Economics Edexcel As Macro 2016

Pearson Edexcel Level 3 Advanced

Subsidiary GCE in Economics A (8EC0)

Course Companion

THEME 2:
THE UK ECONOMY –
PERFORMANCE AND POLICIES

Geoff Riley

A Level Economics Year 1 (AS) Macro Topics

This Course Companion for the macroeconomics content for the Year 1 (AS) Economics
specification is organised into the following core topics:

1. Introducing Macroeconomics .................................................................................................................... 3
2. Use of Index Numbers ............................................................................................................................... 6
3. The Circular Flow of Income ...................................................................................................................... 8
4. Measuring National Income .................................................................................................................... 10
5. Standard of Living and Well-‐Being .......................................................................................................... 15
6. What are the Objectives of Macroeconomic Policy? .............................................................................. 22
7. Aggregate Demand .................................................................................................................................. 23
8. Consumer Spending ................................................................................................................................ 27
9. Household Saving .................................................................................................................................... 33
10. Capital Investment ................................................................................................................................. 36
11. Understanding Aggregate Supply .......................................................................................................... 39
12. Macroeconomic Equilibrium .................................................................................................................. 47
13. The Economic Cycle ............................................................................................................................... 51
14. Multiplier and Accelerator Effects ......................................................................................................... 59
15. Economic Growth ................................................................................................................................... 63
16. Inflation .................................................................................................................................................. 72
17. Deflation ................................................................................................................................................ 83
18. Employment and Unemployment .......................................................................................................... 86
19. Labour Migration and Macroeconomic Performance in the UK ............................................................ 98
20. Introduction to Globalisation and International Trade ........................................................................ 101
21. The Balance of Payments ..................................................................................................................... 109
22. Monetary Policy ................................................................................................................................... 115
23. Exchange Rates .................................................................................................................................... 124
24. Fiscal Policy .......................................................................................................................................... 128
25. Supply-‐side Policies .............................................................................................................................. 144
26. Keynesian Economics ........................................................................................................................... 155
27. Strengths and Weaknesses of Demand Side Policies ........................................................................... 157
28. Possible Conflicts between Macro Objectives ..................................................................................... 158
29. AS Macro Glossary ............................................................................................................................... 162

Page 2 www.tutor2u.net

1. Introducing Macroeconomics

What is Macroeconomics?
Macroeconomics considers the economy as a whole
• Macroeconomics studies relationships and connections between one country and another for
example, how a slowdown in the Chinese economy can affect UK businesses.
• Or how a change in the exchange rate affects British firms exporting to countries around the world
• The scope of macroeconomics includes looking at the success or failure of government policies –
for example does the government have effective and fair policies for cutting unemployment? Or
has the government succeeded in creating the conditions for a sustainable and balanced recovery?
• Macroeconomics involves looking at some big numbers! GDP is a good example, or figures for a
country’s balance of payments.
• Macroeconomics involves studying inflation, economic growth, human development, international
trade and globalisation. These are BIG topics and BIG issues – welcome to macro!

The City of London is a centre for global finance and The spending decisions of millions of consumers
a major source of income for our balance of add up to affect the performance of the economy –
payments but it has been hit hard by a deep crisis in a fall in consumer spending nearly always leads to a
banking and related financial services downturn

Searching for work – unemployment has been rising Businesses need to forecast demand changes –
quickly during the recent recession – how best can what might happen to sales and profits if there is a
an UK reduce the level of unemployment? severe downturn in the Chinese economy?

Households, Businesses, Government and the Trade Sector
In macroeconomics we look at things ‘in the whole’ and, in doing so, we use these terms:
• Households: receive income through wages and salaries from their jobs and from their investments
and then buy the output of firms (this is known as consumer spending and is labelled as C)
• Firms: Businesses hire land, labour and capital inputs when making products for which they pay
wages and rent (income). Firms receive payment from consumers and profitable businesses may
invest (I) a percentage of profits in new producer goods such as equipment and technology
• Government: collect taxes (T) to fund spending on public services such as education, healthcare
and defence. Government spending is given the label (G)
• International sector: The UK buys imports from other countries, (M) and overseas businesses and
consumers buy UK products – known as exports (X). International trade is important for the UK.
Millions of jobs depend directly or indirectly on the UK remaining competitive in overseas markets

A Selection of Key Economic Indicators for the UK
The table below provides an overview of some of the main macroeconomic indicators for the UK economy.

Economic Indicator 2014 2015* 2016*
Real gross domestic product (GDP) % change 3.0 2.4 2.3
Real GDP levels (2014=100) 100.0 102.4 104.8
Output gap (per cent of potential GDP) -‐1.0 -‐0.6 -‐0.4
Expenditure components of GDP

Household consumption (% change) 2.5 3.0 2.5
General government consumption (% change) 1.6 1.2 0.5
Business investment (% change) 8.0 6.0 7.2
General government investment (% change) 3.4 2.4 -‐0.1
:
Net trade (exports -‐ imports) (per cent of GDP) -‐0.6 -‐0.5 -‐0.4
Inflation

Consumer price index (annual % change) 1.5 0.1 1.1
The Labour Market

Employment (millions) 30.7 31.2 31.5
Average earnings (annual % change) 2.6 2.2 3.6
Labour Force Survey unemployment (% rate) 6.2 5.4 5.1
Claimant Count Unemployment (millions) 1.04 0.78 0.73

* Data for 2015 and 2016 is a forecast using data published at the time of the July 2015 Budget (Source:
Office for Budgetary Responsibility)

Macroeconomic stability
• Macroeconomic stability describes a situation where the key macro variables such as growth,
inflation, interest rates and investment do not change much from time to time.
The UK economy has enjoyed macro stability in the last few years. Economic growth has been above 2% per
year, inflation has remained low and unemployment has been falling. But our trade deficit has been getting

bigger and there remain some underlying long-‐term problems such as unaffordable housing and rising
levels of income inequality.

How do we measure the economic performance of developed and developing countries?
• Macroeconomic performance is how well a country is doing in reaching objectives of policy.
• The main aims are macroeconomic policies are to improve outcomes in these indicators:
1. Jobs – how high is unemployment? Is the economy creating enough new jobs for people entering
the labour market each year? Are there sufficient opportunities for people looking for work?
2. Prices –are price rises under control? Can the economy avoid a period of price deflation? Price
stability refers to low, stable, positive inflation of between 1-‐3% per year.
3. Trade – is the economy performing well in trading goods and services with other countries? How
competitive are British businesses in the global economy?
4. Growth – how successful has the country been in achieving growth and in laying the foundations
for future expansion and development
5. Development -‐ the expansion of people’s freedom to live long, healthy and creative lives
6. Efficiency -‐ is the economy improving productivity so that more goods and services can be supplied
at lower cost? Are we cutting the amount of energy we use per unit of output?
7. Public services – have the benefits of growth flowed through into better provision of state services
such as education, law and order, the National Health Service and transport?
8. The environment – whether economic growth is sustainable in terms of environmental impact.
9. Inequality of income and wealth -‐ leaving aside changes in average living standards, has the
economy made progress in achieving an acceptable distribution of income and wealth? Or has the
gap between lower and higher-‐income families become wider causing higher relative poverty?

The macroeconomic performance of any one nation is affected by events, policies and shocks in other
countries. No economy is immune to what is happening in the global financial and economic system.

Share of global GDP for a selection of countries (per cent, PPP adjusted) in 2014

18.0% 16.86%
16.1%
16.0%
Share in global GDP (per cent)
14.0%
12.0%
10.0%
8.0% 7.11%
6.0%
4.3%
4.0% 3.39% 3.07% 2.9%
2.35% 2.34%
2.0%
0.0%
China USA India Japan Germany Russia Brazil United France
Kingdom


2. Use of Index Numbers
Introduction to index numbers
• Index numbers are a useful way of expressing economic data time series and comparing /
contrasting information
• An index number is a figure reflecting price or quantity compared with a base value
• The base value always has an index number of 100
• The index number is then expressed as 100 times the ratio to the base value
• Note that index numbers have no units e.g. £, Euros or $
Examples of economic data in index number format
• FTSE-‐100 Share Index
• Consumer Prices Index (CPI)
• Exchange Rate Index
• Index of House Prices or Index of Property Rents
• Index of GDP or GNI (Gross National income)
• Human Development Index (HDI)
• Index of Production in Manufacturing

Calculating an index number
• Index number in Year Y = (Data Value in Year Y / Base Year Value)*100

Example of the calculation – UK house prices

Year Average UK House Price (£s) Index of UK House Prices
(2007=100)
2007 192,651 100.0 (Base Year)
2008 194,658 101.0
2009 159,961 82.2
2010 167,973 105.0
2011 162,915 97.0
2012 161,648 99.2
2013 163,593 101.2


Consumer Price Index
• The consumer price index is the main measure of changes in the cost of living in the UK.
• The base year for the chart below is 2005 and shows that – on average, prices in 2014 were 28%
higher in 2014 than they had been in 2005. It also shows that inflation in 2015 was close to zero as
the CPI remained at 128.
Consumer Price Index (CPI) in the United Kingdom from 2000 to 2015

140
128 128
130 126.1
123
119.6
120
Index (2005=100)
114.5
110.8
108.5
110 104.7
102.3
100
98
100 95.4 96.7
93.1 94.2
90
80
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Index numbers can be used to calculate percentage changes. The chart below shows the forecast rate of
inflation for the UK economy using data published in the July 2015 Budget by the Office for Budgetary
Responsibility.

Forecasted percentage change of the consumer price index (CPI) in the United Kingdom from 2015 to 2020

2.5%
2%
2.0% 1.9%
1.8%
1.6%
Percentage change
1.5%
1.1%
1.0%
0.5%
0.1%
0.0%
2015 2016 2017 2018 2019 2020


3. The Circular Flow of Income
What is the circular flow?
• This is a basic way of understanding how different parts of the economy fit together
• The circular flow of income and spending shows connections between different sectors
• It shows flows of goods and services and incomes to factors of production
• The circular flow shows how national income or Gross Domestic Product can be calculated
• Businesses produce goods and services and in the process of doing so, incomes are generated for
factors of production (land, labour, capital and enterprise)
What are injections into the circular flow?
There are three types of injection of extra spending into the circular flow model.
• Investment spending
• Exports of goods and services
• Government spending
What are leakages (withdrawals) from the circular flow
Not all income will flow from households to businesses directly.
The circular flow shows that some part of household income will be:
1. Put aside for future spending, i.e. savings (S) in banks accounts and other types of deposit
2. Paid to the government in taxation (T) e.g. income tax and national insurance
3. Spent on foreign-‐made goods and services, i.e. imports (M) which flow into the economy
Withdrawals are increases in savings, taxes or imports so reducing the circular flow of income and leading
to a multiplied contraction of production (output)

The Domestic Circular Flow of Income and Spending Diagram


The Circular Flow of Income and Spending with the External Sector added

Macroeconomic equilibrium
• An economy is in equilibrium when the rate of injections = the rate of withdrawals
• A rise in net injections will lead to an expansion of national output and income
• A rise in net leakages will bring about a contraction of national output and income
Net trade balances and injections / leakages
• When the value of exports > the value of imports, a country is running a trade surplus and this is a
net injection into the circular flow
• When the value of exports < the value of imports, a country is running a trade deficit and this is a
net leakage from the circular flow
The Budget Balance and the Circular Flow
• When a government is running an expansionary fiscal policy and operating with a bigger budget
deficit, government spending is greater than tax revenues, i.e. injections into the circular flow will
be higher than leakages, this will cause a rise in equilibrium national output
• At a time of fiscal austerity when a government is seeking to reduce the size of the budget deficit,
leakages from taxation will rising and/or injections from government spending will be falling. The
net effect of a reduction in the budget deficit is to cause a contraction of national output.

4. Measuring National Income

What is National Income?
• National income measures the monetary value of the flow of output of goods and services
produced in an economy over a period of time.
Measuring the level and rate of growth of national income (Y) is important for keeping track of:
• The rate of economic growth
• Changes to living standards
• Changes to the distribution of income between groups within the population

Gross Domestic Product
• Gross domestic product (GDP) is the total value of output produced in a given time period
• GDP includes the output of foreign owned businesses that are located in a nation following foreign
direct investment. For example, the output from the Nissan car plant in the north east contributes
to UK GDP
There are three ways of calculating GDP -‐ all of which in theory should sum to the same amount:

National Output = National Expenditure (Aggregate Demand) = National Income

(i) The Expenditure Method -‐ Aggregate Demand (AD)

The full equation for GDP using this approach is

GDP = C + I + G + (X-‐M) where
C: Household spending on goods and services
I: Capital Investment spending
G: Government spending
X: Exports of Goods and Services
M: Imports of Goods and Services

The Income Method – adding together factor incomes
GDP is the sum of the incomes earned through the production of goods and services. This is:
Income from people in jobs and in self-‐employment (e.g. wages and salaries)
+
Profits of private sector businesses
+
Rent income from the ownership of land
=
Gross Domestic product (by sum of factor incomes)

Only those incomes that are come from the production of goods and services are included in the
calculation of GDP by the income approach. We exclude from the calculation:
• Transfer payments e.g. the state pension; income support for families on low incomes; the
Jobseekers’ Allowance for the unemployed and other welfare assistance such housing benefit and
incapacity benefits

• Private transfers of money from one individual to another
• Income not registered with the tax authorities Every year, billions of pounds worth of activity is
not declared to the tax authorities. This is known as the shadow economy.
• Published figures for GDP by factor incomes will be inaccurate because much activity is not officially
recorded – including subsistence farming and barter transactions

The Distinction between Income and Wealth

Income Wealth
Income is a flow of money going to factors of Wealth is the current value of a stock of assets
production owned by someone or society as a whole
Wages and salaries from jobs Savings in bank accounts
Rental income from property Ownership of property
Interest from savings Shares / stocks in businesses
Profits flowing to shareholders Wealth held in pension schemes

Gross Value Added and Contributions to a nation’s GDP
• There are three main wealth-‐generating sectors in an economy – manufacturing and construction,
primary (including oil& gas, farming, forestry & fishing) and a wide range of service-‐sector
industries.
• This measure of GDP adds together the value of output produced by each of the productive sectors
in the economy using the concept of value added. .
Value added is the increase in the value of goods or services as a result of the production process

Value added = value of production -‐ value of intermediate goods

Say you buy a pizza from Dominos for £9.99. This is the retail price and will count as consumption. The
pizza has many ingredients at stages of the supply chain – tomato growers, dough, mushroom farmers and
also the value created by Dominos as they put the pizza together and deliver to the consumer. Some
products have a low value-‐added, for example cheap tee shirts selling for little more than £5. These are low
cost, high volume, low priced products. Other goods and services are such that lots of value can be added
as we move from sourcing the raw materials through to the final product. Examples include designer
jewellery, perfumes, meals in expensive restaurants and sports cars. And also the lucrative video games
industry.

GDP by Output (Value Added)
• The majority of UK GDP comes from service industries such as banking and finance, tourism,
retailing, education and health.
• In 2012, the service sector accounted for 79% of economic output, the manufacturing sector for
10% and the construction sector for 6%
Manufacturing
• Manufacturing is one of the production industries, which also include mining; electricity; water and
waste management; and oil and gas extraction.
• Production industries accounted for 16% of UK output in 2013. Many jobs have been lost in
manufacturing and construction in recent years.
• In 2013 there were 2.6 million jobs in manufacturing, 8% of all jobs in the UK

• Manufacturing and service industries are linked For example the health of a car exporting business
will have a direct bearing on demand, output, profits and jobs in many service businesses such as
transportation, design, marketing and vehicle retailing.
• Equally service businesses such as online banking require plenty of physical inputs such as
machinery and infrastructure to be successful.
Service sector industries
The main service sector industries in the UK are:
• Hotels and restaurants, and a range of services provided by local government
• Transport, logistics, storage and communication
• Business services and finance, motor trade, wholesale trades and retail trade
• Land transport and air transport, post and telecommunications
• Real estate activities, computer and related activities, Education, Health and social work
• Sewage and refuse disposal
• Recreational, cultural and sporting activities

Gross National Income (GNI)
• Gross National Income (GNI) measures the final value of incomes flowing to UK owned factors of
production whether they are located in the UK or overseas.
• Gross Domestic Income is concerned only with the incomes generated within the geographical
boundaries of the country. For example the value of the output produced by Toyota in the UK
counts towards British GDP but some of the profits made by overseas companies with production
plants here in the UK are sent back to their country of origin – adding to their GNP.
GNI = GDP + Net property income from abroad (NPIA)
• NPIA is the net balance of interest, profits and dividends (IPD) coming into the UK from our assets
owned overseas matched against the flow of profits and other income from foreign owned assets
located in the UK.
• There has been an increasing flow of foreign direct investment (FDI) into and out of the UK. Many
foreign firms have set up production plants here whilst UK firms have become multinationals
Remittances and Gross National Income
• Remittances are transfers of money across national boundaries by migrant workers. Despite a dip
because of the global recession, remittance flows have grown in the world economy over the
longer-‐term as the scale of migration between countries has grown.
• For many developing countries, money coming in from remittances is an importance source of
income adding to their Gross National Income (GNI)
• The top recipients of migrant remittances in 2012 were India ($70 billion), China ($66 billion), the
Philippines ($24 billion), Mexico ($24 billion), and Nigeria ($21 billion).
• The size of remittance flows to developing countries is now more than three times that of official
development assistance (aid).
• The United States accounted for the highest portion of remittances sent to other coutneries in
2014 with approximately $131 billion. Saudi Arabia's large migrant workforce saw it send $45
billion in remittances in 2014 while the UAE remitted $29 billion.


Nominal and Real GDP -‐ Measuring Real National Income
• Nominal income measures income at current prices with no adjustment for inflation e.g. if nominal
income is £40,000 in 2015 and rises by 5% in the next year, then nominal income will rise to
£42,000
Nominal Real
Monetary values
for data e.g. Adjusted for
inflaton
money GDP
Prices held at

Not inflaton level of the
adjusted
chosen base year
Data expressed
at current prices Data expressed
at constant
(i.e. today’s
prices
prices)

• When we want to measure growth we adjust for the effects of inflation and consider data in real
terms
• Real GDP measures the volume of output. An increase in real output means that AD has risen
faster than the rate of inflation and therefore the economy is experiencing positive growth.
This chart shows the nominal or money value of national output for the UK economy since 2000. It is
expressed at current prices i.e. it has not been adjusted for the effects of rising prices (inflation).

Nominal (money) value of UK GDP

2000000
1800000
1600000
1400000
UK GDP in £ million
1200000
1000000
800000
600000
400000
200000
0
00/01 01/02 02/03 03/04 04/05 05/06 06/07 07/08 08/09 09/10 10/11 11/12 12/13 13/14


Data on the Value and Growth of UK GDP and for Key Industries

Real GDP Real GDP Manufacturing Construction All Services

£ Million at
Per cent change Per cent change Per cent change Per cent change
Year constant 2011
year on year year on year year on year year on year
prices
2007 1,637,432 2.6 0.7 2.2 3.1
2008 1,631,995 -‐0.3 -‐2.9 -‐2.6 0.6
2009 1,561,646 -‐4.3 -‐9.4 -‐13.2 -‐2.9
2010 1,591,494 1.9 4.7 8.5 1.4
2011 1,617,677 1.6 1.8 2.2 2.1
2012 1,628,338 0.7 -‐1.3 -‐7.5 2
2013 1,655,447 1.7 -‐0.7 1.4 1.9
2014 1,704,998 3 3.1 9.5 3

Purchasing Power Parity (PPP) Measures of National Income
• PPP stands for purchasing power parity
• PPP measures how many units of one country’s currency are needed to buy exactly the same
basket of goods and services as can be bought with a given amount of another country’s currency
• In countries where the cost of living is relatively high, there will be a downward adjustment to a
nation’s PPP-‐adjusted GDP or GNI per capita
• Volatile exchange rates can have a big effect on real purchasing power of $100 in each country


5. Standard of Living and Well-‐Being
What is meant by the standard of living?
• The standard of living measures our material welfare
• The baseline measure is real national output per head of population or real GDP per capita
• Real income per capita is an inaccurate and insufficient indicator of living standards
• For many economists, there is a growing disconnect between GDP and wellbeing
Measuring Per Capita Gross National Income
• Income per capita is a way of measuring the standard of living for the inhabitants of a country.
• Real GDP Per Capita = real income per head of population
• Real Disposable Income = income after deduction of taxes + addition of benefits
Real GDP Per Capita Real Household Disposable Income

Year Q1 2008 = 100 Q1 2008 = 100
2007 Q1 98.6 101.0
2008 Q1 100.0 100.0
2009 Q1 93.5 99.1
2010 Q1 93.6 102.4
2011 Q1 94.8 99.1
2012 Q1 95.1 98.4
2013 Q1 95.4 98.6
2014 Q1 97.3 97.7
2015 Q1 99.4 101.4

GDP and GNI per capita
In recent years UK GNI per capita has fallen below GDP per capita because the net flow of investment
income has become negative. It has also taken a long time for real GDP per person to recover ground lost
in the recession.

7,000 1
£ per capita, at
6,800 0.9
constant 2011
6,600 prices 0.8
6,400 0.7
6,200 0.6
6,000 0.5
5,800 0.4
5,600 0.3
5,400 0.2
5,200 0.1
5,000 0
1997 Q1
1998 Q3
1999 Q2
2000 Q1
2001 Q3
2002 Q2
2003 Q1
2004 Q3
2005 Q2
2006 Q1
2007 Q3
2008 Q2
2009 Q1
2010 Q3
2011 Q2
2012 Q1
2013 Q3
2014 Q2
1997 Q4
2000 Q4
2003 Q4
2006 Q4
2009 Q4
2012 Q4
Real GNI per Capita Real GDP per capita


Data on Real Per Capita GDP for European Union Nations (2014)

GDP per capita GDP per capita
(Euros) (Euros)
Austria 34,900 Italy 26,500
Belgium 32,500 Latvia 17,600
Bulgaria 12,300 Lithuania 20,100
Croatia 16,100 Luxembourg 74,300
Cyprus 23,400 Malta 23,100
Czech Republic 22,900 Netherlands 36,000
Denmark 33,900 Poland 18,600
Estonia 19,900 Portugal 21,400
Finland 30,200 Romania 14,600
France 29,400 Slovakia 20,800
Germany 33,800 Slovenia 22,600
Greece 19,600 Spain 25,500
Hungary 18,500 Sweden 34,100
Ireland 36,100 United Kingdom 29,600

Countries with the highest per capita GDP in 2015

GDP per capita in U.S. dollars

0 20000 40000 60000 80000 100000 120000
Luxembourg 96,268.65
Switzerland 84,069.79
Qatar 81,602.85
Norway 80,748.9
United States 56,421.39
Iceland 54,331.4
Singapore 53,604.15
Denmark 52,821.79
Australia 52,454.12
Sweden 49,582.12
San Marino 49,139.01
Ireland 47,329.05
Canada 45,028.93
Austria 44,475.59
Netherlands 44,249.48


Problems in using national income statistics to measure living standards
1. Official data on GDP understates the growth of real national income per capita over time due to the
shadow economy and the value of unpaid work by volunteers and people caring for their family
2. The "shadow economy" includes illegal activities such as drug production and distribution,
prostitution, theft, fraud and concealed legal activities such as tax evasion on otherwise-‐legitimate
business activities such as un-‐reported self-‐employment income
3. Often official GDP data is inaccurate, e.g. many countries in sub-‐Saharan Africa do not update their
reporting often enough, and so their GDP numbers may miss large and fast-‐growing sectors, like
cell phones. In 2014 Nigeria became the largest economy in Africa (over-‐taking South Africa) after a
fundamental reassessment of their GDP calculation.
4. Reasons why GDP data may give a distorted picture of living standards in a country:
5. Regional variations in income and spending: National data can hide regional variations in output,
employment and income per head of the population
6. Inequalities in income and wealth: Average (mean) incomes might rise but inequality could grow
7. Leisure and working hours and working conditions: An increase in real GDP might have been
achieved at the expense of leisure time if workers are working longer hours or if working conditions
have deteriorated
8. Imbalances between consumption and investment: High levels of investment as a share of GDP
might be superb for creating extra capacity to produce but at the expense of consumer goods and
services for the current generation
9. Changes in life expectancy: Improvements in life expectancy don’t always show through in GDP
accounts. Putting a monetary value on the benefits of increased longevity is difficult
10. The value of non-‐marketed output: Much useful and valuable work is not sold in markets at
market prices. The value of the output of people working for charities, self-‐help groups and of
housework might reasonably be added to national income statistics
11. Innovation and the development of new products: New goods and services become available
because of invention and innovation that simply would not have been available to the richest
person on earth less than fifty years ago. About half of what we spend our money on now was not
invented in 1870. Examples include air travel, cars, computers, antibiotics, hip replacements, insulin
and many other life-‐enhancing and life-‐saving drugs
12. Environmental considerations: Rising output might have been accompanied by an increase in air
and noise pollution and other externality effects that have a negative effect on our social welfare
13. Defensive expenditures: Much spending is to protect against an economic or social bad e.g. crime,
or spending to clean up the effects of pollution and waste
Sex, Drugs and GDP in the UK
• In 2014 the UK started the process of including estimates of incomes and spending from the
shadow economy in the GDP figure
• According to estimates, sex work generated £5.3bn for the British economy in 2013
• £4.4bn came from the sale of cannabis, heroin, powder cocaine, crack cocaine, ecstasy and
amphetamines
• It was estimated that there were 2.2 million cannabis users in the UK in 2009, growing cannabis
worth more than £1.2bn. Half was home-‐grown – costing £154m in heat, light and "raw materials"
to produce


What has happened to Living Standards in the UK?

There are two measures of living standards shown here – real GDP per capita and also real household
disposable income (RHDI)

Index numbers, 2008Q1 = 100 106
GDP per Capita RHDI Per Capita

104
102
100
98
96
94
92
90
2007 Q2 2008 Q2 2009 Q1 2010 Q1 2011 Q4 2012 Q4 2013 Q3 2014 Q3 2015
Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1

The difference between economic growth and economic welfare

Economic Economic
growth welfare
A broader measure of
Sustained growth of real well-‐being (social +
GDP over tme
economic)
Many aspects of well-‐

Contributes to rising being are not material
living standards as per aspects of life -‐ and are
capita incomes grow not measured by GDP
statstcs
Welfare measure might

Long run growth is an include changes in
increase in a country’s income and wealth
productve potental inequality + trends in
median incomes

GDP as the traditional yardstick for measuring living standards has come under pressure. Economic
wellbeing is a multi-‐dimensional concept and covers a much wider range of indicators:

Real Gross Domestc Product per capita
Real Household Spending per head
Median Household Income
Household Net Wealth (i.e. value of assets – liabilites)
Unemployment rate (household income and net wealth.
Financial situaton of households + feeling of security

Median Incomes
• Household income measures the flow of income that finds its way to households each year.
• The median is better than the mean since it is reflective of progress in the middle of the income
distribution. For example, increases in GDP that go solely to the rich would not increase this
measure.
• Looking at median income would create more focus on inclusive growth that generates wider
benefits.
Links between real incomes and subjective happiness
• Traditional economic theory assumed a positive relationship between income and happiness
• Standards measures of progress such as GDP per capita are increasingly considered an incomplete
picture of the state of the nation
• Plenty of evidence that happiness does not increase beyond a certain income threshold
• The Easterlin Paradox emerged in the 1970s associated with US economist Richard Easterlin
• The Easterlin Paradox concerns whether we are actually happier and more contented as our living
standards improve over time
The Easterlin Paradox
• Within a society, rich people tend to be much happier than poor people.
• But, rich societies tend not to be happier than poor societies (or not by much).
• As countries get richer, they do not get happier.
• Easterlin argued that life satisfaction does rise with average incomes but only up to a point. Beyond
that the marginal gain in happiness declines.
• One of Easterlin’s conclusions was that someone’s relative income weighs heavily on people’s
minds.
• Faced with this choice what would you rather have?
o You get £5,000 and a friend gets £3,000 or
o You get £10,000 and a friend gets £15,000


Data on Income Satisfaction in the UK from 2006-‐2012
• To what extent has the slow recovery in Britain affected measured economic wellbeing?
• 2009 was a year of recession and the following years saw a delayed, slow recovery including the
start of a period of fiscal austerity (rising taxes and deep cuts in government spending)
• The percentage of people somewhat, mostly or completely satisfied with their income has declined
from 60.2% in 2007 to 43.4% in 2012.
Satisfaction with current

2006 2007 2008 2009 2010 2011 2012
income (% of responses)
Completely satisfied 9.7 9.6 8.5 8.6 9.3 7.0 8.7
Mostly satisfied 20.7 22.4 20.4 28.7 28.6 26.7 27.9
Somewhat satisfied 28.0 28.2 29.5 19.9 19.4 18.9 16.9
Somewhat dissatisfied 12.0 11.3 11.9 14.8 15.1 16.2 15.3
Mostly dissatisfied 5.6 5.2 5.3 8.1 8.3 11.8 11.1
Completely dissatisfied 3.7 3.2 3.6 5.8 5.6 6.1 6.7
Somewhat, mostly or

58.4 60.2 58.5 57.2 57.3 52.6 53.4
completely satisfied

Some Strategies to Improve Living Standards
• Living standards improve when an economy is able to sustain a rise in real per capita incomes over
the long run and when the benefits of growth are widely spread
• Some policy ideas for improving the standard of living are summarised in the graphic below
Incentves to increase A living wage to boost

Improving human capital employment productvity
Accessible + high quality Bewer / affordable housing Wealth from successful

public services to rent & buy businesses


Persistent low pay and low living standards
One of the main barriers for people to raise their living standards is the high percentage of people in work
who are poorly paid – the chart below shows the percentage shares of a selection of occupation groups
earning below the Living Wage in Great Britain in April 2013.

Share earning below Living Wage

0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0%
Elementary occupatons 59%
Sales & customer service 55%
Personal services 35%
Process, plant & machinery operatves 23%
Skilled trades 17%
Admin & secretarial 14%
Managers & senior officials 5%
Associate professional & technical 4%
Professional 1%

The pay gap between skilled and unskilled workers is actually greater in UK than anywhere else in the OECD

Median gross full-‐time annual salary for the highest earning occupations in the UK as of November 2014

Median gross annual earnings in GBP

0 20000 40000 60000 80000 100000
Aircraz pilots and flight engineers 90,420
Chief executves and senior officials 81,521
Air traffic controllers 79,874
Medical practtoners 71,141
Marketng and sales directors 70,742
Informaton technology and telecommunicatons 64,511
Financial managers and directors 61,108
Senior police officers 57,896
Financial insttuton managers and directors 53,621
Senior professionals of educatonal establishments 50,367


6. What are the Objectives of Macroeconomic Policy?

Price Stability (CPI Inflakon Growth of Real GDP Falling Unemployment /
of 2%) (Nakonal Output) Raising Employment
Higher Average Living

Standards (nakonal income Stable Balance of Payments An Equitable Distribukon of
on the Current Account Income and Wealth
per capita)

What are objectives of macroeconomic policy?
• Objectives are the goals of government policy
• Instruments are the means by which these aims might be achieved
Additional macroeconomic objectives

Balancing the budget and Improving economic Beler regional balance in
reducing the nakonal debt well-‐being the UK economy
Improved access to Improved Environmental

public services compekkveness sustainability

The importance attached to each of these macroeconomic objectives will change over time and will vary
across countries depending on their stage of economic development.

7. Aggregate Demand

Growth Rates for the Components of Aggregate Demand in the UK
Consumption Government Exports Imports
Investment (I)
(C) Spending (G) (X) (M)
Year Per cent Per cent Per cent Per cent Per cent
2008 -‐0.5 2.0 -‐4.7 1.6 -‐1.8
2009 -‐3.3 1.2 -‐14.4 -‐8.2 -‐9.8
2010 0.5 0.0 5.9 6.2 8.7
2011 -‐0.1 0.0 2.3 5.6 1.0
2012 1.5 2.3 0.7 0.7 3.1
2013 1.7 -‐0.3 3.4 1.5 1.4
2014 2.6 1.6 8.6 0.5 2.4

The Characteristics of Aggregate Demand
• Aggregate demand (AD) = total spending on goods and services
AD = C + I + G + (X-‐M)
• C: Consumers' expenditure on goods and services: Also known as consumption, this includes
demand for durables e.g. audio-‐visual equipment & non-‐durable goods such as food and drinks
• I: Capital Investment – This is spending by businesses and the government on capital goods such as
plant and equipment, technology and new buildings to produce consumer goods in the future.
o Capital investment spending accounts for between 15-‐20% of GDP in any given year.
o Of this investment, 75% comes from private sector businesses such as Tesco, British
Airways and British Petroleum and the remainder is spent by the government – for example
building new schools or in improving rail or road networks.
o Investment has important effects on the supply-‐side as well as being a component of AD.
o A small part of investment is the change in the value of stocks. Producers may find either
than demand is running higher than output (i.e. stocks will fall) or that demand is weaker
than expected and below current output (in which case the value of stocks will rise.)
• G: Government Spending – This is spending on state-‐provided goods and services including public
goods and merit goods. Decisions on how much the government will spend each year are affected
by developments in the economy and the political priorities of the government.
o Government spending on goods and services is around 18-‐20% of GDP but this tends to
understate the true size of the government sector in the economy. Firstly some spending is
on investment and a sizeable amount goes on welfare state payments.
o Transfer payments in the form of benefits (e.g. state pensions and the job-‐seekers
allowance) are not included in current government spending because they are a transfer
from one group (i.e. people paying income taxes) to another (i.e. pensioners)
• X: Exports of goods and services -‐ Exports sold overseas are an inflow of demand (an injection) into
our circular flow of income and spending, adding to aggregate demand.
• M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from the
circular flow of income and spending.
• Net exports measure the value of exports minus the value of imports. When net exports are
positive, there is a trade surplus (adding to AD); when net exports are negative, there is a trade
deficit (reducing AD). The UK has been running a large trade deficit for several years now.

Components of Aggregate Demand for the UK Economy

Consumption Government Exports Imports
Investment (I)
(C) Spending (G) (X) (M)
Year £ Billion £ Billion £ Billion £ Billion £ Billion
2008 1016 333 281 485 528
2009 982 337 240 445 476
2010 987 337 254 472 518
2011 985 337 260 499 523
2012 1000 345 262 502 539
2013 1018 344 271 510 547
2014 1044 349 294 512 560

Shocks to Aggregate Demand
• Many unexpected events cause changes in the level of demand, output and employment
• These events are called “shocks”. Some of the causes of AD shocks are as follows:
1. A large rise or fall in the exchange rate – affecting export demand and second-‐round effects on
output, employment, incomes and profits of businesses linked to export industries.
2. A recession in main trading partners affecting demand for exports of goods and services.
3. A slump in the housing market or a big change in share prices
4. An event such as the credit crunch (global financial crisis) – involving a fall in the amount of credit
available for borrowing by households and businesses.
5. An unexpected cut or an unexpected rise in interest rates or change in government taxation and
spending – for example deep cuts in government spending as part of fiscal austerity
These shocks will bring about a shift in the aggregate demand curve

The Aggregate Demand Curve
• The AD curve shows the relationship between the general price level and real GDP
The Relationship between Aggregate Demand and the General Price Level
• There are several explanations for an inverse relationship between AD and the price level
1. Falling real incomes: As the price level rises, the real value of people’s incomes fall and consumers
are less able to buy the items they want or need. If over the course of a year all prices rose by 10
per cent whilst your money income remained the same, your real income would have fallen by 10%
2. The balance of trade: A persistent rise in the price of level of Country X could make foreign-‐
produced goods and services cheaper in price terms, causing a fall in exports and a rise in imports.
This will lead to a reduction in net trade and a contraction in AD
3. Interest rate effect: if the price level rises, this causes inflation and an increase in the demand for
money and a possible rise in interest rates with a deflationary effect on the economy. This assumes
that the central bank (in our case the Bank of England) is setting interest rates in order to meet a
specified inflation target.


FACTORS CAUSING A SHIFT IN AGGREGATE DEMAND
Changes in Expectations • When confidence falls, we see an increase in saving and
Current spending is affected by businesses postpone investment projects because of worries
anticipated income and inflation over weak demand and lower expected profits.
Changes in Monetary Policy – i.e. • If interest rates fall – this lowers the cost of borrowing and the
a change in interest rates incentive to save, encouraging consumption & investment
• There are time lags between changes in interest rates and AD
Changes in Fiscal Policy • The Government may increase its expenditure e.g. financed by
Fiscal Policy refers to changes in a higher budget deficit -‐ this directly increases AD
government spending, taxation • Income tax affects disposable income e.g. lower income tax
and borrowing raises disposable income and should boost consumption.
Economic events in the world • A depreciation in a currency makes imports dearer and exports
economy cheaper -‐ the result should be that AD grows
International factors such as the • An increase in overseas incomes raises demand for exports. In
exchange rate and foreign income contrast a recession in a major export market will lead to a fall
in exports and an inward shift of aggregate demand.
Changes in household wealth • Changing share and property prices affect the level of wealth
• Declining asset prices can hit confidence / a fall in expectations
Changes in the supply of credit • The availability of credit from the banking system is vital for
the smooth functioning of most modern economies

Examples of Causes of Shifts in Aggregate Demand

Fall in AD Increase in AD
Fall in exports Depreciaton of the exchange rate
Cut in government spending Cuts in direct and indirect taxes
Higher interest rates Increase in house prices
Expansion of supply of credit + lower

Decline in household wealth interest rates


8. Consumer Spending
Introduction
• Consumption is spending by households on goods & services
• Consumption is the biggest single component of aggregate demand
• The main sources of consumer incomes are wages, savings, investments, pensions and benefits.
• In 2012 consumer spending in the UK was £927 billion out of a total GDP level of £1504 billion
• Consumption is the biggest component of UK aggregate demand; in 2012 it was 61% of GDP
Some Key Terms

Base interest rate Set by the Bank of England, it is the rate of interest used by commercial banks
as the basis for their lending rates. Base rates are set by the Monetary Policy
Committee
Consumer price index A measure of the price level based on the prices of a collection of goods and
(CPI) services that are designed to reflect the consumption basket of the average
consumer / household
Disposable income Household income after the deduction of taxes and the addition of welfare
benefits.
FTSE-‐100 Index The FTSE-‐100 tracks the share-‐prices of the 100 largest companies listed on the
London Stock Exchange, based on their market capitalisation
Savings ratio The ratio of personal saving to household disposable income
Unemployment The official definition includes someone who is either out of work and actively
looking for a job or out of work and waiting to start a job in the next two weeks.
Value added tax (VAT) A tax on consumption, which is paid to the tax authorities by the seller on
behalf of the consumer. The standard rate of VAT in the UK is 20%

Disposable income and spending – the propensity to spend
• John Maynard Keynes was a major figure in the history of economics
developed a theory of consumption that depended mainly on disposable
income.
• Disposable income is household income after the deduction of taxes and
the addition of welfare benefits such as the state pension and family credit
The Marginal Propensity to Consume and the Propensity of Save
• What matters is the rate at which consumers increase their spending as
income rises. This is called the marginal propensity to consume.
• Say that someone receives extra pay of £2000 in a year and they spend
£1500, thus the marginal propensity to consume is £1500 / £2000 = 0.75.
• The remainder is saved so the marginal propensity to save is 0.25.
• A simple rule to remember is that the marginal propensity to consumer added to the marginal
propensity to save must always equal 1.
Generally, people on lower incomes tend to have a higher propensity to spend. This matters when the
government announces changes in taxation and the level of welfare benefits because if incone is
redistributed to lower income families, there might be an overall increase in consumer demand. A fall in
the marginal propensity to spend will cause a lower level of consumption for a given level of income.

Some Factors that Determine Consumer Spending
Many factors have an influence on the total level of consumer spending in an economy.
• Real incomes – if people’s money wages rise faster than prices, then real incomes will increase and
this leads to a higher level of real purchasing power
• Direct and indirect taxation – if there is a cut in direct taxation then, other factors remaining the
same, consumers will experience an increase in their disposable income and spending power. In
contrast, a hike in indirect taxes such as import duties or VAT will cause prices to rise and real
incomes to decline.
• Interest Rates – lower interest rates cuts the cost of paying the debt on a mortgage and increases
the effective disposable income of homeowners. Official interest rates in the UK have been at 0.5%
since March 2009.
• Household Wealth – for example a sustained drop in house prices might cause a decline in
personal wealth and spending as homeowners have less housing equity available to borrow. This is
sometimes referred to as the negative wealth effect. Housing equity is the difference between the
market value of property and the outstanding mortgage loan.
• Consumer Confidence – for example, fears of rising unemployment and expectations of higher
taxes will hit consumer sentiment and spending. If you don’t have enough confidence, you are
unlikely to go ahead with major purchases such as a new car or home improvements
• The Supply of Credit: In recent years banks have appeared to become less willing to lend and if
they do, the rate of interest on the loan has increased. The supply of mortgage finance has dried up
and would-‐be homebuyers now need to find a bigger deposit before getting a home loan.
• The Distribution of Income: Lower income families tend to have a higher propensity to consume
than better-‐off households (who tend to have a higher savings ratio). Thus a redistribution of
income towards poorer families may have the effect of boosting total consumer demand.
• Demographics: The size and growth rate of a country’s population and the age structure has a
direct effect on total consumer spending. Some countries have a strongly positive natural rate of
population growth perhaps aided by net migration of labour. An expanding population will add to
demand for many different goods and services including housing, health care and education.
Consumer Confidence
• Consumer confidence is measured using surveys that ask people about their own financial situation
• When consumer confidence is low, people save more because of low job security
• The Global Financial Crisis brought about a big shock to consumer and business confidence in many
countries across the world
• Expectations are really important – Keynes wrote about the uncertain “animal spirits” of agents in
the economy that affect their planned spending, saving and investment.
• Consumer confidence is affected by many factors including the following

Economic growth Household debt
Unemployment House prices

Mortgage Interest Rates and Consumer Spending

Average interest rates for mortgages in the United Kingdom (UK) as of March 2014, by type of mortgage

5.0%
4.43%
4.5%
4.0%
3.47%
3.5%
Average interest rate
2.97%
3.0% 2.83%
2.37%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
2 year fixed rate 3 year fixed 5 year fixed Tracker mortgages SVR mortgages**
mortgages mortgage mortgage

(SVR stands for standard variable rate mortgage)
• If mortgage interest rates fall then the effective disposable income of families with a mortgage will
rise giving them more purchasing power to buy other goods and services
• A sizeable majority of home-‐owners have fixed rate mortgages in which case changes in mortgage
interest rates will not affect them immediately

• Since 2009, mortgage interest rates have been lower, giving a significant increase to the spending
power of existing people in the housing market and this has helped to bolster consumer confidence
The Wealth Effect
• Wealth represents the value of a stock of assets
• For most people the majority of their wealth is held in property, shares in quoted companies on
the stock market, savings in banks and money building up in occupational pension schemes
• Many economists think that there is a positive relationship between wealth and spending although
the size of the effect is open to question.
• For millions of people, assets in the form of savings and occupational pension schemes are
important. So the real value of their savings and the income that flows from deposit accounts from
interest payments will have a direct effect on their spending power.
• In recent years the average rate of interest on UK savings deposits have less than the rate of
inflation – causing a cut in the real purchasing power of savers
House Prices
• There was a surge in house prices between 2004 and 2007. This was a direct result of the credit
boom and, as a result, property prices climbed to unsustainable levels.
• Recession helped bring prices down but in 2013 they started to rise once more at a fast rate and
they continued to rise in 2014 and 2015. Will this help the UK economy or be a problem going
forward?
• The next chart shows average house prices in the UK using data from the Halifax House Price Index

280000
Average mix-‐adjusted house price in £s
275000
270000
265000
260000
255000
250000
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May
'14 '14 '14 '14 '14 '14 '14 '14 '14 '14 '14 '14 '15 '15 '15 '15 '15
January 2014 to May 2015


Share prices and consumer spending

Yearly highs and lows of the FTSE 100 Index (London Stock Exchange) between 1995 and 2014

Highs Lows
8000
7000
Changes of the FTSE 100 Index in points
6000
5000
4000
3000
2000
1000
0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

• The FTSE-‐100, tracks share-‐price movements in the 100 largest companies by market capitalization
listed on the London Stock Exchange.
• A rise in the FTSE-‐100 might help to increase consumer spending if it causes a rise in confidence.
• Consumer spending power might also be boosted from a rise in share dividend payments from
listed companies, dividend income adds directly to disposable incomes for shareholders.
Consumer borrowing
• Most of us at some time in our lives need to borrow money to finance spending. The credit market
for individuals is complex. Broadly speaking we can distinguish between:
1. Unsecured borrowing – that is a loan or an overdraft not tied to the value of another asset.
Examples of this are student overdrafts, bank loans and money borrowed on store and credit cards
2. Secured borrowing – is lending where the borrower must use another asset as collateral for the
loan. The best example is a mortgage with a bank or building society. Homebuyers are at risk if they
fail to keep up with mortgage repayments and ultimately, the lender may seek repossession of the
property.


Annual growth rates of consumer credit in high street banks in the United Kingdom (UK) from 2010 to 2015

4.6%
5.0%
4.0%
3.0%
2.1%
2.0%
Growth rate
1.0%
0.0% -‐0.5%
-‐1.1%
-‐1.0%
-‐1.9%
-‐2.0% -‐2.8%
-‐3.0%
-‐4.0%
June 2010 Jun 11 Jun 12 Jun 13 Jun 14 Jun 15

In Britain, the majority of the outstanding debt owed by households is secured debt in the property market
and this reflects the significance of the housing market in influencing consumer spending and financial
stability.

Affordability of buying or moving house according to the United Kingdom (UK) adults as of 2015, by issue

Very serious problem Somewhat serious problem
60.0%
54%
48%
50.0%
40% 40%
Share of respondents
40.0% 35% 36%

32%
30%
30.0%
20.0%
10.0%
0.0%
Ge•ng onto property Saving for a deposit to House prices Ability to get a mortgage
ladder (first-‐tme buyers) buy or remortgage


9. Household Saving
Savings in the Economy
• Saving is household disposable income that is not spent i.e. it is deferred spending
• Disposable income = income after taxes and benefits
• The savings ratio is the % of disposable income saved rather than spent e.g. if a person has an
annual income of £25,000 and saves £2500 of this, then the savings ratio is 10%
• A high savings ratio lowers consumption and aggregate demand for goods and services
Motivations for saving
There are many different motivations. Some are short term e.g. for a holiday, others are long-‐term e.g.
funding college fees. The chart below tracks motivations for saving from a survey of US households.


0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0%
Rainy day fund/unexpected expenses 65%
Retrement 52%
Vacaton 31%
College 20%
Car purchase 15%
Home purchase 11%
Marriage 4%
Birth of a child 4%
Other 14%

What factors affect how much of their income people save?

= Nominal interest rate adjusted for inflation, a positive real interest
Real Interest Rate
rate incentivises saving
If consumers expect prices to fall (i.e. deflation) they may choose to
Price Expectations
save more now
Consumer borrowing counts of dis-‐saving (spending > current
Availability of Credit
income)
Unemployment / Job Security When unemployment is rising, people save more as a precaution
Consumer Confidence / Expectations When consumer confidence is strong, people are more willing to
/ Uncertainty borrow and save less
Interest on many types of saving is taxed, some savings schemes
Taxation of Savings
are tax-‐free or low-‐tax
Deposit guarantees can encourage a higher level of household
Trust in Savings Institutions
saving in banks
Short-‐term saving to repay credit card bills or save for a mortgage
Need to pay back debt
deposit


Data for UK Households on Level of Savings Balances

60.0%
55%
50.0%
40.0%
30.0%
19%
20.0%
15%
12%
10.0%
0.0%
No savings Have between 1 and Have over 50,000 GBP in Don't know
50,000 GBP in savings savings

• Around one fifth of households in the UK have no savings at all – indeed many are dependent on
short term credit from month to month.
• The majority of households with savings have less than £10,000 saved. One third have less than
£500. One family in 20 has more than £100,000
Savings for All UK Families with Savings

80.0% 75%
70.0%
60.0% 56%
48%
50.0%
41%
40.0% 35%
31%
30.0%
20.0%
10.0% 5%
0.0%
Less than Less than Less than Less than Less than Less than More than
£500 saved £1000 saved £2000 saved £5000 saved £10000 saved £50000 saved £100,000
saved

Evaluating the importance of saving for an economy

Decisions by people and by businesses about how much to save have a powerful effect on economic
performance – here are some reasons:
1. Corporate savings provide a cushion during a recession when demand and profits fall. Business
savings can be used as finance for takeovers and for capital investment projects
a. Savings by families flow into financial institutions
b. Banks need deposits as capital from which they can lend. Many small businesses have
complained about the difficulty in getting loans in the aftermath of the global financial
crisis
c. Savings flow into pension funds – these can be reinvested in stock markets providing funds
for businesses that need to raise capital to finance expansion plans.
2. Savings provide a source of household wealth and a buffer against uncertain times allowing people
to smooth out their consumption when times are tough. They allow people to reduce debts and
save to allow a reasonable standard of living during retirement.
The Paradox of Thrift
• The paradox of thrift is an idea from Keynesian economics. Saving is regarded as positive because it
provides the funds to finance the capital investment needed to promote long-‐term growth
• But if many people start saving more at the same time, this causes a drop in consumer demand and
an even deeper recession
• What might be rational for an individual might be damaging for the economy as a whole

The UK Household Savings Ratio
• The chart below shows the published measure for the savings ratio
• The savings ratio is the percentage of household disposable income that is saved rather then spent
• The savings ratio climbed during the recession but has been falling since then back towards 6%
Household Savings Ratio (Per Cent of Disposable Income)

14
12
10
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

10.Capital Investment
Introduction to Investment
• Investment is spending on capital goods such as new factories & other buildings machinery &
vehicles
• Much investment include and takes advantages of advances in technology
• Investment is a component of AD, and is a factor affecting competitiveness in a globalising world
• In market economies, most investment is done by private sector businesses but a substantial
amount comes from the government (in the state sector)
• A broader definition of investment includes spending on improving the human capital of the
workforce through training and education to improve the skills and competences of workers
• Infrastructure is spending on new sewers, roads, wind farms, telecommunications networks and
ports done by both the private and the public sector.
Gross and Net Investment
1. Gross investment spending is the total amount that the economy spends on new capital. But this
figure includes an estimate for the value of capital depreciation since some investment is needed
each year just to replace technologically obsolete or worn-‐out plant and machinery.
2. If gross investment is higher than depreciation, then net investment will be positive and this means
that businesses will have a higher productive capacity and can meet rising demand in the future
3. Gross investment – capital depreciation = net investment
Gross Net
Investment Investment
Gross investment spending is
total investment on new = Gross investment adjusted
for capital consumpton
capital inputs
It is the total amount that Some new investment

the economy spends on new needed each year to replace
capital worn out machinery

Investment and Aggregate Demand
• Investment is a component of AD i.e. (C+I+G+X-‐M). Businesses involved in developing,
manufacturing, testing, distributing and marketing the capital goods themselves stand to benefit
from increased orders for new plant and machinery.
• A rise in capital spending will have a positive multiplier effect Increased spending on capital goods
boosts demand for industries that manufacture the technology / hardware / construction sector


Investment and Jobs
• Some investment projects cost jobs when a business replaces labour with capital inputs.
• Investment also creates jobs in producing, designing and installing plant and equipment
Importance of the Quality of Capital Investment

• A high level of investment on its own may not be sufficient to create an increase in LRAS as workers
need training to work the new machinery and there will be time lags between new capital spending
and the effects on output and productivity.
• If there is insufficient demand, a growing capital stock may lead to excess capacity putting
downward pressure on prices and profits

Implications of a Rise in Business Investment
Higher investment can raise actual and potential GDP and also help to control inflationary pressures.

Macroeconomic advantages of a higher level of capital
Evaluation point
investment
Investment is an injection into the circular flow of Some of the investment (capital) goods might
income – it is a component of AD be imported – a leakage from the circular flow
New capital can boost productivity and creates Might be a lengthy time lag between workers
additional capacity to supply getting more capital and productivity rising
Creates extra demand in investment goods industries Some capital investment replaces labour and
and can lead to multiplier effects on the level of GDP therefore might cause unemployment
Investment will boost a country’s competitiveness and Many other factors affect competitiveness –
therefore improve the trade balance including the level of the exchange rate

The Accelerator Effect (The Link between Consumption and Investment)
• The accelerator effect is a relationship between planned capital investment and the rate of change
of national income (GDP)
• Consider an industry where demand is rising quickly
• Firms may respond initially by using their existing productive capacity more intensively or running
down stocks of finished products
• If they expect high demand will be sustained – they may increase spending on plant and machinery,
factories and new technology in order to increase their supply capacity
• This causes an accelerator effect – where a given change in demand for consumer goods and
services will cause a bigger percentage change in demand for capital goods
The Negative Accelerator Effect
• When the rate of growth of demand in an industry slows then net investment spending by
businesses often falls. E.g. declining investment in steel plants in a recession or a drop in
investment demand when government subsidies for renewable energy are cut


Examples of the Accelerator Effect in Action

Investment to create extra capacity in Investment in 4G mobile networks to
cloud computng storage services meet rising household and business
demand
Expanding the fleet sizes of growing Capital investment in renewable
airlines especially for low-‐cost short energy as the balance of energy
destnatons supply shizs towards renewables

Economic Importance of Infrastructure Investment
Infrastructure spending includes projects for new sewers, roads, wind farms, telecommunications networks
and ports by both the private and the public sector. The UK has a national infrastructure plan designed at
fast-‐forwarding major projects including transport investment and capital spending in the energy sector.

Examples of UK infrastructure projects
•  2nd Forth Road Bridge
•  Cross Rail and the High Speed Rail project
•  London Gateway Port & new London super sewer
•  Nuclear power plants including Hinkley Point
Economic significance of infrastructure

•  Potentally high mulkplier effects from mult-‐billion investment projects – boosts
AD and jobs
•  Lack of infrastructure may discourage FDI
•  Increases the capital stock / produckve potenkal


11.Understanding Aggregate Supply

What do we mean by aggregate supply?
• Aggregate supply (AS) measures the volume of goods and services produced each year. AS
represents the ability of an economy to deliver goods and services to meet demand
• Short run aggregate supply (SRAS) shows total planned output when prices can change but the
prices and productivity of factor inputs e.g. wage rates and the state of technology are held
constant.
• Long run aggregate supply (LRAS): LRAS shows total planned output when both prices and average
wage rates can change – it is a measure of a country’s potential output and the concept is linked to
the production possibility frontier
• In the long run, the LRAS curve is assumed to be vertical (i.e. it does not change when the general
price level changes)
• In the short run, the SRAS curve is assumed to be upward sloping (i.e. it is responsive to a change in
aggregate demand reflected in a change in the general price level)
Short Run Aggregate Supply Curve
A change in the price level brought about by a shift in AD results in a movement along the short run AS
curve. If AD rises, we see an expansion of SRAS; if AD falls we see a contraction of SRAS.

Shifts in Short Run Aggregate Supply (SRAS)

Shifts in the position of the short run aggregate supply curve in the price level / output space are caused by
changes in the conditions of supply for different sectors of the economy:

The main cause of a shift in the aggregate supply curve is a change in business costs – for example:
1. Changes in unit labour costs: Unit labour costs are wage costs adjusted for productivity. A rise in
unit labour costs might due to higher wages or a fall in the level labour of productivity
2. Changes in other production costs: For example rental costs for retailers, the price of building
materials for the construction industry, a change in the price of hops used in beer making or the
cost of fertilisers used in farming.

3. Commodity prices Changes to raw material costs and other components e.g. the prices of oil,
natural gas, electricity copper, rubber, iron ore, aluminium and other inputs will affect a firm’s costs
4. Exchange rates: Costs might be affected by a change in the exchange rate which causes fluctuations
in the prices of imported products. A fall (depreciation) in the exchange rate increases the costs of
importing raw materials and component supplies from overseas
5. Government taxation and subsidies:
a. An increase in taxes to meet environmental objectives (known as green taxes) will cause
higher costs and an inward shift in the SRAS curve – for example a higher price for carbon
emissions
b. Lower duty on petrol and diesel would lower costs and cause an outward shift in SRAS
6. The price of imports:
a. Cheaper imports from a lower-‐cost country has the effect of shifting out SRAS
b. A reduction in an import tariff on imports or an increase in the size of an import quota will
also boost the supply available at each price level causing an outward shift of SRAS
7. Short run shocks to production: Temporary non-‐economic factors affect SRAS in different
countries, for example a hurricane, a tsunami or the effects of drought, flooding or political crisis.

Key revision point:
The main driver of SRAS for the economy is the level of production costs some of which are influenced by
government policy, others by world prices. Remember that the exchange rate is important for the UK
because a large percentage of our components / raw materials / energy are imported.


External Factors affecting Aggregate Supply (AS)

World oil and gas prices
• The UK is a net importer of oil – an input used in many different industries
Energy prices / costs
• The UK is also a net importer of energy source such as coal
Other mineral / metal prices
• E.g. Rubber, iron ore, rare earths (used in many electronic products)
Foodstuff prices
• E.g. Internatonal prices for fresh foods, coffee, wheat, cocoa, sugar
Import tariffs / quotas
• The UK is a member of the European Union which sets a common import tariff on different goods
and services coming into the EU Single Market


Changes in global oil prices affect aggregate supply

Year on Year change in
US Dollar Oil Price UK Oil Price
oil prices
Year US $ per barrel £ per barrel Per cent
2007 73 36.2 0.9
2008 98 52.1 43.9
2009 63 39.7 -‐23.9
2010 80 52.0 31.0
2011 111 69.2 33.0
2012 112 70.5 1.9
2013 109 69.5 -‐1.3
2014 99 60.1 -‐13.5
2015 (May) 65 42.7 -‐34.3

Evaluating Economic Effects of Falling Oil Prices

Changes in world oil prices have effects on the demand and supply-‐side of an economy. The UK is a net
importer of oil but is also an oil producer and exporter. On balance, lower oil prices are good for economic
growth in the UK because lower prices for consumers and businesses effectively act like a tax cut.

Cheaper fuel for motorists and

businesses if lower costs are Decline in value of oil exports + Possible fall in exploraton &
cheaper imports extracton in the North Sea
passed on in retail prices
Falling energy costs bring down As oil exporter, the UK

Renewable energy may be less inflaton -‐ possible risk of exchange rate may fall helping
economically viable
deflaton other export industries


Long Run Aggregate Supply (LRAS)

In the long run, the ability of an economy to produce goods and services to meet demand is based on the
state of production technology and the availability and quality of factor inputs.

Trend Growth
Trend growth is the estimated rate of growth of a nation’s productive potential. The table shows data for
the UK and finds that productivity growth is the main driver of potential output over the long run. The main
measure of productivity used is output per person-‐hour.

Components of Trend Growth for the UK Economy

Annual growth rate (per cent)
Overall
Potential Potential Potential
Potential Potential
productivity employment rate population
average hours Output for the
(output per hour) for those aged 16+ growth
UK Economy
2015 1.4 0.0 0.0 0.6 2.1

2016 1.8 -‐0.1 -‐0.1 0.6 2.2
2017 2.0 -‐0.2 -‐0.1 0.6 2.3
2018 2.1 -‐0.2 -‐0.1 0.5 2.3
Data for 2015 and 2016 are forecasts published at time of July 2015 budget


Key Factors affecting Long-‐Run Aggregate Supply

Gains from Innovakon

Higher Produckvity of Increased Labour Market and Enterprise Capital Investment
Labour and Capital Parkcipakon
These are two key factors Including capital spending
I.e. a rise in output per i.e. A growing labour by businesses, inward
that determine
person employed or supply and a rise in the investment from overseas
compettveness
increased efficiency of number of people in paid (FDI) and the Public
especially in internatonal
technology work Sector (Government)
markets

Productivity
Productivity measures the efficiency of the production process
• In the long run, productivity is a major determinant of economic growth and of inflation.
• A fall in labour productivity leads to a rise in firms’ (unit) costs of production (assuming that the
level of wages remains the same)
• Higher productivity allows businesses to pay higher wages and achieve increased profits at the
same time.
The UK Productivity Gap
The table below measures an index of constant price GDP per hour worked for a range of countries –
evidence of the productivity gap where productivity in the UK lags behind many other major countries.

France Germany Italy Japan UK USA

2007 100.0 100.0 100.0 100.0 100.0 100.0
2008 99.3 99.6 98.9 100.0 99.5 100.5
2009 98.7 96.9 96.7 99.1 97.8 102.9
2010 100.2 98.5 99.0 102.8 99.3 105.5
2011 101.4 99.5 99.1 102.8 101.7 106.0
2012 102.1 99.9 98.3 103.9 99.7 106.3
2013 102.4 99.4 98.5 105.5 99.4 107.6


Why does the UK economy lag on productivity?

Low rate of new capital Banking crisis affectng Possible slowing rates of
investment in the UK lending to businesses innovaton
Persistent skills Relatvely low levels of Low aggregate demand

shortages in key market competton & high spare capacity
industries

Impact of improved productivity on key macroeconomic indicators
All other things being equal, an improvement in labour productivity is most likely to:

Macroeconomic Objective Comment on the Effect
Inflation Lower – unit costs will be falling

Economic growth Higher – gains in aggregate supply
Unemployment Lower in long run as growth rises
Balance of trade in goods & services Improved – more competitive exports
Spare capacity in the economy Rise from extra capacity in short run
Business investment Higher – profits will have increased
Productivity gains in government will help to reduce
Government fiscal balance
state spending

Explaining the non-‐linear AS curve
• When spare capacity is high then SRAS will be elastic
• A rise in AD can be met easily by increased output
• There is little threat of rising prices (inflation)
• The elasticity of SRAS curve falls as output increases
• The amount of spare capacity declines
o Possibility of diminishing returns in production
o Bottlenecks in supply of inputs and components
o Resource shortages as the economy approaches full employment e.g. Skilled labour
becomes more scarce

• When SRAS becomes perfectly inelastic the economy is at full capacity (this is equivalent to being
on the PPF boundary)
• Further increases in AD at this point are inflationary in the short run with little extra real output
Showing non-‐inflationary growth – a rise in AD when SRAS is elastic

Inelastic aggregate supply – inflationary pressures are strong when AD is increasing


12.Macroeconomic Equilibrium
Equilibrium for the whole economy
1. Macro-‐economic equilibrium is established when AD intersects with SRAS
2. If the general price level is too high, there will be an excess supply of output and producers will
experience an increase in unsold stocks. This is a signal to cut back on production to avoid an
excessive level of inventories.
3. If the price level is below equilibrium, there will be excess demand in the short run leading to a
rundown of stocks – this is a signal for businesses to expand output.
Equilibrium is where the level of income flowing round the system is constant in successive time periods.

Macroeconomic Equilibrium using AD-‐AS Diagrams

Some people question whether it can ever be the case that an economy can come close to reaching
equilibrium since it would only take one market to be out of equilibrium for this to be blocked?

What matters here is whether the total demand for goods and services is close to the actual level of
production from domestic and external sources.

Changes in Aggregate Demand
In our diagram below we see the effect of an increase in aggregate demand which causes an expansion of
aggregate supply and a higher equilibrium level of national output / income (i.e. higher real GDP)

Impact of an increase in Aggregate Demand
• An increase in AD causes an expansion of aggregate supply and a higher equilibrium level of
national output (i.e. higher real GDP)
• An outward shift of aggregate demand will bring about a cyclical rise in output and employment.

Impact of an increase in Aggregate Supply
• An increase in aggregate supply causes an expansion of AD and a higher equilibrium level of
national output (i.e. higher real GDP)
• An outward shift of aggregate supply e.g. caused by lower unit costs should help to increase
business profits and prompt a rise in planned capital investment


Impact of a fall in Aggregate Demand
• A decrease in aggregate demand causes a lower equilibrium level of national output

Impact of a fall in Aggregate Supply
• A decrease in AS causes a contraction of AD and a lower equilibrium level of national output
• An inward shift of AS caused by a rise in unit resource costs will lead to lower business profits.
• The effects of a decrease in aggregate supply will depend on the cause. A fall in investment can be
particularly harmful as it will also decrease the level of aggregate demand

Aggregate supply can fall both in the short run and the long run – some of the possible causes are outlined
on the left and some of the macroeconomic effects are covered on the right


Causes of Fall in AS Possible Macro Consequences
Brain drain – an outward migraton of skilled

workers May cause higher inflaton
Steep decline in business capital investment

spending May reduce real GDP growth
Higher producton costs from higher commodity May lead to lower profits, investment and
prices employment
Effects of a major natural disaster / politcal conflict May worsen the trade balance

Aggregate supply shocks -‐ Impact of rising energy prices on the UK Economy

All other things being equal, a rise in the global price of energy such as gas, electricity and other fuels is
most likely to cause:

Macroeconomic Objective Comment on the Effect
Inflation Higher – at least in short term
Economic growth Lower – negative external shock
Unemployment Higher – as economy slows down
Balance of trade in goods & services Deterioration – rising import bills
Spare capacity in the economy Increase – from weaker growth
Business investment Fall – higher costs hits profits
Government fiscal balance Deterioration – less tax revenues


13.The Economic Cycle

An Economic Cycle
A cycle is when GDP growth fluctuates around the trend (or underlying) growth

Key Concepts Linked to the Economic Cycle

A period when the rate of growth of real GDP is fast and higher than the long-‐term
Boom
trend. This is likely to lead to a positive output gap
Business cycle Short-‐run fluctuations of national output (real GDP) around its long-‐term trend.
National income Everything produced, earned and spent in a country over a period of time
A weakening of the rate of growth, real GDP is still rising but increasing at a slower
Slowdown
rate
A period of at least six months when an economy suffers a fall in output. Or a
Recession
broadly-‐based contraction in output, employment, investment and confidence
A phase of the cycle, after a recession, during which real GDP starts to increase and
Recovery
unemployment begins to fall
A prolonged downturn in the economy and where a nation’s real GDP falls by at
Depression
least 10 per cent from peak to trough

Real GDP Growth in the UK – The Economic Cycle
The chart shows real GDP growth for the UK from 2010-‐2014. Data for 2015 onwards shows forecast
growth using data from the International Monetary Fund (IMF)

3.5%
GDP growth rate compared to previous year
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
2010 2011 2012 2013 2014 2015* 2016* 2017* 2018* 2019* 2020*

The last recession in the UK economy was in 2008 and 2009 when there was a cumulative fall in real
national output of approximatelt 5 per cent. Since then the economy has experienced a strengthening
recovery although the rate of growth slowed markedly in 2012 when there were fears (unrealise) of a
double-‐dip recession.

Economic Recovery and the PPF Diagram

Since the end of the last recession, there has been a wide variation in output growth in different British
industries-‐ the data I the chart below shows the average % pa increase in output from Q3 2009 – Q1 2015

Prof & business services 6.0%

Retail & wholesale 3.2%
Transport & comms 2.6%
Property services 2.4%
Hotels & restaurants 2.1%
Constructon 1.8%
Other services 1.8%
Manufacturing 1.4%
Water & waste 1.2%
Agriculture 0.4%
Electricity & gas -‐0.9%
Finance/insurance -‐1.9%
Mining, oil, etc -‐6.5%
-‐8% -‐6% -‐4% -‐2% 0% 2% 4% 6% 8%


The Output Gap
• How much spare capacity does an economy have to meet a rise in demand?
• How close is an economy to operating at its productive potential?
• Will the recession have a permanent effect on our ability to supply goods and services?
The output gap is the difference between the actual level of GDP and its estimated potential level. It is
usually expressed as a percentage of the level of potential output.

Showing a negative output gap using an AD-‐AS diagram

Negative output gap – brings downward pressure on inflation
• The actual level of real GDP is given by the intersection of AD & SRAS – the short run equilibrium.
• If actual GDP is less than potential GDP there is a negative output gap
• Some factor resources such as labour and capital machinery are under-‐utilized; the main problem is
likely to be higher unemployment.
• More people out of work indicate an excess supply of labour, which causes downward pressure on
real wage rates.

Positive output gap – creates upward pressure on inflation

• If actual GDP is greater than potential GDP then there is a positive output gap.
• Some resources including labour are likely to be working beyond their normal capacity e.g. making
extra use of shift work and overtime.
• The main problem is likely to be an acceleration of consumer price inflation.


Problems in Measuring the Output Gap
• The output gap measures the difference between actual real GDP and its potential output.
• Estimating the output gap is difficult because we cannot observe directly the supply potential of an
economy directly
Problems in estimating the output gap include:
1. Inaccurate data on the labour force for example errors in measuring net inward labour migration
2. Problems in accurately measuring productivity
3. Surveys of producers about spare capacity may be inaccurate
4. Gaps in knowledge about how much businesses are investing and the potential output from new
capital e.g. in digital sectors
5. Uncertainties about the number of people who may have left the labour market as “discouraged
workers”
6. It is hard to measure the amount of under-‐employment in the labour market at different stages of
the economic cycle


External Shocks and the Economic Cycle

Demand-‐side Shocks Supply-‐side Shocks
Steep rise in oil and gas prices or other

Economic downturn in a trading partner commodites
Unexpected tax increases Politcal turmoil / strikes
Natural disasters causing sharp fall in

Financial crisis causing bank lending to fall producton
Unexpected breakthroughs in producton

Bigger than expected rise in unemployment technology

Identifying Possible Causes of a Recession

External events
• A recession in a trading partner e.g. the European Union or the USA
• A sharp rise in global commodity prices e.g. rising oil and gas prices
Tightening of macro policy
• Higher interest rates leading to more expensive loans

• A rise in taxaton or a cut in government spending
Fall in asset prices or supply of credit
• Steep decline in the level of share or house prices
• A collapse in the supply of credit (e.g. Global financial crisis)
Drop in business and consumer confidence
• Lower business confidence cuts investment and may lead to job losses
• Declining consumer confidence leads to less spending and more saving


Short Term Economic Effects of a Recession
The impact of a recession depends in part on causes and how long it lasts

Business profits and capital investment
• Falling demand can cause more businesses to fail and profits fall
• Planned investment declines – hi•ng industries that make the capital goods
Unemployment
• A steep decline in aggregate demand causes a fall in the demand for labour
• This causes a contracton in employment and a rise in cyclical unemployment
Government finances
• Recession causes a decline in tax revenues and more welfare spending
• The result is usually an increase in the budget deficit and a rising natonal debt
Inflaton
• Many business offer price discounts to off-‐load excess unsold stocks
• A deep recession risks causing a period of sustained deflaton (negatve inflaton)

Longer Term Economic & Social Effects of a Recession
A deep recession / depression can having economic and social costs

Long Term Economic Effects Long Term Social Effects
Rising structural long-‐term unemployment Falling real wages hits average living standards
and regional decline and reduces demand
Low rates of investment can reduce the size of Widening inequality of income and wealth
the capital stock leading to rising poverty
Persistent budget (fiscal) deficits and a rising

natonal debt leads to austerity (cut in public Social costs such as loss of social cohesion and
threats to democracy
services)


Effects of Recession -‐ Hysteresis v Creative Destruction

Here are two competing views about the effects of a recession
Creakve
Hysteresis When an economy is disabled by Destruckon Recessions can cast a dark
recession there is a big risk of a shadow but capitalist market
permanent loss of natonal economies usually bounce back
output eventually
Recessions prompt the

Loss of productve capacity due emergence of new business
to low capital investment + many models and an increase in start-‐
business closures ups
High rates of structural New technologies can act as a

unemployment may cause a catalyst for renewed economic
shrinking labour force perhaps growth and investment
through outward migraton

The Difference between Recession and Depression
A depression is a prolonged slump over a number of years where real GDP falls by more than 10% from the
peak of the cycle to the trough.

Real Per Capita Income in Greece 2010-‐2020 (Source IMF)

30000
25000
GDP per capita in U.S. dollars
20000
15000
10000
5000
0
2010 2011 2012 2013 2014 2015* 2016* 2017* 2018* 2019* 2020*


Measuring the Misery Index!
• The Misery Index is a light-‐hearted attempt to use macroeconomic data to track the scale and
extent of misery for different countries.
• The misery index is calculated according to this formula:
• Uneployment rate + official interest rate + the inflation rate minus the percent change in real GDP
per capita of a country
Data for the Misery Index in 2014

Misery index score

0 20 40 60 80 100 120
Venezuela 106.03
Argentna 68
Syria 63.9
Ukraine 51.8
Iran 49.1
Brazil 42.79
Sao Tome And Principe 42.06
Serbia 40.32
Jamaica 39.85
South Africa 39.16
Sudan 38.71
Macedonia 36.53
Kyrgyzstan 35.17
Belarus 34.81
Armenia 34.45
\

Why is GDP growth difficult to forecast?
When economists make forecasts about the future path for an economy they have to accept the
inevitability of forecast errors.

Uncertain
business
confidence levels
Rate of business

job creaton hard Fluctuatons in
exchange rate
to forecast
Uncertain
reactons to External events
e.g. volatle oil
macro policy
and gas prices
changes


14.Multiplier and Accelerator Effects
What is the multiplier process?
• An initial change in aggregate demand can have a much greater final impact on the level of
equilibrium national income (GDP)
• This is known as the multiplier effect
• It comes about because injections of new demand for goods and services into the circular flow of
income stimulate further rounds of spending leading to an expansion of output, incomes and
profits
• In other words “one person’s spending is another’s income”
• This can lead to a bigger final effect on output and employment
• The multiplier is a number – a coefficient showing the size of the final impact on national income
What is a simple definition of the multiplier?
It is the number of times a rise in national income exceeds the rise in injections of demand that caused it

Examples of the multiplier effect at work
• Consider a £300 million increase in capital investment– for example created when an overseas
company decides to build a new production plant in the UK
• This can set off a chain reaction of increases in expenditures.
• Firms who produce the capital goods and construction businesses who win contracts to build the
new factory will see an increase in their incomes and profits
• If they and their employees in turn, collectively spend about 3/5 of that additional income, then
£180m will be added to the incomes of others.
At this point, total income has grown by (£300m + (0.6 x £300m).

The sum will continue to increase as the producers of the additional goods and services realize an increase
in their incomes, of which they in turn spend 60% on even more goods and services.

The increase in total income will then be (£300m + (0.6 x £300m) + (0.6 x £180m).

Each time, the extra spending and income is a fraction of the previous addition to the circular flow.

Positive Multiplier and Negative Multiplier Effects

Positve multplier Negatve multplier
When an inital increase in an When an inital decrease in an
injecton (or a decrease in a injecton (or an increase in a
leakage) leads to a greater final leakage) leads to a greater final
increase in real GDP. decrease in real GDP.


Importance of the Marginal Propensity to Consume and Save
Marginal propensity to consume (MPC) Marginal propensity to save (MPS)
MPC = change in consumpton following a MPS = change in savings following a change
change in income in income
= change in total consumpton / change in = change in total savings / change in gross
gross income income
E.g. if gross income increases by £5,000 and
spending rises by £4,000 then the MPC = If rise in gross income = £5,000 and rise in C
= £4,000, then change in saving = £1,000
£4,000 / £5,000 = 0.8
Therefore MPS = £1,000 / £5,000 = 0

Marginal Rate of Leakage and the Multiplier Value


Simple and a more complex Multiplier Calculation

Simple Multplier More Complex Multplier
Three leakages (savings,

Assume no tax or imports imports and taxaton)
Multplier coefficient k = 1 /
Only leakage is saving (MPS +MRT + MPM)
Multplier coefficient k = 1 / If sum of marginal rate of

(1-‐MPC) leakage = 0.7
Then multplier = 1/0.7 =

If MPC = 0.8 1.43
Then multplier = 1 / (1-‐0.8)

= 1/0.2 = 5

The main factors that affect the value (coefficient) of the multiplier effect

Propensity
to import
Avoiding
crowding Propensity
to save
out
The value of the
multplier
Amount of
spare Propensity
to tax
capacity

1. The multiplier process requires that there is sufficient spare capacity for extra output to be
produced. If short-‐run aggregate supply is inelastic, the full multiplier effect is unlikely to occur,
because increases in AD will lead to higher prices rather than a full increase in real national output.
In contrast, when SRAS is perfectly elastic a rise in AD causes a large increase in national output.
2. Crowding out – this is where (for example) increased government spending or lower taxes can lead
to a rise in government borrowing and/or inflation which causes interest rates to rise and has the
effect of slowing down economic activity.


In short – the multiplier effect will be larger when

1. The propensity to spend extra income on domestic goods and services is high
2. The marginal rate of tax on extra income is low
3. The propensity to spend extra income rather than save is high
4. Consumer confidence is high (this affects willingness to spend gains in income)
5. Businesses in the economy have the capacity to expand production to meet increases in demand

Time lags and the multiplier effect
• It is important to remember that the multiplier effect will take time to come into full effect
• A good example is the fiscal stimulus introduced into the US economy by the Obama government.
They have set aside many billions of dollars of extra spending on infrastructure spending but these
capital projects can take years to be completed. Delays in sourcing raw materials, components and
finding sufficient skilled labour can limit the initial impact of the spending projects.
Elasticity of Aggregate Supply & the Multiplier Effect

The Multiplier and Keynesian Economics
• The concept of the multiplier process became important in the 1930s when John Maynard Keynes
suggested it as a tool to help governments to maintain high levels of employment
• This “demand-‐management approach”, designed to help overcome a shortage of capital
investment, measured the amount of government spending needed to reach a level of national
income that would prevent unemployment.


15.Economic Growth
What is meant by economic growth?
• Economic growth is a long-‐term expansion of productive potential
• Short term growth is the annual % change in real national output
• Long term growth is shown by an increase in trend or potential GDP
Fastest Growing Countries in 2015
The table below is taken from the IMF world economic outlook and shows projected real GDP growth

Real GDP growth compared to previous year (per cent), Source: IMF
0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
Papua New Guinea 19.33%
Congo 9.19%
Turkmenistan 9%
Ethiopia 8.56%
Myanmar 8.33%
Côte d'Ivoire 7.75%
Chad 7.59%
Bhutan 7.56%
India 7.46%
Lao P.D.R. 7.31%
Tanzania 7.23%
Cambodia 7.2%
Qatar 7.13%
Rwanda 7%
Kenya 6.86%

Distinction between Short Run and Long Run Economic Growth
Short term economic growth Long run economic growth
Cyclical changes in real GDP Potental output / trend growth
Changes in AD (C+I+G+X-‐M) Productvity of labour & capital
Technological progress and strength

Changes in short run AS of enterprise
Short term external shocks to both
demand and supply Changes in the labour force
Short term policy changes e.g.

changes in interest rates Investment rates


Key Factors Affecting Short Run Economic Growth

Interest rates set by the central Fiscal policy -‐ government Commodity prices such as oil,
bank spending and taxaton gas and foodstuffs
Exchange rates e.g. Trading conditons / economic Confidence of businesses and
appreciaton or depreciaton growth in other countries households (animal spirits)

Key Factors Affecting Long Run Economic Growth

Capital Investment Factor Productvity Growth of the Labour supply
Research and Development Innovaton Enterprise and A•tudes to Risk-‐

Taking


Economic Growth using PPF Diagrams

Economic growth is a sustained rise in a country’s productive potential and real national output.

What are the main Benefits of Economic Growth?

Higher living standards – i.e. Real GNI per capita – helps to liz people out of extreme
poverty and improve development outcomes (e.g. rising HDI)
Employment effects – sustained growth stmulates jobs and contributes to lower
unemployment rates which is turn helps to reduce inequality.
Fiscal dividend – higher economic growth will raise tax revenues and reduce government
spending on unemployment-‐related welfare benefits
Accelerator effect -‐ rising growth stmulates new investment e.g. in low-‐carbon
technologies. Bewer growth may awract foreign direct investment projects


Is there a Virtuous Circle of Growth?
Higher
output
Rising
consumer Increased
investment
demand
Increased Higher
wages productvity

Three Perspectives on Economic Growth – Balanced, Sustainable and Inclusive Growth

Balanced Growth Sustainable Growth Inclusive Growth
Sector balance e.g. between Benefits of growth widely

industries Meets the needs of current distributed
generations without limiting
Regional balance resources for future generations Rising median per capita incomes
Progress in reducing relative

Urban / rural balance Macroeconomic stability
poverty
Internal v external balance (e.g. Improving opportunities for all
Financial stability
BoP) groups
Balance between consumption Environmental sustainability – Measures to tackle discrimination

and investment protection of natural capital and barriers for affected groups


How Best to Sustain Economic Growth in the Long Run
Improving Insttutons and

Building Trust / Social Capital Growing Intra-‐Regional Trade Protectng Property Rights
Growing a Dynamic Innovatve Sound Macro Policies to control Focusing on addressing Equity /
Private Sector Inflatonary Pressures Fairness Issues

Capital Investment’s Contribution to Economic Growth
Provides an injecton of demand for Bigger capital stock can liz productvity /
capital goods industries incomes e.g. in farming
Economies of scale & bewer Investment helps to sustain export-‐led
compettveness lower prices growth adding to GDP growth


Policies to attract Inward Foreign Investment
Many countries rely on foreign direct investment (FDI) as a key source of extra demand and as a driver of
growth
Awractve rates of Soz loans and tax Trade and Investment
corporaton tax reliefs / other subsidies Agreements Flexible labour markets
Open capital markets

Special Economic High quality to allow remiwed Availability of low cost
Zones infrastructure labour
profits
Economic and Social Costs of Growth

High rates of GDP growth can bring about undesirable economic and social costs

Risks of higher inflakon and higher interest rates

• Fast-‐growing demand can lead to demand-‐pull and cost-‐push inflaton – this
leads to a conflict between macro objectves
• The central bank may decide to raise interest rates to control inflaton
Environmental effects
• More negatve externalites such as polluton & waste
• Risk of unsustainable extracton of finite resources – i.e. fast growing countries
may cause a long-‐run depleton of natural resources
Inequalikes of income and wealth

• Rapid increases in real natonal income can lead to a higher level of inequality
and social divisions
• Many of the gains from growth may go to only a few people


Economic Growth and Inequality
• Not all of the benefits of growth are evenly distributed. A rise in real GDP can lift millions of people
out of absolute poverty but it can often be accompanied by widening income and wealth
inequality in society that is reflected in an increase in relative poverty
• If inequality grows as a country becomes richer, this raises important questions about a potential
trade-‐off between equity and efficiency
Countries with the Highest Income Inequality (2012)
The table below shows the countries with the highest income inequality as measured by the Gini
Coefficient. The maximum value for the Gini Index is 100.

Inequality as measured by the Gini Index

0 10 20 30 40 50 60 70
Seychelles 65.8
Comoros 64.3
Namibia 63.9
South Africa 63.1
Micronesia (Federated States of) 61.1
Hait 59.2
Zambia 57.5
Honduras 57
Central African Republic 56.3
Bolivia (Plurinatonal State of) 56.3
Colombia 55.9
Guatemala 55.9
Brazil 54.7
Belize 53.1
Suriname 52.9

Data on Income Inequality in the United Kingdom

Real Household Disposable Income (£ per year, at constant 2013/14 prices) Source: ONS
Mean Mean
Median 80/20 Ratio Gini Coefficient
Bottom quintile Top quintile
£ £ £ Ratio

1979 13,373 6,843 27,142 3.97 27
1989 16,966 7,448 42,156 5.66 34
1999 20,709 8,743 54,036 6.18 36

2007/2008 25,001 10,945 63,444 5.80 34
2010/2011 24,320 11,699 62,958 5.38 34
2013/2014 24,500 11,286 59,505 5.27 32


What can limit the rate of economic growth?

Weaknesses Infrastructure Primary Export Dependency
Macro Instability Conflict and Corrupton
Human Capital Weaknesses Savings and Foreign Exchange Gap
Natural Capital Depleton High levels of Inequality


Economic Growth of China
• China has experienced rapid growth over the last twenty years helping to lift hundreds of millions
of people out of deep poverty
• Real GDP growth has been over 9% per year since 1979 but that growth is now slowing down
• The government has set a new growth target for real GDP to grow by 7 per cent each year
• Much of the growth in China over the last twenty years has come from very high rates of
investment and strong exports leading to a rising trade surplus
• Estimates find that of the growth achieved by China over the last twenty-‐five years:
o 60-‐70% has come from increasing capital and labour inputs
o 30-‐40% has come from rising factor productivity
• Looking at increases in per capita output research finds that:
o 11-‐14% from improving human capital (quality of labour)
o 8-‐14% from improving allocative efficiency (e.g. moving from state-‐owned businesses to
private and from rural to urban)
o 16-‐17% has come from the productivity-‐enhancing effects of innovatin
Real GDP Growth for China since 1997

15
10
5
1997 2000 2003 2006 2009 2012 2015

China in transition to a more sustainable and balanced growth rate
China is now in a period of transition away from the fast export and investment-‐led growth of the last 20
years. The service sector is likely to take a bigger share of GDP in the years ahead. In 2014, it still accounted
for less than 50 per cent of Chinese national output.

Economic reform challenges facing China
• More reliance on their own domestic market and less on exports
• Raise consumption and reduce inefficient savings
• Grow the private sector and reduce distortions from state-‐owned sector
• Increase the pace of innovation as imitation limits are reached
• Continue to integrate the Chinese economy into the global economic / financial system
Changes in the rate of growth and type of growth in China will have profound effects on many other
countries – not least China’s main trade and investment partners in developed and developing countries.

16.Inflation

What is inflation?
• Inflation is a sustained increase in the cost of living or the general price level leading to a fall in the
purchasing power of money
How is the rate of inflation measured?
• The rate of inflation is measured by the annual percentage change in consumer prices
• The UK government has set an inflation target of 2% using the consumer prices index (CPI)
• It is the job of the Bank of England (BoE) to set monetary policy interest rates so that inflationary
pressures are controlled and the inflation target is reached
Falling inflation does not mean falling prices!
• A slowdown in inflation is not the same as deflation! For this to happen, the annual rate of price
inflation would have to be negative.
• Disinflation describes a period when the rate of inflation is falling, i.e. prices are rising at a slower
pace
Inflation – Some Key Terms

A measure of the price level in the economy based on the prices of a
Consumer Price Index (CPI) collection of products designed to reflect the consumption basket of the
average consumer
A decline in the general price level in an economy, signified by an annual
Deflation
inflation rate below 0% (negative).
Disinflation is a fall in the rate of inflation e.g. from 5% to 2%. Prices are
Disinflation
still rising but at a slower rate.
A period of very high rates of inflation, usually leading to a loss of
Hyper-‐inflation
confidence in an economy’s currency.
Inflation rate The annual rate of change of the average price of goods and services.
Reflect total labour costs, including social security and employers’ pension
Unit labour costs contributions, and including the costs of self-‐employed labour, incurred in
the production of a unit of economic output.

How is the Rate of Inflation Calculated?
• Inflation in the UK is measured by the consumer prices index (CPI)
• A base year is selected and an expenditure survey carried out – the survey covers 40,000
households
• A representative basket of goods and services used and weights are attached to each item -‐ based
on these items’ importance in people’s expenditure as measured the family spending survey
• Each month government officials collect 120,000 separate price quotations in 141 locations of
around 600 products
• Weights are multiplied by price changes -‐ the weighted price changes are then totalled to calculate
the inflation rate
• At the start of each year the weights used to compile both the CPI are updated using the latest
information on household spending

An example of how to calculate a weighted price index

The table below shows a made-‐up listing of spending categories together with price index data and the
weight attached to each category. From this information a weighted price index can be calculated:

Category Price Index Weighting Price x Weight
Food 104 19 1976
Alcohol & Tobacco 110 5 550
Clothing 96 12 1152
Transport 108 14 1512
Housing 106 23 2438
Leisure Services 102 9 918
Household Goods 95 10 950
Other Items 114 8 912
100 10408

Weights are attached to each category; we multiply these weights to the price index for each item of
spending for a given year.
• The price index for this year is: the sum of (price x weight) / sum of the weights
• So the price index for this year is 104.1 (rounding to one decimal place)
• The rate of inflation is the % change in the price index from one year to another.
• So if in one year the price index is 104.1 and a year later the price index has risen to 112.5, then the
annual rate of inflation = (112.5 – 104.1) divided by 104.1 x 100. Thus the rate of inflation = 8.07%.
Weighting the Consumer Price Index in the UK

Category in the CPI Weights CPI in June 2014 CPI in June 2015
Food and non-‐alcoholic beverages 110 143.2 140.1
Alcoholic beverages and tobacco 43 156.5 160.1
Clothing and footwear 70 83.4 82.8
Housing, water, electricity, gas and other fuels 128 154.7 155.4
Furniture, household equipment and
59 120.9 120.5
maintenance
Health 25 130.0 132.0
Transport 149 137.6 135.0
Communication 31 112.5 113.7
Recreation and culture 147 102.9 101.9
Education 26 222.2 244.3
Restaurants and hotels 121 132.6 135.1
Miscellaneous goods and services 91 120.3 120.5
Overall consumer price index 1000 128.3 128.2


Limitations of the Consumer Price Index as a measure of inflation

The published figure for inflation is rarely the actual rate of inflation experienced by different people
1. The CPI is not fully representative -‐ it will be inaccurate for the ‘non-‐typical’ household, e.g. 14% of
the CPI index is devoted to motoring costs -‐ inapplicable for non-‐car owners.
2. Spending patterns: e.g. Single people have different spending patterns from households that have
one or more children
3. Changing quality of goods and services: Although the price of a good or service may rise, this may
also be accompanied by improvements in quality / performance of the product
4. New products: The CPI is slow to respond to new products and services – the CPI basket is changed
each year but only a few items fall out / come in
UK Consumer Price Index (CPI) from 2000-‐2015
• The chart below tracks the annual value for the consumer price index. From this data the annual
inflation rate can be calculated.
• Note that the CPI in 2015 is expected to be the same as in 2014, implying a zero rate of inflation

140
128 128
130 126.1
Consumer Price Index (2005=100)
123
119.6
120
114.5
110.8
108.5
110
104.7
102.3
100
98
100
94.2 95.4 96.7
93.1
90
80
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015


Inflation Rate in the UK Economy in Recent Years
The CPI inflation target for the Bank of England is 2% plus or minus 1%

5.0%
4.5%
4.5%
4.0%
3.6%
3.5% 3.3%
3.0% 2.8%
Inflaton rate
2.6%
2.5% 2.3% 2.3%
2.2%
2.1%
2.0%
1.5%
1.4%
1.5% 1.3% 1.3%
1.2%
1.0% 0.8%
0.5%
0.0%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

CPI Inflation in the UK over the last 20 Years (Detail for Goods and Services)
The inflation rate for goods such as clothing and computers has been, on average, lower than for service
such as car and home insurance and education and services such as hairdressing and leisure clubs.

-1 CPI all items

CPI goods
-2
CPI services
-3
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN


The UK Inflation Target
• The Bank of England’s target is for inflation to be 2%.
• The Governor of the Bank of England must write an open letter to the Chancellor if inflation is more
than one percentage point higher or lower than this target (i.e. more than 3% or less 1%).
• CPI Inflation in the UK has been either above 3% or less than 1% in 25 of 57 months since May 2010
Key Inflation Data for the UK in Recent Years

UK Whole
UK Consumer Price Halifax House Price Inflation in the
Year Economy Average
Inflation Inflation European Union
Earnings
Per cent Per cent Per cent Per cent

2011 4.5 2.5 -‐2.5 3.1
2012 2.8 1.4 -‐0.6 2.6
2013 2.6 1.2 4.6 1.5
2014 1.5 1.1 8.8 0.6
2015 (April) 0.1 2.7 8.6 0.3

What are the Main Causes of Inflation?
• Inflation can come from both the demand and the supply-‐side of an economy
• Inflation can arise from internal and external events
o Some inflationary pressures direct from the domestic economy, for example the decisions
of utility businesses providing electricity or gas or water on their tariffs for the year ahead,
or the pricing strategies of the food retailers based on the strength of demand and
competitive pressure in their markets.
o A rise in the rate of VAT would also be a cause of increased domestic inflation in the short
term because it increases a firm’s production costs.
o Inflation can also come from external sources, for example a sustained rise in the price of
crude oil or other imported commodities, foodstuffs and beverages.
o Fluctuations in the exchange rate can also affect inflation – for example a fall in the value
of the pound against other currencies might cause higher import prices for items such as
foodstuffs from Western Europe or technology supplies from the United States – which
feeds through directly or indirectly into the consumer price index.
Demand-‐Pull Inflation
• Demand pull inflation occurs when aggregate demand is growing at an unsustainable rate leading
to increased pressure on scarce resources and a positive output gap
• When there is excess demand, producers can raise their prices and achieve bigger profit margins
• Demand-‐pull inflation becomes a threat when an economy has experienced a boom with GDP rising
faster than the long-‐run trend growth of potential GDP
• Demand-‐pull inflation is likely when there is full employment of resources and SRAS is inelastic
Main Causes of Demand-‐Pull Inflation
1. A depreciation of the exchange rate increases the price of imports and reduces the foreign price of
a country’s exports. If consumers buy fewer imports, while exports grow, AD in will rise – and there
may be a multiplier effect on the level of demand and output
2. Higher demand from a fiscal stimulus e.g. from lower direct or indirect taxes or higher government
spending. If direct taxes are reduced, consumers have more disposable income causing demand to

rise. Higher government spending and increased borrowing creates extra demand in the circular
flow
3. Monetary stimulus: A fall in interest rates may stimulate too much demand – for example in raising
demand for loans or in leading to house price inflation. Monetarist economists believe that
inflation is caused by “too much money, chasing too few goods” and that governments can lose
control of inflation if they allow banks to expand the money supply too quickly.
4. Fast growth in other countries – providing a boost to UK exports overseas. Export sales provide an
extra flow of income and spending into the UK circular flow – so what is happening to the economic
cycles of other countries definitely affects the UK

Cost-‐Push Inflation
Cost-‐push inflation occurs when businesses respond to rising costs, by increasing prices to protect their
profit margins. There are many reasons why costs might rise:
1. Component costs: e.g. an increase in the prices of raw materials and other components. This might
be because of a rise in commodity prices such as oil, copper and agricultural products used in food
processing. A recent example has been a surge in the world price of wheat.
2. Rising labour costs -‐ caused by wage increases, which are greater than improvements in
productivity. Wage costs often rise when unemployment is low because skilled workers become
scarce and this can drive pay levels higher. Wages might increase when people expect higher
inflation so they ask for more pay in order to protect their real incomes. Trade unions may use
their bargaining power to bid for and achieve increasing wages, this could be a cause of cost-‐push
inflation
3. Expectations of inflation are important in shaping what actually happens to inflation. When people
see prices are rising for everyday items they get concerned about the effects of inflation on their
real standard of living. One of the dangers of a pick-‐up in inflation is what the Bank of England calls
“second-‐round effects” i.e. an initial rise in prices triggers a burst of higher pay claims as workers
look to protect their way of life. This is also known as a “wage-‐price effect”

4. Higher indirect taxes – for example a rise in the duty on alcohol, fuels and cigarettes, or a rise in
Value Added Tax. Depending on the price elasticity of demand and supply for their products,
suppliers may choose to pass on the burden of the tax onto consumers.
5. A fall in the exchange rate – this can cause cost push inflation because it leads to an increase in the
prices of imported products such as essential raw materials, components and finished products
6. Monopoly employers/profit-‐push inflation – where dominants firms in a market use their market
power (at whatever level of demand) to increase prices well above costs

Cost-‐push inflation such as that caused by a large and persistent rise in the world price of crude oil can be
shown in a diagram by an inward shift of the short run aggregate supply curve. The fall in SRAS leads to a
contraction of national output together with a rise in the level of prices.

Inflation Expectations
• Once inflation becomes established in an economy it can be difficult to remove.
• Most agents in the economy (e.g. workers, businesses and lenders) will raise their inflation
expectations and build it into their calculations and decisions
• A rise in inflation can lead to an increase in inflation expectations. This can then feed through to
higher wage claims and rising costs


Internal causes of inflation

A large surge in property Higher wages / labour Boom in credit / money Rise in business taxes
prices costs supply e.g. VAT

External causes of inflation

Increase in world oil / Inflaton in global Depreciaton of the High inflaton in other
gas prices commodity prices exchange rate countries
Countries with Highest Inflation in 2015

The chart below shows actual consumer price inflation in March 2015 drawing on data from the IMF

Inflaton rate (per cent) compared to previous year (March 2015)
0.0% 20.0% 40.0% 60.0% 80.0% 100.0% 120.0%
Venezuela 96.8%
Ukraine 33.48%
South Sudan 28.98%
Belarus 22.08%
Sudan 19.03%
Argentna 18.65%
Russia 17.94%
Malawi 17.31%
Islamic Republic of Iran 16.5%
Sierra Leone 13.07%
Tajikistan 12.85%
Eritrea 12.26%
Ghana 12.2%
Kyrgyz Republic 10.75%
Egypt 10.26%


The Consequences of Inflation For Consumers, Businesses, the Government and Workers
Many government s have a target for a low but positive rate of inflation. They believe that persistently
high inflation can have damaging economic and social consequences.
1. Income redistribution:
o One risk of higher inflation is that it has a regressive effect on lower-‐income families and
older people in society. This happen when prices for food and domestic utilities such as
water and heating rise at a rapid rate.
2. Falling real incomes:
o If people’s pay does not keep pace with rising prices, then real incomes will fall
3. Negative real interest rates:
o If nominal interest rates on savings accounts are lower than inflation, people who rely on
interest from their savings will be poorer.
o Real interest rates for millions of savers have been negative for many years since the global
financial crisis
4. Cost of borrowing:
o High inflation may also eventually lead to higher interest rates for businesses and people
needing loans and mortgages as financial markets protect themselves against rising prices
and increase the cost of borrowing on short and longer-‐term debt.
o There is also pressure on the government to increase the value of the state pension and
unemployment benefits and other welfare payments as the cost of living climbs higher.
5. Risks of wage inflation:
o High inflation can cause an increase in wage claims as people protect their real incomes.
o This can lead to a rise in unit labour costs and lower profits for businesses
6. Business competitiveness:
o If one country has a much higher rate of inflation than others, this will make its exports less
price competitive in world markets. Eventually this may show through in reduced export
orders, lower profits and fewer jobs, and also in a worsening of a country’s trade balance.
o A fall in exports can trigger negative multiplier effects on national income and employment.
7. Business uncertainty:
o High and volatile inflation is not good for business confidence because they cannot be sure
of what their costs are likely to be. This uncertainty might lead to less investment spending.
Possible Winners and Losers from High Inflation
One of the effects of inflation is that it can lead to arbitrary changes in the distribution of real incomes and
wealth in a country.

Winners Losers
• Workers with strong wage bargaining power • Retred on fixed incomes
• Debtors if real interest rates are negatve • Lenders if real interest rates are negatve
• Producers if prices rise faster than costs • Savers if real returns are negatve
• Workers in low paid jobs


Why is the rate of inflation difficult to forecast accurately?
• The rate of inflation is one of the most important macroeconomic indicators that we study in
macroeconomics. Data on prices is published regularly and given lots of attention by the media and
the financial markets.
• Many agents would like to have accurate forecasts of what is likely to happen to prices in the future
because they affect spending, saving and investment decisions.
• The chart shows the UK CPI inflation forecast published by the Bank of England. The probability fan
chart for inflation indicates the range of probabilities for inflation in the forecast period.

Some reasons for difficulties in forecasting inflation
Volatle global
energy prices
Government
indirect taxes can Changes in value
of the currency
change
Uncertain growth
Volatle food of aggregate
prices
demand


Controlling Inflation – Macroeconomic Policies

Inflation can be reduced by policies that (i) slow down the growth of AD or (ii) boost the rate of growth of
aggregate supply (AS)
1. Fiscal policy:
a. Controlling aggregate demand is important if inflation is to be controlled. If the
government believes that AD is too high, it may choose to ‘tighten fiscal policy’ by reducing
its own spending on public and merit goods or welfare payments
b. It can choose to raise direct taxes, leading to a reduction in real disposable income
c. The consequence may be that demand and output are lower which has a negative effect on
jobs and real economic growth in the short-‐term
2. Monetary policy:
a. A ‘tightening of monetary policy’ involves the central bank introducing a period of higher
interest rates to reduce consumer and investment spending
b. Higher interest rates may cause the exchange rate to appreciate in value bringing about a
fall in the cost of imported goods and services and also a fall in demand for exports (X)
3. Supply side economic policies:
a. Supply side policies seek to increase productivity, competition and innovation – all of
which maintain lower prices. These are ways of controlling inflation in the medium term
i. A reduction in company taxes to encourage greater investment
ii. A reduction in taxes which increases risk-‐taking and incentives to work – a cut in
income taxes can be considered both a fiscal and a supply-‐side policy
iii. Policies to open a market to more competition to increase supply and lower prices
b. Rising productivity will cause an outward shift of aggregate supply
4. Direct controls -‐ a government might choose to introduce direct controls on some prices and wages
a. Public sector pay awards – the annual increase in government sector pay might be tightly
controlled or even froze (this means a real wage decrease).
b. The prices of some utilities such as water bills are subject to regulatory control – if the price
capping regime changes, this can have a short-‐term effect on the rate of inflation

Evaluation – how best can inflation be controlled?
1. The best way to control inflation in the short term is for the government and the central bank to
keep control of aggregate demand to a level consistent with our productive capacity
2. Controlling demand to limit inflation is likely to be ineffective in the short run if the main causes are
due to external shocks such as high world food and energy prices
3. The UK is an open economy in which inflation is strongly affected by events in the rest of the world
4. In the long run, it is the growth of a country’s supply-‐side productive potential that gives an
economy the flexibility to grow without suffering from acceleration in cost and price inflation.

17.Deflation
What is deflation?
• Deflation is a persistent fall in a country’s general price level.
• A number of countries were experiencing negative inflation rates in May 2015 among them a
growing cluster of countries inside the European Union.
Countries with the lowest inflation rate in 2015

Inflaton rate compared to previous year
-‐1.8% -‐1.6% -‐1.4% -‐1.2% -‐1.0% -‐0.8% -‐0.6% -‐0.4% -‐0.2% 0.0%
Grenada -‐1.55%
Switzerland -‐1.19%
Zimbabwe -‐1.05%
Bulgaria -‐1.03%
Micronesia -‐1%
Cyprus -‐1%
Croata -‐0.89%
Poland -‐0.83%
El Salvador -‐0.8%
Dominica -‐0.77%
Spain -‐0.73%
Marshall Islands -‐0.59%
Slovenia -‐0.39%
Lithuania -‐0.31%
Camboadia -‐0.31%

Main causes of deflation
Deflation can come from demand and supply-‐side causes

Demand-‐side causes of deflakon
• Deep fall in AD causing a persistent recession / depression

• Large negatve output gap – i.e. high level of spare capacity
Supply-‐side causes of deflakon
• Improved productvity
• Technological advances
• Significant fall in wage rates
• High exchange rate causing import prices to fall


Evaluating the Consequences of Price Deflation
1. Holding back on spending: Consumers may postpone demand if they expect prices to fall in the
future
2. Debts increase: The real value of debt rises with deflation and higher real debts can be a big drag
on consumer confidence
3. The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not
fall in line with prices.
4. Lower profit margins: Lower prices can mean reduced revenues & profits for businesses -‐ this can
then lead to higher unemployment as firms seek to reduce costs by shedding labour.
5. Confidence and saving: Falling asset prices such as price deflation in the housing market hits
personal sector wealth and confidence
6. Income distribution: Deflation leads to a redistribution of income from debtors to creditors – but
debtors may default on loans
7. Deflation can make exporters more competitive eventually – but this often comes at a cost i.e.
higher unemployment in short term

Real interest rates rise Real level of debt rises Pressure for lower wages
Declining business profits Rise in cyclical unemployment Improved price

compettveness

Economic Policies to Avoid Price Deflation

The main approach to avoiding deflation is to use macro-‐stimulus policies either by loosening monetary
policy (i.e. cutting interest rates) and/or fiscal policy (to increase domestic demand for goods and services)

Low interest rates and quanktakve easing
•  In some countries, policy interest rates have become negatve e.g. Switzerland
•  Cheaper loans for businesses and households
•  Expanding the supply of credit in banking system
•  QE used by many central banks including BoE and European Bank
Fiscal skmulus measures

•  Higher government spending (e.g. capital projects)
•  A rise in government borrowing to inject demand into the circular flow
•  Lower direct taxes to increase disposable income and spending
Other measures to skmulate aggregate demand

•  Awempts to lower the value of the exchange rate (perhaps via central bank
interventon to sell their currency in the market)
•  Higher taxes on savings to encourage consumpton


18.Employment and Unemployment

Definition of unemployment
• The unemployed are those people able, available and willing to work at the going wage but cannot
find a job despite an active search for work
• Unemployment means that scarce human resources are not being used to produce goods and
services to meet people’s needs and wants
Measuring Employment and Unemployment – Some Key Terms

The number of people officially claiming unemployment-‐related
Claimant Count (JSA)
benefits – must be actively seeking work
All those actively seeking and available for work, whether or not they
Labour Force Survey (LFS)
are claiming benefit
Long-‐Term unemployed People unemployed for at least one year
The number of people of working age who are able, available and
Labour force
willing to work
When there enough unfilled job vacancies for all the unemployed to
Full employment
take work
People out of work for a long time who may give up on job search and
Discouraged workers
effectively leave the labour market
Those who are of working age but are neither in work nor actively
Economically inactive
seeking paid work
The percentage of the population of working age in full-‐time or part-‐
Employment rate
time paid work
Percentage of the economically active population who are
Unemployment rate
unemployed

Summary of Key UK Labour Market Data in Recent Years

Labour Force Labour Force
Survey Survey
Year Total Employment Employment Rate
Unemployment Unemployment
Level Rate
Per cent of
Per cent of the
Thousands Thousands population of
labour force
working age
2011 2,593 8.1 29,376 70.3
2012 2,572 8.0 29,696 71.0
2013 2,476 7.6 30,043 71.5
2014 2,027 6.2 30,726 72.9
2015 (April) 1,813 5.5 31,053 73.4


The Employment Rate
The employment rate is measured as the percentage of the population of working age in full-‐time or part-‐
time paid work. The employment rate fell sharply during the last recession but since 2012 it has recovered
strongly and it now at its highest level for over twenty years. Nearly 75% of the population of working age
have a job.

74.0%
73.5%
73.3%
73.5%
72.9% 72.8%
73.0% 72.7% 72.6%
72.5%
Employment rate
72.5%
72.0%
71.5% 71.1%
71.0%
70.5%
70.5%
70.0%

Unemployment in the UK Economy over Long Run
The unemployment rate has varied over the last 40 years. Our chart shows the peaks over this period – the
peak rate has been falling. After the last recession, unemployment using the LFS measure peaked at 8.5% of
the labour force and has fallen steadily since, nudging towards an unemployment rate of just 5% by the
summer of 2015.
14
11.9
12 10.7
10
8.5
6 6.9
5.5
4 4.7
-2 18 month change
-4
1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013

Economic Inactivity in the Labour Market
• Economically active people are those in work plus those seeking and available to work.
Economically inactive people are those who have stopped an active search for paid work in the
labour market.
• Between Mar-‐May 2015, the total of economically inactive aged 16-‐64 (thousands) in the UK was
measured at just over 9 million
Distinction between Unemployment and Under-‐Employment
• Under-‐employment occurs when people are counted as:
o Looking for an additional job or actively searching for a new job with longer hours to
replace their current (main) job
o They want to work longer hours in their current job (at their basic rate of pay).
• Under-‐employment can be rising even though unemployment is declining
Estimated under-‐employment in the UK economy 2002-‐2015
The chart below shows the number of people (in thousands) estimated to be under-‐employed.

3,300
3,100
2,900
2,700
2,500
2,300
2,100
1,900
1,700
1,500
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Main Types and Causes of Unemployment

Frictional Unemployment
• Frictional unemployment is transitional unemployment as people move between jobs
• For example, newly-‐redundant workers who have been laid off by their previous employer, or
people joining the labour market for the first time such as university graduates or school leavers
who may take time searching to find work they want at wage rates they are prepared to accept.
• Imperfect information makes unemployment worse if people are unaware of available jobs.
• Incentives problems can also cause frictional unemployment as some people may stay out of work
if they believe the tax and benefit system leaves them little or no better off from taking a job
• When there are disincentives for people to accept work, this is known as the unemployment trap.
• Frictional unemployment happens when it takes time for a country’s labour market to match the
available jobs with people seeking work.

Structural Unemployment
• Structural unemployment happens when there is a long-‐term decline in demand in an industry
leading to fewer jobs as demand for labour falls away.
• Examples might include:
o Jobs being replaced by new technology e.g. online banking and online retailing
o Unemployment caused by foreign competition (or changes in comparative advantage)
• Structural unemployment exists where there is a mismatch between their skills and the
requirements of new job opportunities. This is due to occupational and geographical immobility of
labour and requires investment to improve skills, give the unemployed suitable and effective
training and work experience and make them able to move location if needed to take a new job.
• Globalisation leads to changes in the patterns of trade between countries. Many of workers may
suffer from a period of structural unemployment, particularly if they are in regions of above-‐
average unemployment rates where job opportunities are scarce.
Underlying causes of structural unemployment
Decline of manufacturing Occupatonal immobility Geographical immobility Robotcs replacing jobs
Foreign competton – Long term regional Disincentves e.g. Outsourcing of

rising imports decline Poverty Trap producton overseas

Cyclical Unemployment:
• Cyclical unemployment is involuntary unemployment due to a lack of demand for goods and
services. This is also known as Keynesian unemployment or demand-‐deficient unemployment
• When there is a recession or a slowdown in growth, we see a rising unemployment because of
plant closures, business failures causing worker lay-‐offs and redundancies.
• The economy does not have to go into recession for cyclical unemployment to start rising. Many
jobs can be lost even in a slowdown phase and one reason for this is because of rising productivity.
• Cyclical unemployment is most likely to occur when there is a negative output gap
Technological Unemployment
• The term “technological unemployment” was first coined in the 1930s by John Maynard Keynes to
describe the way in which productivity-‐enhancing innovation displaces workers and creates periods
of higher unemployment. It is linked to structural unemployment.

• Some link the rise of the internet as a cause of technological unemployment for example the US
business Kodak went bust in 2013 with its 140,000 employees, in part the result of the rapid
expansion of Instagram, which, when it was sold to Facebook employed just 13 people
• Over the long term is that innovation and the emergence and uptake of new technologies creates
more jobs than it destroys.
• Those most at risk from the creative destruction of new technologies are those with low and out-‐
dated skills in the labour market.

Long Term Unemployment
• Long-‐term unemployment affects people who have been out of paid work for at least one year
• The longer the duration of unemployment, the harder for people to get a job. Skills decline,
motivation to look for work suffers and employers are less likely offer work to a long-‐term
unemployed person
• The chart below shows the duration of unemployment for people in the UK from 2013 to 2015

Up to 6 months Over 6 and up to 12 months Over 12 months
1400
Number of unemployed people in thousands
1,168
1200 1,104
1,046
999 971
950 923 955
1000 894
848 816
800 741
688
638
588 575
600
427 396
350 333 321
400 300 284 305
200
0
Jul-‐Sep 2013 Oct-‐Dec Jan-‐Mar Apr-‐Jun Jul-‐Sep 2014 Oct-‐Dec Jan-‐Mar Apr-‐Jun
2013 2014 2014 2014 2015 2015

Highest Unemployment Rates among EU Countries

Greece and Spain have the highest rates of adult unemployment in the EU. Youth unemployment greatly
exceeds the average adult rate with over half of young workers in Greece and Spain out of work.

Unemployment rate as % of the labour force

0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%
Greece** 25.6%
Spain 22.5%
Cyprus 16%
Croata 15.8%
Portugal 13.2%
Italy 12.4%
Slovakia 11.8%
Euro area 11.1%
France 10.3%
Latvia** 9.9%
Ireland 9.8%
Bulgaria 9.7%
European Union 9.6%
Finland 9.4%
Slovenia 9.2%


20 Countries with the Highest Unemployment Rate
Staggeringly high rates of “official” unemployment can happen when an economy collapses e.g. Zimbabwe
in 2009 and in the fallout from conflict

Unemployment rate as a % of the labour force

0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0% 90.0% 100.0%
Zimbabwe (2009) 95%
Nauru (2004) 90%
Liberia (2003) 85%
Burkina Faso (2004) 77%
Turkmenistan (2004) 60%
Cocos Islands (2000) 60%
Djibout (2007) 59%
Republic of Congo (2012) 53%
Namibia (2008) 51.2%
Senegal (2007) 48%
Nepal (2008) 46%
Kosovo (2011) 45.3%
Bosnia and Herzegovina (2012) 44.1%
Hait (2010) 40.6%
Swaziland (2006) 40%

The Effects of Unemployment on consumers, businesses, workers, government and society
• High unemployment creates costs for individuals, for communities and for the economy as a whole.
• Some of these costs are difficult to value and measure, especially the social / human costs.
1. Loss of income: Unemployment nearly always results in a loss of disposable income, and majority
of the unemployed suffer a decline in their living standards and are worse off out of work.
2. Risk of deflation: High unemployment brings about a lower level of aggregate demand and can lead
to deflationary pressures due to high levels of spare capacity.
3. Negative multiplier effects: The closure of a local factory with the loss of hundreds of jobs can have
a large negative multiplier effect on the local and regional economy.
a. There is a loss of potential national output and is a waste of scarce resources
b. If some people leave the labour market permanently because they have lost the motivation
to search for work, this can have a negative effect on long-‐ run aggregate supply and
damage the economy’s growth potential. This is called a “hysteresis effect”.
4. Fiscal costs:
a. The government loses out because of a fall in tax revenues and higher spending on
welfare payments for families with people out of work
b. The result can be an increase in the budget deficit that then increases the risk that the
government will have to raise taxation or cut public spending on public and merit goods.
5. Social costs including growing poverty:
a. Rising unemployment is linked to social deprivation and social dislocation including
increased divorce rates, worsening health and lower life expectancy

b. Regions that suffer from persistently high unemployment see falling real incomes and a
widening of inequality of income and wealth.
6. Outward migration (emigration)
a. When unemployment is persistently high and employment rates are falling, many people
may move country in search of work leading to a decline in the active labour supply
Long-‐term unemployment
• The economic and social costs of unemployment depend on (i) how many people are out of work
and how productive they might have been (ii) the length of time they remain jobless.
• In the UK nearly 40 per cent of people of the unemployed have been without a job for at least a
year.
Youth Unemployment
• 740,000 people aged 16-‐24 were unemployed in December 2014.
• The youth unemployment rate was at 15%
• High rates of youth unemployment have serious economic and social consequences
• Young people out of work risk a permanent fall in their expected lifetime earnings from work
NEETS
• Young people not in education, employment or training (NEET)
• NEETS are effectively outsiders in the labour market and this group has become a key area for
policy intervention e.g. via apprenticeship schemes
Some of the main causes of high youth unemployment are shown below

Skills Gaps -‐ Employers

may not be willing to Reluctant Employers –
employ people who lack they may prefer older,
the ability to read and more experienced workers
write
Falling Rekrement Rates Weak Macro

caused by declining Fundamentals – i.e. low
pension incomes = fewer real GDP growth and low
jobs for younger people business confidence


Youth Unemployment Rate in the UK

25.0%
20.0% 19% 19.3% 18.8%

17.9%
Unemployment rate in percent
17.3%
15%
15.0% 13.3%
12.2% 12.2%
10.6% 10.4% 10.4% 10.6% 10.4% 11%
10.0%
5.0%
0.0%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

NEETS in the UK Labour Market

Young people not in education, employment or training in UK from Jan-‐March 2013 to Jan-‐March 2015

1200
1,093 1,092 1,096
1,041
987 966 963
1000 954 943
800
NEET in thousands
600
400
200
0
Jan-‐Mar Apr-‐Jun Jul-‐Sep Oct-‐Dec Jan-‐Mar Apr-‐Jun Jul-‐Sep Oct-‐Dec Jan-‐Mar
2013 2013 2013 2013 2014 2014 2014 2014 2015


Which Economic Policies can be used to Reduce Unemployment?

Distinction can be made between demand-‐side and supply-‐side policies to improve the working of the
labour market in matching people to available jobs
Reducing occupational immobility:
• Immobility is a cause of structural unemployment.

• Policies such as apprenticeship schemes aim to provide the unemployed with the new skills they
need to find fresh employment and to improve the incentives to find work.
• In 2013, over 500,000 people started apprenticeships in the UK. For many years the poor quality of
work-‐place training has been a concern, with evidence of a persistent skills-‐gap in the UK.
• In a report published in 2011, a trade union reported that 11% of British adults do not have any
qualifications. In some areas such as parts of Glasgow and Birmingham, more than a third of people
of working age have no qualifications.
Reducing the geographical immobility of labour:
• Many people have the right skills to find fresh work but factors such as high house prices and
housing rents, family and social ties and regional differences in the cost of living make it difficult
and sometimes impossible to change location in order to get a new job.
• Many economists point to a persistently low level of new house building as a major factor impeding
labour mobility and the chances finding new work.
Benefit and tax reforms:
• To some economists, a policy that reduces the real value of welfare benefits might increase the
incentive for the unemployed to take a job.
• It is rare that the root cause of someone being out work is the prospect of state welfare handouts.
• Targeted measures to improve people’s incentives might include linking welfare benefits to
participation in work experience programmes or lower marginal tax rates for people on low
incomes.
Increasing aggregate demand:
• A Keynesian-‐style stimulus is an active policy during a recession.

• This might include increases in state investment spending or lower taxes to boost disposable
income
• Some economists recommend schemes to create more ‘shovel-‐ready’ jobs, typically involving
construction projects that are labour intensive
• The hope is that extra spending on new roads, housing and other infrastructure projects will lead to
a strong positive multiplier effect on output, incomes and jobs.
Employment subsidies and/or employment tax cuts (demand-‐side policy):
• Government subsidies for businesses that take on the long-‐term unemployed – for example, as
part of the UK Youth Contract, payments of up to £2,275 are available to employers who take on
young people (aged 18-‐24) who have been claiming JSA for more than six months
• Lower taxes on businesses that employ more workers might be effective, for example cuts in
employer national insurance contributions for young, low-‐paid workers
Changing the participation age


• From 2013, young people in the UK will be required to continue in education or training until they
turn 17 and from 2015 they will be required to continue in education or training until they turn 18.
Summary of economic policies to improve mobility and incentives

Reducing occupatonal mobility
• Bewer funding for and more effectve workplace training
• Teaching new skills e.g. Coding for gaming, languages
• An expansion of apprentceship / internship programmes
Improving geographical mobility

• Rise in house-‐building will help to keep property prices lower and encourage more
affordable rents
• Actve regional policy to create new jobs and businesses
Stmulate stronger work incentves

• Higher minimum wage or a living wage
• Reductons in income tax / natonal insurance
• Welfare reforms to reduce the risk of the poverty trap

Evaluating the Benefits of Falling Unemployment

Standard economic and social benefits of falling

Potential disadvantages of falling unemployment
unemployment
Increased employment – boosts real GDP, helps to Extra spending from expanding labour market might
lift living standards, demand worsen the current account
More people in work – creates extra tax revenues

Risk of an acceleration in demand-‐pull and cost-‐push
for the government either to lower the deficit /
inflationary pressures if unemployment falls rapidly
increase spending (G)
Social costs of high unemployment are severe – Fewer spare labour will mean a rise in unfilled
progress in cutting it has important economic + vacancies; labour shortages might put off some
social benefits inward investment


Housing and labour immobility

Average House Prices by Region Average Price

(Price Data is for Q3, 2014)

East Anglia £195K
London £401K
North £121K
North West £146K
South East £234K
South West £210K
Yorks & Humber £145K
Wales £144K
Scotland £142K
Northern Ireland £120K
United Kingdom (average) £188K

• Big differences in regional house prices are perhaps the biggest single cause of geographical
immobility in the UK labour market
• Average house prices in London are more than twice the UK average
• The high cost of renting in major towns and cities is also a barrier
• Many people are reluctant to move to areas where living costs are higher
• And people living in high-‐price areas may want to stay and gain from house price inflation
• The lack of affordable housing is a huge issue in the UK economy and contributes to structural
unemployment.
• Most economists support the idea of a programme of major house-‐building to stimulate demand
and to improve housing affordability to reduce unemployment
Average (mean) private weekly rent in England from 2008/2009 to 2013/2014

200
176
180
160 164 163
153 156
160
Mean weekly rent in GBP
140
120
100
80
60
40
20
0
2008/09 2009/10 2010/11 2011/12 2012/13 2013/14


19.Labour Migration and Macroeconomic Performance in the UK

Background on labour migration
• Labour migration has become an increasingly important feature of our globalizing world and it
raises important economic, social and political issues.
• In the year to June 2013 -‐ 503,000 people immigrated to the UK whilst 320,000 emigrants left the
UK. Net migration = 183,000
• Migration has an economic impact on sending and receiving countries
• Over 250-‐million people are now estimated to live in countries in which they were not born
• The global stock of international migrants grew by 38 per cent from 1990 to 2010. However,
international migrants constitute a small fraction of the world population, just 3.1% in 2010
• Migration is overwhelmingly from less developed to more developed countries and regions but we
are also seeing outward migration from some of Europe’s hardest-‐hit countries.
Official data for inward and outward migration is shown in the chart below. Net migration into the UK has
been positive in recent years.

Migration Data for the UK Economy
700
600
500
400
300
200
100
0
YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE
Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec
05 05 06 06 07 07 08 08 09 09 10 10 10 10 11 11 11 11 12 12 12 12 13 13 13 13 14p 14p 14p 14p
Rolling year (YE = Year Ending, p=provisional data) Revised Net Migraton

The impact of migration on the UK economy

Economic Benefits of Inward Migration
1. Migrants provide fresh skills and higher labour productivity
2. An increase in the size of the active labour supply – boosting potential output
3. A driver of innovation and entrepreneurship
4. Positive multiplier effects if migrants find paid work
5. Reducing skilled-‐labour shortages in growing industries
6. Remittances sent home by migrants add to the gross national income of home nations – creating
potential for rising exports

7. Tax revenues: Legal immigrants in work pay direct and indirect taxes and are likely to be net
contributors to the government’s finances.
Overall, supporters of inward labour migration argue that the process is a positive-‐sum game rather than a
zero-‐sum game.

Arguments against large-‐scale inward labour migration
1. Welfare costs: Increasing cost of providing public services
2. Possible displacement of domestic workers
3. Social tensions arising from problems of integrating thousands of extra workers
4. Rising demand for housing forces up property prices and rents for many groups in the population
5. Poverty risk: Migration may have the effect of worsening the level of relative poverty in a society.
And many migrant workers have complained of exploitation by businesses that have monopsony
power in a local labour market.
Brain Drains
• A brain drain describes the movement of highly skilled or professional people from their own
country to another country where they can earn more money
• It has been used to describe net outward migration of people from several European Union
countries in recent times (notably Ireland, Greece and Spain) -‐ another phrase for this is human
capital flight.
• One disadvantage is that countries lose out on the benefits that might have accrued from the
resources used in educating people who leave. Add to this the loss of tax revenue from those who
choose to live and work overseas.
• A sizeable loss of skilled workers (many of whom may be younger and therefore more
geographically mobile) could lead to labour shortages in the sender country, causing rising wages
and labour costs.
• Some of this income earned overseas returns to the sender country in the form of remittances
(adding to GNP) and many skilled migrants often leave only for a year or two -‐ the percentage of
permanent migration inside the EU is relatively small.

Long Term Migration into UK Economy -‐ Motivations

300
Work related Accompany / join Formal study
250
200
150
100
50
0
YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE YE
Dec Dec Dec Dec Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec
05 06 07 08 09 10 10 10 10 11 11 11 11 12 12 12 12 13 13 13 13 14p 14p 14p 14p
Rolling year (YE = Year Ending, p = Year includes provisional estmates for 2014 onwards)

Evaluating the effects of migration
The net economc benefits and costs of labour migration are hard to quantify and estimate. The benefits
and costs depend in part on:
1. The types of people who choose to migrate from one country to another.
2. The ease with which they assimilate into a new country and whether they find regular jobs.
3. Whether a rise in labour migration stimulates capital spending by firms and by government.
4. Whether workers who come into a country decide to stay in the longer term or whether they
regard migration as essentially a temporary exercise (e.g. to gain qualifications, learn some English)
before moving back to their country of origin.

Impact on the economies of source countries

An important evaluation point is that inward migration into the UK from Eastern European countries has
affected not just the UK labour market but also the labour markets in the countries from which these
migrants have come. Many eastern European countries have suffered from a sustained reduction in the
size of their populations – migration is one factor behind this although not the only one. There are many
potential negative consequences among them the following:
• A reduction in the size of the available labour supply
• A possible reduction in the quality of the labour supply if skilled migrants leave
• A fall in aggregate demand for goods and services
• A worsening problem of labour shortages which could drive up wages, costs and prices
• A decline in the tax-‐paying population which will hit government tax revenues


20.Introduction to Globalisation and International Trade
What is globalisation?
The OECD defines globalization as

“The geographic dispersion of industrial and service activities, for example research and
development, sourcing of inputs, production and distribution, and the cross-‐border networking of
companies, for example through joint ventures and the sharing of assets.”

Globalisation is a process of deeper integration between countries and regions of the world involving:
1. Greater trade in goods and services within and between countries and regions of the world
2. An increase in transfers of capital including the expansion of foreign direct investment (FDI) by
trans-‐national companies (TNCs) and the rising influence of sovereign wealth funds
3. The development of global brands that serve markets in higher and lower income countries
4. Spatial division of labour– for example out-‐sourcing and off shoring of production and support
services as production supply-‐chains has become more international. As an example, the iPhone is
part of a complicated global supply chain. The product was conceived and designed in Silicon
Valley; the software enhanced by software engineers working in India. Most iPhones are assembled
/ manufactured in China and Taiwan by TNCs such as FoxConn
5. High levels of labour migration within and between countries
6. New nations joining the trading system. Russia joined the World Trade Organisation in July 2012
7. A fast changing shift in the balance of economic and financial power from developed to emerging
economies and markets – i.e. a change in the centre of gravity in the world economy
8. Increasing spending on investment, innovation and infrastructure across large parts of the world
9. Globalisation is a process of making the world economy more inter-‐dependent
10. Many of the industrializing countries are winning a rising share of world trade and their economies
are growing faster than in richer developed nations especially after the global financial crisis (GFC)
Share of Global GDP (%, at market exchange rates)

Country 2008 2012 2013 2015
Brazil 3.1 3.2 3.1 2.9

Mexico 2.1 2.0 2.0 2.0
United States 17.9 16.5 16.4 16.1
China 12.0 15.2 15.8 17.0
India 5.5 6.3 6.5 7.0
South Korea 1.6 1.7 1.7 1.6
Germany 4.0 3.6 3.5 3.4
Russia 3.8 3.5 3.4 3.1
Spain 1.9 1.6 1.5 1.5
United Kingdom 2.7 2.4 2.4 2.4

• The British economy accounts for less than 3 per cent of world output.

• China’s share has grown from 12% in 2008 to 17% in 2015 – although her economy is now slowing
to a more moderate pace of growth. Using this measure of GDP at market exchange rates, China is
now the world’s largest economy, over-‐taking the United States, although it is a long way from
being the richest. China’s per capita GDP (PPP adjusted) remains a small fraction of the income
levels of the richest advanced countries.
Key Aspects of Globalisation – Our Interconnected World

Trade to GDP ratos are rising for Big expansion of Financial Capital Rise in Foreign Direct Investment
most countries Flows between countries and Cross Border M&A
Rise of global brands – including Deeper specializaton of labour – Global supply chains & new trade
many from emerging countries i.e. components from many and investment routes
natons

International Trade
• Trade is the exchange of products between countries
• When conditions are right, trade brings benefits to all countries involved and can be a powerful
driver for sustained GDP growth and rising living standards
• One way of expressing the gains from trade in goods and services is to distinguish between static
gains (i.e. improvements in allocative and productive efficiency) and dynamic gains (i.e. gains in
welfare that occur from improved product quality, increased choice and faster innovative
behaviour).
The concept of an Open Economy
In an open economy, one nation trades openly with other
• Trade in goods
• Trade in services
• Free flow of financial capital
• Free flow of labour resources
An open economy is integrated with and connected to the world economy


Gains from Trade – Understanding Comparative Advantage
• First introduced by David Ricardo in 1817, comparative advantage exists when a country has a
‘margin of superiority’ in the supply of a good or service i.e. where the marginal cost of production
is lower
• Countries will generally specialise in and export products which use intensively the factors inputs
which they are most abundantly endowed
• If each country specializes, total output can be increased leading to better allocative efficiency and
welfare.
• Because production costs are lower, providing that a good price can be found from buyers,
specialisation should focus on goods and services that provide the best value
• In many countries, comparative advantage is shifting towards specialising in producing and
exporting high-‐value and high-‐technology manufactured goods and high-‐knowledge services
Example of Comparative Advantage
Usually we take a standard two-‐country + two-‐product example to illustrate comparative advantage.
• Consider two countries producing digital cameras and vacuum cleaners
• With the same factor resources (inputs) evenly allocated by each country to the production of both
goods, the production possibilities are as shown in the table below:
OUTPUT BEFORE SPECIALISATION DIGITAL CAMERAS VACUUM CLEANERS

UK 600 600
United States 2400 1000
Total 3000 1600

Stage 1: Working out the comparative advantage
o To identify who should specialise in a particular product, consider the internal opportunity costs
o Were the UK to shift their resources into supplying more vacuum cleaners, the opportunity cost of
each vacuum cleaner is one digital television
o For the United States the same decision has an opportunity cost of 2.4 digital cameras. Therefore,
the UK has a comparative advantage in vacuum cleaners
o If the UK chose to reallocate resources to digital cameras the opportunity cost of an extra camera
is one vacuum cleaner. But for the USA the opportunity cost is only 5/12ths of a vacuum cleaner.
o USA has comparative advantage in producing digital cameras because its opportunity cost is lowest
Stage 2: Showing the Output after Specialisation

OUTPUT AFTER SPECIALISATION DIGITAL CAMERAS VACUUM CLEANERS
UK 0 (-‐600) 1200 (+600)
United States 3360 (+960) 600 (-‐400)
Total 3360 1800
o The UK specializes totally in producing vacuum cleaners – doubling its output -‐ now1200
o The United States partly specializes in digital cameras increasing output by 960 having given up 400
units of vacuum cleaners
o As a result of specialisation output of both products has increased -‐ a gain in economic welfare.

Key point:
For mutually beneficial trade to take place, the two nations have to agree an acceptable rate of exchange
of one product for another. If the two countries trade at a rate of exchange of two digital cameras for one
vacuum cleaner, the post-‐trade position will be as follows:
o The UK exports 420 vacuum cleaners to the USA and receives 840 digital cameras
o The USA exports 840 digital cameras and imports 420 vacuum cleaners
Stage 3: Showing the Gains from Trade -‐ Post Trade Output / Consumption

DIGITAL CAMERAS VACUUM CLEANERS
UK 840 780
United States 2520 1020
Total 3360 1800

Compared with the pre-‐specialisation output levels, consumers now have an increased supply of both
goods

What are the key assumptions behind this theory of trade?
This theory of trade based on comparative advantage rests on a number of assumptions:
1. Occupational mobility of factors of production -‐ this means that switching factor resources from
one industry to another involves no loss of efficiency and productivity. In reality we know that
factors of production are not perfectly mobile – labour immobility is a root cause of structural
unemployment.
2. Constant returns to scale (i.e. doubling the inputs used in the production process leads to a
doubling of output) – this is merely a simplifying assumption.
3. Insignificant externalities from production and/or consumption – no discussion about the overall
costs and benefits of specialisation and trade should ignore environmental considerations arising
from increased production and trade between countries.
The Changing Balance of World Economic Power: The Share of Global GDP from 1980 to 2015 By Region

40%
35%
30%
25%
20%
15%
10%
5%
0%
1980 1990 2000 2010 2015
US EU-‐28 Asia-‐Pacific


What are the Main Sources of Comparative Advantage?
• Comparative advantage is a dynamic concept meaning that it changes over time.
• For a country, some of the factors below are important in determining the relative unit costs of
production:
1. The quantity and quality of natural resources available for example some countries have an
abundant supply of good quality farmland, oil and gas, or easily accessible fossil fuels. Climate and
geography have key roles in creating differences in comparative advantage. More recently the
shale gas revolution in the United States and elsewhere is leading to shifts in the future pattern of
world energy production and trade as North America becomes more energy sufficient. Severe
worries about water scarcity in the future in large parts of the developing world might have hugely
significant effects on their ability to export products.
2. Demographics -‐ An ageing population, net outward or inward migration, educational
improvements and women’s participation in the labour force will all affect the quantity and quality
of the labour force available for industries engaged in international trade.
3. Rates of capital investment including infrastructure: Greater public infrastructure investment can
reduce trade costs and hence increasing supply capacity. Investment in roads, ports and other
transport infrastructure strengthens regional trade ties. ICT infrastructure is particularly important
for countries wanting to build a competitive advantage in information-‐intensive sectors such as
mobile telecommunications, gaming and financial services
4. Increasing returns to scale and the division of labour – increasing returns occur when output
grows more than proportionate to inputs. Rising demand in markets where trade takes place helps
to encourage specialisation, higher productivity and internal and external economies of scale.
These long-‐run scale economies can give regions and countries a significant unit cost advantage.
5. Investment in research & development which can drive innovation and invention
6. Fluctuations in the exchange rate, which affect the relative prices of exports and imports and cause
changes in demand from domestic and overseas customers.
7. Import controls such as tariffs, export subsidies and quotas – these can be used to create an
artificial comparative advantage for a country's domestic producers.
8. Non-‐price competitiveness of producers -‐ covering factors such as the standard of product design
and innovation, product reliability, quality of after-‐sales support. Many countries are now building
comparative advantage in high-‐knowledge industries and specializing in specific knowledge sectors
– an example is the division of knowledge in the medical industry, some countries specialize in
heart surgery, others in pharmaceuticals – health tourism is becoming more important.
9. Institutions – these are important for comparative advantage and for growth too. Banking systems
are needed to provide capital for investment and export credits, legal systems help to enforce
contracts, maintaining transparent and effective political institutions and the stability of democracy
is a key factor behind decisions about where international capital flows.
Comparative advantage is often a self-‐reinforcing process
o Entrepreneurs in a country develop a new comparative advantage in a product either because they
find ways of producing it more efficiently or they create a genuinely new product that finds a
growing demand in home and international markets
o Rising demand and output encourages the exploitation of economies of scale; higher profits can be
reinvested in the business to fund further product development, marketing and a wider distribution
network. Skilled labour is attracted into the industry and so on
o The expansion of an industry leads to benefits from exploiting external economies of scale.


Trends in global export volume of trade in goods from 1950 to 2014 (in billion U.S. dollars)

20000
18000
16000
Export volume in billion U.S. dollars
14000
12000
10000
8000
6000
4000
2000
0
2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2000 1995 1990 1985 1980 1975 1970 1965 1960 1955 1950

Summary of the main gains from trade

Bewer access to new

Helps to reduce scale of Increased market technologies from
extreme poverty competton
different countries
Inflows of specialist Exploitng economies of Bewer use of our scarce
knowledge scale in bigger markets resources


Why is Trade important for Growth and Development?
Successful international trade provides:
• A source of foreign exchange to help a nation’s balance of payments
• A way of financing imports of essential capital equipment / technology and components
• An injection of demand into the circular flow of income and spending
• Increased employment in export industries and multiplier effects in other businesses and sectors
helping to service export suppliers
But overseas trade also has risks
• Volatile global prices affecting export revenues and profits
• Risks that exports will be affected by geo-‐political uncertainty and cyclical shifts in demand
• Opening up an economy to trade and investment may cause rising structural unemployment in
some industries as the pattern of demand changes over time
Wider gains from international trade
1. Welfare gains from lower prices and increased consumer choice
2. Economies of scale – trade encourages firms to exploit scale economies leading to lower unit costs
that passed on in lower prices
3. Market competition – trade promotes increased competition particularly for monopolies that
would otherwise face little competition. Trade is also a spur for higher labour productivity
4. Gains from innovation – trade stimulates innovations bringing better products for consumers
5. Access to new technology and inflows of new knowledge: trade gives countries access to new
technologies. Trade is a stimulus to the exchange of ideas and inflow of human capital
6. Rising living standards and a reduction in extreme poverty – countries that are more open to
trade achieve faster economic over the long run and have higher per capita incomes. Growth
through trade directly benefits the world's poor although free trade is not necessarily equitable
UK”s Main Import Partners in 2013

16.0%
13.9%
14.0%
12.0%
Share of total imports
10.0%
8.5% 8.5%
8.0%
6%
5.6%
6.0% 5%
4.0%
2.0%
0.0%
Germany Netherlands China France United States Belgium


The European Union (28 countries) is the biggest source of imported goods and services for the UK. But
China is now ahead of USA as a supplier of products

UK”s Main Export Partners in 2013

16.0%
13.8%
14.0%
12.0%
Share of total exports
10.0% 9% 8.8%
7.6%
8.0%
6.4%
5.7%
6.0%
4.3%
4.0%
2.0%
0.0%
Switzerland Germany United States Netherlands France Ireland Belgium

More than half of the UK’s exports go to the other nations inside the European Union. Switzerland is our
biggest export market but is outside of the EU.

Top export countries worldwide in 2013 (in billion U.S. dollars)

Exports in billion U.S. dollars

0 500 1000 1500 2000 2500
China 2,209.63
United States 1,578.97
Germany 1,452.8
Japan 715.1
Netherlands 663.52
France 579.65
Korea, Republic of 559.63
United Kingdom 541.35
Hong Kong, China 535.55
Russian Federaton 523.33
Italy 517.67
Belgium 468.82
Canada 458.14
Singapore 410.25
Mexico 380.19


21.The Balance of Payments

What is the Balance of Payments?
• The balance of payments (BOP) records all financial transactions made between consumers,
businesses and the government in one country with other nations
• Inflows of foreign currency are counted as a positive entry (e.g. exports sold overseas)
• Outflows of foreign currency are counted as a negative entry (e.g. imported goods and services)
Measuring the current account
• The current account of the balance of payments comprises the balance of trade in goods and
services plus net investment incomes from overseas assets and net transfers
Trade in goods includes items such as: Trade in services includes:
! Manufactured goods ! Banking, insurance and consultancy
! Semi-‐finished goods and components ! Other financial services including foreign
! Energy products exchange and derivatives trading
! Raw Materials ! Tourism industry
! Consumer goods ! Transport and shipping
! (i) Durable goods ! Education and health services
! (ii) Non-‐durable goods e.g. foods ! Research and development
! Capital goods (e.g. equipment) ! Cultural arts

A summary of items on the current account of the balance of payments is shown below

•  Finished manufactured goods, components, raw

Trade Balance in Goods materials
•  Energy products, Capital technology
•  Banking, Insurance, Consultancy

•  Tourism, Transport, Logistcs
Trade Balance in Services
•  Shipping, Educaton, Health,
•  Research, Cultural Arts
•  Overseas aid / debt relief

Net Money Transfers
•  Private money transfers e.g. From migrant workers
Net Investment Income from •  Profits, interest and dividends from investments in other
Overseas Assets countries e.g. The profits from transnatonal businesses

Worked example of the current account balance calculation
• The current account is trade in goods and services, net investment incomes and net transfers.
• If a country is running a deficit, there is a net outflow of demand and income from the circular flow.

Net Balance
Item of the Balance of Payments
$ Billion
Current Account

(1) Balance of trade in goods -‐25
(2) Balance of trade in services +10
(3) Net investment income -‐12
(4) Net overseas transfers +8
Sum of 1+2+3+4 = Current account balance -‐19

UK BoP Current Account Balance in Recent Years

Current balance = sum (1) Transfers and (2) Net trade balance (3) Net investment
* Forecast
of 1 + 2 + 3 other in goods and services income
% Of GDP % Of GDP % Of GDP % Of GDP

2008 -‐3.7 -‐0.9 -‐3.0 0.2
2009 -‐2.8 -‐1.0 -‐1.9 0.1
2010 -‐2.6 -‐1.3 -‐2.4 1.1
2011 -‐1.7 -‐1.4 -‐1.5 1.2
2012 -‐3.7 -‐1.4 -‐2.1 -‐0.3
2013 -‐4.5 -‐1.6 -‐2.0 -‐0.9
2014 -‐5.9 -‐1.5 -‐2.0 -‐2.4
2015*
-‐5.0 -‐1.3 -‐1.8 -‐1.8
(Forecast)

UK Trade in Services

15%
10%
5%
% of GDP
0%
-‐5%
-‐10%
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1
Net trade Exports Imports


The UK runs a large trade surplus in services. Net exports of business and financial services are strong as is
the sale of creative service e.g. films and television series. Britain runs a trade deficit in travel and tourism.

UK Trade in Goods

30%
25%
20%
15%
% Of GDP
10%
5%
0%
-‐5%
-‐10%
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1
Net Trade Exports Imports

The UK runs a large and growing trade deficit in goods. The economy is a big net importer of finished
manufactured products and is also now a net importer of oil and gas.

UK Trade Balances in Goods and Services with the EU
The chart below shows the annual trade balance in goods and services that the UK runs with a selection of
fellow EU member countries. The data is measured in £ billion.


20
10
-10
-20
-30
-40
-50
-60
-70
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Rest of the EU Spain Netherlands Ireland Germany France

China – An Example of a Country with a Structural Trade Surplus

China: trade balance from 2004 to 2014 (in billion U.S. dollars)

450
400 382.46
Trade balance in billion U.S. dollars
350
298.13
300
264.34 259.24
250 230.75
195.69
200 177.52 181.51
154.9
150
102
100
50 32.1
0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

What does a current account deficit mean?
• Running a deficit on the current accout means that a country is not paying its way in the global
economy. There is a net outflow of demand from the circular flow of income and spending.
• The current account does not have to balance because the balance of payments also includes the
capital account. The capital account tracks capital flows in and out of a country. This includes
portfolio capital flows (e.g. share transactions) and direct capital flows arising from foreign
investment.

• If a country is running a current account deficit, it needs to balance this with a surplus on the
capital account; this is achieved by measures to attract inflows of capital from other countries.
What are the main causes of a current account deficit?
• Poor price and non-‐price competitiveness
o Higher inflation than a nation’s main trading partners
o Low levels of capital investment and research and development / innovation
o Weaknesses in design, branding and other non-‐price factors
• Strong exchange rate affecting exports and imports
o High currency value increases the prices of exports in overseas markets
o Appreciating currency also makes imports cheaper causing domestic consumers to switch
their spending towards cheaper imported products
• Recession in one or more major trade partner countries
o Recession cuts the total value of exports to these countries
• Volatile global prices (e.g. Commodities)
o Exporters of primary commodities might be hit by a fall in world prices
o Importing nations could be hit by higher prices for oil and gas
The Export Multiplier Effect:
Many industries rely heavily on our key export industries remaining competitive – these include:
• Transportation / freight / logistics businesses / service businesses at airports
• Trade finance businesses and insurance businesses
Economic policies to reduce a trade deficit
• Demand management: A tightening of fiscal and/or monetary policy reduces real spending power
of consumers and leads to lower spending on imports (fall in M improves trade balance)
• Currency adjustment: Lower exchange rate reduces the foreign price of exports and makes imports
more expensive – causes changes in demand
• Supply-‐side improvements:
o Policies to raise labour productivity and encourage start-‐ups with export potential e.g. Life
sciences, digital etc
o Investment in human capital to boost productive capacity and competitiveness in high-‐
value industries such as bio-‐technology, engineering, medicine, tourism
• Protectionist measures such as import quotas, tariffs and other non-‐tariff barriers (NB: The UK is
limited by global trade agreements and cannot impose tariffs unilaterally to improve their trade)


Competitiveness
External competitiveness is the ability to sell goods and services at competitive prices in a foreign country
• Cost competitiveness
o Differences in unit labour costs – reflected in producer prices
• Non-‐price competitiveness
o Product quality, design, reliability and performance, choice, after-‐sales services, marketing,
branding and the availability and cost of replacement parts
• Non-‐wage costs:
o Costs of meeting environmental / health regulations
o Environmental taxes e.g. carbon taxes and waste taxes
o Employment protection laws and health and safety laws
o Requirements to provide pensions for employees
Index of the 25 most competitive countries in 2014 (World Economic Forum Rankings)

120
100
80
Index Value
60
40
20
0
Switzerland
Singapore
Hong Kong
Sweden
Canada
UAE
Luxembourg
Malaysia
Taiwan
Netherlands
Ireland
Australia
Finland
New Zealand
Japan
Austria
China Mainland
Israel
Iceland
Norway
Germany
Denmark
Qatar
USA
UK


22.Monetary Policy
Introduction to monetary policy
• Monetary policy involves changes in interest rates, the supply of money & credit and exchange
rates to influence the economy
• Monetary policy influences the decisions that we make about how much we save, borrow and
spend
• Decisions made by the central banks that operate monetary policy can have a powerful effect on
consumers and businesses and on macroeconomic indicators such as GDP growth and inflation
• Changes in interest rates have both demand and supply-‐side effects. The demand-‐side effects are
most likely in the short term
What is Money?
Money is any asset that is acceptable as a medium of exchange in payment for goods and services. The
functions of money are as follows:
1. A medium of exchange used in payment for goods and services
2. A unit of account used to relative measure prices and draw up accounts
3. A standard of deferred payment – for example when using credit to purchase goods and services
now but pay for them later
4. A store of value -‐ money holds its value unless there is a situation of accelerating inflation. As the
general price level rises, so the internal value of a unit of currency decreases.

All of the following are important aspects of monetary policy
Market interest rates Bank Lending Currency markets
Inflaton targets Bank of England European Central Bank

Interest Rates
• An interest rate is the reward for saving and the cost of borrowing expressed as a percentage of the
money saved or borrowed
• There are many different interest rates in an economy
o Interest rates on savings in bank and other accounts
o Borrowing interest rates

! Mortgage interest rates (housing loans)
! Credit card interest rates and pay-‐day loans
! Interest rates on government and corporate bonds
• The Bank of England uses nterest rates to help regulate the economy and meet macro objectives
The Real Rate of Interest
• The real rate of interest is the money rate of interest minus the rate of inflation.
• So if a saver is receiving a money rate of interest of 6% on his savings, but price inflation is running
at 3% per year, the real rate of return on these savings is only + 3%.
• Real interest rates become negative when the nominal rate of interest is less than inflation, for
example if inflation is 5% and nominal interest rates are 4%, the real cost of borrowing money is
negative at -‐1%.
UK Monetary Policy – A Brief History

1980s
•  Belief in the theory of monetarism, money supply targets
•  Late 1980s – shadowing the German Mark to control inflaton
1990-‐1992
•  UK entered the EU exchange rate mechanism in October 1990
•  A system of semi-‐fixed exchange rates – pegged to the Mark
1992-‐1997
•  Sept 1992 – Sterling devalued / UK leaves ERM on Black Wednesday
•  Move back to floatng exchange rates – government stll sets rates
1997 to 2015

•  May 1997 -‐ Bank of England made independent of government
•  Monetary Policy Commiwee set up to set official interest rates


Monetary Policy Interest Rates (Per Cent) for Selected Nations (Annual average)

2007 2008 2010 2012 2013 2015

Brazil 12.1 12.4 9.9 8.6 8.3 13.5
United States 5.1 2.1 0.1 0.1 0.1 0.3
Australia 6.4 6.7 4.4 3.7 2.7 2.1
China 2.3 2.8 1.8 2.3 2.3 1.6
Hong Kong, China 6.6 3.4 0.5 0.5 0.5 0.5
India 7.7 8.0 5.5 8.1 7.5 7.3
Japan 0.5 0.5 0.1 0.1 0.1 0.1
New Zealand 8.3 5.0 3.0 2.5 2.5 3.5
Singapore 2.8 1.3 0.4 0.3 0.3 0.5
South Korea 4.7 4.8 2.2 3.1 2.6 1.7
Eurozone 3.9 3.7 1.0 0.9 0.6 0.1
United Kingdom 5.5 4.7 0.5 0.5 0.5 0.5

The Bank of England and the handling of Monetary Policy
• Founded in 1694 and nationalized in 1946, the Bank of England is charged with providing monetary
and financial stability for the United Kingdom
• The Bank of England has been independent of government since 1997
• The Monetary Policy Committee (MPC) has nine members, some appointed by the government and
some by the Bank of England.
• The Governor of the Bank (currently Mark Carney) has the casting vote if there is an equally split
decision on interest rates
• Each month the MPC meets to consider the latest news on the UK and global economy
• Their job is to make a judgement on what is the appropriate level of policy interest rates for the UK
economy consistent with the need to meet an inflation target set by the government
• That inflation target is consumer price inflation of 2%
• The MPC has one eye on maintaining GDP growth (although a set rate of GDP growth is not part of
their target). Inflation is allowed to vary by 1% either side of the 2% target – so they have some
leeway.
• Policy interest rates in the UK have remained the same (0.5%) since March 2009
Key Roles for a Central Bank
• Monetary stability: Conducting monetary policy to ensure stable prices and confidence in the
currency. Many countries have an inflation target – often set by the Government for a central
bank to achieve. E.g. the UK Government sets the Bank of England an inflation target of 2%. Their
aim is to keep the annual rate of consumer prices inflation (CPI) within 1% of the target.
• Financial stability: This means overseeing the financial system so that there is an efficient flow of
savings and loans and confidence in financial intermediaries such as banks. Depositors need to
know for example that their savings are safe and that banks and other lenders are acting
responsibly.
• When financial stability breaks down there are damaging economic and social consequences.

Factors considered by the Bank of England when setting interest rates
At each of their rate-‐setting meetings, the members of the MPC consider a huge amount of information on
the state of the economy. Here are some of the factors they consider when making rate decisions.
• GDP growth and spare capacity: The rate of growth of GDP and the size of the output gap. Their
main task is to set monetary policy so that AD grows in line with the country’s productive potential.
• Bank lending and consumer credit figures -‐ including the levels of equity withdrawal from the
housing market and also data on credit card lending which supports demand on the high street
• Equity markets (share prices) and house prices -‐ both are considered important in determining
household wealth, which then feeds through to borrowing and retail spending
• Consumer confidence and business confidence – confidence surveys can provide “advance
warning” of turning points in the economic cycle. These are called ‘leading indicators’
• Growth of wages, average earnings and unit labour costs -‐ wage inflation might be a cause of cost-‐
push inflation so the Bank of England looks carefully at what is happening to wages
• Unemployment figures -‐ and survey evidence on job vacancies and shortages of skilled labour.
• Trends in global foreign exchange markets – a weaker exchange rate could be seen as a threat to
inflation because it raises the prices of imported goods and services. A strong exchange rate might
bring down inflation but risk causing a deeper economic slowdown via a fall in exports
• International data -‐ including recent developments in the Euro Zone, BRIC nations, emerging
market countries and the United States and Japan.
1. The key point is that the Monetary Policy Committee considers many indicators from both the
demand and the supply-‐side of the economy.
2. They then have to make a judgement about what this evidence says about inflationary pressures
over a two year forecast horizon.
3. Why do they have to look up to two years ahead? Because when interest rates are changed, it
takes time for them to have an effect on aggregate demand and prices. Uncertain time lags in a
world of many external shocks make the handling of monetary policy a difficult job!
Forward Guidance in Setting Interest Rates
• Forward Guidance was first introduced by Bank of England Governor, Mark Carney in August 2013
• It has been signalled that the Bank of England will leave their policy interest rates unchanged as
long as the unemployment rate is above 7.0% and inflation is under control
• The aim is to build confidence by signalling that official interest rates would stay at low levels for
some time
• In 2014, Mark Carney signalled that forward guidance would evolve – LFS unemployment is not the
sole data measure to be used – they will look at a range of measures of spare capacity


The Monetary Policy Transmission Mechanism

What are the main effects of changes in interest rates?

It is worth remembering that when the Bank is making a decision, there will be lots of other events and
policy decisions being made elsewhere in the economy, for example changes in fiscal policy by the
government, or perhaps a change in world oil prices or the exchange rate. In macroeconomics the ceteris
paribus assumption (all other factors held equal) rarely applies!
• There are several ways in which changes in interest rates influence aggregate demand, output and
prices. These are collectively known as the transmission mechanism of monetary policy
• One of the channels that the Monetary Policy Committee in the UK can use to influence aggregate
demand, and inflation, is via the lending and borrowing rates charged in the financial markets.
• When the Bank’s own base interest rate goes up, then commercial banks and building societies will
typically increase how much they charge on loans and the interest that they offer on savings.
• This tends to discourage businesses from taking out loans to finance investment and encourages
the consumer to save rather than spend — and so depresses aggregate demand
• Conversely, when the base rate falls, banks cut the market rates offered on loans and savings and
the effect ought to be a stimulus to demand and output.
A key influence played by interest rate changes is the effect on confidence – in particular household’s
confidence about their own personal financial circumstances.

Changes in interest rates affect:
1. Housing market & house prices:
a. Higher interest rates increase the cost of mortgages and reduce the demand for housing.
This will affect household wealth and put a squeeze on equity withdrawal (where
consumers borrow money secured on rising house prices)
2. Effective disposable incomes of mortgage payers:
a. If interest rates increase, the income of homeowners who have variable-‐rate mortgages
will fall – leading to a decline in their effective purchasing power

b. The effects of a rate change are greater when the level of existing mortgage debt is high as
this makes property owners more exposed to higher costs of repaying debts.
3. Disposable income of savers:
a. A rise in interest rates boosts the disposable income of people who have paid off their
mortgage and who have positive net savings in bank and building society accounts
b. But if the rate of interest is lower than the rate of inflation, then the annual real return on
saving will be negative.
4. Consumer demand for credit:
a. Higher interest rates increase the cost of paying the debt on credit cards and should lead to
a deceleration in retail sales and spending on consumer durables especially items such as
cars and household appliances typically bought on credit.
5. Business capital investment:
a. Firms often take the actual and expected level of interest rates into account when deciding
whether or not to go ahead with new capital investment spending
b. A rise in interest rates may dampen confidence and lead to a reduction in planned capital
investment. However, many factors influence investment decisions other than rate
changes.
6. Consumer and business confidence:
a. The relationship between interest rates and business and consumer confidence is complex,
and depends crucially on prevailing economic conditions
b. When businesses and consumers are worried about the recession, an interest rate cut can
boost confidence because it reassures the public that the Bank is alert to the dangers of a
slump
c. Some people might take emergency interest rate cuts as a sign that the wider economy is
in difficulty and hard times lie ahead.
7. Interest rates and the exchange rate:
a. Higher UK interest rates might lead to an appreciation of the exchange rate particularly if
UK interest rates rise relative to those in the Euro Zone and the United States attracting
inflows of “hot money” into the banking system.
b. A stronger exchange rate reduces the competitiveness of UK exports in overseas markets
because it makes our exports appear more expensive when priced in a foreign currency
leading to a decline in export volumes and market share.
c. It also reduces the sterling price of imported goods and services leading to lower prices and
rising import penetration. If the trade deficit in goods and services widens, this is a net
withdrawal of demand from the circular flow and acts to reduce excess demand in the
economy.
Key points:
1. A reduction in interest rates and/or an increase in the supply of money and credit in an economy is
called an expansionary monetary policy or a reflationary monetary policy
2. An increase in interest rates and/or attempts to control or reduce the supply of money and credit is
called a contractionary monetary policy or a deflationary monetary policy

Conventional monetary policy -‐ How changes in interest rates feed through the economy to affect prices
Market interest rates

E.g. savings rates & credit cards
Domestic
Demand
I.e. C + I + G
Asset prices e.g. housing
E.g. house prices
Aggregate Domestic
Demand Inflationary
Official Interest Pressure
Rate
Net
Business Expectations and External
Consumer Confidence Demand
Businesses & consumers i.e. X -‐ M
Import
Prices
Consumer Price
Inflation
Value of the e xchange rate

Summary of likely effects of a rise in interest rates

Signals tghter monetary Market interest rates

MPC raises interest rates policy increase
Possible slowdown in Main effect will be

housing market through via mortgages Cost of borrowing rises
Higher rates might also Makes UK exports more

And contracton in retail cause currency expensive in overseas
credit
appreciaton markets


Monetary Policy Asymmetry
• Fluctuations in interest rates do not have a uniform impact on the economy.
• Some industries are more affected by interest rate changes than others, for example exporters and
industries connected to the housing market
• Some regions in the UK are also more sensitive to a change in the direction of interest rates.
• The markets and businesses most affected by changes in interest rates are those where demand is
interest elastic i.e demand responds elastically to a change in interest rates or indirectly through
changes in the exchange rate
• Good examples of interest-‐sensitive industries include those linked to the housing market¸
exporters of manufactured goods, the construction industry and leisure services
• In contrast, the demand for basic foods and utilities is less affected by short-‐term fluctuations in
interest rates and is affected more by changes in commodity prices such as oil and gas.
Quantitative Easing (QE)
• When policy interest rates are at zero or close to zero, there is a limit to what conventional use of
monetary policy can do
• In 2009 the Bank of England started a policy of quantitative easing (QE) for the first time.
• The aim of QE is to support aggregate demand and avoid a recession becoming a deflationary
depression
• The Bank of England uses QE to increase the supply of money in the banking system.
• The Bank does not print new £10, £20 and £50 notes
• Instead it uses money to buy government bonds
• There are doubts about the effectiveness of quantitative easing – bank lending has struggled to
recover since the end of the recession. In the summer of 2015, the QE programme totalled £375bn
How Quantitative Easing (QE) is meant to work
The graphic below provides a flow chart of how quantitative easing is designed to work. The main
transmission mechanism is through the market for government bonds that then has an effect on other
long-‐term interest rates such as mortgage interest rates in the property market.

Central bank creates money electronically -‐ It adds money to
their balance sheet
This money is used to buy financial assets -‐ Mainly the
purchase of government bonds
More demand leads to higher prices for assets e.g. bond
prices. Rise in price of bonds leads to a lower yield (%) on
government bonds
Can feed through to fall in long term interest rates e.g.
mortgages and corporate bonds
Lower interest rates and increased cash in the banking system
should stmulate the economy


Consequences of Low Interest Rates for the Distribution of Income and Wealth
Consider the effect of a period of very low nominal interest rates
• The real income of savers:
o If the rate of interest paid on savings falls below the rate of inflation, people with positive
net savings will see a reduction in their real incomes
• The disposable incomes of mortgage-‐payers:
o If interest rates fall, the income of home-‐owners who have variable-‐rate mortgages will
increase leading to an rise in their purchasing power
• Interest rates, house prices and wealth:
o Many factors affect house prices but when the cost of a mortgage falls, standard theory
predicts that the demand for housing will expand driving property values higher.
o This increases the net wealth of people who own property but makes it difficult for lower-‐
income families including young people to find the money to afford to purchase a house or
flat.
In summary -‐ when interest rates fall, there is a re-‐distribution of income away from lenders (who receive
less) towards those with variable rate loans.

Evaluation Arguments: Are very low interest rates helping the UK economy?

Arguments that low interest rates are helping UK Counter-‐arguments – the disadvantages of low
macro performance interest rates
1. Savers have been hit badly by negative real

1. Keeping interest rates at 0.5% helps maintain
interest rates + income from pensions has
consumer & business confidence leading to
fallen – both are bad for long term economic
higher C+I and thus " AD. This is important
health. Raising interest rates will increase the
given continued slow growth in our main
disposable incomes of millions of savers
export markets in Europe
2. Low interest rates are causing another
2. If interest rates started to rise now, the £
unsustainable housing boom that in the long
would appreciate as hot money flowed into
run is damaging for the economy. We need
the UK. This could choke off demand for UK
higher interest rates now to control
exports # negative multiplier effect and
mortgage debt and learn lessons from 2007
some lost jobs in manufacturing businesses
3. Deflation is due to external pressures e.g. oil
3. At a time when the government is pursuing prices. Unemployment is falling (5.5%) and
fiscal austerity, it makes sense for interest wages are starting to rise (2%) so this is right
rate to remain low to keep the economy moment to start raising interest rates
growing and prevent deflation because they take time to have an effect


23.Exchange Rates

Introduction to Exchange Rates
• The exchange rate measures the external value of one currency against another currency
• The value of the currency is determined in the foreign exchange market where billions of $s of
currencies are traded every hour.
• The main currency traders are businesses, international investors and governments

Data on the UK Exchange Rate over recent years

Sterling Exchange Rate Sterling v US Dollar Sterling v Euro
Index
Year Jan 2005 = 100 £1 Buys £1 Buys
2007 103.7 2.00 1.46
2008 91.1 1.85 1.26
2009 80.6 1.57 1.12
2010 80.4 1.55 1.17
2011 80.0 1.60 1.15
2012 83.0 1.59 1.23
2013 81.4 1.56 1.18
2014 87.0 1.65 1.24
2015 (May) 91.4 1.55 1.39

Floating exchange rates
• The UK operates with a floating exchange rate system where the forces of market demand and
supply determine the daily value of one currency against another
• The value of the pound depends in how strong is demand for the currency relative to supply
• If overseas investors want to buy into sterling to take advantage of higher interest rates on offer in
UK bank accounts, they will swap their own currencies for pounds.
• This causes an increase in the demand for sterling in the foreign exchange markets, and in the
absence of other offsetting factors, this will cause an appreciation.
• Causes of a currency appreciation
o Currencies tend to go up in value either when a country is running a large trade surplus –
which brings in extra demand for a currency from sales of exports
o Currencies appreciate when overseas investors regard the currency as a good one to buy.
This might be because attractive interest rates are on offer by putting money into savings
accounts in that currency.
o Another cause is because there are high expected returns from other types of investment
notably property, stocks and shares and so on.
How does a change in the exchange rate influence the economy?
• Changes in the exchange rate affects demand for exports and imports, real GDP growth, inflation,
business profits and jobs
• As with most variables in economics, there are time lags involved. The impact of movements in
currencies on the economy depends in part on:
1. The scale of any change in the exchange rate i.e. a 5%, 10% or even larger movement

2. Whether the change in the currency is short-‐term or long-‐term – i.e. is the change in the
exchange rate temporary or likely to persist for some time?
3. How businesses and consumers respond to exchange rate fluctuations – price elasticity of
demand is important here i.e. will there be a large change in demand for exports and imports?
4. The size of any multiplier and accelerator effects
5. When the currency movement takes place – i.e. at which point of an economic cycle
Macroeconomic effects of currency depreciation
Consider for example a fall (depreciation) in the value of the pound sterling against the US dollar

When the pound depreciates against the US dollar
It makes UK import prices RISE It makes UK export prices FALL
Changes in import and export prices will affect demand
Import sales will CONTRACT Export sales will EXPAND
This will have an effect on a number of economic indicators
Domeskc produckon " Trade deficit $ Domeskc jobs "

How can changes in the exchange rate affect the rate of inflation?
The exchange rate affects the rate of inflation in a number of direct and indirect ways:
1. Changes in the prices of imports – this has a direct effect on the consumer price index. For
example, an appreciation of the exchange rate usually reduces the sterling price of imported
consumer goods and durables, raw materials and capital goods.
2. Commodity prices: Many commodities are priced in US dollars – so a change in the sterling-‐dollar
exchange rate has a direct impact on the UK price of commodities such as foodstuffs. A stronger
dollar makes it more expensive for Britain to import these items.
3. Changes in the growth of UK exports: A higher exchange rate makes it harder to sell overseas
because of a rise in relative UK prices. If exports slowdown (price elasticity of demand is important
in determining the scale of any change in demand), then exporters may choose to cut their prices,
reduce output and cut-‐back employment levels.
The Marshall Lerner Condition

The Marshall Lerner condition states that a depreciation / devaluation of the exchange rate will lead to a
net improvement in the trade balance provided that the sum of the price elasticity of demand for exports
and imports > 1.


Will fall in
Sum of price
Ped for exports Ped for imports currency improve
elasticity
the trade balance?
Country A 0.4 0.3 0.7 No
Country B 1.2 0.7 1.9 Yes
Will leave it
Country C 0.8 0.2 1.0
unchanged

The Sterling Exchange Rate and UK Exports & Imports
This chart tracks the value of the sterling exchange rate index together with an index of the volume of
exports and imports of goods and services. A fall in the sterling exchange rate index is called a depreciation
and means that a currency will buy less of other currencies in the markets.

Sterling exchange rate index,
2005 = 100 Sterling Exports (RHS) Imports (RHS)
130 160
120 140
110 120
100 100
90 80
80 60
70 40
60 20
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Evaluation points on the effects of exchange rate changes
Changes in the exchange rate have quite a powerful effect on the economy but we tend to assume ceteris
paribus – all other factors held constant – which of course is highly unlikely to be the case
1. Counter-‐balancing use of fiscal and monetary policy: For example the government can alter fiscal
policy to manage aggregate demand
2. Time lags – it takes time for demand for exports and imports to change following a movement in
the currency. Businesses need to have the capacity and access to credit to expand their production.
3. Low price elasticity of demand: In the short term, the effects of exchange rates on export and
import demand tends to be low because of low price elasticity of demand

4. Business response to the challenge of a high exchange rate: Businesses adapt to a high exchange
rate. There are several ways in which industries can adjust to the competitive pressures that a
strong pound imposes. Some of the options include:
• Cutting their export prices when selling in overseas markets and therefore accepting lower profit
margins to maintain competitiveness and market share
• Out-‐sourcing components from overseas to keep production costs down
• Seeking productivity / efficiency gains to keep unit labour costs under control or perhaps trying to
negotiate a reduction in pay levels
• Investing extra resources in new product lines where demand is price inelastic and less sensitive to
exchange rate fluctuations. This involves producing products with a higher income elasticity of
demand, where non-‐price factors such as product quality, design and effective marketing are as
important in securing orders as the actual price
Currency appreciation using AD and AS analysis diagrams
Currency appreciation and the demand for imports – explaining the process
Rise in external

purchasing power
Cheaper to import goods
Appreciaton of currency •  £1 buys more Euros/S and services
Rising demand for imports Worsening of the trade Fall in aggregate demand
balance
•  Depends on elastcity of •  Because of rising
demand for imports •  Trade deficit may rise leakages from circular
flow


24.Fiscal Policy
Introduction to Fiscal Policy
• Fiscal policy involves using government spending, taxation and borrowing to affect the level and
growth of aggregate demand, output and jobs
• Fiscal policy is also used to change the pattern of spending on goods and services
• It is also a way of redistributing income & wealth, for example by changing different tax rates on
varying levels of income or wealth
• It can be used as an instrument of micro-‐economic government intervention to correct for free-‐
market failures such as pollution or the sub-‐optimal provision of public and merit goods
• Changes in fiscal policy affect aggregate demand (AD) and aggregate supply (AS)
• Fiscal policy also concerns how much a government must borrow to finance their spending.
Fiscal Policy Economics – Some Key Terms

Bond Yield The rate of interest paid on government debt
The budget deficit is the difference between what the government receives
Budget (Fiscal) Deficit
in revenue and what it spends
The size of the deficit is influenced by the state of the economy: in a boom,
Cyclical Fiscal Deficit tax receipts are relatively high and spending on unemployment benefit is
low
Taxes on income, profits and wealth, paid directly by the bearer to the tax
Direct Taxation
authorities.
Taxation and spending measures that allow the government to guide the
Fiscal Policy
economy.
Taxes on expenditure (e.g. VAT). They are paid to the tax authorities, not by
Indirect Taxation
the consumer, but indirectly by the suppliers of the goods or services.
Debt is the total amount owed by the government that has accumulated
National Debt
over the years.
The structural deficit is that part of the deficit which is not related to the
Structural Fiscal Deficit state of the economy. This part of the deficit will not disappear when the
economy recovers.

The Public and the Private Sector of the Economy
• Public sector businesses are owned and operated by the government
• The public sector is not profit-‐driven, while this is usually the case with the private sector.
• In September 2013, there were 5.7 million people working in the UK public sector (18.8% of people
in employment). The National Health Service (NHS) employs over 1.5 million people
• Public sector businesses / corporations include the following:
• Met Office and Ordnance Survey
• Channel 4, National Nuclear Laboratories
• Eurostar, NATS (National Air-‐Traffic Control Services)
• Network Rail (not for profit business that operates the UK rail network)
• Royal Mail was part privatised in 2013 (the UK Govt currently retains a 30% stake)

Overview of key roles for fiscal policy
Fiscal policy decisions impact on millions of consumers and businesses in the short and the long term

Financing government Changing final income Providing a welfare

spending and wealth state safety-‐net
Managing the Improving long run Tackle important

economic cycle compettveness market failures

Fiscal Policy and Aggregate Demand
• Traditionally fiscal policy has been seen as an instrument of demand management.
• This means that changes in government spending, direct and indirect taxation and the budget
balance can be used “counter-‐cyclically” to help smooth out some of the volatility of national
output particularly when the economy has experienced an external shock and is in a recession.
Keynesian and Monetarist Views
• The Keynesian school argues that fiscal policy can have powerful effects on aggregate demand,
output and employment when the economy is operating below full capacity national output, and
where there is a need to provide a demand-‐stimulus.
• Monetarist economists believe that government spending and tax changes only have a temporary
effect on aggregate demand, output and jobs and that the tools of monetary policy are a m ore
effective instrument in controlling inflation and maintaining macroeconomic stability


Government Spending and Tax Revenue in the UK

Revenue Spending
850
800
Revenue / Spending in billion pounds
750
700
650
600
550
500
2010 2011 2012 2013 2014 2015* 2016* 2017* 2018* 2019* 2020*

Source: International Monetary Fund, data from 2015 onwards is a forecast

How Fiscal Policy Works -‐ The Transmission Mechanism
The next flow-‐chart identifies some of the channels involved with the fiscal policy transmission mechanism
– in the example shown we focus on an expansionary fiscal policy designed to boost demand and output

Cut in personal Boost to disposable Adds to consumer

income tax rates income demand
Cut in indirect taxes Lower prices – leads Adds to consumer
e.g. VAT to higher real demand
Expansionary Fiscal incomes
Policy
Cut in corporation Higher “post tax” Adds to business capital
tax profits for businesses spending
Cut in tax on interest Boost to disposable Adds to consumer
from saving income of p eople with demand
net savings

The multiplier effects of an expansionary fiscal policy depend on how much spare productive capacity the
economy has; how much of any increase in disposable income is spent rather than saved or spent on
imports. And also the effects of fiscal policy on variables such as interest rates and the exchange rate.


A contractionary fiscal policy (commonly known as fiscal austerity) would involve one or more of the
following:
• A cut in government expenditure either in real terms or as a share of GDP
• An increase in direct and/or indirect taxes
• An attempt to reduce the size of the budget deficit

Government spending
Spending by the public sector can be broken down into:
1. Transfer Payments:
a. These are welfare payments made available through the social security system including
the Jobseekers’ Allowance, Child Benefit, State Pension, Student Grants, Housing Benefit,
Income Support and the Working Families Tax Credit
b. The main aim of transfer payments is to provide a basic floor of income or minimum
standard of living for low-‐income households. And they allow the government to change
the final distribution of income.
2. Current Government Spending: i.e. spending on state-‐provided goods & services that are provided
on a recurrent basis -‐ for example salaries paid to people working in the NHS and resources for
state education and defence. The NHS is the country’s biggest employer with over one million
people working within the system! Current spending is also known as resource spending
3. Capital Spending: Capital spending includes infrastructure spending such as new motorways and
roads, hi-‐speed rail projects, hospitals, schools and prisons. It also includes military equipment,
buildings or land. Public sector investment spending adds to the economy’s capital stock and can
have important demand and supply side effects in the long term.

Breakdown of government spending in the UK
Government spending is spending on goods and services such as education, health care and defence


Welfare protection is the largest single element of government spending, with the NHS and Education the
biggest single departmental items.
• Total UK government spending is forecast to be £745 billion in 2015
• This is 43.1% of GDP. £50 billion or 7% will be on capital spending
• Spending on public services such as education & health is 22% of GDP
Transfer Payments Recurring spending Investment Projects

Welfare Spending Public Services State Investment

Government Current and Capital Spending

Current spending is on providing public services
Salaries of NHS Drugs used in health Road maintenance Army logistcs
employees care supplies
Capital spending – new public infrastructure

Constructon of new New equipment in Flood defence Extra defence
motorways the NHS schemes equipment

What are the Justifications for Government Spending?
1. To provide a socially efficient level of public goods and merit goods and overcome market failure
a. Public goods and merit goods tend to be under-‐provided by the private sector
b. Improved and affordable access to education, health, housing and other public services can
help to improve human capital, raise productivity and generate gains for society as a whole

2. To provide a safety-‐net system of welfare benefits to supplement the incomes of the poorest in
society – this is also part of the process of redistributing income and wealth. Government
spending has an important role to play in controlling / reducing the level of relative poverty
3. To provide necessary infrastructure via capital spending on transport, education and health
facilities – an important component of a country’s long run aggregate supply
4. Government spending can be used to manage the level and growth of AD to meet macroeconomic
policy objectives such as low inflation and higher levels of employment
5. Government spending can be justified as a way of promoting equity.
6. Well-‐targeted and high value for money public spending is also a catalyst for improving economic
efficiency and competitiveness e.g. from infrastructure projects

Welfare spending by the UK Government

£ Billion per year 2014-‐15 2015-‐16 2016-‐17
Welfare capped spending
Department of Work and Pensions (DWP) social security 74.4 76.0 74.8
of which:
Housing benefit (not on JSA) 21.4 22.1 21.9
Disability living allowance and personal independence payments 15.3 15.6 15.1
Incapacity benefits 14.1 14.8 14.7
Winter fuel payments 2.1 2.1 2.1
Personal tax credits 29.7 29.5 25.3
Child benefit 11.6 11.5 11.4
Tax free childcare 0.0 0.0 0.1
Total welfare cap 119.1 120.6 115.2
Welfare spending outside the welfare cap
DWP social security spending 92.0 94.0 96.1
of which:
State pension 86.5 89.7 92.1
Jobseeker's allowance 3.1 2.2 2.3
Housing benefit (on JSA) 2.4 1.6 1.7
Total welfare outside the welfare cap 95.1 96.4 98.6
Total welfare 214.3 216.9 213.8


Taxation
• Direct taxation is levied on income, wealth and profit. Direct taxes include income tax, inheritance
tax, national insurance contributions, capital gains tax, and corporation tax.
• Indirect taxes are taxes on spending – such as excise duties on fuel, cigarettes and alcohol and
Value Added Tax on many different goods and services

What are the main sources of tax revenues for the UK government?

Direct taxes
• Direct taxation is levied on income, wealth and profit
• Direct taxes include income tax, inheritance tax and corporation tax
• The burden of a direct tax cannot be passed on
Indirect taxes
• Indirect taxes are taxes on spending
• Examples of indirect taxes include excise duties on fuel, cigarettes and alcohol and Value Added Tax
(VAT) on many different goods and services
• Producers may pass on an indirect tax – depending on price elasticity of demand and supply
Progressive, proportional and regressive taxes and the distribution of income
• With a progressive tax, the marginal rate of tax rises as income rises. I.e. as people earn more
income, the rate of tax on each extra pound goes up. This causes a rise in the average rate of tax
• With a proportional tax, the marginal rate of tax is constant. National insurance contributions are
the closest example in the UK of a proportional tax, although low-‐income earners do not pay NICs
below an income threshold
• With a regressive tax, the rate of tax falls as incomes rise – I.e. the average rate of tax is lower for
people of higher incomes. In the UK, regressive taxes come from excise duties of items of spending
such as cigarettes and alcohol. Indirect taxes form a larger percentage of the disposable income of
those who earn less, even though they may also spend less

Income Tax
Income tax in the UK is progressive
1. Most people have a tax free personal allowance
2. Basic rate of income tax = 20%
3. Higher rate of income tax = 40%
As income rises, the rate of tax rises so that people on the highest incomes will pay a higher percentage of
their income to the government.

Corporation Tax
• This is a tax on business profits.
• There is a tax free allowance for businesses making low annual profits
Value Added Tax (VAT)
• Value Added Tax (VAT) is a tax that's charged on most goods and services that VAT-‐registered
businesses provide in the UK. It's also charged on goods and some services that are imported from
countries outside the European Union (EU), and brought into the UK from other EU countries
• There are three rates of VAT
• Standard -‐ 20 per cent
• Reduced -‐ 5 per cent i.e. energy bills
• Zero -‐ 0 per cent (i.e. exempt) including children’s clothes, congestion charge, doctor’s fees

Percentage of gross income taken up by different taxes in the UK in 2013-‐14
Lowest 20% Highest 20% All

2nd Quintile 3rd Quintile 4th Quintile
of Income of Income households
Income Tax 2.5 4.4 8.2 11.2 16.9 11.8
Value Added
11.0 7.9 7.7 7.0 5.5 6.8
Tax (VAT)
Duty on
1.5 1.0 1.0 0.9 0.7 0.9
alcohol
Duty on
2.8 1.7 1.3 0.6 0.3 0.8
tobacco
All indirect
28.1 19.1 17.8 15.3 11.3 15.3
taxes

• Income tax is progressive – the average burden of income tax rises across income groups.
• Duties on tobacco and alcohol are regressive
Original and Final Income – Redistribution in the UK
• The tax and welfare benefit system helps to redistribute income so that the distribution of final
income (after taxes and benefits) is less unequal than for original incomes.
• The UK tax and welfare system is mildly progressive because it leads to a smaller gap between
households when final income is measured

The effects of direct and indirect taxes and welfare benefits on household income by
quintile groups, 2013/14
£ per week Original income Final income
1800
1600
1400
1200
1000
800
600
400
200
0
1 2 3 4 5 All households
Disposable income quintile
Benefits in Kind
Benefits in kind include the estimated value to households of consuming services such as state education
and the National Health Service

Summary of the effects of taxes and benefits on all households, 2013/14
£ per week
400
300
200
100
0
-100
-200
-300
-400
-500
-600 Indirect taxes Direct taxes Benefits in kind Cash benefits Net position
-700
1 2 3 (median) 4 5 All households
Disposable income quintile

Automatic Stabilisers and Discretionary Changes in Fiscal Policy
• Discretionary fiscal changes are deliberate changes in direct and indirect taxation and govt
spending – for example, increased capital spending on roads or more resources going into the NHS.
• Automatic stabilisers are changes in tax revenues and government spending that come about
automatically as an economy moves through the business cycle

1. Tax revenues: When the economy is expanding rapidly the amount of tax revenue increases which
takes money out of the circular flow of income and spending
2. Welfare spending: A growing economy means that the government does not have to spend as
much on means-‐tested welfare benefits such as income support and unemployment benefits
3. Budget balance and the circular flow: A fast-‐growing economy tends to lead to a net outflow of
money from the circular flow. Conversely during a slowdown or a recession, the government
normally ends up running a larger budget deficit During a recession, revenue is likely to be lower
due to less income earned, less profits made and fewer goods being bought and at the same time
government expenditure on transfer payments e.g. income support and unemployment benefit

Fiscal Policy and Aggregate Supply

Work incentves / actve Inward migraton of key Capital investment e.g.
labour supply workers FDI projects
Enterprise / Taxaton and incentves Tariffs affect import

Entrepreneurship to study costs

• Fiscal policy can have important effects on the supply-‐side of the economy.
• Indeed many fiscal decisions are made with improving the supply-‐side in mind.
1. Labour market incentives:
a. Changes in income tax can improve incentives for people to actively look for work
b. Lower taxes might also have a positive effect on work effort and labour productivity
c. Cuts to national insurance contributions might help to expand the active labour supply
d. Some economists argue that welfare benefit reforms are more important than tax cuts in
improving incentives – to create a gap between the incomes of people in a job and the
unemployed. Some people favour a move towards targeted benefits where the transfer
payment is linked to participation in employment schemes or community work
2. Capital spending:
a. Spending on infrastructure (e.g. improvements to a motorway network) helps provide the
capacity needed for other businesses to flourish.
b. Lower rates of corporation tax might attract inward investment from overseas.

3. Entrepreneurship and investment:
a. Government spending can be used to fund an expansion in new small business start-‐ups
4. Research and development and innovation:
a. Government spending, tax credits and other tax allowances could be used to encourage
research and development to improve competitiveness and contribute to a faster pace of
innovation and invention
b. A key aim going forward is to use tax incentives to stimulate an increase in investment in
low carbon technologies to promote green growth
5. Human capital of the workforce:
a. Spending on education and increased investment in health and transport can also have
important supply-‐side effects in the long run
b. Government spending on apprenticeships can help to improve human capital,
employability and productivity

The Free Market Agenda
• Free market economists are sceptical of the effects of government spending in improving the
supply-‐side of the economy
• They argue that lower taxation and tight control of government spending and borrowing is
required to allow the private sector of the economy to flourish
• They believe in a smaller sized state sector so that in the long run, the overall burden of taxation
can come down and thus allow the private sector of the economy to grow and flourish.
Tax competition between countries
• Changes in business taxation are now regarded as an important form of supply-‐side policy.
• Tax competition happens when a national government uses reforms to the tax system as a supply-‐
side strategy to attract investment and jobs into their economy.
• Some countries have introduced a flat tax system, examples include Russia, Estonia and Poland
• Is tax competition between countries a fair way of bidding for investment?
Examples of countries with flat tax systems

Income Tax Lowest and Highest Rate the same (%)
Russia 13%
Ukraine 17%
Mongolia 10%
Costa Rica 15%

Differences in business profits (corporation) tax

Business Profits Tax (Corporation Tax) Standard rate (%)
Macedonia 15%
Hong Kong 17.5%
Bahrain 0%
Macao 12%


Evaluating the Arguments for a Low Tax Economy

Case for lower tax burdens (tax revenues as a share of GDP)
• Stimulates work incentives and productivity
• Helps to create more jobs because businesses have less tax to pay
• Encourages an inflow of FDI from businesses looking for low tax country
• Incentivizes enterprise and start-‐ups – a source of long term wealth and jobs
• Lower tax rates might end up increasing total tax revenues

Counter-‐arguments to the low-‐tax economy
• Taxation is a key instrument for changing the final distribution of income and wealth. It is equitable
for those with the greatest resources to pay more
• Tax cuts don’t necessarily lead to an increase in total tax revenues for the government
• Consider the relative economic success of countries such as Denmark, Norway and Sweden who all
have higher tax burdens and progressive tax and welfare systems
• Taxes are needed to fund high quality public services such as education and health which benefit
millions of people in the long run

Economics of a Budget (Fiscal) Deficit
• When the government is running a budget deficit it means that in a given year, total government
expenditure exceeds total tax revenue
• If the government is running a budget deficit, it has to borrow this money through the issue of debt
such as Treasury bills and bonds
• Most of the government debt is bought up by financial institutions but individuals can buy bonds,
premium bonds and buy national savings certificates
• The budget balance is the annual difference between tax revenues and government spending
• Gross government debt is total debt owed by the government – also known as the national debt
UK Budget Balance (Actual and Forecast)

0.0%
-‐0.31%
-‐0.57% -‐0.33%
-‐2.0% -‐1.52%
Budget balance to GDP rato
-‐3.08%
-‐4.0%
-‐4.78%
-‐6.0%
-‐5.74% -‐5.69%
-‐8.0% -‐7.64% -‐7.78%
-‐10.0% -‐9.67%
-‐12.0%
2010 2011 2012 2013 2014 2015* 2016* 2017* 2018* 2019* 2020*


Does the size of a budget deficit matter for the economy?
A persistently large budget deficit can be a problem:
1. Financing a deficit:
a. If the budget deficit rises to a high level, the government may have to offer higher interest
rates to attract sufficient buyers of debt.
b. This raises the possibility of the government falling into a debt trap where it must borrow
more to repay the interest on accumulated borrowing.
c. Many high debt countries in the European Union have suffered from this in recent years –
high profile examples have included Ireland, Greece, Spain and Portugal.
2. A government debt mountain:
a. Annual budget deficits over a number of years will cause the total amount of unpaid
government debt to climb.
b. There is an opportunity cost involved because interest payments on bonds might be used
in more productive ways, for example on health services or extra investment in education.
Every 0.05% saved on £220bn of new debt pays one year’s salary for 46,000 teachers.
c. Higher public sector debt also represents a transfer of income from people and businesses
that pay taxes to those who hold government debt and cause a redistribution of income
and wealth in the economy.
3. Crowding-‐out:
a. If a larger budget deficit leads to higher interest rates and taxation in the medium term and
thereby has a negative effect on growth in consumption and investment spending, then a
process of ‘fiscal crowding-‐out’ is occurring
b. The Institute of Fiscal Studies has estimated that reducing the UK budget deficit over the
next five years will require every person in the UK to pay £1250 of extra taxes each year.
4. Risk of capital flight:
a. Some economists believe that high borrowing risks causing a ’run on a domestic currency’.
This is because the government may find it difficult to find sufficient buyers of its debt and
the credit-‐rating agencies may decide to reduce the rating on a nation’s sovereign debt
The difference between government borrowing and government debt

• Government borrowing:
o Public sector borrowing is the amount borrowed each year to finance spending
• National debt
o Public sector debt is a measure of the accumulated national debt owed by the government


Countries with Highest Government Debt in 2015

Public (government) debt as a percentage of GDP

0.0% 50.0% 100.0% 150.0% 200.0% 250.0% 300.0%
Japan 246.14%
Greece 172.73%
Italy 133.76%
Jamaica 132.82%
Lebanon 131.82%
Enritrea 129.24%
Portugal 126.35%
Cape Verde 121.08%
Bhutan 115.89%
Ireland 107.75%
Grenada 107.11%
Antgua and Barbuda 106.91%
Belgium 106.57%
Cyprus 105.67%
United States 105.06%

Countries with the Lowest Government Debt in 2015

Natonal (government) debt measured as a percentage of GDP, Source: IMF
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%
Saudi Arabia 1.82%

Brunei Darussalam 3.28%
Hong Kong SAR 6.37%
Uzbekistan 8.32%
Oman 8.56%
Kiribat 8.87%
Kuwait 9.46%
Estonia 10.13%
Nigeria 11.48%
Iran 11.88%
Botswana 12.73%
Solomon Islands 13.62%
Algeria 13.64%
United Arab Emirates 14.75%
Chile 16.25%

UK government debt is forecast to reach 90% of GDP in 2015. This is lower than the average of advanced
(OECD) economies.


Government Debt for a selection of EU Countries

2006 2008 2010 2012 2015

France % of GDP 81.9 87.7 103.5 113.4 127.5
Germany % of GDP 64.1 61.2 67.4 65.1 60.0
Greece % of GDP 103.4 109.4 145.7 156.8 186.0
Ireland % of GDP 44.1 84.4 280.3 334.0 316.0
Italy % of GDP 116.2 114.5 126.0 138.1 144.9
Spain % of GDP 45.7 47.1 66.7 91.0 118.6
United Kingdom % of GDP 42.5 51.8 76.4 85.8 90.0

Potential benefits of a budget deficit
1. Government borrowing can benefit growth:
a. A budget deficit can have positive macroeconomic effects if it is used to finance capital
spending that leads to an increase in the stock of national assets
b. For example, spending on transport infrastructure improves the supply-‐side capacity and
productivity of the economy
c. Improved provision of public goods can create positive externalities (social benefits)
2. The budget deficit as a tool of demand management:
a. Keynesian economists support borrowing as a way of managing aggregate demand
b. An increase in borrowing can be a useful stimulus to demand when other sectors of the
economy are suffering from weak or falling spending
c. A change in the government budget deficit may lead to a more than proportional change in
aggregate demand – this is known as the (positive) fiscal multiplier effect.
National Debt for the UK measured as a percentage of GDP

100.0%
90.0%
80.0%
Natonal debt to GDP rato
70.0%
60.0%
50.0%
40.0%
30.0%
20.0%
10.0%
0.0%
2010 2011 2012 2013 2014 2015* 2016* 2017* 2018* 2019* 2020*


UK Government’s Fiscal Austerity Policies
The UK government has a b with the emphasis on cutting government spending in some areas in real terms
and a series of direct and indirect tax increases:

Key policies for deficit reduction:
• Rise in standard rate of VAT to 20%
• Rise in employee national insurance contributions (11%)
• Deep cuts in real government spending e.g. for local authorities
• Welfare caps including £26k pa cap on welfare for each family
Some taxes have been cut
• A series of cuts to corporation tax (main rate is now 20%)
• Freezing of fuel duties (meaning a cut in real terms)
• Increases in the real value of the income tax free allowance
• Cuts in employer national insurance for long term unemployed
• Freezing of council tax (so that council tax falls in real terms)
The Government has been helped by lower interest rates on newly issued debt as a result of quantitative
easing and by the decisions of the Bank of England to keep monetary policy interest rates at just 0.5% since
March 2009. It is easier for the government to introduce fiscal austerity at a time when the economy is
growing and when monetary policy remains supportive of a higher level of aggregate demand.

UK Government’s New Fiscal Rule (2015)
• In the July 2015 Budget, the Chancellor George Osborne announced a new fiscal rule.
• The government’s fiscal rules now include a target for a budget surplus by 2019/20 and for all
subsequent years when in ‘normal times’.
• The economy will be viewed as being in ‘normal times’ if real annual growth is above 1%
Countries running budget (fiscal) surpluses in 2015

Public surplus in relaton to GDP

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0%
Timor-‐Leste 9.72%
Norway 7.3%
Kuwait 6.2%
Qatar 5.62%
Hong Kong SAR 3.15%
Micronesia 2.83%
Marshall Islands 2.36%
Palau 1.69%
Republic of Congo 1.58%
Singapore 1.46%
St. Kiws and Nevis 1.4%
Seychelles 1.21%
Nepal 1.12%
Botswana 0.68%
Korea 0.34%


25.Supply-‐side Policies

What are supply-‐side policies?
• Supply-‐side policies are policies aimed at making markets and industries operate more efficiently
and contribute to a faster underlying-‐rate of growth of real national output
• Successful policies shift the LRAS curve to the right leading to a rise in potential output
• Most governments believe that improved supply-‐side performance is the key to achieving
sustained growth without causing a rise in inflation.
• There must also be a high enough level of aggregate demand so that the productive capacity of an
economy is actually brought into play.
• Supply-‐side policies can be implemented by both the public and/or the private sector
Supply-‐side objectives
Key concepts to focus on are incentives, enterprise, technology, mobility, flexibility and efficiency.
1. Improve incentives to look for work and invest in people’s skills
2. Increase labour and capital productivity
3. Increase occupational and geographical mobility of labour to help reduce the rate of
unemployment
4. Increase investment and research and development spending
5. Promoting more competition and stimulate a faster pace of invention and innovation to improve
competitiveness
6. Provide a platform for sustained non-‐inflationary growth
7. Encourage the start-‐up of new businesses / enterprises especially those with export potential
8. Improve the trend rate of growth of real GDP
Key Supply-‐Side Challenges for the UK Economy
Low trend growth rate Rise of Emerging Low capital Rising inequality /
of real GDP Natons investment & research relatve poverty
Persistent High rates of youth Deep and widening Structural trade
Productvity Gap unemployment regional economic deficit (current
divide account of BoP)


UK Government Growth Objectives
The government has 4 aims to help the economy to grow: to create the most competitive tax system in the
G20; to make the UK the best place in Europe to start, finance and grow a business; to encourage
investment and exports as a route to a more balanced economy; and to create a more educated workforce
that is the most flexible in Europe

Market-‐based supply-‐side policies
1. Cutting government spending and borrowing
2. Lower business taxes to stimulate investment and lower income taxes to improve work
incentives
3. Reducing red-‐tape to cut the costs of doing business
4. Measures to improve the flexibility of the labour market / reforming employment laws
5. Policies to boost competition such as deregulation and anti-‐monopoly and anti-‐cartel laws
6. Privatisation of state assets (selling off public sector businesses into the private sector)
7. Opening up an economy to overseas trade and investment
8. Opening up an economy to inward labour migration
Interventionist policies
1. State has key role in investing in public services and building critical infrastructure
2. Tax incentives and welfare reforms can encourage more people into work
3. A commitment to a fair minimum wage / living wage to improve work incentives
4. Active regional policy to boost under-‐performing areas / areas of high unemployment
5. Some case for selective import controls to allow domestic industries to expand
6. Management of the exchange rate to improve competitiveness of export industries
7. Nationalisation of some key industries
8. Stronger regulation of industries
There are two main approaches to the supply-‐side.
1. Firstly policies focused on product markets where goods and services are sold to consumers and
2. Secondly the labour market – a factor market where labour is bought and sold
Product Market Reforms
• Product markets refer to markets in which all kinds of goods and services are made and traded, for
example the market for airline travel; smart-‐watches, new cars; pharmaceutical products and the
markets for financial services such as banking, mortgages and pensions.
• Supply-‐side policies in product markets are designed to increase competition and efficiency
Privatisation
• Over the last thirty, many former state-‐owned businesses have been privatised – i.e. transferred
from the public to private sector.
• Examples in Britain include British Gas, British Telecom, British Airways, British Steel, British
Aerospace, regional water companies, electricity generators and distributors, and the Royal Mail
• Privatization is designed to break-‐up state monopolies and create more competition. The
government also created utility regulators such as OFCOM and OFWAT who have in the past
imposed price controls and who are now in charge of over-‐seeing moves towards competitive
markets in areas such as gas and electricity supply and telecommunications.


Deregulation of Markets
• De-‐regulation or liberalisation means the opening up of markets to greater competition
• The aim of this is to expand market supply (driving prices down) and increase choice for
consumers
• Good examples of deregulation to use include: urban bus transport, post and parcel delivery
service, telecommunications, and gas and electricity supply.
Toughening up of Competition Policy
• Most supply-‐side economists believe that competition forces business to become more efficient in
the way in which they use scarce resources.
• A tougher competition policy regime includes policies designed to curb anti-‐competitive practices
such as price-‐fixing cartels and other abuses of a dominant market position – in other words –
intervention to curb some of the market failure that can come from monopoly power

A commitment to free (open) trade
• Trade between nations creates competition and should be a catalyst for improvements in costs and
lower prices for consumers
• The UK is committed to an expansion of free trade within the European Union Single Market and
also negotiating a liberalisation of trade in the global economy through the World Trade
Organisation.
Measures to encourage small business start-‐ups / entrepreneurship
• The small businesses of today often become the larger businesses of tomorrow employing more
workers and contributing to innovation that can have positive spill over effects in other industries.
• Governments of all political persuasions argue that they want to promote an entrepreneurial
culture and to increase the rate of new business start-‐ups.
• Supply side policies include loan guarantees for new businesses; regional policy assistance for
entrepreneurs in depressed areas of the country; advice for new firms
Capital investment and innovation:
• Capital spending by firms adds to aggregate demand and also has an important effect on long run
aggregate supply.
• Tax relief on research and development and reductions in the rate of corporation tax
• A key policy for the Coalition has been the creation of 24 new Enterprise Zones that offer lower
taxes and easier planning laws for businesses in designated areas supported by a Regional Growth
Fund
• Raising investment is a key ingredient in helping labour productivity to grow.
Supply Side Policies for the Labour Market
• These policies are designed to improve the quality and quantity of the supply of labour
• They seek to make the British labour market more flexible so that it is better able to match the
labour force to the changing demands placed upon it by employers helping to cut structural
unemployment.
• An expansion in the labour supply increases the productive potential of an economy.

• That expansion in the supply of people willing and able to work can come from several sources for
example: encouraging older people to stay in the work force, a relaxed approach to labour
migration and measures to get non-‐working parents to actively look for work.
The UK labour market is one that has to contend with a wide range of problems many of which are related
to persistently high rates of unemployment. Some of these weaknesses are mentioned in the graphic
below. Supply side labour market reforms are designed to improve the employment prospects for workers
of different ages, in different occupations and industries and in different regions of the country.

A Selection of Structural Weaknesses in the UK Labour Market

Labour
Immobility
Limited
Apprentceship Work
Disincentves
Supply
High Economic
Inactvity Skills Gaps
High Youth Long Term

Unemployment Unemployed

Trade Union Reforms
• Many of the traditional legal protections enjoyed by the trade unions have been taken away –
including restrictions on their ability to take industrial action. The result has been a decrease in
strike action in virtually every industry and an improvement in industrial relations in the UK
• Improved partnerships between trade unions and employers can make a big contribution to raising
productivity and improving the flexibility of workers in their jobs


Public and private sector membership of trade unions in the UK labour market

Private sector Public sector
4500
4000
Number of members (in thousands)
3500
3000
2500
2000
1500
1000
500
0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Trade union density:
Percentage of employees that were members of a trade union in the United Kingdom from 1995 to 2013

34.0%
32.4%
31.4%
32.0%
30.7%
29.9%29.7%29.8%
30.0% 29.3% 29.3%
28.8% 28.8%28.6%
Percentage of employees
28.3%
28%
27.4%27.4%
28.0%
26.6%
26% 26%
25.6%
26.0%
24.0%
22.0%
20.0%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Increased Spending on Education and Training
1. The economic returns from extra education spending vary according to the stage of development
2. Government spending on education and training improves workers’ human capital

3. Most economists agree, with the move away from industries that require manual skills to those
that need mental skills, investment in education, and the retraining of manual workers, is vital.
4. Improved training, especially for those who lose their job in an old industry should improve the
occupational mobility of workers. This should reduce the problem of structural unemployment
5. A well-‐educated workforce acts as a magnet for foreign investment in the economy.
Income Tax Reforms and the Incentive to Work
• Economists who support supply-‐side policies believe that lower income tax improve incentives for
people to work longer hours or take a new job – because they keep more of the money they earn.
• Cutting tax rates for lower paid workers may help to reduce the ‘unemployment trap’ – where
people may be no better off from working than if they stay outside the labour force.
• Do lower taxes always help to increase the active labour supply in the economy? Some people may
choose to work the same number of hours and simply take a rise in their post-‐tax income! Millions
of other workers have little choice over the hours that they work.
Showing the effects of supply-‐side improvements
• Supply-‐side factors help to explain why some countries grow faster than others
• With globalisation, improving competitiveness is vital in achieving success in world markets.
• A rising share of GDP in most countries is devoted to international trade
• Markets are becoming more competitive and those countries whose supply-‐side lets those down
can find a rising level of import penetration and a weak export performance.
Recent UK Government Supply-‐Side Policies
Privatsaton of Royal Patent Box Incentve Modern Welfare Caps / and
Mail (2013) Apprentceships – e.g. other Welfare Benefit
the Youth Contract Reforms
Shale Gas Tax Cut Large Fall in UK Natonal Launch of a Green
Incentves Corporaton Tax -‐ Infrastructure Plan Investment Bank
main rate now 19% including HS2


Research and Development (R&D)
• Spending on research and development (R&D) in the UK has remained low as a % of GDP – usually
between 1.5 and 2% of national income
• This ‘research gap’ is a constraint on innovation and affects global competitiveness
• Only two British firms are in the top 50 global research spenders.
• Other countries e.g. Finland, Germany and Israel devote higher share of GDP to research
• The biggest barriers to innovation are risk aversion, uncertainty about ability to exploit research
and make a profit, a lack of high-‐skilled workers and a lack of information on technology and
markets
• There is some evidence of higher R&D spending in the UK among smaller businesses in computing
technology, biotechnology and nanotechnology
• The top EU companies for research are Nokia, Volkswagen, Bosch and Siemens
• Siemens holds about 53,300 patents, and filed 8,600 in 2011 – just under 40 per working day
• The top two UK firms are GlaxoSmithKline and AstraZeneca
• The British government has tried to boost R&D spending through tax credits but critics say that this
policy has been ineffective. Recently the government has introduced an incentive known as a
Patent Box – where profits from research projects are taxed at a lower rate
• Research is important for supply-‐side competitiveness but a key evaluation point is that the level of
research spending is not necessarily a guide to the pace and success of innovation in a country.
• Many businesses do not patent their most innovative ideas, preferring to keep them as trade
secrets
• Steve Jobs once said, “Innovation has nothing to do with how many R&D dollars you have. When
Apple came up with the Mac, IBM was spending at least 100 times more on R&D.”


Unemployment rate in the United Kingdom from April 2015 to June 2015, by region/country

LFS Unemployment rate, per cent of labour force

0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0%
North East 8.1%
London 6.7%
Yorkshire and The Humber 6.5%
Northern Ireland 6.5%
North West 6%
West Midlands 6%
Wales 5.9%
Scotland 5.6%
United Kingdom 5.6%
East Midlands 4.7%
East of England 4.7%
South East 4.5%
South West 4.4%

Regional Policy – The Northern Powerhouse Project
• The UK government wants more regional balance to help supply-‐side potential growth
• The main goal of Northern Powerhouse idea is to have a balanced regional recovery
• The North has a relatively higher concentration of public sector and manufacturing jobs and has
grown less quickly since the end of the last recession
• The North suffers from higher levels of long term unemployment
• The key aim is to increase growth in major cities including Liverpool, Manchester, Leeds and Hull
• Policy options include:
1. Investment to improve transport connections
2. Supporting science and innovation including the universities
3. Backing clusters of businesses such as life sciences and marine engineering
International Competitiveness
Competitiveness is the ability of an economy to compete fairly and successfully in markets for
internationally traded goods and services that allows for rising standards of living over time.
o Cost competitiveness – differences in unit costs between producers – reflected in prices
o Non-‐price competitiveness – involving technical factors such as product quality, design, reliability
and performance, after-‐sales services, marketing, branding and availability of replacement parts
Unit labour (wage) costs
• These are the labour costs of supplying goods and services per unit of output
• Unit labour costs are determined by
o The costs of employing people (wage rates, salaries, payroll taxes)
o The productivity of these people
• Data on unit labour costs is normally expressed in relative terms i.e. we compare unit labour costs
in one country relative to another
• Unit labour costs will rise when wages rise faster than the annual improvement in productivity

Non-‐Wage Costs
The main non-‐wage costs for businesses include:
• The costs of meeting environmental regulationsand environmental taxes
• Employment protection laws and health and safety laws
• Requirements to provide business pensions
World Economic Forum – Global Competitiveness Report
This is a report published annually and is an attempt to rank countries using a group of indicators including:
• Institutions (property rights protection, trust, judicial independence, corruption)
• Infrastructure (transport, telephony, and energy, ports)
• Macroeconomic environment (including stability of key macro indicators)
• Health and primary education, Higher education and training
• Financial markets (including stability of markets, strength of banks)
• Technological readiness (readiness to exploit, adapt to new technologies) and innovation
• Market size (linked to population size and per capita incomes)
• Business sophistication (quality of supply chains, industrial clusters, quality of management)
Top 100: Ranking of countries according to general quality of infrastructure in 2014

Index (1 = underdeveloped, 7 = extensively by internatonal standards)

0 1 2 3 4 5 6 7
Switzerland 6.6
Hong Kong SAR 6.5
United Arab Emirates 6.4
Finland 6.4
Singapore 6.3
Netherlands 6.3
Austria 6.2
Iceland 6.2
Japan 6.2
France 6.1
Germany 6
Portugal 6
Spain 5.9
Luxembourg 5.9
Denmark 5.8

UK ranking in global competitiveness: The UK was ranked 9th in 2014
Strengths included:
• Efficiency of its labour market (7th)
• Sophisticated (8th) and innovative (13th) businesses
• A large consumer market (it is ranked 6th for market size)
Weaknesses included:
• Macroeconomic environment (85th)
• Large fiscal deficit (placing the country 138th) and high public debt (77 percent of GDP, 120th)
• Comparatively low national savings rate (12.3 percent of GDP in 2010, 119th)

Ranking of the 10 countries who filed the most international patent applications in 2014

Number of applicatons

0 10000 20000 30000 40000 50000 60000 70000
United States 61,492
Japan 42,459
China 25,539
Germany 18,008
Republic of Korea 13,151
France 8,319
UK 5,282
Netherlands 4,218
Switzerland 4,115
Sweden 3,925

Policies to improve international competitiveness of the UK economy

Improving funckoning of Labour Markets

• Investment in all levels of educaton and training
• Encouraging inward migraton of skilled workers
• Improvements in management quality
Infrastructure Investment
• Bewer motorways, ports, hi-‐speed rail
• Northern Powerhouse project
• Communicatons e.g. super-‐fast broadband, 4G networks
Supporkng Enterprise / Entrepreneurship

• Improved access to business finance e.g. for start-‐ups
• Incentves for business innovaton and inventon
• Reductons in business red tape
Macroeconomic Stability
• Maintaining low inflaton / price stability
• A sustainable and more compettve banking system
• A compettve exchange rate v major trading partners


Supply-‐Side Investment: Shale Gas and the UK Economy

Will successful exploration and extraction of
shale gas provide a crucial kick-‐start to UK The Bowland Shale Gas Area
economic growth and help lower the price of
fuels whilst increasing the UK's energy security?
Suddenly the opportunities and risks of
investing in shale gas have become hot topics.
Fracking has produced a glut of natural gas in
the USA and pushed down the price to the
benefit of households and industry -‐ could it do
the same in the UK?

Background on the shale gas sector
• The UK has been a net importer of gas
since 2004
• North sea oil production is also on a long term declining trend
• ‘Shale gas’ is found within shale beds -‐ Gas is accessed through a technique called “fracking”
• Fracking involves injecting water, sand and chemicals under pressure into dense shale rock to
release the oil and gas trapped inside,
• Potentially recoverable resources of shale gas in the UK are highly uncertain but the British
Geological Survey has recently confirmed that the UK has substantial onshore shale gas reserves.
• The largest business involved in shale gas at the moment is Cuadrilla Resources
• Recovery rates for shale gas are low -‐ around 15-‐30% of original gas in place
• The overhead costs of exploration are high, a single test well operation costs around £10 million
• In 2000, shale represented just two per cent of US natural gas supply. By 2012 it was 37 per cent.
Last year, the surge in output helped to push the US gas price to 10-‐year lows.
For shale extraction
1. Supporters of fracking claim that investment will bring down the cost of energy bills, create jobs in
Britain and bring money to local neighbourhoods. For example, shale gas companies have agreed
to pay £100,000 to communities near wells, plus 1 per cent of revenue if gas is extracted.
2. Lower energy bills will help to make British businesses more competitive in global markets
3. Reduced gas prices would help to reduce fuel poverty concentrated among low-‐income families
Opposing arguments
1. Opponents of fracking are deeply concerned about the carbon footprint and climate risks
associated with the extraction and use of shale gas including possible ground and surface water
contamination
2. Shale gas fracking is also highly water intensive at a time when water scarcity is becoming an
important economic and environmental issue.
Competitive advantage and human capital issues
Britain has decades of experience and expertise in offshore oil and gas exploration and extraction but it
remains to be seen whether the same human capital will be as effective in on-‐shore fracking. Another
related question concerns the possible impact of shale gas on the cost of electricity generated at gas-‐fired
power plants and how will it compare to other forms of generation including coal, nuclear and renewable
sources.


26.Keynesian Economics
• An understanding of Keynesian ideas can be
helpful in evaluating macro policies and the search
for macroeconomic stability in terms of prices,
jobs, incomes and profits
• Keynesian economics focuses on psychology,
uncertainty and expectations in driving
macroeconomic decisions. In Keynesian economics,
the state of animal spirits is vital.

Keynesian economists and free markets John Maynard Keynes was born on 5
June 1 883. He was educated at Eton
Keynesian economists believe that free markets are volatile College and at Cambridge University -‐
and not self-‐correcting. where he later taught. He died on 21
April 1946
• Free market volatility:
o The free-‐market system is naturally prone
to periods of recession & depression
o The volatility of aggregate demand can be explained by changes in consumer and business
sentiment – also known as animal spirits.
o In a world of stagnation or depression direct intervention in the economy may be essential
• Free markets are not always self-‐correcting:
o When a recession or a depression occurs, the free market system is not necessarily self-‐
correcting – indeed en-‐masse, individuals can become trapped in a deflationary depression
which is in no one’s interest but which, left on our own, no one can counter-‐act.
o Persistent deflation can be as costly as high inflation – it can be damaging especially in
economies where there is a huge level of private & public sector debt
o You cannot always rely on new inventions / innovations and other natural stabilisers to
drag an economy out of a recession
Savings and aggregate demand
• The paradox of thrift helps to explain why a rise in precautionary saving (people looking for
security) can lead to a fall in demand and incomes and a reduction in output, income and wealth
• Negative multiplier and accelerator effects can drag production and employment to a low level
where it can stay unless there is some external stimulus to lift demand and output again
• On an international level, when the global desire to save exceeds the global willingness to invest
the result is a contraction in demand and production leading to a fall in incomes and employment
The risks of a deflationary depression
• Recession (and worse – a depression) represents a pure waste of scarce resources. Unemployed
workers want to work, and businesses want to use their productive capacity to supply goods and
services. If they had work, the things they produced would be available for all to buy, and the
incomes they received would enable them to purchase the products of others. Incomes from higher
wages and stronger profits would feed through the circular flow in the standard macro model.
• But in a recession a country can experience a persistent state where output is well below a
country’s capacity to produce
• The key is to take measures to lift AD and bring about an expansion of short-‐run aggregate sup


The Liquidity Trap:
• In normal circumstances it is possible to boost demand by cutting interest rates. But there is a level
below which interest rates cannot go (they have been at 0.5% in the UK since the spring of 2009
and at low levels in other countries) and at that point monetary policy may become powerless.
• Moreover, even if interest rates can be lowered this may have no effect if people cannot or will not
borrow. This is known as the liquidity trap.
• At this point, aggregate demand can only be boosted by the Government borrowing more, either to
spend directly or to give to others via tax cuts or the like.
• In other words, we need a targeted Keynesian fiscal stimulus.
• Keynesians believe that fiscal multiplier effect is higher for spending than it is for tax cuts.
• The aim is simple – when private sector demand for goods and services is low, the government
needs to find a compensating source of demand to rebalance the economy
The Importance of Animal Spirits
• Keynes coined the notion of animal spirits
• Animal spirits refers to a broad mix of confidence, trust, mood and expectations and animal spirits
can fluctuate very quickly as populations of people change their thinking
• This focus on animal spirits helps to explain why psychology is so important in macroeconomics
• When animal spirits are poor, individuals save more, businesses save more too and, because
demand and profits are lower than expected, they cut back on production and perhaps postpone or
cancel capital investment projects.
• Higher saving and reduced investment both have the effect of reducing demand and incomes in the
circular flow causing an economic contraction
Forecasted Base Interest Rate in the United Kingdom from 1st quarter 2014 to 1st quarter 2020

2.5%
2.0%
1.5%
Bank rate
1.0%
0.5%
0.0%
2014 Q1
2014 Q2
2014 Q3
2014 Q4
2015 Q1
2015 Q2
2015 Q3
2015 Q4
2016 Q1
2016 Q2
2016 Q3
2016 Q4
2017 Q1
2017 Q2
2017 Q3
2017 Q4
2018 Q1
2018 Q2
2018 Q3
2018 Q4
2019 Q1
2019 Q2
2019 Q3
2019 Q4
2020 Q1

Office for Budget Responsibility; July 8, 2015


27.Strengths and Weaknesses of Demand Side Policies
• Demand side policies focus on the use of monetary and fiscal policies to manage the level and rate
of growth of aggregate demand to influence macroeconomic indicators such as GDP growth,
unemployment, inflation and the balance of trade.
• It is important to note that demand and supply-‐side policies do not operate in isolation
o Effective demand-‐side policies can help to stimulate aggregate supply
o Successful supply-‐side policies can create their own positive effect on aggregate demand
Examples of demand side policies during an economic slowdown / recession
Some policies used to counter an economic slowdown becoming a recession are shown below

Relax credit
rules to Cut direct and
increase bank indirect taxes
lending
Quanttatve Increase
easing by the government
central bank spending
Depreciaton of
Lower interest Economic the exchange
rates Slowdown
rate

Questioning the effectiveness of these demand side policies
• Business and consumer confidence may be low
• A reduction in direct tax might be saved rather than spent
• Lower interest rates might not stimulate business investment if confidence is low
• Low interest elasticity of demand
• Cuts ininterest rates might not cause higher demand if people have low confidence
• If very low interest rates are ineffective, this is called a liquidity trap
• Low price elasticity of demand for exports
• Demand for exports might have a low price elasticity of demand meaning that the effect of
lower export prices in overseas markets will be relatively small
• Limits to how much a government can borrow
• One option to expand demand if for the government to increase their budget deficit either
by increases in government spending and/or reductions in tax
• But a rise in borrowing might lead to higher interest rates (this is a form of crowding out)
• And there are doubts about the size of the fiscal multiplier effect. I.e. a fiscal stimulus might
only have a modest effect on aggregate demand, output and incomes
• Real interest rates
• Nominal interest rates can be cut close to zero, but if there is deflation in an economy, then
real interest rates can actually rise leading to a contraction of aggregate deman


28.Possible Conflicts between Macro Objectives

Price Stability Growth of Real GDP Falling Unemployment /

(CPI Inflakon of 2%) (Nakonal Output) Raising Employment
Higher Average Living

Standards (nakonal income Stable Balance of Payments An Equitable Distribukon of
on the current account Income and Wealth
per capita)

Possible conflicts between macro objectives
• It is rare for a country to achieve all of its main macroeconomic objectives at the same time
• Frequently conflicts can appear between the different aims and as a result, choices might have to
be made about which objectives are to be given greatest priority.
• This will vary from one country to another since the needs of different nations will differ according
to their stage of economic development.
Unemployment and inflakon (price stability) Economic growth and inflakon
Conflickng Aims?
Economic growth and the balance of

payments Economic Growth and Inequality

1. Inflation and unemployment: Falling unemployment might create demand-‐pull and cost-‐push
inflationary pressures leading to a fall in the value of money
2. Economic growth and environmental sustainability: Rapid growth and development frequently
puts extra pressure on scarce resources threatening the sustainability of future living standards
3. Economic growth and inflation – an overheating economy may suffer accelerating inflation which
then has negative effects on trade performance, business profits and jobs

4. Economic growth and the balance of payments: Strong GDP growth fuelled by high levels of
consumer demand for goods and services might lead to a worsening of the trade balance. This is
particularly true when an economy has a high marginal propensity to import.

Unemployment and inflation – the Phillips Curve Concept
• In 1958 AW Phillips plotted 95 years of data of UK wage inflation against unemployment
• It suggested a short-‐run trade-‐off between unemployment and inflation
• Falling unemployment might cause rising inflation
• If a Government wanted to reduce the unemployment rate, it could increase aggregate demand
but, although this might temporarily increase employment, it could also have inflationary effects
The key to understanding this trade-‐off is to consider the possible inflationary effects in both labour and
product markets from an increase in national income, output and employment.
• The labour market: As unemployment falls, labour shortages may occur where skilled labour is in
short supply. This puts pressure on wages to increase and prices may rise as businesses pass on
these costs to their customers.
• Other factor markets: Cost-‐push inflation can also come from rising demand for commodities such
as oil, copper and processed manufactured goods such as steel, concrete and glass. When an
economy is booming, so does the derived demand for components and raw materials.
• Product markets: Rising demand can lead to suppliers raising prices to increase their profit
margins. The risk of rising prices is greatest when demand is out-‐stripping supply-‐capacity leading
to excess demand (i.e. a positive output gap.)

The possible conflict between unemployment and inflation can be moderated if:
1. The economy achieves higher labour productivity – this raises efficiency, reduces the unit costs of
production and also leads to higher real wages which boosts consumer demand
2. Innovation allows businesses to produce new products at cheaper costs
3. Expectations of inflation remain stable – a credible inflation target can help here

4. Workers are prepared to accept cuts in real wages to keep their jobs – this helps to lower the rate
of cost push inflation and can help to limit increases in unemployment during a recession
5. The economy is sufficiently flexible to cope with external demand and supply-‐side shocks such as
unexpectedly volatility in the prices of raw materials and components.

Unemployment and Inflation Rates in the UK Economy

The data in the table below shows that in the last four years, both inflation and unemployment have been
been falling at the same time. The economy has been able to sustain a fall in the rate of unemployment
without a pick up in inflationary pressures. There are a number of factors behind this, not least the slow
rate of growth of pay for people in the labour market and also a steep fall in global commodity prices.

Consumer price Unemployment
Inflation Unemployment
inflation (%) rate (per cent)
2007 2.3 5.3

2008 3.6 5.7 Rising Rising
2009 2.2 7.6 Falling Rising
2012 2.8 8.0 Falling Falling
2015 (June) 0.0 5.5 Falling Falling

Earnings for People in Work – Rate of Growth of Pay
There have been several years of slow pay growth since 2009 although wage inflation is now accelerating
again with pay growing more quickly than prices.

% change in earnings, latest 3 months on same period a year earlier
6
0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar


Economic Growth and the Balance of Payments
• A period of fast growth may come into conflict with the balance of payments. Much depends on
the income elasticity of demand for traded goods and services
• Say for example, real disposable incomes grow by 3% and the income elasticity for imports = +2.5.
That would lead to a 7% rise in the volume of imports. Unless there is a corresponding rise in
exports, we expect to see a worsening of the balance of trade (i.e. a widening trade deficit).
UK Economic Growth and the BoP Current Account
The data in the table shows the growth of real national output and the current account balance. Britain has
run a current account deficit in each year, the size of the deficit during the economic recovery.

Real GDP Growth BoP Current Account Balance (% of
(% Per annum) GDP)
2007 2.6 -‐2.7
2008 -‐0.3 -‐3.7
2009 -‐4.3 -‐2.8
2010 1.9 -‐2.6
2011 1.6 -‐1.7
2012 0.7 -‐3.7
2013 1.7 -‐4.5
2014 3.0 -‐5.5

Policies to improve the trade balance at a time of economic growth

Supply-‐Side Policies
•  Reforms to improve labour productvity
•  Incentves to boost research & development & innovaton
•  Measures to increase investment in export sectors
Exchange Rate Depreciakon

•  A depreciaton of the currency (in theory) makes exports more price
compettve and imports are more expensive
•  But the effects are dependent on price elastcity of demand
Sound / Effeckve Macro Economic Policies

•  Monetary policy to help keep inflaton low relatve to the inflaton of
major trading compettors
•  Infrastructure investment to increase export compettveness


29.AS Macro Glossary

AAA credit rating The best credit rating that can be given to a corporation's or a government’s bonds,
effectively indicating that the risk of default is negligible
Accelerator effect Where planned capital investment is linked positively to the past and expected
growth of consumer demand or national income
Aggregate supply Either an inflation shock or a shock to potential national output; adverse aggregate
shock supply shocks of both types reduce output and can increase the rate of inflation
Animal spirits The state of confidence or pessimism held by consumers and businesses.
Appreciation A rise in the market value of one exchange rate against another
Austerity Economic policy aimed at reducing a government's deficit (or borrowing). Austerity
can be achieved through increases in government revenues -‐ primarily via tax rises -‐
and/or a reduction in government spending or future spending commitments.
Automatic Automatic fiscal changes as the economy moves through stages of the business cycle
stabilisers – e.g. a fall in tax revenues from the circular flow in a recession.
Bank run When a large number of people suspect that a bank may go bankrupt and withdraw
their deposits. Bank runs are rare, one happened with the Northern Rock in 2007.
Bond Both companies and governments can issue bonds. The issue of new government
debt is done by the central bank and involves selling debt to capital markets
Brain drain The movement of highly skilled people from their own country to another nation
BRIC economies The BRIC grouping – Brazil, Russia, India and China – short hand for the rise of
emerging markets. The BRICs have a bigger share of world trade than the USA
Bubble When the prices of securities or other assets rise so sharply and at such a sustained
rate that they exceed valuations justified by fundamentals, making a sudden collapse
likely (at which point the bubble "bursts")
Budget deficit Occurs when government spending is greater than tax revenues. Reducing the deficit
can be achieved by tax increases or cuts in government spending or a period of
economic growth which brings about a rise in direct and indirect tax revenues
Business Expectations about the future of the economy – vital in influencing business decisions
confidence about how much to spend on new capital goods
Capacity utilisation Measures how much of the productive potential of the economy is being used.
Utilisation falls during a recession leading to a rise in spare capacity
Capital market A stock or a bond market where firms can raise money for investment purposes
Capital stock The value of the total stock of capital inputs in the economy
Capital-‐labour Replacing workers with machines in a bid to increase productivity and reduce the unit
substitution cost of production. This can lead to structural unemployment
Claimant Count The number of people claiming unemployment-‐related benefits
Closed economy An economy operating without imports and exports – i.e. closed to global trade
Comparative Comparative advantage refers to the relative advantage that one country or producer
advantage has over another. Countries can benefit from specializing in and exporting the
product(s) for which it has the lowest opportunity cost of supply
Constant prices Constant prices tells us that the data has been inflation adjusted

Consumer Expectations about the future including interest rates, incomes and jobs
confidence
Consumer Products such as washing machines that are not used up immediately when
durables consumed and which provide a flow of services over time
Consumer price The consumer price index (CPI) is the government's preferred measure of inflation
index
Corporation Tax A tax on the profits made by companies
Cost push inflation An increase in the price level caused by a sustained increase in costs of production
Credit crunch Where banks reduce lending due to falling confidence that loans will be repaid.
Creeping inflation Small rises in the general price level over a long period
Current account The overall balance of credits minus debits for trade in goods, trade in services,
investment income and transfers
Current account The amount by which money relating to trade, investment etc going out of a country
deficit is more than the amount coming in. A current account deficit implies a net fall of
demand in a country’s circular flow
Cyclical trade A trade deficit that arises purely due to changes in the economy’s cycle, for example
deficit many countries run a trade deficit when their economy is growing strongly
Cyclical Unemployment caused by a lack of aggregate demand for goods and services, where
unemployment national output < potential output leading to a negative output gap
Default A default occurs when a borrower has broken the terms of a loan or other debt, for
example if a borrower misses a payment
Deflation A persistent fall in the general price level of goods and services
Depreciation A fall in the market value of one exchange rate against another
Depression Used to describe a severe recession which may become a prolonged downturn in the
economy and where a nation’s GDP falls by at least 10 per cent
Deregulation Reducing barriers to entry in order to make a market more competitive
Discouraged People often out of work for a long time who give up on job search
workers
Discretionary fiscal Deliberate attempts to affect aggregate demand using changes in government
policy spending, direct and indirect taxation and borrowing
Disposable income Gross income less income tax and national insurance contributions plus cash welfare
benefits. Disposable income is the money that comes into a household from various
sources, including welfare benefits but after taxes on income
Double dip When an economy goes into recession twice without a full recovery in between
recession
Dumping When a producer in one country exports a product to another at a price below the
price it charges in its home market or below the costs of supply
Economic cycle Variations in the annual rate of growth of an economy over time
Economic growth An increase in the real value of goods and services produced in a country or area as
measured by the annual % change in real national output. Also a long-‐run increase in
a country’s productive capacity.
Economic shocks Unpredictable events such as volatile prices for oil, gas and foodstuffs

Economic stability When growth, prices and unemployment do not change much from year to year
Economically Those who are unemployed and actively seeking new job
active
Economically Those who are of working age but are neither in work nor actively seeking work
inactive
Emerging markets The financial markets of developing countries
Exchange rate The rate at which one currency can be exchanged for another.
Expansionary A relaxation of monetary policy means an attempt to use an expansionary monetary
monetary policy policy to boost aggregate demand, output and jobs – includes lower interest rates
Expectations How we expect the future to unfold
Expenditure-‐ Policies that are designed to ‘switch’ expenditure from imports to domestically
switching policies produced goods in order to improve the balance of payments and stimulate GDP
Export revenue Sales from selling goods and services overseas, an injection of demand
Financial assets For consumers the main financial assets are property, pensions, equities, unit trusts
and cash
Fine-‐tuning Changes in monetary policy or fiscal policy designed to gradually manage the level of
aggregate demand and prices e.g. small changes in policy interest rates
Fiscal austerity or Fiscal austerity refers to decisions by a government to reduce the amount of
fiscal tightening government borrowing (i.e. cut the size of a fiscal deficit) over a period of years
Fiscal deficit When government expenditure is higher than the revenue from tax recei
Fiscal policy A government's policy regarding taxation and public spending. It can be loose (with
the emphasis on increased spending and lower tax revenue to boost economic
activity, with the acceptance of a wider fiscal deficit) or tight (with the emphasis on
cutting spending and boosting tax revenue, resulting in a slower economy
Fiscal stability Many governments seek to maintain a degree of balance between tax revenues and
public sector spending. A balanced budget is one in which spending equal revenue
Fiscal stimulus Government measures, normally involving increased public spending and lower direct
and/or indirect taxation, aimed at giving a positive jolt to economic activity
Forecast A prediction made about the likely future performance of an economy
Foreign direct FDI stands for Foreign Direct Investment. FDI is investment from one country into
investment another (normally by companies rather than governments) that involves establishing
operations or acquiring tangible assets, including stakes in other businesses
Free trade When trade is allowed to occur without any form of restriction such as a tariff
Full capacity A level of national output where all available factor inputs are fully employed – this is
output a factor influencing the underlying growth rate (LRAS)
Full employment When there enough job vacancies for all the unemployed to take work
GDP Gross domestic product (GDP) is the total value of output in the UK and is used to
measure change in economic activity
Gini Coefficient A measure of the extent to which groups of households, from the bottom of the
income distribution upwards, receive less than an equal share of income.
Globalisation The deepening of relationships between countries of the world reflected in an
increasing level of overseas trade and investment

GNI Gross National Income – income generated from the resources owned by inhabitants
and businesses of a given country
Government debt The total stock of unpaid debt issued by a government. A government will normally
borrow money by issuing bonds or other securities
Gross Domestic National income per head of population, a baseline measure of living standards
Product per capita
Hard landing A full-‐scale recession shown by a decline in real national output
Hot Money Money that flows freely and quickly around the world looking to earn the best rate of
return. It might be invested in any asset whose value is expected to rise (e.g. property
or shares) or placed in an account offering the best real rate of interest.
Household wealth The value of assets – including property, shares, savings and pension fund assets
Human capital Investment in education and training to increase the quality of the labour force and
to make people more flexible in a changing world of work
Human An index to assess comparative levels of development in countries, quantified in
Development terms of literacy, life expectancy and purchasing power
Index
Hysteresis When a sustained period of low aggregate demand can lead to permanent damage to
the supply side of the economy
Immobility of Barriers to the movement of people between areas and between jobs
labour
Inflation A sustained increase in the general price level for goods and services
Inflation The rate of increase of consumer prices expected by consumers. Expectations can
expectations influence spending and saving decisions.
Inflation target The Bank of England has a CPI inflation target, which is currently 2 per cent
Inflationary Demand and supply-‐side pressures that can cause a rise in the general price level.
pressures Demand-‐pull inflationary pressure is greatest when actual GDP exceeds potential GDP
causing a positive output gap. Cost-‐push inflationary pressure can arise from
increases in unit wage costs, rising import prices and an increase in the prices of raw
materials, fuel and components used in production
Infrastructure The transport links, communications networks, sewage systems, energy plants and
other facilities essential for the efficient functioning of a country and its economy
Innovation Changes to products or production processes – innovation is important in delivering
improvements in dynamic efficiency and generating better goods and services
International An organisation of over 180 countries, promoting global monetary cooperation,
Monetary Fund financial stability, international trade, employment and sustainable economic growth.
(IMF) It has provided help for several nations in the wake of the 2007-‐09 financial crises.
International A nation’s stock of foreign currency and gold
reserves
Inventories These consist of materials and supplies which are stored for use in production, work-‐
in progress, finished goods and goods for re-‐sale
Investment Spending on capital goods including plant & machinery and infrastructure
Investment income Interest, profits and dividends from assets owned and located overseas
Job search The process by which workers find appropriate jobs given their tastes and skills

Keynesian The economics of John Maynard Keynes. The belief that the state can directly
economics stimulate demand in a stagnating economy. For instance, by borrowing money to
fund public works projects like new roads, housing, schools and hospitals
Keynesian Unemployment caused by a lack of aggregate demand in the economy – a deficiency
unemployment of private sector spending causes output and employment to contract
Labour shedding Cut backs in employment often seen in a slowdown or a recession
Labour shortages When businesses find it difficult to recruit the workers they need
Labour supply The number of people able, available and willing to work at prevailing wage rates
Lagging indicators Indicators which tend to follow economic cycles e.g. unemployment
Leading indicators Indicators which predict future economic trends e.g. consumer confidence
Leveraging The use of borrowed funds to increase your capacity to spend or invest
Liquidity The ease with which something can be converted to cash with little loss of value
Liquidity trap When very low interest rates cease to have a strong effect on aggregate demand
Macroeconomic The overall performance in terms of output, prices, jobs, trade and living standards.
performance
Propensity to The proportion of any change in income that is spent rather than saved
consume
Propensity to save The change in total saving as a result of a change in income
Marginal rate of The rate of tax on the next unit (£1) of income earned
tax
Monetary Policy Bank of England committee of 9 people meets every month to set interest rates.
Committee (MPC)
Monetary stimulus Changes in monetary policy designed to increase aggregate demand including lower
policy interest rates and measures to increase the supply of credit
Money supply The entire quantity of a country's commercial bills, coins, loans and credit
Multiplier effect If there is an initial injection (e.g. a rise in exports) into the economy then the final
increase in aggregate demand and real GDP will be greater.
NAFTA North American Free Trade Agreement signed in 1994 involving US, Canada & Mexico
National debt A government's total outstanding debt -‐ effectively what the government still owes
from the budget deficits accumulated over time
Negative equity When the value of an asset falls below the debt left to pay on that asset. Term is most
commonly used in connection with property prices after a slump in prices
Negative interest An interest rate that is below zero. For real interest rates, this can occur when the
rate inflation rate is higher than nominal interest rates
Net investment Gross investment minus an estimate for capital depreciation
Net inward When the number of migrants coming into a country is greater than those leaving
migration
Net trade The balance between the value of exports and imports
Nominal GDP Monetary value of all goods and services produced expressed at current prices
Nominal wage The annual growth of wages unadjusted for inflation

growth
Non-‐inflationary Sustained growth of real national output whilst maintaining price stability
growth
Output gap Difference between actual and potential national output. A negative output gap
means that an economy has a large margin of spare productive capacity
Output measure Value of the goods and services produced by all sectors of the economy; agriculture,
GDP manufacturing, energy, construction, the service sector and government
Overseas assets Assets such as businesses, shares, property which are owned in overseas countries
and which might generate a flow of income which is a credit item on the current
accot
Paradox of thrift If people save more in a recession, it will reduce consumption and thus AD will fall,
impeding economic growth and, eventually, lowering the general level of savings
Patent box A reduced rate of Corporation Tax applied to profits from patents – designed to
stimulate research and innovation and improve the supply-‐side of the economy
Peak The high point of the economic cycle beyond which a recession starts
Pension Fund Fund that pools employees' pension benefits and holds them so that they can be paid
at retirement. The money is invested in stocks, bonds and other assets to boost
returns and ensure that there are sufficient funds to be paid out
Per capita incomes Income per head of the population – a measure of average living standards
Phillips Curve A statistical relationship between unemployment and inflation
Precautionary Saving because of fears of a loss of real income or employment
saving
Price stability Price stability occurs when there is low inflation and the price changes that do occur
have little impact on day-‐to-‐day decisions of people
Productive Productive capacity of the economy – boosted by high quality investment
potential
Productivity A measure of efficiency e.g. output per person employed or output per person-‐hour
Propensity to Proportion of any change in income that is spent on overseas products
import
Propensity to save Proportion of any change in income that is saved rather than spent
Protectionism Restricting trade through tariffs and other forms of import controls
Purchasing power The buying power of a unit of currency. It is inversely related to the rate of inflation
Quantitative The introduction of new money into the national supply by a central bank
easing
Quota A physical limit on the quantity of a good that can be imported into a country
Real disposable Income after taxes and welfare benefits, adjusted for the effects of inflation
income
Real income Nominal income adjusted for price changes, expressed at constant prices
Real interest rate Nominal rate of interest adjusted for inflation
Real wage Nominal wage adjusted for the effects of inflation
Recession A period of at least six months when an economy suffers a fall in output. Or a

broadly-‐based contraction in output, employment, investment and confidence
Recovery A phase of the economic cycle, after a recession/depression, during which real GDP
starts to increase and unemployment begins to fall
Redundancy Making someone redundant is to end their employment
Relative deflation An economy with an inflation rate, which is lower than comparable economies. Over
time, a low relative rate of inflation can lead to improved competitiveness
Remittances Sending of money to people in another country. For many lower-‐income nations,
remittance income is now a big contribution to Gross National Income (GNI)
Risk averse Exhibiting a dislike of uncertainty, often seen in a recession
Saving ratio The percentage of disposable income that is saved rather than spent
Slowdown A fall in the rate of growth of an economy but not a full-‐scale recession
Slump A sustained decrease in real GDP and a persistent rise in unemployment
Soft landing A slowdown in economic activity but which does not result in a recession
Sovereign debt Debt issued by or guaranteed by a government
Spare capacity When a business is not making full use of its available capacity – there are spare
factors of production including land, labour and capital. When an economy has plenty
of spare capacity, short run aggregate supply tends to be elastic.
Stagflation A combination of slow growth and rising inflation. The most notable recent period of
stagflation occurred during the 1970s, when world oil prices rose dramatically, and
UK inflation rose at one point to nearly 30 per cent
Sterling exchange External value of sterling calculated using a weighted index of a basket of currencies –
rate index weightings are based on the value of trade with different countries
Stimulus Monetary policy and/or fiscal policy aimed at encouraging higher growth and/or
inflation. This can include interest rate cuts, quantitative easing, tax cuts and
government spending increases
Structural budget The size of a fiscal (budget) deficit adjusted to take account of the effects of changes
deficit in the economic cycle
Structural trade A trade deficit that arises due to supply-‐side weaknesses rather than a change in GDP
deficit or currency – caused by poor competitiveness
Structural Unemployment that results from the decline in n industry which leaves people
unemployment unemployed because they do not have the skills needed by industries that are
growing
Sustainable growth Growth that meets the needs of the present without compromising the ability of
future generations to meet their own needs. Growth that can continue without
damage to the environment, or the exhaustion of non-‐renewable resources
Target A target is an objective of government policy e.g. low inflation
Tariff A tax on imported products that may be ad valorem (%) or a specific tax (a set
amount per unit imported).
Tight labour When demand for labour is high and there are shortages of labour. Businesses may
market have to offer higher wages to attract and keep the workers they need
Time lags The time it takes for one change e.g. a change in interest rates to affect other
variables e.g. consumer confidence and spending

Trade deficit A trade deficit occurs when a country imports a greater value of goods and services
than it exports. A trade deficit as a net withdrawal from the circular flow of income
Trade-‐off A trade-‐off implies that choices have to be made between different objectives of
economic policy for example a trade-‐of between economic growth and inflation
Transmission How a change in interest rates affects the various sectors of the economy
mechanism
Trend growth The long run average growth rate – mainly determined by changes in the stock of
available factor inputs and also improvements in productivity. Trend growth is
represented by a rightward shift in the LRAS (or PPC boundary)
Trough The low point of the economic cycle beyond which a recovery starts
Twin Deficits Twin deficits refer to a situation where an economy is running both a fiscal deficit and
also a deficit on the current account of the balance of payments
Under-‐ Workers are underemployed when they are willing to supply more hours of work
employment than their employers are prepared to offer.
Unemployment When the prospect of the loss of unemployment benefits dissuades those without
trap work from taking a new job – creates a disincentives problem
Unit wage costs Labour costs per unit of output
Unsecured credit Credit not secured by another asset – i.e. money borrowed on credit cards
Wage price spiral Where workers bid for higher wages because they have seen their real income
eroded by rising prices. This can lead to a further burst of cost-‐push inflation
Wealth effect The supposed link between changes in wealth and household spending
World Bank A source of financial and technical assistance to developing countries. It can provide
loans and grants for a wide array of purposes that include investments in education,
health, public administration, infrastructure, financial and private sector
development, agriculture and environmental and natural resource management
World Trade WTO oversees trade agreements, negotiations and disputes between member
Organisation countries. The WTO is an organisation that was formed in 1995 to control trade
agreements between countries and to set rules on international trade. It replaced
GATT(the General Agreement on Tariffs and Trade)
Zero Hours An employment contract under which the employee is not guaranteed work and is
Contract paid only for work carried out
Zombie Companies Weak and inefficient companies which are able to survive thanks to low interest rates
and a supposedly more tolerant attitude to corporate borrowers by banks.


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Pearson Edexcel Level 3 Advanced

Page 10 www.tutor2u.net

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Prices held at

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2008 1,631,995 -­‐0.3 -­‐2.9 -­‐2.6 0.6

2009 1,561,646 -­‐4.3 -­‐9.4 -­‐13.2 -­‐2.9

2010 1,591,494 1.9 4.7 8.5 1.4

2011 1,617,677 1.6 1.8 2.2 2.1

2012 1,628,338 0.7 -­‐1.3 -­‐7.5 2

2013 1,655,447 1.7 -­‐0.7 1.4 1.9

2014 1,704,998 3 3.1 9.5 3

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Real GDP Per Capita Real Household Disposable Income

Real GNI per Capita Real GDP per capita

GDP per capita in U.S. dollars

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GDP per Capita RHDI Per Capita

Many aspects of well-­‐

Welfare measure might

Real Household Spending per head

Median Household Income

Household Net Wealth (i.e. value of assets – liabilites)

Unemployment rate (household income and net wealth.

Financial situaton of households + feeling of security

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Satisfaction with current

Mostly satisfied 20.7 22.4 20.4 28.7 28.6 26.7 27.9

Somewhat satisfied 28.0 28.2 29.5 19.9 19.4 18.9 16.9

Somewhat dissatisfied 12.0 11.3 11.9 14.8 15.1 16.2 15.3

Mostly dissatisfied 5.6 5.2 5.3 8.1 8.3 11.8 11.1

Completely dissatisfied 3.7 3.2 3.6 5.8 5.6 6.1 6.7

Somewhat, mostly or

Incentves to increase A living wage to boost

Accessible + high quality Bewer / aﬀordable housing Wealth from successful

Share earning below Living Wage

Elementary occupatons 59%

Sales & customer service 55%

Personal services 35%

Process, plant & machinery operatves 23%

Skilled trades 17%

Admin & secretarial 14%

Managers & senior oﬃcials 5%

Associate professional & technical 4%

Median gross annual earnings in GBP

Aircraz pilots and ﬂight engineers 90,420

Chief executves and senior oﬃcials 81,521

Air traﬃc controllers 79,874

Medical practtoners 71,141

Marketng and sales directors 70,742

Informaton technology and telecommunicatons 64,511

Financial managers and directors 61,108

Senior police oﬃcers 57,896

Financial insttuton managers and directors 53,621

Senior professionals of educatonal establishments 50,367

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Higher Average Living

Improved access to Improved Environmental

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Fall in AD Increase in AD

Fall in exports Depreciaton of the exchange rate

2008 1,631,995 -‐0.3 -‐2.9 -‐2.6 0.6

2009 1,561,646 -‐4.3 -‐9.4 -‐13.2 -‐2.9

2012 1,628,338 0.7 -‐1.3 -‐7.5 2

2013 1,655,447 1.7 -‐0.7 1.4 1.9

Many aspects of well-‐

-‐8% -‐6% -‐4% -‐2% 0% 2% 4% 6% 8%

Demand-‐side Shocks Supply-‐side Shocks

• Higher interest rates leading to more expensive loans