MACRO Unit 2 The UK Economy

The performance of the economy can have a major impact upon people‟s lives. It
will influence the type of jobs people have and the goods and services available to
them, and whether they can afford to buy them.

The government has 4 macro-economic objectives:

1) low unemployment
2) low and stable inflation
3) sustainable Economic growth
4) balance of payments equilibrium

A number of key indicators can be used to illustrate the success of an economy:

1) the level of output, and Economic growth

2) the inflation rate
3) level and rate of unemployment
4) the Balance of Payments

If the economy is growing it can normally be judged as successful.

In addition the government will also consider:

a more equal the distribution of income

protection of the environment & sustainability of growth

The Circular Flow of Income and Injections & Leakages

In the simple, closed economy, it is assumed that households own all factors of
production, which they then sell to firms for financial rewards. It is these rewards
which enable households to carry out their day to day purchases.

Unit 2 The UK Econom y 6EC02 1 St Pau l’s School 2011

However the simple circular flow, as depicted in Figure 7, is too simplistic to be of
any real use. In the open economy there are 3 injections into the circular flow.

Investment by firms (I)

Government spending (G)
Exports (X)

Each represents an autonomous addition to the circular flow income. Leakages on

the other hand represent withdrawals from the circular flow and are:

Savings (S)
Taxes (T)
Imports (M)

TP Transfer Payments are payments received for no corresponding level of output,

such as unemployment benefit or Job Seeker‟s Allowance.

For an economy to be in equilibrium, injections must equal leakages. If injections are

greater, then the economy will overheat and inflation may result. However, if the
leakages are greater than injections, then the economy will shrink in size and an
economic downturn or recession will ensue.

ECONOMIC GROWTH

An economy‟s growth can be measured in terms of its Gross Domestic Product

(GDP) or its Gross National Product (GNP). GDP is the total output of goods and
services produced by domestic factors in production (in the UK) over a period of
time usually 1 year.

It is also the sum of all incomes earned in one year and all expenditure in one year.
Consider this in terms of the circular flow where for everything that is earned

Unit 2 The UK Econom y 6EC02 2 St Pau l’s School 2011

(income), there must be an output produced, and equally something must be spent
(expenditure). The government measures all three money flows, goods & services,
expenditure and income and they should be identity be equal.

The preferred measure is the expenditure method which takes spending by

consumer (C), government spending (G), spending by firms (I) and the net trade the
UK enters into (X-M).

The Expenditure Method: C + I + G + (X - M)

For this method to be accurate the value of subsidies must be added and taxes on
goods deducted. This converts the product‟s value from market prices to factor
cost.

Converting from Nominal to Real

Nominal GDP is GDP measured in terms of money values, and so is influenced by

the level of inflation. This can give a misleading impression of a country‟s
performance. If inflation is running at 20%, then at the end of a year, GDP will have
risen by 20%, this will suggest that output has remained the same but the value of the
output has risen as prices rise. Thus to overcome such calculation difficulties GDP
figures are returned to a base year to remove the affects of inflation. This is known
as converting to real GDP.

Real GDP is Nominal GDP x price index in base year.

100
Nominal GDP £1048 x = Real GDP = £873m
120

It is often suggested that as a measure of the standard of living, GDP per capita has
its weaknesses. This is undoubtedly true; however, whilst many criticisms exist, and
there are also alternative measures, GDP per capita is still the most widely used
measure of economic performance.

Concerns exist as to what is meant by “Standard of Living”. It is subjective, and

therefore can only mean different things to different people. Thus a purely monetary
measure such as GDP will not deal with the issue of Standard of Living as
comprehensively as many economists would like.

Other areas that may be considered:

When dealing with standard of living, it is worth considering some of the factors
outlined.

(1) Birth Rates. (6) No. of doctors. per head.

(2) Mortality Rates. (7) Distribution of Income.
(3) Life Expectancy. (8) Climate.
(4) % of Population in Agric. (9) Political Freedom.
(5) Literacy Rates. (10) % of GDP spent on Military.

Unit 2 The UK Econom y 6EC02 3 St Pau l’s School 2011

HUMAN DEVELOPMENT INDEX

HDI is an index which measures national socio-economic development developed by

the United Nations. Up until 2009, it was based on measures of life expectancy,
educational attainment and was adjusted for real per capita income.
The HDI combined three basic dimensions:

Life expectancy at birth, as an index of population health and longevity

Knowledge and education, as measured by the adult literacy rate
(with two-thirds weighting) and the combined primary, secondary,
and tertiary gross enrollment ratio (with one-third weighting).
Standard of living, as measured by the natural logarithm of gross
domestic product (GDP) per capita at purchasing power parity (PPP)
in United States dollars.

In 2010, the measures of knowledge and living standards were changed so that now
HDI is defined as:

Access to knowledge: mean years of schooling and expected years of

schooling
Standard of living: measured by GNI per capita (PPP US $)
Life expectancy at birth (as an index)

However HDI is not perfect as a measure of development:

Advantages Disadvantages
Broader measure than GNI or GDP. It gives no indication of income
distribution, or by region or gender.
The data is compiled regularly by the UN There may be problems of data accuracy,
and is relatively easy to construct, as the especially with some developing
three elements can be easily found on countries that will have an incentive to
their own and exist independently, and paint a rosier picture of their citizens'
the fact it is put together by the UN well being. This could undermine the
suggests neutrality. HDI's validity in practice.
Takes into account income but adjusts Its weightings of 1/3 each seem arbitrary
for PPP and so living costs. and one might argue that rising incomes
have a diminishing impact the richer a
country becomes.
Focused on government policies and so Limited in its inclusion of only three
it is a good target for governments to quality of life indicators when other
aim towards, and is obtainable. measures like access to clean water
omitted.

Unit 2 The UK Econom y 6EC02 4 St Pau l’s School 2011

ECONOMIC GROWTH

If a country‟s output is rising, this suggests that a country‟s citizens are experiencing
higher living standards. The most common indicator of economic growth is a rise in
real GDP.

Actual and Potential Growth

An increase in the productive capacity of an economy increases the potential

growth, whilst an increase in output results in an actual increase in output. A shift in
the PPF illustrates an increase in productive potential.

However a movement in the actual amount of output from A to B illustrates an

increase in economic growth. There is however still potential to increase actual
output from B to the boundary of PPF2 by employing previously unemployed
sources.

Production and Productivity

A country‟s output can increase either because greater resources are employed or
because of a rise in productive potential. However an increase doesn‟t necessarily
result in an increase in output, this will depend upon whether this increase in
productive capacity is matched by an increase in actual output or a great level of
employment.

Output gaps

Growth above the trend growth rate, where AD grows faster than LRAS,
leads to a positive output gap and demand-pull inflation, as well as cost-push
inflation

Unit 2 The UK Econom y 6EC02 5 St Pau l’s School 2011

 Growth below the trend growth rate, where AD and so actual growth is
below LRAS and the economy‟s potential growth rate. This leads to a negative
output gap and so unemployment and downward pressure on prices.

GDP Measurement Problems

1. Black Economy: This exists because when the output of some goods and
services is deliberately not declared. This can be for 2 reasons, to avoid tax, for
example „cash in hand‟ deals with plumbers etc. In addition some people may not
declare economic activity if that activity is illegal, for example drug dealers will
not declare their income.

As people will spend any income they might receive in this undeclared way, a gap
will tend to exist between the final figures for the expenditure method and
income method of calculating GDP. The gap that exists will give an indication as
to the size of the black economy.

2. Non-Marked Goods and Services: GDP figures only include those goods that
are bought and sold and so have a price attached to them. Services which are
produced and which either are not traded, or which are exchanged without
money being exchanged. For example homegrown products, DIY or voluntary
work are not included in the official figures.

3. Government Spending: Some government spending goes on financing some

services which are not sold, such as Defence, and the Police. The cost of
production is therefore used, however this can be misleading. If productivity in
the Police Force were to rise as a result of the introduction of some new
technology, staff numbers and so cost could be reduced. This overall reduction
will result in a fall in the Police services contribution to the final GDP figures.

To overcome this problem the government has introduced a method for

estimating output based on key performance indicators.

Cost and Benefits of Economic Growth

Benefits

Standard of Living Improves: This is usually measured by per-capita real

income. If the economy is growing faster than the population then per-capita
incomes are rising and the standard of living is said to be improving as
households can buy more goods and services than before.

There are problems with this notion; mainly the belief that standard of living
is more than a monetary factor. GDP ignores factors such as the
distribution of income, the size of the informal economy, the nature of public
spending, such as on health or education, the size of negative externalities &
political freedom.

Unit 2 The UK Econom y 6EC02 6 St Pau l’s School 2011

 Increased Tax Revenue: Greater economic growth could result in higher
tax revenue allowing the government to increase spending on health,
education or whatever else is seen to be a priority.

Higher Employment: Economic growth can result in greater demand and

therefore greater employment.

Increased investment as confidence improves, or due to the accelerator,

or higher profits for firms. This means the economy will have more capital
per worker and so higher productivity and more future growth.

Costs

Inflation: Increases in demand, without a rise in supply can create demand-

pull inflation (see AD2 and AD3 on LRAS1, causing a rise in average prices),
or alternatively if wage pressures persist cost-push inflation may occur.

Non-Renewable resources: The use of non-renewable resources to

produce goods and services for use in the current time period means that
these are unavailable in the future and so growth may not be sustainable.

Environmental Costs: As the economy grows, and output increases,

manufacturing firms may increase pollution, resulting in a decline in the ozone
layer for example. As living standards rise, the number of cars, or other
consumables rises, further increasing pollution and also the need for landfill
sites to deal with rubbish.

Structural Unemployment: As an economy grows its structure changes

and demand for certain skills decreases, resulting in structural unemployment.

Stress & Psychological problems: Professor Yew Nwang Ng has

suggested that Economic Growth can create competitive pressures between
families trying to outdo each other materially. This can result in, suicide,
stress and depression.

Sustainable Economic Growth

Governments are keen to encourage sustainable economic growth rather than rapid
economic growth which results from the rapid depletion of scarce resources.
Sustainability in part implies the need for recycling of natural resources such as
aluminium, paper and glass, whilst encouraging the use of renewable sources of
energy for power.

Unit 2 The UK Econom y 6EC02 7 St Pau l’s School 2011

INFLATION

Inflation can be defined as a sustained rise in the agreed general price level.

A low and steady inflation rate allows business to maintain confidence in the
economy. A high level of inflation, in excess of a country‟s main trading partners can
create problems in competitiveness resulting in a decline in trade.

The main measure of inflation in the UK is calculated through the use of the Retail
Price Index (RPI). This is a measure of changes in the prices of consumer goods
bought in the UK.

Calculating the RPI

The RPI is a weighted price index, so not only must price variations be obtained, but
also weights must be attributed to various goods and services.

In order to establish appropriate weights the Office for National Statistics (ONS)
uses the Expenditure and Food survey to establish what items people buy in what
quantities. Approximately 7000 families are asked to keep a record of what they
spend over a 2 week period, and to give details of other major spending such as the
telephone bill.

Expressed as a fraction the weights are draw from the information gathered by the
ONS.

The ONS will then record how much the price of some 650 goods and services have
changed by. This is due in a variety of locations throughout the country. In total
approximately 180,000 price quotations are collected from 150 areas around the UK
each month.

Finally the percentage change in price for each item is multiplied by its weight.

Unit 2 The UK Econom y 6EC02 8 St Pau l’s School 2011

Other measures of inflation

RPI X: This measure is the RPI minus mortgage interest payments. There are 2
arguments for excluding mortgage interest.

1. For comparison purposes a number of other countries do not include it

2. Mortgage interest payments are influenced by changes in interest rates, so a

rise in interest rates designed to reduce inflation may have opposite effect of
raising it.

The Bank of England target is 2.0% ± 1% (was 2.5% ± 1% until Dec 2003) using the
CPI measure of inflation.

RPI Y: This measures the RPI minus mortgage interest payment and also both
indirect and local authority taxes. This shows the underlying rate of inflation
undistorted by changes in tax or interest rates.

CPI: This measure excludes a number of items that are included in RPI, mainly
related to housing. These included council tax and a range of owner-occupier
housing costs such as mortgage interest payments, house depreciation, buildings
insurance, estate agents‟ and conveyancing fees.

The CPI covers all households, while the RPI excludes the top 4% of income earners.
The CPI also includes university accommodation and foreign students‟ university
tuition fees.

Measurement Problems

1. Changes in Quality: Measures of price change do not take into account

changes in quality. For example a computer is less expensive now in comparison
to 15 years ago, but is also a great deal more powerful and better in quality.

2. Special Offers: the retail price index doesn‟t make special account for out of
season discounts or special offers. This may act to reduce the rate of inflation.

3. Changes in expenditure: although the weights are reviewed each year, even
this might not be enough. Spending patterns can change more quickly as new
products become available.

4. Due to the limited number (6785) of households surveyed, there is potential

for sampling error.

Unit 2 The UK Econom y 6EC02 9 St Pau l’s School 2011

Causes of Inflation

There are two main causes of inflation:

Demand-pull inflation -
This occurs when AD increases (due
to greater consumption, investment,
government spending or net exports),
pushing against the limits imposed by
the AS curve at full employment. In
the diagram (left), as AD shifts from
AD to AD1, the price level rises to P2.

Cost-push inflation - This is when

costs of production increase (for
example due to high wage demands
or a weakening exchange rate which
makes imported raw materials more
expensive), and are then passed on
to consumers in the form of higher
prices. In the diagram (right), this is
shown by a shift to the left in the AS
curve, which sees prices rise to P2.

Consequences of Inflation

Anticipated and unanticipated inflation

Anticipated inflation is when the rise in the general price level is the one, or close to
the one expected. If firms workers, consumers and governments can correctly
anticipate the inflation rate, then they can take measures to avoid the harmful effects.
However, anticipated inflation can bring with it a number of problems. As a result of
being caught unawares people will be unsure what to expect about future inflation.
This can result in a fall in consumption. Fiscal drag may also occur, for example with
no adjustment for tax thresholds, higher minimal pay will drag incomes into higher
tax bands and therefore workers disposable income will actually fall.

Borrowers tend to gain and lenders to lose, whilst state pensions rise with the rate
of price change, they tend to fall behind wages, which rise faster than prices.

Costs of Anticipated Inflation

Menu Costs - Prices become out of date and need to be updated; the
costs of doing so are menu costs. This would include the costs of reprinting
catalogues/menus, updating vending machines etc.

Unit 2 The UK Econom y 6EC02 10 St Pau l’s School 2011

 Shoe Leather Costs - As inflation increases, the opportunity cost of
holding cash increases. People will hold more money in interest-bearing
accounts, and more trips to the bank will become necessary.

Costs of Unanticipated Inflation

Confusion of Market Mechanism - Consumer sovereignty relies on

producers responding to changes in prices. Inflation means that producers
may believe that demand for their good has risen (and hence increase
production) when, in fact, only the general price level has increased. As a
result, scarce resources may not be allocated in the most efficient way.

Uncertainty - Inflation creates uncertainty, particularly amongst the

business community and when inflation fluctuates, firms cannot predict
costs and revenues and may be deterred from investment projects.

Redistributional Costs - Income is distributed, away from those on fixed

incomes and those in a weak bargaining position (e.g. pensioners), to those
who can use their economic power to gain large increases in income.
Furthermore, borrowers benefit as the real value of debt is eroded; savers
lose out.

International Costs - Exports lose their competitiveness, whilst imports

become relatively cheaper. The trade position will therefore deteriorate,
unless the exchange rate deteriorates to compensate, other countries have
higher inflation, or exports do not sell on the basis of price alone.

Accelerating Inflation

If for example inflation was rising at a faster rate each year, i.e. 80% in year 1, 12% in
year 2 and 18% in year 3 people would naturally expect prices to continue to rise.
As a result they will demand higher wages, and firms may raise prices to cover
expected higher costs, and consumers may bring forward consumption before prices
rise. All of this will contribute to increasing inflation.

Unit 2 The UK Econom y 6EC02 11 St Pau l’s School 2011

EMPLOYMENT AND UNEMPLOYMENT

Unemployment will result in output being less than potential output, tax revenue will
be reduced and greater state benefits will have to be paid. The unemployed may
experience increased incidence of divorce, and mental breakdown in addition to
falling behind in training, so making it harder to get employment in the future.

Measures of unemployment

In the UK there are two main measures of unemployment. The claimant count, and
the labour force survey.

The claimant count is the number of people claiming the jobs seekers allowance. It
is easy and cheap to collect, however it has been criticised for a number of reasons.
It might actually overstate the number of people unemployed. For example some of
those collecting benefit may not be actively seeking work. In addition there are
groups of people who have productive potential, who would like to work but are
excluded from the calculations. For example those over 60, and those under 18, in
addition to those on government training schemes.

The alternative method adopted in 1998 is the Labour Force Survey. This is based
on the International Labour organisations definition of unemployment; this includes
all people of a working age who are without work during a specified period and
available to work in the next two weeks, having sought work in the previous four
weeks. Typically the ILO/LFS measure of unemployment is greater than the claimant
count measure, as it includes a greater number of the unemployed, as illustrated
below.

This method is based on a survey of sixty thousand households (100 000 people),
asking whether they have a job, and what steps they have taken to seek employment.
As a result of this method being based on all international standards, comparisons
with other countries are easier.

Unit 2 The UK Econom y 6EC02 12 St Pau l’s School 2011

Measurement Problems

1. If the Claimant count is used, everytime government changes the eligibility for
claims, the unemployment figures will change e.g. as occurred when males over
the age of 60 were excluded.

2. If the Labour Force Survey is used, the sample questioned may not be truly
representative.

3. Whichever measure is used it can be difficult to assess whether those included in

the unemployment figures are genuinely unemployed.

Consequences of Unemployment

To the Individual

Loss of earnings means a lower standard of living.

An unemployed person loses work skills, thus decreasing their chances of

becoming employed again.

The unemployed tend to feel useless and not a part of society. This can lead
to problems such as depression, worse health, lower life expectancy.
To the Economy

There is lost tax revenue to the government but more spending on benefits.
This could lead to a budget deficit.

There can be a negative multiplier effect and so lower demand for local
goods and services, housing etc.

Loss of national output – this could lead to a negative output gap or if

people lose skills or leave labour market then “hysteresis” could occur and
LRAS shift inwards.

Areas of high unemployment tend to suffer from increased crime, violence

and vandalism.

Unit 2 The UK Econom y 6EC02 13 St Pau l’s School 2011

BALANCE OF PAYMENTS

The Balance of Payments is a record of all monetary payments between one country
and the rest of the world over a period of time. The Balance of Payments is made of
3 sections:

a) The Current Account

b) The Capital Account
c) The Financial Account

In addition to these there is also the International Investment position, which shows
the level of external assets and liabilities at the end of the calendar year.

Current Account

The current account is made up of 4 main parts.

a) Trade in Goods: This covers the export and import of goods and services.

b) Trade in Services: This covers the export and import of services such as
shipping, financial services, insurance and tourism.

c) Income flows: income from investments is the main component - interest,

profits and dividends (IPD) from overseas assets such as bank deposits, UK
owned companies overseas, shares quoted on foreign stock markets but held
by UK residents (less IPD earned in the UK by foreign held assets).

d) Current transfers: These include central government transfers, including

for example the UK‟s net contribution to the European Union and aid which

Unit 2 The UK Econom y 6EC02 14 St Pau l’s School 2011

 is provided to developing countries, and net remittances from migrants and
immigrants. In this category, no goods or service is being exchanged, just a
flow of money.

The Capital Account

This is a minor part of the Balance of Payments, and includes government investment
grants, and the purchase or sale of non-produced, non financial assets such as
patents, trademarks and land for foreign embassies.

The Financial Account

This was previously known as the capital account, and refers to the flows of money
entering and leaving the country. This can take a number of forms, including the
purchase and sale of companies and foreign exchange.

Net errors and omissions

Formerly known as the balancing item, this figure is included to ensure that the
current account, plus the capital account plus the financial account equals zero. In
other words to ensure that the Balance of payments always balances.

International Investment Position

This account reflects the total of external assets held by the UK government,
companies and individuals and the total of UK assets held by foreign governments,
companies and individuals.

Causes of a Current Account deficit

1. High levels of income (economic growth) in the domestic

economy. Imports tend to have a high income elasticity of demand so that,
in a boom, imports are 'sucked' into the economy. The UK has a high
marginal propensity to import (MPM), therefore economic growth usually
results in greater demand for imports.

2. An overvalued exchange rate which makes exports less price

competitive in foreign currency and imports more price competitive in
Sterling.

3. High unit labour costs – the average cost of labour per unit of
output (perhaps a reflection of low investment in capital and labour in the
past and hence lower productivity) means that average production costs
may be higher than our competitors, again making UK goods seem less
price competitive. Higher wage costs in the UK than in low cost LEDC
manufacturers would also raise our unit labour costs.

Unit 2 The UK Econom y 6EC02 15 St Pau l’s School 2011

 4. Poor non price competitiveness of UK goods in terms of quality,
design, reliability, delivery times, after sales service may mean the 'taste' for
UK goods is low.

However, the current deficit is not such a problem if:

it is only short term and is caused by high rates of economic growth which
should subside

if it can be easily financed, perhaps by investment inflows on the financial

account
the deficit is caused by the import of raw materials and capital equipment
which will be used to produce final goods for export or helps to raise
productivity

Policies to remove the Current Account deficit

Although there are several policy options, including reducing AD and consumption
and so import spending, or devaluating the exchange rate or being protectionist, the
policy favoured by the UK government is to focus on increasing
competitiveness by applying Supply Side policies – these policies will aim to
boost productivity and so lower the UK‟s unit labour costs:

increase investment (perhaps through lower corporation tax) and thus capital
per worker and productivity

increase spending on education and training to improve human capital

encourage R & D spending to promote the use of new technology, perhaps

by giving tax breaks on profits reinvested into R & D

EXCHANGE RATES

A fixed exchange rate system, is one determined by the government or an

international body. The rate is maintained through the purchase or sale of the
currency on the money market, and through the manipulation of interest rates. On
the other hand a managed rate is one which is permitted to move within bands.
Whilst a floating exchange rate is allowed to float, and so is determined by changes
in the demand and supply of the currency.

Consequences of unstable exchange rates

1. Planning – frequent changes in the exchange rate may create a number of

problems with firms trading abroad finding it difficult to plan ahead, particularly as
they will not know how much they are to receive or owe in terms of their
domestic currency.

Unit 2 The UK Econom y 6EC02 16 St Pau l’s School 2011

2. Trade – uncertainty about the amount to be paid may mean that trade will be
reduced, cheaper imports may be sought.

3. Productive potential – productive potential may decline as a result of firms going

out of business when the exchange rate is high, as they find it hard to export
goods. Investment may also fall as the chances of additional output being sold
declines.

CONFLICTS IN MACROECONOMIC POLICY

Governments will find it hard to achieve all four macro-economic objectives at once.
For example a government may wish to reduce unemployment by raising aggregate
demand. This will have the desired effect, but also encourage firms to expand
output, accelerating economic growth. This may however result in demand-pull
inflation. The increase in growth may result in an increase in the demand for goods
from abroad and raise imports causing a deficit.

For the government to reduce inflationary pressure and correct any deficit that
exists on the current account a government might decide to reduce aggregate
demand. This policy of inflating the economy, followed by deflation is referred to as
the stop-go cycle.

Governments often decide that sacrificing one policy objective is a price worth
paying to satisfy the others. For example if unemployment is high, then a rise in AD
will act to reduce unemployment, but result in raised prices. The trade-off between
unemployment and inflation exists.

Unit 2 The UK Econom y 6EC02 17 St Pau l’s School 2011

AGGREGATE DEMAND

Aggregate demand can be defined as the total demand of goods and services in an
economy. It consists of 4 components, and is usually expressed as:

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

where C= consumer spending

I = investment expenditure
G= government spending
(X-M) = The net expenditure on exports and imports

The AD curve depicted in Figure 2, shows the level of output or Real GDP at a given
price level.

The AD curve is downward sloping for 3 main reasons:

1. Exports of goods and services are likely to be higher when the price level is low
as they are more internationally competitive. Imports, on the other hand are
likely to appear more expensive, domestic demand may therefore transfer into
domestically produced goods adding to the increase in AD.

2. If the average price level were to fall, then people‟s purchasing power with their
disposable income would increase, allowing them to raise their spending and so
adding to AD.

3. People‟s expectations also play a part in the shape of the AD curve. If prices are
low people will tend to expect prices to rise in the future, and so bring forward
their spending. This will act to raise AD. On the other hand, if prices are high,
and expected to fall, people will delay spending and so demand will be low.

Unit 2 The UK Econom y 6EC02 18 St Pau l’s School 2011

Determinants of Consumer Spending

Consumer spending is the most significant component of Aggregate Demand. A key

determinant of this spending is the level of disposable income, in other words
income after the addition of state benefits and deduction of direct.

The marginal propensity to consume (MPC) is the amount of new income that is
spent on consumption.

At low levels of income any increase in income is taken up entirely on increased

consumption, the MPC is 100 per cent. So if a family is very poor, and it receives
some additional money, this will be spent on food, clothing and other essential items.
As living standards and income rises the MPC will fall, yet remain high, reflecting the
ability to save, so the MPC may be 80%. As incomes increase, the very rich are
unconcerned by increases in their income, as they are already spending to meet their
needs. Most of the new income received is therefore saved.

Ultimately as depicted in figure 3 – as income rises so does consumption, even if it is

at a slower rate, thus the MPC steadily declines.

where a= Autonomous consumption – spending which occurs at 0

income financed by borrowing, using savings or state benefit
on basic food, clothing and shelter

Other factors affecting consumption

If the government increases old age pensions and increases tax thresholds for low
income earners, whilst increasing taxes for the highest income earners, total
disposable income may remain the same. However consumer spending will increase,
as will aggregate demand. This will result in a rightwards shift of AD.

Unit 2 The UK Econom y 6EC02 19 St Pau l’s School 2011

Higher interest rates will reduce consumer spending, and require those with a
mortgage to make higher monthly repayments, therefore consumer spending falls, as
does aggregate demand, which results in a leftwards shift of the AD curve.

Determinants of Investment Expenditure

Investment by the private sector, varies inversely with the rate of interest, i.e. the
cost of borrowing money. If interest rates rise, businesses find that fewer projects
yield a sufficient rate of return for the investment to be profitable. This concept is
referred to over the Marginal Efficiency of Capital (MEC). If rates of interest rise and
investment falls, the AD curve will shift to the left.

The accelerator principle also influences the level of investment. It is felt that will
react to increases in demand and national income by increasing their demand for
capital goods to meet this growth. The result of this increase in I is a shift in the AD
curve to the right.

Accelerator: I = a (Yt-Yt-1)

I= Investment by firms

a= Capital – output ratio

Yt = Income in current time period

Yt-1 = Income in previous time period

Investment is therefore a function of „a‟, where the capital-output ratio represents

the amount of capital i.e. machinery required to meet a level of output. For example
should £3 be required to raise output by £1 per year then the capital-output ratio is
equal to 3.

Unit 2 The UK Econom y 6EC02 20 St Pau l’s School 2011

Therefore I = a (Yt-Yt-1)

or I = 3 (£100m - £80m)

ie I = 3 (£20m)

therefore I = £60m

Another factor which has an impact on investment is the role of expectations in the
future. Keynes referred to this as „Animal Spirits‟, with firms often basing investment
plans on all sorts of external factors which may affect business well being.

Determinants of Government Spending

Government spending is particularly sensitive to a change in economic policy on the

part of government in order that many achieve their particular macro-economic
objectives. On the other hand it is important to remember that the pattern of
taxation and expenditure may be manipulated in line with political beliefs and
aspirations.

Determinants of expenditure on Exports and Imports

One of the key determinants of a country‟s trade position, is the value of its
currency, its exchange rate. For example if Japanese importers are purchasing
Scottish whisky they will be offering Yen for the goods, whilst the Scots will seek
payment in £. The relative strength of the Yen will determine how much whisky the
Japanese will demand, and therefore the amount the Scots can export.

Interest rate changes can have an influence on the exchange rate, a rise in the UK
rate of interest will result in Hot Money flowing in, (Hot Money is money that is
highly liquid, seeking out the highest rates of return anywhere in the world) and
therefore an increase in the demand for £, thus raising the value of the £ and the
exchange rate. This rise in the value of the £ means that it is easier (and cheaper) to
import goods and more expensive to export goods and services, hence it is likely
our Balance of Trade will deteriorate.

Beyond this the other main determinant of imports is the level of overall demand in
the economy. The UK has a relatively high Marginal Propensity to Import (MPM)
therefore as the level of income in the economy rises, the demand for imports rises.

Unit 2 The UK Econom y 6EC02 21 St Pau l’s School 2011

AGGREGATE SUPPLY

Aggregate supply can be defined as the total output of the economy. The aggregate
supply curve shows the relationship between the total quantity supplied in the
economy and the price level. It is therefore upward sloping, as at low prices
businessmen collectively do not feel that it is worth producing commodities, because
they do not expect to be able to sell them and make a profit. However, as the price
level rises entrepreneurs feel that it is worthwhile to start producing, or produce
more and therefore supply increases.

In the short-run changes in the price level result in a movement along the AS curve.
If there is spare capacity in the economy, any increase in demand will result in a rise
in output rather than a rise in prices. Using Figure 4, this is shown by the movement
along the AS curve from A to B. Beyond B as the economy reaches full capacity,
costs rise and diminishing marginal returns set in, so the AS curve becomes steeper.

In the long-run there are many factors, which can cause a shift in the entire curve.
There are referred to over Supply Side policies (see section below on Supply Side
policies for further information) and include:

1. Education and Training

2. Technological change
3. Increasing geographical mobility of both employees and employers

The period since 1979 has seen a strong commitment on the part of the government
to create economic candidates which favour such a shift.

The problem with supply side policies, is that their actions are relatively uncertain in
impact and can take a long time to have any effect. In addition, their use is likely to
impinge on other government policies because they may involve greater government
expenditure, interfere with other social objectives, involve foregoing tax revenue, or

Unit 2 The UK Econom y 6EC02 22 St Pau l’s School 2011

require the reduction of interest rates, when other objectives require the opposite.
Therefore supply side policies are difficult to introduce, uncertain in their impact and
may take a long time to have an impact.

Long-Run Aggregate Supply

Keynesian

The Keynesian Long-Run Aggregate Supply curve contains two main elements, an
area which represents unemployed resources and the economy operating below full
capacity (region A-B in Figure 6) the second element corresponds to the economy
operating close to or at full capacity. With little or no unemployed resources
(region B-C in Figure 6).

The economy operates at equilibrium, where aggregate demand intersects with

aggregate supply. It is clear at AD, the economy is not operating at full capacity, a
shift to the right in the AD curve will cause output to rise, but with unemployed
resources still in existence prices remain stable. It is only when the economy
reaches full employment and the AD curve continues to shift to the right that prices
will rise P1 to P2), as a result of the economy‟s inability to increase supply at fast
enough a rate to meet the rise in demand. At this point, the only way to expand the
economy without experiencing inflation is to employ supply side policies and shift the
AS curve to the right, LRAS1 to LRAS2.

Classical

The classical long-run aggregate supply curve is vertical, as a result of the belief that
the economy always operates at full employment. Any unemployment which exists
is voluntary unemployment, in other words the market left to itself would be able to

Unit 2 The UK Econom y 6EC02 23 St Pau l’s School 2011

clear this unemployment, however workers who remain unemployed, according to
this theory, do not wish to take the available jobs at the prevailing wage rate.

Classical economists argue that any expansion in AD, such as AD1 to AD2 will only
result in price rises (inflation) from P1 to P2. Therefore if demand management
policies employed to shift the AD curve are to be successfully utilised they must be
accompanied by supply side policies, which will shift the LRAS to the right, LRAS 1 to
LRAS2.

The accepted relationship between output and employment is that, as output

increases, employment increases. However, in the long-run if aggregate supply
increases, as a result of an improvement in technology or a better educated
workforce, output may increase without an increase in employment.

THE MULTIPLIER EFFECT

Changes in AD or AS may actually have a larger total effect on GDP than the
particular tax reduction or expenditure that set it off. This is known as the
multiplier effect. The multiplier can be defined as the factor by which an increase in
one of the factors of aggregate demand is multiplied by to calculate the total rise in
national income. The multiplier, in a closed economy can be calculated through the
formula

1 1
or
1 MPC MPS

Where MPC is the marginal propensity to consume, and the MPS is the marginal
propensity to save. In a closed economy the MPC and MPS must always total 1.

Therefore if the MPC = 0.8 then the multiplier can be calculated as 5.

Unit 2 The UK Econom y 6EC02 24 St Pau l’s School 2011

 1 1 1
or = =5
1 MPC 1 0.8 0 .2

Therefore a rise in AD of £200m will result in a total rise in national income of

£1000m. In the more realistic open economy the multiplier formula follows the
same principle but includes both leakages and injections.

1 1
or
(1 MPJ ) (1 MPC MPI MPG MPX )

1 1
or or
MPL (MPS MPT MPM )

If for example the government were to increase expenditure on health and

education, this will not only mean that the salaries of nurses and teachers increase
but also there is an increase in expenditure on school buildings, computers, hospitals
and scanners. This increase in expenditure is referred to as the first round effect.
However with their increased salaries, teachers and nurses will increase their
spending on clothing, cinemas and restaurants. This increase in demand results in a
second round effect, which is added to by the builders of the schools, hospitals,
computes and scanners. Furthermore, the owners of the clothing manufacturers,
cinemas and restaurants see their income rise and their purchasing power increase,
this is the third round effect.

These successive rounds of expenditure carry on and would seem to have the
potential to carry on forever, however their impact diminishes with each round
because of the leakages inherent in the system.

However the multiplier works, its impact must be taken into account by
policymakers when investigating the impact on the economy of a change in AD.

Unit 2 The UK Econom y 6EC02 25 St Pau l’s School 2011

MACROECONOMIC POLICY INSTRUMENTS

Fiscal Policy

Fiscal policy refers to the manipulation of taxation and government spending to

achieve macroeconomic objectives. It is used by governments to influence the level
of AD in the economy and it can also affect aggregate supply through changing
incentives facing firms and individuals.

A boom in the economy will raise employment, but at the same time, because of
increased incomes and expenditures, the government automatically receives more
revenue from income tax, excise duty and VAT. In addition, government spending
on social security for the unemployment falls.

On the income side the key areas that may be manipulated are income tax, VAT,
excise duties and national insurance contributions. An increase in almost all types of
government expenditure will have an impact on aggregate demand, but other
increases may have a greater impact on aggregate supply.

To boost aggregate demand the government has two main options, either cutting
taxes or increasing expenditure. Consumers will have greater disposable incomes
than before, and as a result consumer expenditure rises and aggregate demand is
boosted. Disposable incomes rising will result in a high proportion being dependent
upon the marginal propensity to consume. If on the other hand, government were
to cut excise duties, the price of petrol, on inelastic goods will fall. As a result
consumers will have more money to spend on other goods and services, raising
consumer spending and aggregate demand.

Monetary Policy

Monetary Policy is the manipulation of interest rates, the money supply and
exchange rates to achieve government‟s macro-economic objectives. The
importance of monetary policy over the last 20 years has risen, as successive
governments have sought to combat inflation.

All three monetary variables (money supply, interest rates and exchange rates) are
inter-related and furthermore have an impact on aggregate demand.

If the government were to print money, for example, to finance an increase in

spending, the money supply would increase. The rate if interest would fall and as a
consequence AD would shift to the right. The impact of too much money being
printed, and not enough goods to meet this increase in demand is inflation.
However, as the rate of interest falls, the exchange rate will depreciate as hot money
flows out of the economy. Exports will become more competitive and rise, and
imports more expensive, with wither delayed falling or if they are inelastic the price
of the imports rising. Either way the impact of this change will place added pressure
on aggregate demand.

Unit 2 The UK Econom y 6EC02 26 St Pau l’s School 2011

This same series of events would apply if the government were to lower the interest
rate, or sell £ on the foreign exchange market and depreciate the £.

Supply Side Policies

A wide-range of supply side policies are potentially available, these policies are much
more focussed in their objectives, although they can be expensive to introduce and
have limited and relatively uncertain long-run effects on the economy. The aim of
government when using supply side policies is to remove market imperfection and
restrictive practices so that the economy can operate in a more efficient manner.

Providing incentives to work

The guiding principle here has been to encourage more people to join the labour
force and bring about an increase in output. The Labour government has introduced
the working families tax credit to supplement working families income and increase
the number participating in the labour market.

By reducing income tax, the government can also raise the incentive for individuals
to provide their labour. Laffer suggested that individuals would be willing to offer
more hours of labour if taxes fell, whilst enabling the government to take in more
revenue, as illustrated in Figure 10.

Education and Training

Many people who are unemployed lack the skills necessary to obtain a job,
particularly those 16 year olds leaving school with few if any qualifications or those
who have unemployed for some time. The provision of training opportunities will
reduce skill shortages in the economy, making the workforce more effective. Recent
years have seen many schemes designed to promote educational opportunities for
the young, through Training and Employment Agencies, the New Deal, and Youth
Training Scheme.

Unit 2 The UK Econom y 6EC02 27 St Pau l’s School 2011

Trade Union Reform

By restricting the supply of workers, trade unions seek to increase wages for their
members, but at the cost of unemployment. It is argued that the existence of trade
unions seeks only to increase costs, reduce efficiency and international
competitiveness. During the last 20 years there has been a succession of
employment acts designed to reduce the impact of trade unions. This has seen the
number of days lost through strike action fall dramatically from the watershed era of
the late 1970s.

Privatisation and Deregulation

Under private ownership, companies are more efficient, more competitive and felt
to be less of a drain on the public purse. In the period since 1979 privatisation has
been extensive and including some high profile programmes of denationalisation,
such as BT, BGas, and the railways. Through privatisation there has been a greater
movement toward private individuals owning shares, adding to the incentive for
these firms to improve their efficiency, and maintain growing profits.

Deregulation, the removal of barriers to enter an industry, has also taken place,
creating a greater competitive environment, or indeed has contracting out of
activities normally undertaken by the private sector, such as hospital and school
cleaning and catering.

Application of the AD/AS model

The policies employed to influence AD and AS do not operate independently. If the

government tries to boost aggregate demand in the economy by lowering taxes, this
will raise consumption and the demand for money, with the result that interest rates
must rise. The rise in interest rates will result in a fall in AD as both investment and
consumption are hit by the rise in interest rates. So a policy designed to raise AD
can have the opposite effect, or at the very least see its positive impact mitigated by
the effects of other variables. The interest rate rise will also have an impact on the
exchange rate, causing exports to fall and imports to rise.

Furthermore if the government were to attempt to influence AD by increasing

spending through borrowing this may also cause interest rates to rise. By borrowing
the government is entering the money market, and reducing the available funds for
private firms to borrow, which means that firms must compete to borrow for
investment projects, causing the price, i.e. the rate of interest to rise. This is
referred to as crowding out, and is a concern of many monetarist economists when
advising government not to increase the public sector net cash requirement
(PSNCR: Government borrowing).

The application of any policies to influence AD or AS, such as fiscal, monetary or

supply side policies involves a time lag. Some policies will undoubtedly have a more
immediate effect, such as changes in fuel duties and VAT, while changes to
government spending or direct taxes, take much longer to have an effect on the

Unit 2 The UK Econom y 6EC02 28 St Pau l’s School 2011

 macro-economy. The Bank of England estimates it can take between 18 months and
2 years to witness the impact of a change in interest rates.

Supply side policies tend to be a long-term measure and can be difficult to predict
the outcome of successfully, as they require structural changes to be made to
increase aggregate supply in the economy.

Table 1, below provides a summary of the policies a government might adopt to

achieve their macro-economic objectives.
Objective SR Policies LR Policies Problems

Reduce 1. cut direct and 1. Education and 1. Short run the rise
Unemployment. indirect tax training for in AD may cause
2. raise Govt spending structurally inflation
Aim to shift: 3. cut the rate of unemployed 2. Not all the
AD to right and interest 2. Reduce social unemployed can
AS to right security payments realistically be
retrained

Reduce Inflation 1. Raise direct and 1. Remove restrictive 1. Appreciation of

indirect tax practices Exchange rate = fall in
Aim to shift: 2. Cut Govt spending 2. Privatisation exports
AD to left and 3. Raise the rate of 2. Reduced demand in
AS to right interest economy =
unemployment
i.e. The Phillips curve
relationship

Reduce Balance of 1. Raise direct taxation Promote international Unemployment in SR

Payment deficit cutting D for M competitiveness
2. Cut rate of interest:
Aim SR: Shift AD to left to 3. Depreciate currency
cut D for M, but Shift AR and raise X
to right in the LR as X rise
Shift the AS to right

Policies to reduce unemployment

Fiscal and monetary policies can be applied in the short-run to increase aggregate
demand and so reduce unemployment. However this can result in a rise in prices, ie.
inflation. This trade-off is referred to as the Phillips Curve, and suggests that it is
virtually impossible to have both low unemployment and inflation, and certainly this
is the case if supply side policies are not used.

Unit 2 The UK Econom y 6EC02 29 St Pau l’s School 2011

If interest rates are cut to reduce the unemployment, consumption, investment and
exports will rise, raising aggregate demand and putting pressure on prices; fuelling
inflation in the domestic economy. In the long-run this problem with inflation can be
overcome through the use of supply side policies.

Policies to control inflation

In recent years the government has had as its principle economic objective the aim
of law and stable inflation. To control inflation governments have moved away from
the use of fiscal policy to using monetary policy, through regular changes in interest
rates. This task has been in the hands of the Bank of England‟s Monetary Policy
Committee, since the Bank was given independence and a target of 2.5% in 1997.

Policies to promote Economic Growth

Most governments seek to promote economic growth as a means to improve living

standards. By increasing the quantity and quality of factors of production the
economic growth can be achieved through an expansion of the PPF. This increase in
quality and quantity can be achieved through the employment of supply side policies,
such as education and training designed to improve productivity per worker.

Policies to affect the Balance of Payments

The UK has experienced a Balance of Payments deficit in most of the last 20 years.
However, the importance of this as a government objective in recent years has
declined, in part because the deficit remains a very small proportion of GDP and also
its growth is continuing to be managed.

In theory the best way to control a balance of payments deficit is to apply fiscal and
monetary policies to depress the economy by cutting AD, and so cut imports. In the
long-run supply side policies concentrating on an improvement of competitiveness
could result in an increase in exports. This is a long process, which may coincide
with other countries seeking to increase their competitiveness.

Unit 2 The UK Econom y 6EC02 30 St Pau l’s School 2011