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AGGREGATE DEMAND The total demand for a country’s goods and
services at a given price and in a given time
period
This planned expenditure on domestic output
comes from firms, households, the government
and foreigners
There are five components to aggregate
demand and the formula is
AD=Consumer expenditure + Investment +
Government Spending + (Exports –
Imports)
AD = C + I + G (X – M)
PRICES
The average each of the prices of all the products
produced in an economy
CONSUMER EXPENDITURE
Spending by households on consumer products
INVESTMENT
Spending on capital goods
GOVERNMENT SPENDING
Spending by central government and local government
on goods and services
NET EXPORTS
The value of exports minus the value of imports
TRANSFER OF PAYMENTS
Money transferred from one person or group not in
return for any goods or services
COMPONENTS OF AGGREGATE DEMAND
CONSUMER EXPENDITURE
Consumer expenditure is also know as
consumption
This is usually the largest component in most
countries
It is the spending by households on clothes, foods
and insurance.
INVESTMENT
Is the most volatile of the components of
aggregate demand
It is the spending on capital goods such as
delivery vehicles
This fluctuates highly depending on the economy
GOVERNMENT SPENDING
It is the spending from the local and central government
They spend on things such as education, healthcare and
police services
This does not include transfer of payments such as benefits
NET EXPORTS
This is calculated by the exports of foreigners spending on
a country’s goods and services and then deducts spending
by any imports by the country's population
This can create a positive or a negative effect on aggregate
demand but this is highly reliant if the country has a trade
surplus or a deficit.
TRADE SURPLUS
the value of exports exceeds the value of imports
TRADE DEFICIENT
The value of imports exceeds the value of imports
CONSUMER EXPENDITURE
There is a range of influences on how much a household
spends:
Real disposable income
Richer households and economies tend to spend more in total
to the poorer, as they have more money to spend.
The proportion of income or the APC, will fall as the income
rises. A banker would have a smaller APC because they are a
larger income.
AVERAGE PROPENSITY TO INCOME
the proportion of disposable income spent. It is the consumer
expenditure divided by the disposable income
Wealth
The more wealth there is the more people have to spend, this is
in form of their houses, shares and saving account. This is a clear
result in greater consumer confidence, because if the market
prices for houses were to go up, people tend to spend more
because, house prices are a crucial indication of how the
economy is doing.
WEALTH
A stock of assets, e.g. Property, shares and money held in a
saving account
CONSUMER EXPECTATION AND CONFIDENCE
This is a significant influence on consumer expenditure
When consumers are feeling optimistic about the future,
expecting their job prospects to be good they spend more.
The proportion of income spent can rise at income rises
THE RATE OF INTEREST
Change in the rate of interest are another important influence
A fall in rate of interest will stimulate a rise in consumer
expenditure. It becomes cheaper for consumers to borrow, it
reduces the incentive for people save as they would get less in
return. Also mortgages and loans are easier to pay off, leaving
extra money for consumption.
Net savers will lose out if the rate of interest falls.
NET SAVERS
People who save more than they borrow
THE AGE STRUCTURE OF THE POPULATION
It is generally thought that the young and the elderly spend a
large amount of their disposable income.
So the government measures that to redistribute the income of
the rich to the poor, so that it can likely cause an increase in the
consumer spending
DISTRIBUTION OF INCOME
How income is shared out between households in a country
INFLATION
A sustained rise in the price level
This is difficult to determine as to what impacts the effects of
spending
If you expect a high inflation in the future, the spending now
may increase rapidly
However at times there as a high amount of saving during a
time of inflation, as they were trying to maintain the real value of
their money
SAVING
Real disposable income minus spending
This is not a component of aggregate demand, but influences the
spending undertakes by governments, foreigners, firms and
households
INFLUENCES OF SAVINGREAL DISPOSABLE OF INCOME
If the real disposable income increases, household will not only save
more but will also save a larger proportion of income
Their average propensity to save increases
AVERAGE PROPENSITY TO SAVE
The proportion of disposable income saved. It is saving divided by
disposable income
THE RATE OF INTEREST
A rise in the rate of interest would increase the rewards of saving
and then therefore would encourage people to save more.
These are some target savers who would have to put less money in
the account as the interest would be reduce the amount to save
TARGET SAVERS
People who save with a target figure in mind
CONFIDENCE AND EXPECTATIONS
Households and firms tend to save more when they are uncertain or
concerned about the future
For example, if people were worried of losing their jobs there would
be this sudden precaution to save, as there may be a drop in income
SAVING SCHEMES
If there is a range of saving scheme this should lead to more saving
as there is more variety
RANGE OF FINANCIAL INSTITUTIONS
Saving can be affected by the well respected institutions, as there are
many highly established institutions in the country, which would lead
to confidence.
However in practise it has been found that financial systems have
become more sophisticated and developed, causing a fall in saving
rates
GOVERNMENT POLICIES
A decision by the government to introduce a tax free saving scheme
will encourage people to save more
In contrast, if there is a raise in the state pension scheme then there
would be a decrease in the incentive of people saving for a pension
THE AGE STRUCTURE OF THE POPULATION
It has been found that people save little
when they are young, but when having
reached middle ages the saving increases
It is also known that the elderly dissave,
drawing in their saving to maintain their
living standards when they retire
DISSAVE
Spending more than disposable income
SAVING RATIO
Saving as a proportions of disposable income
INVESTMENT
Firms invest when they expect returns from the capital goods that they
buy to be greater than their cost
INFLUENCES INCLUDE CHANGES IN DISPOSABLE INCOME
If the real disposable income increases, demand for the goods and
services would increase. This would then encourage firms to invest so
that they can expand their capacity.
Firms would also have to believe that the increases in demand would
be sufficient and will last so that they can produce the extra output
EXPECTATIONS
Firms are more likely to invest more if they are optimistic about the
future and future prospects.
The extent and speed of changes in expectations are the main
reasons for the volatility of investment
CURRENT PROFIT LEVELS
High profits can encourage investments in two ways. They provide
the finance to invest and they would also contribute to the firms
optimism about the future
CAPACITY UTILISATION
The extent of which firms are using their capital goods
Firms are more likely to invest if they are operating close to full
production
In contrast, if they have considerable space of capacity, they may be
able to increase the output without having to buy new capital goods
CORPORATION TAX
A tax on the firm’s profit
A cut in corporation tax would lead to an increase in the amount of
profit that the firm is likely to keep, which would be mean more money to
invest.
Government can stimulate investment by providing investment subsidy
ADVANCES IN TECHNOLOGY
A firm may invest in new capital goods if they think that the equipment
would produce at a much faster rate or better quality, so it return they
would expect higher profit because of an increase in demand or a fall in
unit price
PRICE OF CAPITAL EQUIPMENT
A reduction in the price of capital equipment may also increase
investment. Such a fall may make it available for more firms to use the
equipment so that it can expand their capacity
THE RATE OF INTEREST
As with consumer expenditure, investment is influenced by
the rate of interest
A rise in the interest would reduce the chances of
investment for four reasons:
It will increase the opportunity cost of the investment,
they can use the profit on something else, although
most investment is made from the retained profits
A higher interest rate would make it more expensive
to borrow and may discourage an investment projects
A change in the interest would affect the return of the
investment, a higher rate would reduce the chances of
investment; firms will anticipate the demand to fall
Also a rise in interest rates causes a decrease in the
interest of shares. Lower demand for shares would
cause a reduction in the price level and decrease the
funds for the investment
GOVERNMENT SPENDING
The decisions for government spending are influenced by a number of
factors:
GOVERNMENT VIEW ON THE MARKET
The governments view on the extent of the market failure and the ability to
correct it
Economies where the government plays a large part usually has a high
government spending and this would form a larger proportion of aggregate
demand
THE LEVEL OF ECONOMIC ACTIVITY
If there is a high unemployment rate, government may increase the
spending in a bid to increase the aggregate demand and the output of the
economy.
In contrast if there is high inflation the government may reduce the amount
of spending
THE DESIRE TO PLEASE ELECTORATE
Voters can add pressure on the government to spend money on education,
healthcare and safety, so that there can they can attempt to increase the
political support
WAR
If there is war, terrorism and rising crime, this can also increase the
government spending
NET EXPORTS
The influences on export revenue and import expenditure
REAL DISPOSABLE INCOME ABROAD
A rise in income abroad would mean more exports abroad, they
will but more goods and services from the UK
REAL DISPOSABLE INCOME AT HOME
An increase in income at home would result in a fall in exports
and an increase in imports. Or the export market would divert some
of the goods to the population of the country
THE DOMESTIC PRICE LEVEL
If domestically produced products are to become expensive, firms
and households at home and abroad will switch from them to
products made by other countries
THE EXCHANGE RATE
A fall in the exchange rate would result in more exports but fewer
imports as it would be more expensive to buy from them
GOVERNMENT RESTRICTIONS ON TRADE
A country’s exports may rise if the government were to remove
any restrictions
THE RELATIONSHIP BETWEEN AGGREGATE DEMAND
AND THE PRICE LEVEL
Three effects as to why the AD curve slopes downward
THE WEALTH EFFECT
This relates to the changes in households and firms
wealth when there is a change in price
When there is an increase in the price level then it
reduces the purchasing power of wealth and causing the
AD to contract fall in rate
THE INTERNATIONAL TRADE EFFECT
A rise in price level, assuming no change in the exchange
rate will make the country’s goods less competitive
This would cause an increase in the foreign goods, or
imports
Net exports would fall and AD would contract
THE RATE OF INTEREST
A rise in the price would result in high number of selling as they
would get more in return such as government bonds
This leads to an increase in supply of the government bonds which
would lead to a fall in price, such changes could raise the percentage
of interest
This is because the interest rate changes in proportion with the
change in price level
For example a bond pays £5 interest, if initially sold for £100, the
interest rate in 5%. When the price fall to £50 then the interest rate
would be 10%
A higher interest rates like this would result in a decrease in
investment and consumption
In contrast a fall in price leads to a so AD slopes from left to right
because a rise in the price level would reduce the monetary wealth,
raise the interest rate and reduce the international competiveness
GOVERNMENT BOND
A financial asset issued by the central or local government as a means
of borrowing money
SHIFTS IN AD
A price change will only cause a
movement along the curve
The influences for a shift are:
Expectations
Changes in government policy
Changes in the exchange rate
Change in the population size
If households become more optimistic
about the future, increases the consumer
expenditure and investment
A cut in the restrictions and taxation
AGGREGATE SUPPLY
The total amount that producers in an
economy are willing and able to supply at
a given price and at a given time period
the shape of the AS curve is determined
by the capacity existing in the economy
When the output is low and there is high
unemployment, this is shown at the
beginning of the AS curve
AS is perfectly elastic , meaning that more
can be supplied without raising the price
SHIFTS IN AS
A change in AS means that the total
output that producers are willingly and
able to supply at any given price level alters
The influences for a shift on the short run
are:
Changes in the cost of production
Changes in the cost of raw material
Shifts on the long run
Changes in the quality or the quantity of
resources
Such as labour and efficiency
MACROECONOMIC EQUILIBRIUM
A situation where AD equals the same as AS and the real GDP is
not changing
AD
When AD is higher than AS, there would be a shortage of
goods and services
Firms would find their stocks declining
The excess demand would encourage firms to expand their
output
The surplus in AD would push the price higher, depending on
the level of capacity
AS
When AS is exceeding AD, would lead to pressure that would
move the economy back to equilibrium
The existence eon the unsold of goods and services would
cause the AS to contract
The price level would fall but depending on the level of
capacity
THE CIRCULAR FLOW ON INCOME
2 SECTOR MODEL
THE CIRCULAR FLOW ON INCOME
5 SECTOR MODEL
LEAKAGES
Withdrawals of possible spending from the
circular flow of income
Taxes, saving, spending on imports
Leakages reduces the aggregate demand
INJECTIONS
additional of extra spending into the circular
flow of income
Investment, government spending, exports
Increases the aggregate demand
When the injections and leakages are equal
the output will not be changing
THE MULTIPLIER EFFECT
The process by which any change in a component of
aggregate demand results in a greater final change in
real GDP
When injections exceeds leakages, aggregate
demand will increase
The rise in AD will have a greater final effect on the
economy, this occurs when people spend money, that
expenditure becomes the income for those who sell
them
They will in return spend that money that they
receive, so there is a knock on effect, with AD rising by
more than the initial amount
Spending will continue to rise until leakages match
the initial injection
At AD1, it is the post injection , at
AD2, is the rise of the injection.
After this there should be a final
change in AD which should be the
final rise in AD. This should result in
a great change in GDP and little
change in price
CHANGES IN AD
Three key influences on the effect of a
change in AD on the
Output of an economy
Unemployment rate
Inflation
They all depend on the
Size of the initial change
The size of the multiplier
Original level of economic activity
If the economy is initially operating with
a considerable spare capacity, an increase
in AD is likely to effect the output of the
economy, reduce the unemployment, and
leave the price level unchanged
AD1
AD
An increase in AD
and increasing the
output without
changing the price
level
A rise in AD may increase both output
and price level.
This output will occur if either economy
moves from a position of significant spare
capacity to one where there is a shortage
of resources
AD1
AD
AD1
AD
Finally if the economy is already
operating at full employment, with no
spare capacity an increase in Ad will be
purely inflationary
There would be no change in GDP but
only in price
CHANGES IN AS
The effects on the changes in AS will depend on the
Size of the change
Initial level of economic activity
An increase in AS would result in a increase in GDP
and price falling down
There is a possibility, however when the increase
in AS may have no impact on the economy. This
would only occur when the economy is initially
operating at a low level and there is high level of
unemployment
In this case it would result in no change in GDP or
price as they are working elastic part of the curve
if there is increase is AS as much as AD,
then the economy can enjoy higher output
without encountering any inflationary
pressure
An increase in output but no change in the
price level
However AD does occur rapidly and could
result in inflation or result in overheating
OVERHEATING
The growth of aggregate demand
outstripping the growth of aggregate
supply, resulting in inflation
OUTPUT GAP
The difference between an economy’s
actual and potential real GDP
Occurs when the economy is not
producing to the full capacity
A negative output gap occurs when the
economy’s actual output is below its
potential output
A positive output gap arises when the
economy’s actual output is above the
potential
ECONOMIC GROWTH
In the short run, an increase in real GDP, and in the long run an
increase in the productive capacity that is, in the maximum output that
the economy can produce
REAL GDP
The country’s output measured in constant prices and is adjusted with
inflation
NOMINAL GDP
Output measured in current prices and no adjusted to inflation
REAL GDP = GDP figure x base year price index
current price index
Calculating the percentage change in nominal GDP
Difference in GDP
Original
SUSTAINABLE GROWTH
Economic growth that can continue over time and does not endanger
future generations’ ability to expand productive capacity
TREND GROWTH
The expected increase in potential output over time. It is a measure of
how fast the economy can grow without generating inflation
X 100
MEASURING ECONOMIC GROWTH
Economic growth is usually measured by the annual percentage
change in real GDP, or the country’s output
The circular flow of income shows that the country’s income is equal
to the country’s output and its expenditure
So real GDP can be calculated by total of output, income and
expenditure, without the inclusion of leakages and injections
Care must be taken when doing this for output, you may calculate the
raw material but the price of the finished product, so avoid double
counting
Income, only income which have been earned in return for providing
goods and services, not the transfer of payments such as benefits
Expenditure, to include exports as they are made by the producers of
the country and to exclude the exports, as the money goes to foreign
country
PRODUCTION AND PRODUCTIVITY
Production is what is produced, so if there is an increase in GDP then
the output has increased
If a productivity rises more than the wages, then labour costs will fall
resulting for the country to become more price competitive
WHAT CAUSES ECONOMIC GROWTH
In the short run, an economy with spare capacity
can experience economic growth as a result of an
increase in aggregate demand
There can be consumption led growth, which is
based on the cut of income tax or the rise in
consumer confidence
In the long run an increase in the quantity or the
quality of the resources increases
The increase in the labour force, such as more
women entering the labour force
The ability to produce the products
The advances in technology
Improvements in training and education
THE BENEFITS OF ECONOMIC GROWTH
A likely rise in the standard of living, if the GDP
increases then the population can enjoys the
increased in goods and services
enable poverty to be low, higher output increases
the tax revenue so that it can be used to finance the
poor
Reducing poverty by increasing the rate of
employment, however the risk of this is that there is
not an increase in aggregate demand in line with the
increase in the labour force
Increases the output level of the country and
thereby increases the status and power in the
international organisations and in international
organisations
UNEMPLOYMENT
a situation where people are out of work but are willing and
able to work
The unemployed X 100
Labour force
UNEMPLOYMENT RATE
The percentage of the labour force who are out of work
There are two methods of measuring unemployment
LABOUR FORCE SURVEY
A measure of unemployment based on a survey using the ILO
definition of unemployment
INTERNATIONAL LABOUR ORGANISATIONAL (ILO)
A member organisation of the United Nations that collects
statistics on the labour market conditions and seeks to improve
the working conditions, they use the claimant count
CLAIMANT COUNT
A measure of unemployment that includes those receiving
unemployment related benefits
CAUSES OF UNEMPLOYMENT
This can be examined from the demand and the supply side
There are three causes of this
CYCLICAL UNEMPLOYMENT
Unemployment arising from a lack of aggregate demand, in
this case demand for products would be low and resulting in
a high unemployment
STRUCTURAL UNEMPLOYMENT
Unemployment caused by a decline of certain industries and
occupations due to changes in demand and supply. People
may loose there jobs because of technological advances or
when firms produce abroad because of cheaper labour force
FRICTIONAL UNEMPLOYMENT
Short term unemployment occurring when workers are in
between jobs. It is less serious than cyclical and structural
unemployment as they are for short periods
DIFFICULTIES IN INTERPRETING REAL GDP
On the surface an increase in real GDP suggests that living standards
are improving, as more goods and services are being produced
However, it eliminates the rise in output may be the case of an
increase in population, the solution to this is to asses the real GDP by
per capita
Real GDP takes inflation into account, so a raise in income may not
necessarily mean an increase in the standard of living
Another problem which can occur is the existence of an informal
economy, this is when there is unrecorded economic activity
The existence of this causes the GDP to be lower as the informal
economy is not taken into account it also understates the rate of
unemployment. Also the inflation rate is usually lower in this type of
economy which also overstates the rate of inflation
INFORMAL ECONOMY
Economic activity which is not recorded or registered with the
authorities
Tax revenue is lower than would be possible if all economies where
taxed. Firms tend to stay small in an informal economy as they want to
avoid the attention of authorities
MEASURING INFLATION
INFLATION
A steady rise in price as measured by a change in
cost overtime by a standard basket of goods and
There are two methods which are used to measure
inflation
CONSUMER PRICE INDEX (CPI)
Excluded all housing costs, such as mortgages
interest payments, council tax and television license
Includes university accommodation fees
Based on spending in private households
Geometric means in contrasting the index
The basket is then compared with a sample from
the month before and the inflation is calculated
RPI (RETAIL PRICE INDEX)
The basket is referred as the basket of which a typical
customer would buy products so that they can
calculate the product index
RPIX
Minus the interest rates of mortgages
Arithmetic means of methodology
The exclude the mortgagees rates because when
there is an increase in the interest rates it would take a
up large proportion of income, resulting in a decrease
in demand
RPIY
Mortgages interest payments plus any indirect taxes
such as VAT.
Excludes food prices and energy prices
DEMAND PULL INFLATION
Occurs when there is excess demand
Businesses respond to high demand by raising prices to increase
their profit margins
Demand-pull inflation is associated with the boom phase of the
cycle
The main causes of demand pull inflation
Very fast growth of demand for credit / borrowing
High levels of consumer spending
CAUSES OF PULL INFLATION A depreciation of the exchange rate increases the price of imports and reduces the foreign price of UK exportsA reduction in direct or indirect taxation - consumers will have more disposable income causing demand to riseRapid growth of the money supply as a consequence of increased bank and building society borrowingRising consumer confidence and an increase in the rate of growth of house pricesFaster rates of economic growth in other countries – providing a boost to UK exports overseas (an injection of AD)
COST PUSH INFLATION
Occurs when costs of production are increasing
Causes:
External shocks (e.g. commodity price rises)
A depreciation in the exchange rate
Rises in labour costs (wages)
Higher indirect taxes on goods(e.g. VAT)
Leads supply falling
Firms raise prices to protect their profit margins –
better able to do this when market demand is price
inelastic
“Wages often follow prices”
A rise in inflation can lead to rising inflationary
expectations
CONSEQUENCE OF INFLATION
Fall in the value of money
Menu costs
The costs of changing prices due to
inflation
Shoe leather costs
Costs in terms of the extra time and effort
involved in reducing money holdings
Admin costs
adjusting accounts, negotiating with
unions about wage rises, assessing raw
materials costs
Inflationary noise
The distortion of price signals caused by
Inflation
CONSEQUENCE OF INFLATION
Random redistribution of income
Some workers will get a rise in income in line with
inflation whilst others don’t
Fiscal Drag
People’s incomes being dragged into
higher tax bands as a result of tax brackets
not being adjusted in line with inflation
Uncertainty
Inflation causing inflation
People thinking that inflation will go up and would
stock up causing an increase in demand, pushing
prices higher
Loss of international competitiveness
Often seen as fewer exports
BENEFITS
If low and steady, higher prices from D-pull
inflation may encourage firms to increase output
Workers like rises in their pay, even if nominal
Allows flexibility for firms to alter wages.
Most would resist a cut in nominal (money) wage
but accept a small rise smaller than inflation
SIGNIFICANCE DEPENDS ON
The rate of inflation
Cost push vs Demand pull
Its cause
Fluctuating or stable?
Correctly anticipated?
Relative rate (compared to other countries)
CAUSES OF INFLATION
The exchange rates
If the exchange rate is low then there would be little
inflation as there would be high exports and high
demand
Government restrictions on free trade
This would add to the cost of exports which would
change the price level resulting in inflation
The domestic price level
If the price is rational with the cost of production
and there is high demand this may cause inflation
Real disposable income at home
If there is high income at home, this would increase
the demand and would then increase the price
BALANCE OF PAYMENTS
A record of all the money which is flowing in and out of the country
INFLUENCE ON THE BOP
REAL DISPOSABLE INCOME AT HOME
A rise in income at home may result in a fall in exports as firms divert
some products from the export market to the domestic market. Also,
consumers can afford to import more.
REAL DISPOSABLE INCOME ABROAD
More money people have abroad, the more they are likely to import
UK goods.
THE EXCHANGE RATE
If the exchange rate lowers, it will make UK goods more competitive
and drive up exports. It also makes imports more expensive
THE DOMESTIC PRICE LEVEL
If inflation rises it makes UK goods less competitive, therefore exports
are likely to fall
GOVERNMENT RESTRICTIONS ON FREE TRADE
The more restrictive governments are of foreign imports, the greater
the net exports. Such as tariffs and quotas
There are three parts of BOP
CURRENT ACCOUNT
Trade in goods and services
Income, money which flows in as wage, dividends
and interest
Current transfers, money from the government or
international transfers money form individuals
CAPITAL ACCOUNT
Patens, buying foreign land for embassies
Big transfers to invest in capital parts
FINANCIAL ACCOUNT
Covers all investment into and out of the economy
Foreign Direct Investment is when companies are
moving out to operate in another country
CONSEQUENCES OF DEFICIT IN THE CURRENT ACCOUNT
Results in an increase in the deficit
Lowers the economy's output
Raises the unemployment
Put a downward pressure on the price
A fall in the exchange rate
Increase in the country's debt
A SURPLUS IN CONTRAST
Experiencing a inflow of money in the economy
An increase into he money would result in the banks
having more to lend
Increase in the number of entrepreneurs as they would
be invested by the banks because of the increase in money
This would lead to an increase in employment and
growth may result hence
The cause of a defect or a surplus is the same for the Balance of
Payments
STRUCTURAL ISSUES
Poor quality products
Products being too expensive
Products not in line with changing demand
SIGNIFICANCE
Its size
E.g. what percentage of GDP.
Duration
If it lasts a short time it is unlikely to be significant.
Cause
Price and income fluctuation are not always a major
cause for concern, but structural problems are more
serious. E.g. high inflation and low productivity are
structural problems that may persist.
What’s happening in the capital and financial account.
EXCHANGE RATES
the price of one currency in terms of another
currency
FIXED EXCHANGE RATE
when the government intervene in the currency
market so that, that can stay close to the exchange
rate target
ADVANTAGES
Provides a greater certainty for exporters as there is
less speculative activity
Can exert a strong discipline on firms to control the
costs as it would make them internally competitive
Helps maintain low inflation eventually bringing the
interest rates down
FLOATING RATES
Changes in the market of demand and supply of
the currency to cause a change
ADVANTAGES
Fluctuations acts a price signals when the
economy is not doing goods
Countries with a large deficit would be able to
reduce it as the rates change dues to the demand
and supply of the currency
This should reduce the deficit in the current
account, only if the price elasticity of demand for
imports and exports are high
Allows the government and authorities to have
flexibility in determining interest rates
INFLUENCE ON DEMAND AND SUPPLY OF
CURRENCIES
International competiveness (especially
labour productivity, investment and relative
inflation rises
Change in income abroad
Change in income at home
Domestic interest rates, demand and supply
would cause a change in exchange rate
For investment reasons, such as foreign
direct investment
Speculation
Interest rates and exchange rates follow in the same
direction
Hot money is injected into the economy when the
interest rates are high as they would be getting more
in return, this would lead to an increase in demand
for that currency
There are time when this is not true, when the there
is an interest rate cut and the foreigners confidence
increases and causes the exchange rate to do up
When talking about the exchange rate follow this
sequence
Rate (change) – Price (change) – Demand (change) –
AD (change) – Inflation (change) – potential (change)
– interest rates (change) – exchange rate (change)
FISCAL POLICIES
The taxation and spending decisions of the
government
The aim of the fiscal policy is to influence AD
The government can either increase or decrease the
use of the fiscal policy
They do this by:
Changing the government spending
Changing consumption through the use of taxes
G and C are both components of AD
If the government increases spending then this
would increase AD and vice versa
If the government were to raise the taxes then this
would reduce the AD and vice versa
Higher spending will often have a multiplier effect
and this will further increase AD
REFLATIONARY POLICIES
Designed to increase AD
For example increase in government spending
and decrease in taxes
This is also known as the expansionary or loose
fiscal policy
Reducing taxes and increasing government
spending has the same effect, greater spending in
the economy
Government will do this if they want to reduce
unemployment, the extra spending will increase the
demand for products which firms will meet by
hiring workers
Firms profit will increase, this will lead to inflation
DEFLATIONARY POLICIES
Policies designed to reduce AD
Reduced government spending and increase in
taxes
Also known as the contractionary or tight fiscal
policy
The government may wish to reduce inflation by
increasing the taxes and reducing the government
spending
There will be less spending in the economy and
firms will make less profit
This prevents the economy from growing too fast
A problem is that the unemployment might
increase as firms are can not expand
OTHER REASONS FOR CHANGES IN THE
FISCAL POLICY
Encouraging consumption of merit goods
Discouraging consumption or demerit
goods
Altering distribution of income
Altering incentives, changing the aims of
people
Simplifying systems
DISCRETIONARY FISCAL POLICIES
The government actively influences AD by
changing tax or expenditure
AUTOMATIC STABILISERS
Forms of government spending that changes
automatically to offset fluctuations in economic activity
When GDP rises government receives more tax
VAT
Income tax
Inheritance tax
Road tax
Co operation tax
PROGRESSIVE TAX
To tax that takes a higher percentage from the rich to
the poor. Such as income tax, the Robin Hood tax
REGRESSIVE TAX
A tax that takes a higher percentage from the income
of the poor. VAT takes a higher proportion of income
to the poor
GOVERNMENT SPENDING
this can be broken into
CAPITAL EXPENDITURE
New hospitals
Schools
Roads
The government only borrows for this
CURRENT SPENDING
Running public services
Teachers wages
Medicines used for NHS
TRANSFER PAYMENTS
Money transferred from taxpayers to benefit
recipients
DEBT INTEREST PAYMENTS
Payments made to the holders of government debts
DEFICITS AND SURPLUSES (BUDGET)
If government spends more than the it
gains in tax revenue then gain a budget
deficit
if the opposite occurs then it is known as
a budget surplus
They raise the tax to raise the revenue to
discourage consumption of the products
EFFECTIVENESS OF THE FISCAL POLICY
Takes time to have an effect- time lag
Takes time to gather information
A lot of government spending is inflexible
Needs to be based on accurate information
Households and firms are not always
rational, they are not predictable
There maybe adverse effects on incentives
and the macroeconomic objectives
The changes in offset they may change in
circumstances with other countries
MONEY SUPPLY
Government increases money supply – easy for banks to lend so
they lend more- people have more money to spend- AD increases
MONETARY POLICY
The main aim of the monetary policy is to help to keep
macroeconomic stability in the economy and also maintain the
value of money
It is also known as demand side policy
Monetary policy involves the use of interest rates and other
instruments of policy to control
The growth of AD relative to the economy’s productive
potential
The demand for the supply of money and credit
Occasionally influence the value of the exchange rate
Currently the monetary policy concerns changes in short term
base interest rates
Monetary policy seeks to influence AD, it has little impact on
LRAS
The government sets the inflation target
IF THE INTEREST RATES INCREASE THEN
Commercial banks will increase rates
Consumption will reduce and lower firms
investment plans
More foreigners want to place money in the UK
Rise in demand for the pound will increase the
exchange rate
Net exports will decrease
Decrease in AD as there is a decrease in exports
DOES IT ALWAYS WORK
There is a chance that C+I will not change
Fixed rate interests will not be effected
High profits so firms may invest anyway
Confidence and expectations may change
LIMITS TO THE RATE OF CHANGE
Mortgage interest rates do not always follow
base rates changes
Many home owners are in fixed rate mortgages
People in rented property have no direct
change if businesses are operating with spare
capacity , a fall in rates will not necessarily lead to
higher planned capital investment
Many sources of funding for capital spending
Lower interest rates causes a fall in in effective
disposable income of millions of people with net
savings
EFFECTIVENESS OF MONETARY POLICY
Time lags- takes 2 years for the full effect of
the interest rate to show
It is difficult to control, banks have profit
motives to increase profits
Speculations working against government
such as the Black Wednesday
Optimism vs. government signals
In relation with other governments, hot
money
Side effects on the Balance of Payments
Interest rates below 0 would lead to no
profits
GOVERNMENT SPENDING
Not all cash would contribute to
increasing AD
Some could be saved and some could
spent on imports
MONETARY POLICIES
Decrease interest rates or increase money
supply – stimulates consumption and
investment-exchange rate falls increasing
net exports- increase AD
SIDE EFFECTS ON POLICIES
Higher AD increases price level
Increases deficit on the current account of the
balance of payments
SUPPLY POLICIES TO REDUCE UNEMPLOYMENT
Time is taken to find job- quality of information
Improved education and training
Better low cost child care
Make work place more accessible for disable
workers
Widening the gap between income from work
and benefits
Reduce employment legislations
EFFECTIVENESS OF SUPPLY SIDE POLICY
They are selected and targeted at particular
markets, and are designed to raise efficiency
AS should increase AD without any
inflationary pressures
Higher quality of resources would make
domestic firms more price and quality
competitive
Improves the country’s current account
position
Some policies such as education and trainining
will take a long time to have an effect
Can be expensive to operate and there is no
grantee that it will work
POLICIES ON INFLATION, ECONOMIC GROWTH AND
BALANCE OF PAYMENTS
POLICIES TO CONTROL INFLATION
If a country is experiencing inflation then measures it
implements will be influenced by what is the cause
In the long run, instruments will be used to main the
price stability
COST PUSH INFLATION
Restriction of wage rates
Main disadvantage of this is that it creates an
inflexibility in the labour force
Reduce the firms cost by reducing cooperation tax
Provide subsidies to cover rising cost
Danger of this is that people will become reliant on
the government subsidies
DEMAND PULL INFLATION
Raise in income tax
Some people may suffer severely such as the poor
Changes in interest rates
People will be uncertain of future prospects
Imports may change due to speculations and
would importers would be uncertain
INFLATION TARGETING
Can reduce demand pull and cost push inflation
by reducing the expectations of inflation
It also makes the monetary policy more
transparent and the central bank more accountable
LONG RUN
A government reduces inflation by
increasing AS
Rightward shifts in AD would result in
shifts equal to AS
SYMMETRIC
deviations above and below the target are given equal
weighting
ASYMMETRIC
deviations below inflation target and seen as less important
that deviations above target
POLICIES TO PROMOTE ECONOMIC GROWTH
SHORT RUN POLICIES
Achieved by increasing AD through either expansionary
fiscal or monetary policy
Some fiscal and monetary instruments have the advantage
that that have the potential to increase both AS and AD
Lowering interest rates will stimulate not only consumption
but investment, higher investment increases AS
Increasing the government spending will shift AS to the
right
LONG RUN POLICIES
Increase output, will continue if
productive capacity steadily rises
For long run economic growth the
quantity or quality has to increase
Reduction in policies
SUPPLY SIDE POLICIES
Most government seek stable growth so
that the growth can match the trend
growth patterns
CHANGES IN UK’S PATTERN OF
INTERNATIONAL TRADE SINCE 2000
The UK was a oil exporter up until 2000
but then turned into a oil importer by 2005
The UK has a surplus in most services
category such as education, insurance and
finance
ADVANTAGES
Exchange of goods and services across national
borders, allows the country to specialise in the
goods and services that they do
Lower prices and higher quality from the
competition
Enjoy a variety of products internationally
There is a larger market to sell their products
DISADVANTAGES
Firms with in the country would lose demand
as everything is price competitive
Competition increased
Become self reliant
POLICIES TO IMPROVE BOP
SHORT RUN
Exchange rate adjustment
Deflationary demand management
The government may want to adopt deflationary
fiscal and monetary policy
Import restrictions
LONG RUN
Giving subsidies to suppliers to become more
internationally competitive
Improve the education and training
Improve the quantity and quality of materials
Work more efficiently
Invest in technology to work effieicenty
PROTECTIONISM
The protection of domestic industries from
foreign competition
TARIFFS
The tax on imported products, the effect of
imposing the tariff is that it should raise the
prices and then should decrease the demand for
it
VOLUNTARY EXPORT RESTRAINT
A limit placed on imports from a country with
the agreement of that country’s government,
this protect the specialised goods made by both
countries
QUOTAS
this is the limit of the supply for importing
goods and services
It can be imposed on exports such as, the
country is experiencing a food shortage
and would prefer to keep the food for their
country
The effect of the quota is to reduce the
supply, which is inelastic
FOREIGN EXCHANGE RESTRICTIONS
By limiting the amount of the foreign
exchange made available to those wishing to
buy imported goods and services or invest
EMBARGOES
Is a total ban on the export or the import for a
product
RED TAPE
Time deploying customs such as legislations, to
make it expensive and time consuming to import
the product
QUALITY MEASURES
Setting high and complex measures to raise
the cost of importing