prices of a representative basket of consumer goods and services RPI – retail price index (this is a bigger basket than the CPI) The CPI is the one

Changes in Quality of goods. Changes in the quality of goods mean that price rises may not reflect inflation, but just the fact it is a different good. For example, computers have many more features than 10 years ago, so it is difficult to compare prices because they are effectively different goods. This is similar situation for many goods such as mobile phones and cars.

People have different inflation rates. Rising electricity and gas prices may affect old people more than young people. Therefore, old people could have a higher inflation rate than

1

that is used by the Bank of England to see if it has met its inflation target

the national average. This is important if pensions are index linked because their cost of living may rise more than prices causing a decrease in living standards.

Balance of payments A record of money flows coming in and going out of a country. Govt wants more money coming in through exports and less going out through imports. See B of P below

Structure of the balance of payments Current account = trade in goods and trade in services (imports and exports)income and transfers Capital account = the movement of direct investment The point of this is that money coming in from the above should exceed money going out (injections>leakages. The foreign currency it has from exports and money coming in can be used to pay for the imports and money going out. If there is more money needed to go out then the difference has to be borrowed. At AS level you are only interested in the current account (exports, imports and income). You need to know that exports – imports = net exports and that this affects aggregate demand.

*price level = the average of the prices of all the products produced in the economy

Difficulties in interpreting economic growth – There may be economic growth as indicated by an increase in GDP but the

income may not be distributed evenly throughout the economy e.g. the rich may have benefited but not the poor. The

rise in output may also be exceeded by a rise in population therefore GDP per capita may have actually fallen meaning

that people weren’t actually better off through an increase in economic growth.

In the short term, economic growth is caused by an increase in AD. If there is

spare capacity in the economy then an increase in AD will cause a higher level

of Real GDP.

AD can increase for the following

reasons.

a) Lower interest rates – this reduces the cost of borrowing and so encourages spending and investment

b) Increased wages. This increases disposable income and encourages consumer spending

c) Increased Govt spending. G is a component of AD d) A fall in the exchange rate could increase net exports and result in export

led growth

In the long run a shift in aggregate supply to the right is also necessary to

achieve economic growth

a) Increased Capital e.g. investment in new factories or investment in infrastructure such as roads and telephones.

b) Increase in working population c) Increase in Labour productivity, through better education and training d) Discovering new raw material e) Technological improvements to improve the productivity of Capital and

labour e.g. Microcomputers and the internet have both contributed to increased economic growth

1

1. Inflation. If AD increases faster than AS then economic growth will be unsustainable. The output gap will narrow causing inflation to increase.

2. Boom and Bust Economic Cycles. If Economic growth is unsustainable then high inflationary growth may be followed by a recession. In the 1980s there was an economic boom with growth over 5% a year. However this caused inflation to rise to over 10%. To reduce inflation the govt increased interest rates, this caused the economy to slow down and then enter into a recession. However if economic growth is at a sustainable rate this will not occur

3. Balance Of Payments Deficit. Increased Economic growth causes an increase in spending on imports therefore causing a deficit

4. Environmental Costs. Increased economic growth will lead to increased output and therefore increased pollution and congestion. This will cause health problems such as asthma and therefore will reduce the quality of life

5. Reduced Inequality. Higher rates of economic growth have often resulted increased inequality, however this depends upon things such as tax rates and the nature of economic growth

The Benefits of economic growth include:

1. Higher Incomes. This enables consumers to enjoy more goods and services 2. Lower unemployment - with higher output firms tend to employ more

workers creating more employment. 3. Lower Government borrowing. Economic growth creates higher tax

revenues and there is less need to spend money on benefits such as unemployment benefit.

4. Improved public services. With increased tax revenues the govt can spend more on the NHS and education e.t.c.

5. Money can be spent on protecting the environment

2

1. Frictional Unemployment: This is unemployment caused by people moving in between jobs, e.g. graduates or people changing jobs. There will always be some frictional unemployment. 2. Structural Unemployment This occurs due to a mismatch of skills in the labour market it can be caused by:

a) Occupational immobility’s. This refers to the difficulties in learning new skills applicable to a new industry, and technological change. b) Geographical Immobility’s. This refers to the difficulty in moving regions to get a job. c) Technological Change. If there is the developments of labour saving technology in some industries there will be a fall in demand for labour. d) Structural change in the economy. The decline of the coal mines due to a lack of competitiveness meant that many coal miners were unemployed and they may find it more difficult to get jobs in new industries such as computers

3. Demand Deficient or “Cyclical Unemployment”

This occurs when the economy is below full capacity.

E.g. in a recession when AD falls there will be a fall in output, therefore firms will

employ less workers because they are producing less goods.

Consequences (costs) of unemployment

Loss of earnings to the unemployed Those who are unemployed will find it more difficult to get work in the future (this is

known as the hysteresis effect) Stress and Health problems of being unemployed Increased govt borrowing (PSNCR). Tax revenue will fall because there is less people

paying income tax and VAT. Also the govt will have to spend more on unemployment benefits.

Lower GDP for the economy, the economy will be below full capacity this is inefficient and will lead to lower output and incomes.

Increase in social problems. Areas of high unemployment (especially youth unemployment) tend to have more crime and vandalism.

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Demand pull inflation

If the economy is at full employment then an increase in AD leads to an increase in the price

level.

AD can increase due to an increase in any

of its components C+I+G+X-M

Cost Push Inflation

If there is an increase in the costs of firms, then firms will pass this on to consumers. There

will be a shift to the left in the AS.

Cost push inflation can be caused by many factors

1.The Labour Market

If trades unions can

present a common front

then they can bargain for

higher wages, this will lead to

wage inflation.

2. Import prices

One third of all goods are imported in the UK. If there is a devaluation then import

prices will become more expensive leading to an increase in inflation

E.G. a German car costs DM 40,000. If the exchange rate is DM £1:3DM then it will

be priced at £13,333. If the E.R falls to £1 : 2DM then it will be priced at £20,000

3. Increased costs of production

The best example is the price of oil, if the oil price increase by 20% then this will have

a significant impact on most goods in the economy and this will lead to cost push

inflation.

4

International competitiveness:

A relatively higher inflation rate will make British goods less competitive, leading to a fall in

exports. However this may be offset by a decline in the exchange rate.

Confusion and Uncertainty:

When inflation is high people are uncertain what to spend their money on. Also, when

inflation is high firms may be less willing to invest because they are uncertain about future

profits and costs. This uncertainty and confusion can lead to lower rates of economic growth

over the long term.

Menu Costs.

This is the cost of changing price lists. When inflation is high, prices need changing

frequently which incurs a cost. However, modern technology has helped to reduce this cost.

Shoe leather costs.

To save on losing interest in a bank people will hold less cash and make more trips to the

bank.

Income redistribution.

Inflation will typically make borrowers better off and lenders worse off. Inflation

reduces the value of savings, especially if the saving is not index linked. However it

does depends on the real rate of interest. e.g. if a saver gets a higher rate of interest

than the inflation rate he will not lose out.

Fiscal Drag.

The amount of tax we pay will increase if there is inflation. This is because with rising wages

more people will slip into the top income tax brackets.

low inflation is often seen as harmless or even beneficial because it allows prices to adjust

more easily

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The Balance of payments – this is just a summary of all the money that has

come into the country and left the country. The government needs to count this up to

check what money has left the economy (leaked out of the circular flow) and what money

has come in (been injected into the circular flow)

What could come in and go out?

IN OUT

Exports

Transfers (Money people have earned

abroad and sent back)

Interest from shares and investments

held abroad

Profits from businesses owned abroad

Money foreign businesses have invested

in the UK (e.g. IKEA, Nissan, Aldi)

Imports

Transfers (Money people have earned in

UK and sent back to their own country)

Interest and dividends on shares and

investments held in UK but owned by

foreigners

Profits from businesses owned by

foreigners

Money UK businesses have invested in

other countries (e.g. Cadburys have

factories in Poland)

This is then divided up between the current account and the capital account. Everything

is in the current account except for the last bullet point which is in

the capital account.

Causes of a current account deficit

1. Exchange rate high

If the currency is overvalued, imports will be cheaper and therefore there will be a higher Q

of imports. Exports will become uncompetitive and therefore there will be a fall in the

quantity of exports.

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2. Economic Growth

If there is an increase in national income, people will tend to have more disposable income

to consume goods. If domestic producers can not meet the domestic demand, consumers

will have to import goods from abroad. In the UK we have a high Marginal propensity to

imports because we do not have a comparative advantage in the production of

manufactured goods. Therefore if there is fast economic growth there tends to be a

significant increase in the quantity of imports.

3. Decline in Competitiveness.

In the UK there has been a decline in the exporting manufacturing sector, because it has

struggled to compete with developing countries in the far east. This has led to a persistent

deficit in the balance of trade.

4. Higher inflation

This makes exports less competitive and imports more competitive. However this factor

may be offset by a decline in the value of sterling.

5. Recession in other countries.

If the UK’s main trading partners experience negative economic growth then they will buy

less of our exports, worsening the current account.

Significance of this….…..

A deficit means a country is consuming more than it is producing. This could put it into

debt, lower unemployment lower economic growth

A small one is not that important or one that lasts a short time

A deficit may indicate that the economy is growing (i.e. people have jobs and have

money to spend, a lot of which will be spent on imported consumer goods.)

The deficit could mean that there is low productivity, inflation and/or a lack of

competitiveness meaning low demand for exports.

Significance of a surplus

It could mean that the economy is in recession and there is little demand for imports

It could mean that the country produces high quality, low priced goods (like China) and

is very competitive, therefore demand for exports is high.

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S

D D

P1

P P

P1

q q1 q q1

This is the value of one currency against another

NB when you change money to go abroad you are actually buying it – Money can be bought and sold in the same way other products are. E.g. you buy Euros with pounds.

Exchange rates are determined through supply and demand

If the exchange rate rises, the cost of imports becomes cheaper and the price of exports becomes more expensive

If the exchange rate falls, the cost of imports becomes more expensive and the price of exports becomes cheaper.

Exports and imports are part of aggregate demand. If exchange rates rise and imports are cheaper and exports are more expensive, demand for exports should fall and demand for imports should rise. This will make net exports fall and aggregate demand fall. This could affect the macro economy as AD could shift to the right which would indicate higher economic growth and output and a decrease in unemployment.

S P I C E D

strong Pound Imports Cheaper Exports dearer

If demand for the pound increases,

the exchange rate will rise

If people want to sell pounds then

supply will increase and the exchange

rate will fall

D1

S S1

P

P

Q Q

8

The application of macroeconomic policy instruments and the

international economy

Fiscal policy

taxation and public spending AFFECTS

AGGREGATE DEMAND (mainly)

Monetary policy

the use of interest rates, money supply and

exchange rates (but mainly interest rates) AFFECTS

AGGREGATE DEMAND (mainly)

Supply side policies

any measure that improves the productive

capacity of the economy. These aim to improve

the efficiency of businesses and make it easier for

them to produce at a lower cost. AFFECTS

AGGREGATE SUPPLY

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1. Fiscal policy

Fiscal policy involves the Government changing the levels of Taxation and Govt Spending in

order to influence Aggregate Demand (AD) and therefore the level of economic activity.

AD is the total level of planned expenditure in an economy (AD = C+ I + G + X – M)

The purpose of Fiscal Policy:

Reduce the rate of inflation, (UK government has a target of 2%)

Stimulate economic growth in a period of a recession.

Basically, fiscal policy aims to stabilise economic growth, avoiding the boom and bust

economic cycle.

This refers to whether the govt is increasing AD or decreasing AD

Expansionary (or loose) Fiscal Policy.

This involves increasing AD,

Therefore the govt will increase spending (G) and cut taxes. Lower taxes will increase consumers spending because they have more disposable income(C)

This will worsen the govt budget deficit

Deflationary (or tight) Fiscal Policy

This involves decreasing AD

Therefore the govt will cut govt spending (G)

And or increase taxes. Higher taxes will reduce consumer spending (C) This will lead to an improvement in the government budget deficit

Automatic Fiscal Stabilisers

If the economy is growing, people will automatically pay more taxes ( VAT and

Income tax) and the Government will spend less on unemployment benefits. The

increased T and lower G will act as a check on AD.

In a recession the opposite will occur with tax revenue falling but increased

government spending on benefits, this will help increase AD

Discretionary Fiscal Stabilisers

This is a deliberate attempt by the govt to affect AD and stabilise the economy, e.g. in a

boom the govt will increase taxes to reduce inflation

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2. Monetary policy

The Bank of England studies inflationary trends in the economy. This involves looking at a

range of economic variables such as:

Unemployment

Consumer confidence

Spare capacity in the economy

Exchange rate index

House prices

Economic Growth

If the Bank of England anticipates inflation falling below the government’s target of 2% and

economic growth is sluggish or the economy is facing a recession. They are likely to cut

interest rates.

Lower interest rates in theory, should stimulate economic activity (BENEFIT). This is because

lower interest rates reduce borrowing costs. This increases the disposable income of

consumers with mortgage interest payments and should encourage spending.

If the Bank feels the economy is growing too quickly and inflation is expected to exceed the

government’s target, then they are likely to increase interest rates to reduce the rate of

growth and inflationary pressures.

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3. Supply side policies

Supply Side Policies are government attempts to increase productivity and shift

Aggregate Supply (AS) to the right.

Examples:

Education and training Better education can improve labour productivity and increase AS. Often there is under-provision of education in a free market, leading to market failure. Therefore the govt may need to subsidise suitable education and training schemes. However govt intervention will cost money, requiring higher taxes, It will take time to have effect and govt may subsidise the wrong types of training

Government assistance to small firms This encourages business start ups and therefore increases production (supply/output)

Reduction in direct taxes It is argued that lower taxes (income and corporation) increase the incentives for people to work harder, leading to more output. However this is not necessarily true, lower taxes do not always increase work incentives

National minimum wage Introducing a minimum wage can help people get back into work as their income should increase. On the other hand a minimum wage could increase a business’s costs. Opinion is divided on this.

Reduction in unemployment and other benefits This may encourage unemployed to take jobs.

Reduction in trade union power This should

a) increase efficiency of firms e.g. less time lost to strikes

b) reduce unemployment ( if labour markets are competitive)

Privatisation This involves selling state owned assets to the private sector. It is argued that the private sector is more efficient in running business because they have a profit motive to reduce costs and develop better services.

Deregulation This involves reducing barriers to entry in order to make the market more competitive. For example BT used to be a Monopoly but now telecommunications is quite competitive. Competition tends to lead to lower prices and better quality of goods / service.

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Where successful supply side policies will

lower firm’s costs of production

increase productive capacity by increasing the efficiency of labour and production markets

Benefits

1. Lower Inflation. - Shifting AS to the right will cause a lower price level. By making the

economy more efficient supply side policies will help reduce cost push inflation.

2. Lower Unemployment - Supply side policies can help reduce structural, frictional and real

wage unemployment and therefore help reduce the natural rate of unemployment.

3. Improved economic growth - Supply side policies will increase the sustainable rate of

economic growth by increasing AS.

4. Improved trade and Balance of Payments.

By making firms more productive and competitive they will be able to export more.

Diagram Showing effect of Supply Side Policies

Most supply side policies aim to enable the free market to work more efficiently by

reducing govt interference.

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Effectiveness of policies

Fiscal

• Good because automatically adjusts to offset fluctuations in real GDP.

• Tax cuts and e.g. training grants affect both AD and AS

but…..

• Can take time to plan and implement tax and spending changes

• Time lag between introducing policies and impact on economy

• Decisions need to be based on accurate information

• Consumers may not react in a desirable way e.g. saving in stead of spending

• Tax cuts/increases and spending cuts/increases could have a negative effect if taken

too far

Success depends on

The size of the tax cut/increase or spending increase/decease

Other factors not affecting it e.g. interest rates

Consumers reacting in the right way e.g. saving/spending

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Monetary

• Influencing the exchange rate can be offset by money speculators (e.g. George

Soros) • Interest rates successful in controlling short run economic activity but MPC criticised

for keeping interest rate too high and limiting growth • Can take up to two years for interest rate change to affect economy • When rate is very low e.g. 1% further cuts are not effective • Effect on other objectives e.g. B of P

Success depends on Depends on accurate information Consumers reacting in the right way e.g. saving/spending

Supply side

• Designed to raise efficiency • If supply side of economy can be improved then growth can be achieved without

inflation. • Exports can be more competitive = better current account B of P • If unemployment is caused by demand deficiency and a fall in AD then supply side

policies may not be effective. • But….if AD does not also increase the extra capacity would not be used • …And e.g. education can take a long time to work and no guarantee that it will work

Success depends on When the economy is an a recession the economy needs higher levels of AD supply side policies would not be able to solve the immediate problem

Policy trade offs

Low and stable inflation Low unemployment Sustainable balance of payments

Growth Growth that is caused by and increase in AD can cause inflation if AS is inelastic (I.e. if there is no output gap or a positive one)

Growth and low unemployment should happen at the same time – no trade off

Growth can cause a trade deficit as some of the extra income can be spent on imported goods. This is especially true in a consumer led boom

15

Trade Protectionism

Despite the advantages of free trade countries may wish to restrict imports for various reasons this can be done through different methods.

1. Tariffs

This is a tax on imports.

2. Quotas

This is a physical limits on the quantity of imports

3. Embargoes

This is a total ban on a good or service entering the country. This may be done to stop dangerous substances

4. Subsidies

If a govt subsidises domestic production this gives them an unfair advantage over competitors. This is quite common

5. Administrative barriers

The advantages that may be gained from international trade are:

Increased exports

Increased competitiveness

Greater choice for consumers and lower prices

Greater efficiency due to increased competition

Higher economic growth