Chapter 24

The Role of the Government

Local and national Level

The role of the government as a producer

 Local governments may provide a range of goods and services for the
local community like refuse collection, public libraries, housing and local
roads which is financed from local taxes or grants from the national
government.

 The government may produce products which are of national

importance and are essential. They are produced by a natural monopoly.
A natural monopoly is an industry where a single firm can produce at a
lower average cost than two or more firms due to economies of scale.eg.
public transport like railways, metro.

 The government may produce goods which are of strategic importance.

Strategic industries are those which are important for the economic
development and safety of the country.eg defense, agriculture.

 The government may produce essential products like education and

healthcare at affordable rates on the grounds of equity.

 The government will produce public goods like roads and street lights
which will not be produced at all if left to the market economy.
 The role of the government as an employer

 The government employs workers and managers to operate the state

owned enterprises.
 The government employs people in public sector jobs such as teaching,
police and fire services, doctors, nurses and military personnel.
 Through its employees it can set examples of good practise and restrict
wage increases to limit inflation.
 The government can also increase or decrease its number of employees
to manipulate unemployment figures.

Role of the Government at an international Level

 Some Governments promote free international trade by reducing the

trade restrictions between countries to allow firms to export and
import. Some governments place trade restrictions on imports and
exports to protect their domestic firms against foreign competition.
 Governments encourage multinational companies to set up in their
countries believing employment opportunities will be created and
output of the country will increase. Some governments do not allow
MNCs to be located in their country.
 Governments get into trade agreements with other countries to form
Trade Blocs to promote trade between member countries and
discourage trade with non-members.
 The Government represents a country in international organisations.
Eg WTO, World Trade Organisation deals with rules of trade on a
global level.
 The Macroeconomic Aims of Government

What are the Macroeconomic aims of the Government?

Macroeconomic aims are economic aims of the government relating to the
whole country.
Macroeconomic aims are:
 Economic Growth
 Low Unemployment
 Price Stability
 Balance of Payments stability
 Redistribution of income

Economic Growth
Economic growth is, in the short run an increase in the output in an economy
and in the long run an increase in the economy’s productive potential.
Aggregate Demand
 It is the total demand for a country’s products at a given price level.
 It consists of Consumer expenditure, Government spending, Investment
and net exports.
Aggregate Supply
 It is the total amount of goods and services that domestic firms are
willing to supply at a given price level.
 Aggregate supply is perfectly elastic when trhe economy has
unemployed resources.
 The AS becomes more inelastic as the economy approaches full
employment, due to shortage of resources, resulting in increase in costs
of production and prices.
 At full employment, AS becomes perfectly inelastic since a further
increase in resources is not possible.
Actual Economic Growth
It is an increase in the output of an economy in the short run due to utilizing
the unemployed resources of the economy as a result of an increase in
aggregate demand.

Causes of Actual economic growth- Increase in Aggregate Demand

 Increase in population
 A cut in Interest rate
 A lower exchange rate
 A cut in taxation
 Greater confidence
 Increase in Government spending
 Increase in Investment
 Increase in consumer spending
 Increase in Net Exports
Potential Economic growth
It is an increase in the productive potential of an economy. This can be
achieved by a rise in the quantity and quality of resources.

Why do governments aim for Economic growth?

 Increase in living standards of the people
 Longer Life expectancy due to improved health care facilities
 Employment rises- government can achieve its aim of Low
Unemployment.
 A country’s trade position is improved
 Reduction in poverty levels
Criteria of Economic growth
 The determinant of the economic growth rate is at its level of output in
relation to the maximum possible output.
 The productive capacity
Low Unemployment
 Governments will aim to keep employment as high as possible and
unemployment as low as possible to ensure best use of resources.
 Governments will achieve a low unemployment rate of around 3%. This
is known as full employment.
Why do governments aim for low unemployment?
  Loss of GDP
 Loss of government tax revenue
 Cost to the government in the form of unemployment benefits
 Various social problems like growing crime rates, homelessness, etc
Criteria for Unemployment
 Governments believe it is not possible to achieve 0% unemployment
rate with demand for labour equaling supply, there will be some workers
changing jobs and being unemployed for short periods of time.
 Governmenta aim for a low unemployment rate of 3%.
Unemployment rate = No. of people *100
Labour force
Unemployment rate – The percentage of the labour force who are willing and
able to work but are without jobs
Labour force= Number of Employed + Number of Unemployed
Price Stability
 Price stability occurs when the average level of prices in the economy
doesn’t change significantly.
Why governments aim for price stability?
 Economic certainty results in consumer and investor confidence to plan
for the future.
 Products don’t lose international competiveness
 Workers will not press for higher wages
 Firms will not increase prices as costs of production will not rise.
Criteria for Price Stability
 Governments set a target inflation rate of 2%
 This moderate but low rate of inflation avoids the costs of inflation but
also avoids the costs of deflation.
 A low and stable inflation rate encourages producers to increase output
as they think higher prices will lead to higher profits
 A small rise in price justifies improvements in products.
 Measures of inflation tends to overstate rises in prices
Balance of Payments stability
 The governments aim for the value of the exports to equal to the value
of the imports so that what the country earns from exports equals to
what it spends on imports.
Why BOP stability?
 If imports exceed exports, the country will have to fiancé the deficit with
a debt.
 If export revenue is greater import expenditure, the citizens of the
country will not be enjoying as many products as possible resulting in fall
in living standards.
Criteria
 Exports > Imports = Surplus in BOP
 Exports < Imports = Deficit in BOP
 All economies try to balance this inflow and outflow of international
trade and payments and try to avoid any deficits
 If it exports too little and imports too much, the economy may run out of
foreign currency to buy further imports
 A BOP deficit causes the value of its currency to fall against other foreign
currencies and make imports more expensive to buy, while a BOP
surplus causes its currency to rise against other foreign currencies and
make its exports more expensive in the international market.

Redistribution of Income
 to reduce the inequality of income among its citizens, the government
will redistribute incomes from the rich to the poor by imposing taxes on
the rich and using it to finance welfare schemes for the poor.
 widening inequality means higher levels of poverty
 poverty and hardship restricts the economy from reaching its maximum
productive capacity.
Conflict of Macroeconomic Aims

When a policy is introduced to achieve one macroeconomic aim, it tends to

conflict with one or more other aims. In other words, as one aim is achieved,
another aim is undone.

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Full Employment v/s Price Stability

Low rates of unemployment will boost incomes of businesses and workers.

This rise in incomes, mean higher demand and consumption in the economy,
which causes firms to raise their prices – resulting in inflation. This is probably
the most prominent policy conflict in the study of Economics.

Economic Growth & Full Employment v/s BoP Stability

Once again, as incomes rise due to economic growth and low unemployment,
people will import more foreign products and consume relatively less domestic
products. This will cause a rise in imports relative to exports and a deficit may
arise in the balance of payments.

Economic Growth v/s Full Employment

In the long run, when economic growth is continuous, firms may start investing
in more capital (machinery/equipment). More capital-intensive production will
make a lot of people unemployed.
 Fiscal Policy

Budget: a financial statement showing the forecasted government revenue

and expenditure in the coming fiscal year.

Government spending
 Governments spend on all kinds of public goods and services.
 Government spending is a part of the aggregate demand in the
economy.
 Government spending includes defence and arms, road and transport,
electricity, water, education, health, food stocks, government salaries,
pensions, subsidies, grants etc.

Reasons governments spend:

 To supply goods and services that the private sector would fail to do, such
as public goods, including defence, roads and streetlights;
 To provide merit goods, such as hospitals and schools; and welfare payments
and benefits, including unemployment and child benefits.
 To achieve supply-side improvements in the economy, such as spending on
education and training to improve labour productivity.
 To spend on policies to reduce negative externalities, such as pollution
controls.
 To subsidise industries which may need financial support, and which is not
available from the private sector, usually agriculture and related industries.
 To help redistribute income and improve income inequality.
 To inject spending into the economy to aid economic growth.

Effects of government spending

 Increased government spending will lead to higher demand in the economy

and thus aid economic growth, but it can also lead to inflation if the increasing
demand causes prices to rise faster than output.
 Increased government spending on public goods and merit goods, especially in
infrastructure, can lead to increased productivity and growth in the long run.

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 Increased government spending on welfare schemes and benefits will increase
living standards, and help reduce inequality.
 However too much government spending can also cause ‘crowding out’ of
private sector investments – private investments will reduce if the increase in
government spending is financed by increased taxes and borrowing (large
government borrowing will drive up interest rates and discourage private
investment).
Tax
 Governments earn revenue through interests on government bonds and
loans, incomes from fines, penalties, escheats, grants in aid, income
from public property, dividends and profits on government
establishments, printing of currency etc; but its major source of revenue
comes from taxation.
 Taxes are a compulsory payment made to the government by all people
in an economy.

Reasons for levying taxes

 It is a source of government revenue: if the government has to spend on

public goods and services it needs money that is funded from the economy
itself. People pay taxes knowing that it is required to fund their collective
welfare.
 To redistribute income: governments levy taxes from those who earn higher
incomes and have a lot of wealth. This is then used to fund welfare schemes
for the poor.
 To reduce consumption and production of demerit goods: a much higher tax
is levied on demerit goods like alcohol and tobacco than other goods to drive
up its prices and costs in order to discourage its consumption and production.
Such a tax on a specific good is called excise duty.
 To protect home industries: taxes are also levied on foreign goods entering
the domestic market. This makes foreign goods relatively more expensive in
the domestic market, enabling domestic products to compete with them. Such
a tax on foreign goods and services is called customs duty.
 To manage the economy: as we will discuss shortly, taxation is also a tool for
demand and supply side management. Lowering taxes increase aggregate
demand and supply in the economy, thereby facilitating growth. Similarly,
during high inflation, the government will increase taxes to reduce demand
and thus bring down prices.

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 Classification of Taxes
Taxes can be classified into direct or indirect and progressive, regressive or
proportional.

Direct Taxes
Direct taxes are levied on incomes, profits and wealth of individuals and firms.
The burden of tax payment falls directly on the person or individual
responsible for paying it.
 Income tax: paid from an individual’s income.
Disposable income is the income left after deducting income tax from it.
When income tax rise, there is little disposable income to spend on goods and
services, so firms will face lower demand and sales, and will cut production,
increasing unemployment. Lower income taxes will encourage more spending
and thus higher production.
 Corporate Tax: tax paid on a company’s profits. When the corporate tax rate is
increased, businesses will have lower profits left over to put back into the
business and will thus find it hard to expand and produce more. It will also
cause shareholders/owners to receive lower dividends/returns for their
investments. This will discourage people from investing in businesses and
economic growth could slow down. Reducing corporate tax will encourage
more production and investment.
 Capital gains tax: taxes on any profits or gains that arise from the sale of assets
held for more than a year.
 Inheritance tax: tax levied on inherited wealth.
 Property tax: tax levied on property/land.

Advantages:

 High revenue: as all people above a certain income level have to pay income
taxes, the revenue from this tax is very high.
 Can reduce inequalities in income and wealth: as they are progressive in
nature – heavier taxes on the rich than the poor- they help in reducing income
inequality.

Disadvantages:

 Reduces work incentives: people may rather stay unemployed (and receive
govt. unemployment benefits) rather than be employed if it means they would
have to pay a high amount of tax. Those already employed may not work

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 productively, since for any extra income they make, the more tax they will
have to pay.
 Reduces enterprise incentives: corporate taxes may demotivate entrepreneurs
to set up new firms, as a good part of the profits they make will have to be
given as tax.
 Tax evasion: a lot of people find legal loopholes and escape having to pay any
tax. Thus tax revenue falls and the govt. has to use more resources to catch
those who evade taxes.

Indirect Taxes
Indirect taxes are taxes on goods and services sold. It is added to the prices of
goods and services and it is paid while purchasing the good or service. It is
called indirect because it indirectly takes money as tax from consumer
expenditure.
 GST/VAT: these are included in the price of goods and services. Increasing
these indirect taxes will increase the prices of goods and services and reduce
demand and in turn profits. Reducing these taxes will increase demand.
 Customs duty: includes import and export tariffs on goods and services flowing
between countries. Increasing tariffs will reduce demand for the products.
 Excise Duty: tax on demerit goods like alcohol and tobacco, to reduce its
demand.

Advantages:

 Cost-effective: the cost of collecting indirect taxes is low compared to

collecting direct taxes.
 Expanded tax-base: directs taxes are paid by those who make a good income,
but indirect taxes are paid by all people (young, old, unemployed etc.) who
consume goods and services, so there is a larger tax base.
 Can achieve specific aims: for example, excise duty (tax on demerit goods) can
discourage the consumption of harmful goods; similarly, higher and lower
taxes on particular products can influence their consumption.
 Flexible: indirect tax rates are easier and quicker to alter/change than direct
tax rates. Thus their effects are immediate in an economy.

Disadvantages:

 Inflationary: The prices of products will increase when indirect taxes are added
to it, causing inflation.

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 Regressive: since all people pay the same amount of money, irrespective of
their income levels, the tax will fall heavily on the poor than the rich as it takes
more proportion of their income.
 Tax evasion: high tariffs on imported goods or excise duty on demerit goods
can encourage illegal smuggling of the good.
Progressive Taxes
Progressive taxes are those taxes which burdens the rich more than the poor,
in that the rate of taxation increases as incomes increase. An income tax is
the perfect example of progressive taxation. The more income you earn, the
more proportion of the income you have to pay in taxes, as defined by income
tax brackets.

Regressive Taxes
Regressive taxes are those taxes which burden the poor more than the rich, in
that the rate of taxation falls as incomes increase. An indirect tax like GST is
an example of a regressive tax because everyone has to pay the same tax when
they are paying for the product, rich or poor.
For example, suppose the GST on a kilo of rice is $1; for a person who earns
$500 dollars a month, this tax will amount to 0.2% of his income, while for a
richer person who earns $50,000 a month, this tax will amount of just 0.002%
of his income. The burden on the poor is higher than on the rich, making its
regressive.
Proportional Taxes
Proportional taxes are those taxes which burden the poor and rich equally, in
that the rate of taxation remains equal as incomes rise or fall. An example is
corporate tax. All companies have to pay the same proportion of their profits
in tax.
For example, if the corporate tax is 30%, then whatever the profits of two
companies, they both will have to pay 30% of their profits in corporate tax.

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 Qualities of a good tax system (the canons of taxation):

 Equity: the tax rate should be justifiable rate based on the ability of the
taxpayer.
 Certainty: information about the amount of tax to be paid, when to pay it, and
how to pay it should all be informed to the taxpayer.
 Economy: the cost of collecting taxes must be kept to a minimum and
shouldn’t exceed the tax revenue itself.
 Convenience: the tax must be levied at a convenient time, for example, after a
person receives his salary.
 Elasticity: the tax imposition and collection system must be flexible so that tax
rates can be easily changed as the person’s income changes.
 Simplicity: the tax system must be simple so that both the collectors and
payers understand it well.

Impacts of taxation

Taxes can have various direct impacts on consumers, producers, government

and thus, the entire economy.

 The main purpose of tax is to raise income for the government which can lead
to higher spending on health care and education. The impact depends on what
the government spends the money on. For example, whether it is used to
fund infrastructure projects or to fund the government’s debt repayment.
 Consumers will have less disposable income to spend after income tax has
been deducted. This is likely to lead to lower levels of spending and saving.
However, if the government spends the tax revenue in effective ways to boost
demand, it shouldn’t affect the economy.
 Higher income tax reduces disposable income and can reduce the incentive to
work. Workers may be less willing to work overtime or might leave the labour
market altogether. However, there are two conflicting effects of higher tax:
 Substitution effect: higher tax leads to lower disposable income, and work
becomes relatively less attractive than leisure – workers will prefer to work
less.
 Income effect: if higher tax leads to lower disposable income, then a
worker may feel the need to work longer hours to maintain his desired level
of income – workers feel the need to work longer to earn more.
 The impact of tax then depends on which effect is greater. If the
substitution effect is greater, then people will work less, but if income
effect is greater, people will work more

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 Producers will have less incentive to produce if the corporate taxes are too
high.

Fiscal Policy

 Fiscal policy is a government policy which adjusts government

spending and taxation to influence the economy.
 Government aims for a balanced budget which means government
expenditure is equal to tax revenue.
 A budget is in surplus, when government revenue exceed government
spending. While this is good it also means that the economy hasn’t
reached its full potential. The government is keeping more than it is
spending, and if this surplus is very large, it can trigger a slowdown of
the economy.
When there is a budget surplus, the government employs an
expansionary fiscal policy where govt. spending is increased and tax
rates are cut.
 A budget is in deficit, when government expenditure exceeds
government revenue. This is undesirable because if there is not enough
revenue to finance the expenditure, the government will have to borrow
and then be in debt.
When there is a budget deficit, the government employs
contractionary fiscal policy, where govt. spending is cut and tax rates
are increased.

Advantages of Fiscal policy

 Fiscal policy helps the government achieve its aim of economic growth,
by being able to influence the demand and spending in the economy. It
also indirectly helps maintain price stability.
 Expansionary fiscal policy will stimulate growth, employment and help
increase prices.
 Contractionary fiscal policy will help control inflation resulting from too
much growth.

Disadvantages of Fiscal policy

 Reduce incentive to work

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Raising taxes on income and profits reduce work incentives, employment and
economic growth. If this occurs there will be a fall in productivity and
Aggregate supply could fall.
 Adverse effect of lowering Public Spending
Reduced government spending to decrease Aggregate demand could adversely
affect public services such as public transport and education causing market
failure and social inefficiency.
 ‘Crowding out’ effect
With an increase in government expenditure, there will be greater competition
for limited resources. This will offset private investments resulting in shrinking
of the private sector.
 Inaccurate forecasting
If the Government’s estimate or forecasting is wrong or inaccurate the Fiscal
policy will suffer. For example, if a recession is expected and the government
practices deficit budget, and yet the recession turns out to be a boom, this will
cause inflation.
 Time Lag
If there is a delay in the implementation of the fiscal policy, it might reduce
the effectiveness of the policy resulting in a time lag.

Scenario one: High rate of Inflation- Contractionary Fiscal

Policy

 Government will use contractionary fiscal policy to curb inflation.

 Government will try to influence aggregate demand by reducing its
public spending. The government will spend less on construction of
roads, bridges and other public spending and thus aggregate demand
will fall.
 Government may increase the tax rates. An increase in tax rates will take
away the extra disposable income out people’s pocket resulting in a
lower consumption on goods and services reducing aggregate demand
and thus lowering the price level.
 An increase in tax rates will reduce retained profits of the firms resulting
in reduction in investments leading to a decrease in Aggregate demand
and price levels.

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 Effect of deflationary fiscal policy

Scenario two: Recession- Expansionary Fiscal Policy

 In an economic recession, aggregate demand, output and employment

all tend to fall.
 The Government will increase the public spending resulting in a rise in
aggregate demand.
 Government may reduce the tax rates so that people have more
disposable income to spend and stimulate aggregate demand in the
economy leading to increase in GDP and the price level of the economy.

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Effect of Expansionary Fiscal policy

10 | P a g e
 Monetary Policy

 Monetary policy refers to decisions by the government to influence

aggregate demand through changes in rates of Interest, money supply
and exchange rates.

 Monetary policy in any country is usually controlled by the Central Bank

of that country. The Central bank alters the interest rates in the
economy after assessing the inflationary pressures in the market.

 Tools

Rate of interest- To influence borrowing

Money Supply - Buying and selling of Government Bonds and securities

Exchange rates- To influence Imports and Exports

Expansionary monetary Policy

 An expansionary policy increases the total money supply in the
economy and is traditionally used to combat unemployment in a
recession by lowering interest rates.
 Lowered interest rates encourage the household and the firms to
increase their consumption and investment. This will shift the AD to the
right and result in higher output more employment.

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Contractionary Monetary policy
 Contractionary policy decreases the total money supply and involves
raising interest rates in order to combat inflation.
 The result will be that investment will fall, and consumption will fall. All
of these changes will shift the AD to the left.

Evaluation of Monetary Policy

 Monetary policy is considered to be more successful during inflationary

times because an increase in interest rates reduces the borrowings and
thus stabilises the prices.

 Whereas, during deflation, Monetary policy may not be as effective.

During deflation or recession, there is uncertainty in the market which
discourages entrepreneurs and producers to take risk and lowering
interest rates may not increase consumption and Investments.

 There is a time lag between the changes in interest rates and the full
effect of it on the economy.

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 Supply side Policies
Supply side policy measures are designed to increase Aggregate supply and
hence increase productive potential of the country.

Aims:

They increase the quality and quantity of resources.

They enable the free market to work more efficiently and attempt to promote
employment, low inflation and economic growth.

Supply side policies include:

Privatisation
Privatisation is the selling of state owned businesses to private individuals and
groups.

This increases the efficiency of these organisations as they face more

competition.

Profit motive increases the incentive to utilise the resources in the best
possible way.

Deregulation
Deregulation involves reducing barriers to entry in order to make the market
more competitive. It does away with unnecessary rules and regulations on
business which results in reduced cost, increased output and lower prices.

Moreover, it increases the competition in the economy, leading to higher

efficiency for businesses.

Increased education and training

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Improving the level of education, training and skills of the workforce will raise
the labour productivity and increase the aggregate supply.

Governments usually give a lot of importance to education and encourage

more and more people to attend universities and colleges that enhances the
skills of the workforce.

However, government intervention will cost money, requiring higher taxes, It

will take time to have effect and government may subsidise the wrong types of
training.

Labour Markets reforms

By controlling the actions of the trade unions the Government can ensure that
there is least disruption in the business activities.

Reducing income tax rates

It is argued that lower income increases the incentives for people to work
harder, leading to an increase in labour supply and more output. Similarly, a
cut in corporation tax gives firms more retained profit they can use for
investment.

However, this is not necessarily true, lower taxes do not always increase work
incentives (e.g. if income effect outweighs substitution effect). Firms may not
invest the increased profit but give to shareholders as dividends.

Encourage immigration

Free-movement of labour can enable firms to fill labour shortages – whether

they are skilled jobs, in construction and engineering or low-skilled jobs such as
fruit picking.

Liberal immigration policies make labour markets more flexible and in boom
times help firms keep up with growing demand.

For countries with relatively low wages, they may lose out on most skilled
labour who move abroad to get higher paying jobs.

Improving transport and infrastructure

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 With transport, there is usually a degree of market failure – congestion and
pollution.

Government spending on improved transport links can help reduce congestion

and overcome this market failure.

Improved transport provision helps reduce the cost of transport and will
encourage firms to invest. Transport bottlenecks on the road, rail and air – are
often cited as a major stumbling block for the UK economy.

 However, in a crowded country like the UK, it can be difficult to increase

transport capacity, especially in London.

Improved healthcare

Business can face substantial costs from time lost to ill-health. Health care
spending which improves a nation’s health can improve labour productivity.

Improved health can also come from discouraging unhealthy habits. For
example, tax on cigarettes, alcohol and sugar can reduce health care costs
associated with drunkenness, obesity and polluted environments.

Limitations of supply-side policies

 Productivity growth depends largely on private enterprise and trends in
technological innovation. There is a limit to which the government can
accelerate the growth of technological change and improvements in working
practices.
 Supply-side policies can be counter-productive. For example, flexible labour
markets may reduce costs for business – but if they cause job-insecurity,
workers may become demotivated and labour productivity stagnates. Since
2009, the UK has seen a fall in structural unemployment due to more flexible
labour markets – but productivity growth is almost stagnant.
 In a recession, supply-side policies cannot tackle the fundamental problem
which is lack of aggregate demand.
 Time Lag. All supply-side policies take a long time to have an effect. Some
policies, such as education spending may not influence the economy for 10
years.

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4|Page
 Chapter 29
Economic Growth

GROSS DOMESTIC PRODUCT

GDP-GROSS DOMESTIC PRODUCT

 Gross means total, domestic refers to the home country and product
means output. So Gross domestic product-GDP means the total output
produced in a country in a given period of time.
 There are three methods of measuring this output. These are- the
output, income and expenditure methods.
 All these three methods should give the same figure. This is because an
output of $20 billion, which in turn, will be spent on the output.
 This relationship is referred to as the circular flow of income and is
illustrated with diagrams
CIRCULAR FLOW OF INCOME

You can see in the above picture that money flows in a circle. It doesn’t matter
where it begins, but money flows from households to firms when goods and
services are purchased, and the money flows back to households from firm’s
factors of production such as labour and capital are purchased. This money
goes back and forth through the economy hence the circular flow.

Market- A group of buyers and sellers of a good or service, and how they come
together to trade.
 Product markets- markets for goods and services, such as cell phones and
haircuts.

Factor markets- markets for the factors of production: labor, capital, natural
resources, and entrepreneurial ability.

Factors of production- inputs used to make goods and services: labour, capital,
natural resources, and entrepreneurial ability.

The circular flow of the income- the movement of expenditure, income and
output round the economy

THE METHODS OF CALCULATING GDP

1. THE OUTPUT METHOD-

 It measures GDP by adding up the output produced by all the industries

in the country.
 Care has to be taken in using this method to ensure that output is not
counted twice.
 For instance, the value of the output of the car industry includes output
produced by the steel and tyre industries also. To avoid this problem,
economists include the value added by each firm at each stages of
production.

Value added- the difference between the sales revenue and the cost of raw
martials used.

2. THE INCOME METHOD-

  It includes all the incomes which have been earned in producing the
country’s output.
 Transfer payments such as pensions, and unemployment benefit, are
not included.

Transfer payments- transfers of income from one group to another not in

return of providing a good or service.

3. THE EXPENDITURE METHOD-

 It calculates GDP by adding up all the expenditure on the country’s

finished output.
 Some of this comes from foreigners when they buy the
country’s exports. Some of the expenditure in the country goes
on imports which are not produced in the country and which do not
generate income for the country’s citizens.
 So, in the expenditure method, it is necessary to add exports and
deduct imports.
 Total expenditure on a country’s output, and hence its GDP, includes
consumption, investment, government expenditure and exports minus
imports.

So the GDP formula is GDP = C + I + G + (X - M)

The parts of the formula are simple:

C = total spending by consumers
I = total investment (spending on goods and services) by businesses
G = total spending by government (federal, state, and local)
(x - m) = net exports (exports - imports)

So the composition of GDP breaks down roughly as follows:

Consumption 65%
Investment 15%
Government 20%
Net Exports 0
100%

C + I + G + (x - m) currently equals over $10 trillion in the United States. That

means the United States produces more than $10 trillion of goods and services
within its borders every year.
Net exports for the United States are close to zero or, oftentimes, a bit
negative. Yes, the United States exports a tremendous amount of goods, but it
imports even more.

NOMINAL AND REAL GDP

NOMINAL GDP
When government calculate GDP, they usually first measure it in terms
of nominal GDP, which is also referred to as money GDP or GDP at current
prices.
Nominal GDP is GDP valued in terms of prices operative at that time.it has
not been adjusted for inflation. For this reason, nominal GDP figures may give
a misleading impression of what is happening to the output of a country, over
time.
For instance, if prices rise by 20% in a year, there will be a 20% rise in nominal
GDP even if output does not change.

REAL GDP
To get the real picture of the GDP and assess the economic growth,
economists adjust nominal GDP BY multiplying nominal GDP with the price
index in the base year, divided by the price index of the current year. This gives
a figure for GDP at constant prices referred to as real GDP
A rise in real GDP of 5% would mean that the country’s output has increased
by 5%.
 For instance, in 2007, the nominal GDP of a country may be $800bn and its
price index may be 100 for base year. In 2008, nominal GDP may increase to
$900bn, giving the impression that output has risen by $100bn/$800bn*100
equal to 12.5%. if, however, the price index rises to 110, the real GDP in 2006
will be $900bn *100/110 equal to $818.18bn.

REAL GDP PER HEAD

A rise in real GDP means that more goods and services have been produced. Its
impact on the goods and services available to people, will depend on the state
of population. If real GDP rises by 5%but population rises 8%, there will be
actually be fewer goods and services per head of the population and standard
of living may fall.

To find out, what happening to peoples living standards, economists calculate

real GDP per head which is also referred as REAL GDP PER CAPITA. It is found
by dividing real GDP by total population.
For instance, real GDP is $80bn and the population is 20m, real GDP per head is
$80bn/20m is equal to $4000.

Activity 1
a. In 2006, a country’s nominal GDP is $375bn. In 2007, it rises to $500bn.
Between the two years, the price index rise from 100 to 125. What was the
percentage increase in real GDP?
b. TABLE 1 shows a country’s real GDP and population over a period of three
years. Calculate the real GDP per head in each year.
Table 1. REAL GDP AND POPULATION BETWEEN 2008 AND 2010
YEAR REAL GDP in POPULATION in
$billion million
2008 50 20

2009 55 22
 2010 45 15

ANSWERS
a. Real GDP=$500bn×100/125=$400bn

Rise in Real GDP=$25bn/$375bn×100=6.67%

b.
year Real GDP per head in $
2008 2,500
2009 2,500
2010 3,000

The difficulty of measuring REAL GDP

GDP figures tend to understate the true level of output. This is because of the
existence of informal economy or sector, which covers unrecorded economic
activity. This covers undeclared economic activities and non-marketed goods
and services.
Economic activity which is not declared is known as hidden, shadow or grey
economy.
There are 2 reasons for concealing economic activity.
1. The activity is illegal such as illegal drug dealing and work undertaken by
immigrants, who have not been given permission to work in the country.

2. Sometimes activity is legal, the person undertaking it does not want to pay
tax on it.in the U.K, it is thought that some workers in building, electrical
installation, plumbing and car repairs do not declare all their earnings to the
tax authorities.
Non-marketed goods and services are products which are not bought or sold.
Family members who help during harvest time, people who clean their own
 houses and repair their own cars, are all providing products but these are not
counted in GDP.
The size of the informal activity or economy is influenced by a number of
factors. These include the number of activities that are declared to be illegal,
tax rates, penalties for tax evasion, number of tasks people perform for
themselves and the size of subsistence agriculture.
KEY POINT SUBSISTENCE AGRICULTURE - The output of agricultural goods for
farmer’s personal use.
ACTIVITY 2
In 2006, Greece announced a 25% upward revision of its gross domestic
product. The revision resulted from government officials recording more
service sector activity including some informal sector activity.
a. Did the revision made by Greece in 2006, mean that the economy had
produced 25% more output?
b. Why is it difficult to measure the size of the informal sector?

CAUSES OF ECONOMIC GROWTH

1. The discovery of more natural resources:
The discovery of more natural resources like coal, gold, iron ore and even new
variety of fruits and cereals would help any economy to increase output
2. Investment in capital:
Investment, or the production of new capital equipment, that is tools,
machinery and factories, is often said to be the key to growth. Investment can
come from private sector firms and government.
3. Technical progress:
New inventions, better production techniques produce more efficiently.

4. Increasing the quality of human resources.

More skilled and knowledgeable work force will be able to produce more, and
better, goods and services, Improving health care and medicines can improve
the quality of human resources.
5. Reallocation of resources.
As the country develops, resources tend to move out of primary production
and into manufacturing and services where large increases in output have
occurred
23. BENEFITS OF ECONOMIC GROWTH
Benefits of economic growth

High living standard

Population can have access to better goods and services. There will be low
level of poverty. People will be able to afford a better and healthy living
standard.

Improved public services

Increased income leads to more tax revenue for the government which in turn
can be used for the welfare of the public in form of health and education
services.

Low level of unemployment

An increase in economic growth leads to rise in demand for goods and services
and thus there will be low level of unemployment.

Increased investment in ‘green technologies’

A country with high level of economic growth can afford to invest in
technologies which have less harmful effect on the environment. People will
have cleaner air and a healthier environment to live.

Cost of economic growth

Inflation
The biggest risk of fast economic growth is inflation. If the aggregate supply
could not match with aggregate demand, it will result in rise in general price
level of goods and services.

Opportunity cost
Economic growth may be achieved because more resources are allocated for
capital goods. This will be at the cost of consumer goods leading to reduced
living standards.

Environmental problems
Increase pace of economic growth can create negative externalities such as
noise and air pollution. Forest will be cut to create space to set up industries.
More over more industries will result in an increase output of polluting
substances.
Depletion of non-renewable resources leading to unsustainable development.
Increased stress on workers
An increase in output may require some workers working longer hours leading
to increased stress on workers.

o
 Chapter 30

Employment and Unemployment

What is Unemployment?

Unemployment occurs when a person who is willing and able to work is actively
searching for a job but is unable to find one.

Unemployment rate is a measure of calculating the unemployment levels in a

country.

It is the number of unemployed people divided by the number of people in the

labour force.
 Types of Unemployment

Frictional Unemployment

 Frictional unemployment occurs when workers leave their old jobs but
haven't yet found new ones. Most of the time workers leave voluntarily,
either because they need to move, or they've saved up enough money to
allow them to look for a better job.
 Frictional unemployment is short-term and a natural part of the job
search process.
 Frictional unemployment is good for the economy, as it allows workers to
move to jobs where they can be more productive.

Types of Frictional Unemployment

Casual: Casual unemployment occurs when people are out of work between
periods of employment. Eg. Contractual workers, actors, migrant farm workers.

Search: This occurs when workers do not accept the first job offered but
spend time looking for a job which offers higher financial and non- financial
benefits.

Seasonal: This occurs in occupations whose labour is not in demand all round the
year.eg. workers in building and tourist industries.

Structural Unemployment

 Structural unemployment occurs as some industries decline and new

industries are formed in the economy that creates a mismatch between
the skills workers have and the skills needed by employers.

 An example of this is an industry’s replacement of machinery workers

with robots. Workers now need to learn how to manage the robots that
replaced them. Those that don't learn need retraining for other jobs or
face long-term structural unemployment.
Types of Structural Unemployment:

Regional: Unemployment caused by a decline in job opportunities in a particular

area of the country.

Technological: Unemployment caused by workers being replaced by capital

equipment caused due to advances in ICT.

Cyclical Unemployment

 Unemployment caused by lack of aggregate demand.

 It has the most serious consequences as it affects more workers and is
spread throughout the country.
 If an economy goes through recession, demand for labour will fall and
cyclical unemployment will occur.
 It is also known as demand deficient unemployment.

Classical Unemployment
Classical unemployment occurs when real wages
are kept above the market clearing wage rate,
leading to a surplus of labour supplied.
Consequences of Unemployment
Effects on the Economy

 The economy will face a high opportunity cost as it is not using all its
resources, leading to the economy not producing as many goods and
services as possible.
 Government tax revenue will reduce as people lose their jobs, as a result
expenditure falls and indirect tax revenue declines.
 Incomes and firm’s profits fall, therefore revenue from income tax and
corporation tax also falls.
 Government expenditure on unemployment benefits will rise. The
government faces an opportunity cost as this money could be spent on
improving healthcare and higher education.
 Unemployment may increase the levels of criminal activities, resulting in
the increased government expenditure on security and police.

Effects on the Unemployed

 People suffer a fall in income, leading to lower living standards.

 The Unemployed experience a loss of self-worth.
 Loss of income can result in stress, decline in mental and physical health
of the unemployed.
 The unemployed may not be able to provide education for his children,
leading to lack of skills and qualifications and lower prospects

Effects on Firms

 They can easily employ unemployed workers to expand production.

 Due to unemployment, the wage rates will be driven down enabling firms
to lower their labour costs.
 Workers may also be prepared to be more flexible in terms of tasks and
working hours due to high unemployment.
 High unemployment results in lower incomes and decrease in demand for
the firm’s products.
 Chapter 31
Inflation and Deflation

What is Inflation?

Inflation is a sustained rise in the general price level of a basket of goods

and services in an economy in a given period of time.

For example, the inflation rate in UK in 2010 was 4.7%. This means that the
average price of goods and services sold in the UK rose by 4.7% during that
year.
The value of money declines.

What is deflation?

Deflation is a sustained fall in the general price level of a basket of goods and
services in an economy in a given period of time.
Deflation occurs when the rate of inflation becomes negative. The general
price level is falling and the purchasing power of say £1,000 in cash is
increasing.
The value of money rises.

What is disinflation?
Disinflation is a decrease in the rate of inflation – a slowdown in the rate of
increase of the general price level of goods and services over a period of time.

For example, if the annual inflation rate for the month of January is 5% and it
is 4% in the month of February, the prices are dis inflated by 1% but are still
increasing at a 4% annual rate.

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 30%
1990 - 100
1991- 105 Price level rises
1992- 115.5 increased rate
Price level rises
1993 - 132.82 15% reduced rate
15%
2000- 146 10%

10%
- 5%

5%
2010

1990 fall in the price level delation

2011

Calculating Inflation
Rate of inflation is measured by calculating the percentage price increase in
goods and services over a period of time.

Inflation is measured using a Consumer price index (CPI) (or Retail price index
(RPI)).

The consumer price index is calculated in this way:

1. Selecting a Base year

The Government selects a relatively standard year with no economic

fluctuations. The average price of the basket in the first year or ‘base year’ is
given a value of 100. CPI of base is 100

2. Selecting a basket of goods and services

A selection of goods and services normally purchased by a typical family or

household is identified by surveys which is known as a basket of goods and
services.

3.Attaching Weights

The weights are meant to reflect the relative importance of the goods and
services as measured by their share in the total consumption of households.

4. Price changes

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The average changes in price of these goods and services over the year
is calculated. If it rises by an average of 25%, the new index is 125%*100=125.
If in the next year there is a further average increase of 10%, the price index
is 110%*125= 137.5. The average inflation rate in the two years is thus 137.5-
100= 37.5%.

5. Constructing a Weighted Price Index.

Weights and the price index of each category is multiplied to get the weighted
price index.

Causes of Inflation

Cost push inflation

The rise in general price level due to an increase in the cost of production.

 Costs of production may rise due to an increase in the wages rising more
than labour productivity.

 Increase in price of raw materials. This reduces the profit margin of the
producers. In order to maintain their profit margins, the producers
increase the selling price of the commodity which results in cost push
inflation.

 Increase in Indirect Taxes will also cause cost push inflation.

 Increase in fuel, transportation, etc

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 General price
level

Stagflation – Stagnation of Real GDP & Inflation

Wage Price spiral – As wages rise, it leads to increase in prices of the products,
workers will press for higher wages resulting in an inflationary spiral.

Demand Pull inflation

Demand Pull inflation occurs due to increase in excessive aggregate demand not
matched by an increase in aggregate supply causing the prices to increase.

Aggregate Demand can increase due to increase of any of its components.

Components of AD= C+G+I+(X-M)

C- Consumer Spending

G- Government Spending

I -Investments

X-M- Net Exports

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 Tax is cut C rises AD rise

G rises AD rises

I rises AD rises

X-M rises - AD rises

Monetary inflation ( demand pull inflation)

Some economists argue that inflation is caused due to an increase in supply of
money in the economy faster than output. This is known as Monetary Inflation.
The idea is that too much money in the economy is chasing too few goods and
thus inflation occurs.

Imported Inflation ( cost push inflation)

An increase in the prices of imported goods will lead to a rise in general price
level in the economy. In this case the exchange rate plays a vital role. If the
currency of a country depreciates it will lead to inflation as imports will become
costlier.

Consequences of Inflation

Harmful Effects of Inflation

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 Lower purchasing power: when the price level rises, the lesser number of
goods and services you can buy with the same amount of money. This is called
a fall in the purchasing power. Thus, inflation causes a fall in the purchasing
power of money.

 Exports are less internationally competitive: if the price of exports are

high, its competitiveness in international markets will fall as lower priced
foreign goods will rival it. This could lead to a current account deficit is
exports lower, especially if they are price elastic.

 ‘Inflation causing inflation ‘: during inflation, the cost of living in the economy
rises as you have to pay more for goods and services. This might cause
workers to demand higher wages increasing the cost of production. If the
price of raw materials also increases, the cost of production again increases,
causing cost-push inflation. (Wage Price Spiral)

 Inflation redistributes income in an unplanned manner: a person who has a

fixed income will lose as he cannot press for higher wages during inflation.
Lenders who lent money before inflation and receive the money back during
inflation will lose valuable purchasing power. The same amount of money is now
worth less (here, the people who borrowed gain purchasing power).
Borrowers Benefit and Savers suffer

 Menu Costs and Shoe Leather Costs: Menu costs are costs involved in
changing prices in catalogues, price lists, and websites.
Shoe leather costs arise because money paid to firms will be losing its value,
thus moving money to a financial institution which will pay higher than the
inflation rate.

AD= C+G+I+(X-M)

 Fiscal Drag: This occurs when governments do not adjust tax brackets in line
with inflation which results in people’s incomes dragged in to a higher tax
bracket, and they are left with lower real disposable income.

 Inflation creates uncertainties: Consumers will find it difficult to plan their

expenditure and firms may be discouraged from investing which reduces
economic growth.

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Beneficial Effects of Inflation

 Inflation may encourage firms to expand: A low and a stable level of

demand pull inflation increases output of firms. It encourages
entrepreneurs to start new businesses and firms to expand, leading to
increase in the GDP of the country.

 Inflation reduces the real burden of debt: As borrowers have to pay

back less in real terms, it means that households and firms are prevented
from going bankrupt.

 Inflation prevents unemployment: When workers receive an increase in

wages by less than inflation rate, the firm’s real wage costs are falling
without laying off workers.

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