2.

1 GOVERNMENT AND THE ECONOMY

What are macroeconomics objectives:

● Reducing unemployment
● Protect the environment
● Balance of payments (current account)
● Economic growth
● Controlling inflation
● Redistribution of income

2.1.25 Economic growth

Key terms:

Economic growth: increase in the level output by a nation

What is economic growth?

● This means that national income will rise
● National income is the value of all incomes in the economy added together (e.g.
wages, profits, royalties, dividends, interest, and income generated from abroad)
● National income is also equal to:
➔ The value of all output or production in the economy
➔ The value of all spending in the economy

Economic growth follows a cycle:

If output increases (the economy is producing more):
● Businesses are more profitable and share prices (the value of a company) rise
● This makes it easier for businesses to raise more capital (money) and employ more
workers
● As more jobs are created, incomes rise
● This means that consumers (the employees) will have more money to spend on
goods and services
● Which will drive economic growth even further

How do we measure economic growth?

● GDP = gross domestic product. This is the market value of all final goods and
services produced in a country over a period of time (usually a year) - i.e. it is a
measure of a country’s output.
● GDP is a standard measure used all over the world, so it allows us to make
comparisons between the growth rates of different countries
 Limitations of GDP as a measure of growth:
Type Explanation

Inflation ● Price increases can mean growth rates are misleading

● E.g if an economy grows 2.6% and prices also rise 2.6%, the economy has not
grown
● However, this problem can be solved by using real GDP to measure growth
● This involves adjusting GDP for inflation
● E.g if inflation is 2.3% and money GDP grows 4.4%, real GDP has grown by 2.1%
(4.4-2.3)

Population ● Population growth must be taken into account when analysing growth patterns
changes ● E.g if GDP grows by 2.8% and the population also rises, this increase in population
will offset the growth in GDP
● GDP will therefore be difficult to calculate
● To overcome this problem, changes in GDP per capita can be calculated (GDP /
size of population)

Statistical ● The gov collects millions of documents for firms, individuals, etc…
errors ● Errors are made because the information has been entered inaccurately or left out
● Therefore, the true value of GDP is never really known

The value of ● Some goods and services are not traded and therefore economic activity is not
home produced recorded
goods ● E.g in undeveloped countries, people rely almost on their own produce to live. It is
not traded and therefore not recorded
● As a result, if such activities are not recorded, the value of national income is
underreported

The hidden ● Sometimes paid work goes unrecorded

economy ● People may do a variety of jobs for cash and not record transactions
● E.g a friend may drive a family to an airport for $25. This $25 will not be recorded.
The transaction becomes part of the hidden economy

GDP and living ● GDP is used to measure living standards

standards ● However, just because GDP rises, it does not mean that living standards have risen
● Other factors need to be taken into account:
➔ The amount of leisure time people have
➔ The way extra income is shared between the population
➔ Whether growth has resulted in pollution
➔ The quality of goods and services

External costs ● GDP doesn’t take into account the external costs
● As a result, GDP does not measure how these costs impact on the well-being of
society

The economic cycle

 Type Explanation

Boom ● During a boom, GDP is growing fast because the economy is performing well
● Existing firms will be expanding and new firms will be entering the market
● Demand will be rising, jobs will be created, wages will be rising and profits made by
firms will be rising
● However, prices may also be rising

Downturn ● The economy is still growing but at a slower rate

● Demand for goods and services will stop increasing or begin to fall
● Unemployment will start to rise and wage increases will slow down
● Many firms will stop expanding, profits may fall and some firms will leave the
market
● Prices will rise more slowly

Recession or ● Demand will start to fall for many goods and services - particularly non-essentials
depression ● Unemployment rises sharply, business confidence is very low, bankruptcies rise
and price become flat
● Prices of some things may even fall

Recovery ● Businesses and consumers regain their confidence and economic activity is on the
increase
● Demand starts to rise, unemployment begins to fall
● Prices start to rise again

IMPACT OF ECONOMIC GROWTH ON…

Employment ● As business produce more, they need more workers

● Consequently, economic growth raises employment levels, reducing unemployment
● Gov also tend to spend more during periods of economic growth
● This helps to create more jobs - in education, healthcare, etc

Standards of ● Increases in GDP mean that on average people have more income - with more
living disposable income, people can buy more goods and services
● Also, as the economy grows, it is possible to spend less time working - because of
improvements in efficiency
● Also, people can live longer - can buy healthier diets

Poverty ● Rapid economic growth reduces poverty (creates new jobs taken by the poor)
● Growing economy means gov collects more tax revenue - gov can spend more on
healthcare, education and provision for poor - reducing poverty

Productive ● Economic growth raises productive potential - meaning a country can produce
potential more goods and services

Inflation ● If economic growth is too fast, the economy may overheat - causing inflation

Environment ● Economic growth leads to more pollution - e.g as economies grow, more cars are
purchased and more flights are taken
● Also, EG uses up non-renewable resources such as oil - once they are used up,
they cannot be replaced - meaning that future generations will have fewer
resources (called unsustainable growth)
2.1.26 Inflation
Key terms:

What is inflation?
● Inflation: general and continuing rise in prices, measured as a rate (%)
● Deflation: a fall in prices OR an economic slowdown (a period of time where
aggregate demand is falling)
● Aggregate demand: total demand in the economy from consumers, businesses, the
government and foreign buyers

How do we measure inflation?

CPI (Consumer Price Index): a measure of the general price level (excluding housing costs
such as house prices and council tax)

How is CPI calculated?

● Every month, the government records the prices of about 600 goods and services
purchased by over 7000 families (UK)
● An average monthly price is calculated
● The average monthly price is converted into an index number
● This allows comparisons to be made between two different periods
● CPI is the measure used worldwide

Types of inflation:
Demand-pull inflation:
● Demand-pull inflation: inflation is caused by increased (too much) demand in the
economy

Possible causes of increased aggregate demand:

● Rising consumer spending encouraged by tax cuts or
low interest rates
● Sharp increases in government spending
● Rising demand for resources by firms
● Booming demand for exports (i.e. foreign buyers
purchasing goods and services from the UK)
Cost-push inflation:
● Cost-push inflation: inflation is caused by rising business costs. Businesses put up
their prices to protect their profit margins

Possible causes of rising business costs:

● Rising costs of imported goods, especially oil
● Wage increases
● Increases in taxation (e.g. indirect taxes such as VAT in
the UK or IVA in Spain)

The relationship between interest rates and inflation:

● Interest rates: Price paid to lenders for borrowed money; i.e. the price of money
● Monetarists: Economists who believe there is a strong link between growth in the
money supply and inflation
● Money supply: the stock of notes and coins (cash), bank deposits, and other
financial assets in the economy

KEY CONCEPT: Monetarists believe that inflation may be caused when households, firms
and the government borrow money from banks to fund extra spending.
● This adds to the money supply because there are now more bank deposits (the
borrowed money increases bank balances).
● The extra money lent creates more demand and prices are driven up.
● This type of inflation is likely to occur if interest rates are low
● This is because borrowing is likely to increase when interest rates are low

How interest rates can be used to lower inflation:

1. Higher interest rates reduce borrowing because the “price of money” increases.
2. Money supply therefore grows less quickly.
3. Demand will therefore fall (as people have less money to spend).
4. The pressure on prices is therefore relieved.
5. Inflation will therefore fall.
 The impact of inflation:
Area affected How inflation affects area

Price ● Prices are rising

● Purchasing power of money is reduced (people cannot buy as much goods/services
with their income) → fall in living standards
● ***Not a problem if wages/incomes rise as much as inflation

Wages ● When prices rise, workers will want higher wages to compensate for their loss of
purchasing power
● So inflation may lead to higher wages, but it is not automatic (depends on employer/
time frame)
● Potential spiral: inflation occurs → firm increases wages → firm increases prices
because costs have gone up → higher wages

Exports ● When prices rise domestically, firms will find it harder to sell goods overseas (price of
exports rise) → demand for exports falls → balance of payments is affected
negatively
● Fall in demand for exports could lead to job loss domesticall

Unemployment ● Inflation means aggregate demand is rising → firms want to increase output since
prices are increasing (more revenue!) → more workers are needed to produce these
goods → reduction in unemployment
● There is a tradeoff between inflation and unemployment

Menu costs ● If inflation is rapid, firms increase their prices frequently

● This represents a cost to businesses because customers have to be informed about
new prices (new brochures printed, websites updated, sales staff informed)
● (Called ‘menu costs’ due to the example of a restaurant having to reprint its menu)

Shoe leather ● When prices change frequently consumers & firms spend more time looking for the
costs lowest price/best value → all of this walking around wears out the leather on your
shoes! (metaphorically…)

Uncertainty ● If inflation is high and varying, firms do not know what prices will be in 3 or 6 months
time → making predictions becomes difficult
○ Will investments be wise?
● It’s not ideal for businesses to make long term (financial) decisions, when inflation is
changing prices rapidly in the short term

Business and ● Consumers may feel anxious about high inflation → less willing to borrow money,
consumer more likely to save ‘just-in-case’ (which means less spending!) → lower aggregate
confidence demand→ potentially few jobs/higher unemployment
● Businesses may postpone growth plans or reduce spending → less likely to take
risks → less economic growth
● Hyperinflation: prices spiral out of control, increase by 100s or 1000s of %, can
destabilise a country

Investment ● Investment requires spending large sums in hopes of future returns (earning that
money back and more!)
● Uncertainty leads to low business confidence, which means investment projects are
likely to be postponed/cancelled. → negative impact on economic growth &
employment
 2.1.27 Unemployment
Key terms:

Unemployment: when those actively seeking work are unable to find a job

How is unemployment measured?

Types of unemployment:
Type Explanation

Cyclical ● Linked to the economic cycle

Unemployment ● Unemployment is high during a recession (demand for goods is low → production
is low → less need for labour)
● People are often laid off, or ‘fired’ but because of the companies reduced need for
labour, not because of any wrongdoing
● This is the ‘worst’ type of unemployment, and governments try to prevent it

Structural This type of unemployment happens as a result of changes in the structure of an economy
Unemployment ● Sectorial unemployment: an industry is in decline (coal, video rental stores)
● Technological unemployment: when workers are replaced by machines
● Regional unemployment: unemployment rates can differ by region

Seasonal Some workers only work part of the year (usually due to weather)
Unemployment

Voluntary Some people simply choose not to or don't need to work

unemployment

Frictional It occurs when people are unemployed as they move from one job to another
unemployment
 IMPACT OF UNEMPLOYMENT ON…

Output ● If people are unemployed, the productive potential of a country is not being fully
exploited
● Levels of output are lower than they could be
● This means that the national income and living standard will be lower
● However, if most of the unemployment is a result of new technology being
introduced, output might not fall. Output could actually increase if productivity rises.

Use of scarce People who are out of work do not make any contribution to production, which is a waste of
resources resources and results in lower levels of national income

Poverty ● High unemployment means higher rate of poverty because less people are earning
money and supporting their family
● When people are unemployed their incomes fall as state benefits tend to be lower
than wages

Gov spending ● In most developed countries, when people are unemployed they are entitled to
on benefits receive financial benefit from the state
● If unemployment levels rise, the government has to allocate more money to
unemployment benefits, which incurs an opportunity cost
● Money could be spent on education, healthcare, etc

Tax revenue ● If unemployment rises, tax revenues will fall because most taxes are related to
income and spending
● This means the government has less to spend and may have to cut public services
● Instead, it may borrow more, which will increase national debt or it may have to
increase tax rate

Consumer ● During periods of high unemployment, consumers lose confidence because they
confidence think that they will get laid off or fired
● This will result in consumers spending less money in order to save it
● Also their income falls because state benefits are generally lower than wages.

Business ● When firms lay off workers, they have to pay them redundancy money
confidence ● The remaining workers may be demotivated because they may fear to be the next
● A firm will be left with spare capacity when laying off people and there is likely to be
a fall in demand
● Sales fall when unemployment rises (people have less to spend)
● These events reduce confidence of business decision makers - as a result, they
may cancel investments)

Society ● Mainly local communities workers are employed by a same big firm , if the big firm
closes then it will cause everyone to have less money
● Therefore this will cause the small firms to struggle which means that the
environment will be worse as the economy is poor
○ Individuals might doubt themselves if they get unemployed
○ Unemployment could also lead to crime and raise stress levels
2.1.28 Balance of Payments on Current Account
Key terms:

● Current account balance: difference between total exports and total imports
● Current account balance = value of exports into a country - value of imports

The relationship between current account balances and exchange rates:

● Exchange rate: the price of one currency in terms of another
➔ $1 costs 1.06€
➔ 1€ costs $0.94
● We say a currency “gets stronger” or “appreciates” when one unit of currency can buy
more units of another currency
➔ Last month: $1 costs €0.93
➔ Today: $1 costs €0.95
● The US dollar has gotten stronger against the euro / appreciated against the euro
because it now costs less (in dollars) to buy euros.
● This means that the euro has depreciated (lost comparative value) against the dollar

***KEY POINT*** Exchange rates can affect international trade

● If a country's exchange rate gets stronger (their currency appreciates)
● So exports become more expensive for foreign consumers to buy, and imports
become cheaper for people living in that country to buy
● Therefore fewer exports will therefore be sold and more imports will be bought
● This will have a negative impact (negative, as in ‘lower numbers’ not ‘bad’) on the
current account and could increase a country's current account deficit.
 REASONS FOR DEFICITS AND SURPLUSES

Quality of domestic ● If a country has a reputation for high quality domestic products, it is likely to
goods enjoy high/rising sales from overseas. (eg. wine or olive oil from Spain) →
Increasing demand for exports → higher current account balance
● This also means people of that country will prefer their own high-quality
products, so imports for that product will be low →high current account balance

Quality of foreign ● If goods and services from overseas are superior to domestic products →
goods Increasing demand for imports → lower current account balance
● ** Less demand for home-produced goods could mean lower domestic output
and higher unemployment rates

Price of domestic If domestic goods and services increase in price (due to inflation perhaps) → demand
goods from overseas buyers will fall → lower current account balance

Price of foreign If foreign goods and services area cheaper than those produced at home → increased
goods demand for imports → lower current account balance

Exchange rates Exchange rates affect prices, which will impact demand for imports and exports, which
between countries affects the current account balance.

IMPACT OF A CURRENT ACCOUNT DEFICIT

Leakages from ● A persistent deficit suggests a reliance on imports

the economy ● Therefore money is flowing out of the economy to businesses overseas
● This could lead to lower output levels domestically, and higher unemployment
“Sending jobs overseas”

Inflation ● A persistent deficit suggests a reliance on imports

● If the price of imports goes up, this will be added to the CPI
● Therefore, rising import prices would result in higher inflation

Low demand ● A country with a high CA deficit may be struggling to sell their goods abroad, due to
for exports low quality or high prices
● This can lead to slow economic growth and high unemployment
● This may also suggest a structural weakness in the economy, that they may not be
able to effectively compete internationally

Funding the ● Foreign currency is needed to pay for the rising quantity of imports
deficit ● It may be necessary to borrow foreign currency (interest!)
● This can be offset with a surplus in the capital account
 2.1.29 Protection of the Environment
Key terms:

Business activity that damages the environment:

BUSINESS ACTIVITY THAT DAMAGES THE ENVIRONMENT

Mining Minerals are extracted from a large hole in the ground

● Commonly mined materials: copper, iron, gold, diamonds, coal
● What is being mined is often rare/scarce, so a lot of ground needs to be dug up and
displaced to find the minerals
● This process involved crushing rock, which can release harmful materials into the
air and water
● During the separation process, waste material called tailings (crushed rock and
liquid) is produced
● Mines themselves are located in countrysides, destroying natural habitats
● Mining also requires a significant amount of water, and wastewater from mining can
make its way to rivers & seas

Power ● Damages the environment if electricity is produced with fossil fuels (coal/oil)
generation ● Fossil fuel plants release: release of hot/dirty water, solid waste, ash, & result in
noise and visual pollution. Worst effect is releasing greenhouse gases
● Nuclear power stations also represent a danger of radioactive waste

Chemical ● Necessary because: chemicals are used in daily life- fuels, paints, cleaning
processing supplies, pesticides, plastics, glues, adhesives, refrigerants.
● Creating chemicals can harm the environment
○ Refineries & chemical processing plants produce HAPs (hazardous air
pollutants) → cause cancer/health problems
○ Some chemical processes release VOCs (volatile organic compounds) into
the air → cause asthma, lung & heart problems

Agriculture ● Use of pesticides and fertilisers: helpful for improving crop yields, but with rainwater
they can pollute rivers & seas and kill aquatic life
● Factory farming is emits huge amounts of greenhouse gases
● Deforestation also results in huge CO2 emissions and destroys wildlife habitats

Construction ● Produces more waste material than any other industry which uses up resources
and causes disposal problems
● Causes of air pollution: land clearing, operation of diesel engines, demolition,
burning/working with toxic materials
○ Also produces lots of dust, which can cause respiratory problems
● Causes of water pollution: Diesel and oil, paint, solvents, cleaners and other
harmful chemicals and construction waste and dirt can be washed into water
systems
 WAYS BUSINESSES DAMAGE THE ENVIRONMENT

Visual pollution ● Business activity results in something physical that looks unattractive
● Eg. Giant office buildings, bright illuminated signed, wind farms, overflowing skips, litter

Noise pollution ● Business activity results in excessive noise, causes a disturbance to everyday life
● Eg. jet engines, loud music from bars, machinery/tools, commercial traffic sounds

Air pollution ● Burning fossil fuels: emissions from vehicles, airplanes, etc
● Emissions from factories & other business activities: manufacturing & processing
businesses discharge harmful greenhouse gases
● Agricultural activities: pesticides, fertilisers, ammonia are all byproducts of agricultural
activity.

Water pollution ● Most harmful substances find their way into waterways as a result of business activity:
○ Industrial waste: manufacturing requires water, and waste water is sometimes
dumped into nearby waterways.Most gov's have regulations forcing businesses to
treat the water before dumping it, but it can still be dangerous
○ Marine and ocean dumping: waste materials from shipping, oil leaks, and waste
from the land can pollute the ocean; waste from some countries is dumped directly
into the sea.z
○ Sewerage: sewage in most developed countries is treated before it reaches the
sea, but untreated sewage is harmful (disease, human waste, pharmaceutical
drugs, plastic, etc)
● Marine life is threatened by water pollution. Pollution can also threaten humans' access to
clean drinking water

GOVERNMENT INTERVENTION TO PROTECT THE ENVIRONMENT

Taxation Cost imposed on businesses who ● Adv: emissions reduced, green jobs created, tax
create externalities revenue goes to the gov (to fund green projects)
● Disadv: represents a cost to businesses

Subsidies Gov offers grants, tax allowances, ● Adv: firms respond to financial incentives
financial incentive ● Disadv: opportunity cost for the government, can
lead to complacency (low effort from firms)

Regulation Laws: regulations, guidelines, codes ● Adv: sets clear expectations for all firms
of practice, ‘rules’ ● Disadv: hard to monitor/enforce, opportunity cost
Gov agencies check on firms for gov resources creating & enforcing laws

Fines Financial penalty for firms & ● Adv: firms are usually very responsive to financial
individuals who break environmental penalties because they reduce profit
laws ● Disadv: not effective if they aren’t large enough

Pollution Gov issued doc that allows firms to ● Adv: incentivises firms to reduce emissions in
permit discharge a certain amount of order to profit from sale of the permit
polluting material ● Disadv: pollution is being allowed; variables
include cost and number of permits issued

Park Gov establishes protected ● Adv: wildlife, historical sites, scenery, unique land
provision national/state parks to & water features are protected
preserve/protect nature ● Disadv: opportunity cost of land & gov resources
 2.1.30 Redistribution of Income
Key terms:

● Income inequality: differences in income that exists between the different groups of
earners in society, that is, the gap between the rich and the poor

Huge differences in income happen for several reasons:

● Workers with natural talent, a good education, valuable work experience or who can
offer labour in a market where there is a shortage of qualified labour, will earn more
● People who don’t work (pensioners) receive less incomes than those in employment
● The extent to which a government redistributes income through taxes and welfare
payments is influential
● People who own assets such as property, shares and capital will enjoy additional
income such as rents, dividends and interest, respectively

Absolute Poverty VS Relative Poverty

Where people do not have enough resources to meet all of Poverty that is defined relative to existing living
the basic human needs
● People are fighting to survive (no adequate food,
water, shelter, education, sanitation, etc)
● Often no income, they live in search of
food/basic needs
● Levels are low in developed countries due to the
government providing basic welfare payments
and programmes for the needy
● An estimated 702 million people live in absolute
poverty (9.6% of world population)
standards for the average individual
● Those in relative poverty are at the bottom of a
nation’s income scales (their income falls short
of the average standard of living)
● Calculation of the EU: those living at 60% or
less of the median national income, so it varies
between countries
● This is always present, even in developed
societies
 REASONS TO REDUCE POVERTY & INEQUALITY

Meet basic ● About 10% of the world population are at risk of starvation, especially those who
needs are children. (3.1 million children died of starvation in 2011).
● Malnutrition increases the risks of other diseases, making people more likely to die
of treatable illnesses.
● If absolute poverty is eliminated, basic needs are met, which would lead to less
death from starvation and more healthy children

Raise living ● Although relative poverty will always exist (mathematically) the living standards will
standards rise as income rises
● Those in relative poverty are more likely to become ill and have lower life
expectancy, likely due to: poorer housing, less nutritious diets, reduced access to
healthcare. They are also likely to have lower self-confidence and less control over
their lives and less choice.
● Reduce poverty → higher living standards → more educated population → boost
economic growth → more employment, more income, more tax revenue for gov

Ethical reasons ● Many believe people and governments have a moral obligation to reduce poverty
● It’s seen as a moral duty of both people and governments to help reduce poverty →
reduce human suffering, ensuring people have happier healthier lives

Government Intervention to Reduce Poverty and Income Inequality

Progressive Taxation Regressive Taxation

● Income paid in tax rises as the income of the taxpayer ● Tax the poor more heavily
rises ● Income tax falls as income rises
● E.g. If I earn $25,000, I will pay 7% tax ● Taxes on spending e.g. VAT are more
If I earn $75,000, I will pay 25% tax regressive (a flat tax on the same
● In most nations, tax on income is progressive purchase represents a higher
● This can help close the gap between the rich & the percentage of income for a poorer
poor individual)

Redistribution through benefits payments Investment in Education

● Welfare system to boost incomes of those in poverty ● If people are educated, they can
○ In EU, payments are made to: the develop skills and become more
unemployed, the disabled, the sick, employable
single-parent families, the elderly, and those on ● School also offers children a safe
very low income place where they can learn life skills
● This payments can help reduce poverty (and is often and can help them prevent disease
effective, see Ecuador example) ● Education can be expensive to invest
● Areas with large absolute poverty do not tend to have in and it can take a long time to see
these welfare systems e.g. developing countries (low the rewards
GDP, low tax revenue) ○ In most developing countries,
public school is not free as
Investment in Healthcare you must pay for books,
● Health programmes can reduce mortality rates, uniforms etc.
increase life expectancy ● On average, every year in education
● If children are healthier → more days in school increases a person's future income
● Longer life expectancy → save for retirement by 10%
● Healthier people → more productive in workplace → ● Several years of education can
increase output reduce poverty
 2.1.31 Fiscal Policy
Key terms:

Why does the government levy taxes?

● To pay for public sector services
● To discourage certain activities (eg. cigarettes are highly taxed)
● To control aggregate demand
● To redistribute wealth in an economy
Type Explanation (only need to know the type, not the explanation)

Direct taxes Taxes imposed on firms or individuals

(It’s direct because it is paid directly to the government)
Types of direct taxes:
● Income Tax: Based on the amount an individual earns. Paid by anyone employed
or self - employed
● Social Insurance Tax: A tax on people's income but the money is used for specific
expenditure e.g. pensions & healthcare
● Corporation Tax: The money firms pay on their profits made (specifically limited
companies)
● Capital Gains Tax: A tax paid on the selling of assets for profit
● Inheritance Tax: Tax when money is inherited when someone dies. Usually a
certain amount is tax free

Indirect tax Any tax on spending

(It’s indirect because the consumer pays the seller, who then pays the government)
Types of indirect taxes:
● Sales Tax: Taxes on spending e.g. VAT - a percentage on a product you buy (VAT
rate in Spain is 21%)
● Duties: Large tax rates on particular goods e.g. Alcohol & Cigarettes
● Customs: Taxes put on imports - Brexit will have big effect on this
● Council Tax: Collected by local council or authorities to pay for local services e.g.
grass cutting & bin collections. Higher the value of property, the higher the payment
● Business Rates: Business pay local authorities money to contribute to local
services
● Stamp Duty: Tax paid when buying certain assets

Environmental Tax designed to protect the environment

tax (reduce negative externalities)
● Landfill Tax: Tax paid on disposing waste in landfill sites. Based on weight of waste
● Climate Change Levies: If greenhouse gas limits are not met (usually paid by
business)
● Aggregates Levy: A tax paid on sand, rock & gravel taken from the ground
 Government expenditure:
Expenditure is the opposite of revenue; it is money that the government spends
● Mandatory spending: based on political system, these are made automatically & the
gov is legally obligated to pay them (pensions, unemployment payments, etc)
● Discretionary spending: ‘extra’ or ‘new’ spending (eg. money for a new motorway)
FISCAL DEFICITS AND SURPLUSES

Fiscal deficit Government expenditure is greater than government revenue

● Gov. will borrow if they are running at a deficit. In future years, the Government
has to spend its revenue paying off its national debt. (*opportunity cost*)
● Eventually, future generations may be left with the burden of paying it off

Fiscal surplus Government expenditure is less than government revenue

● Fiscal surplus could be used to lower taxes in the economy / pay off national debt

Debt as a % of ● Important to focus on size of fiscal deficit in relation to years GDP

GDP ● The amount that needs to be borrowed to cover the deficit is only a serious
problem if it is a large percentage of the GDP
● So we express the deficit as a percentage of the GDP

Expansionary Fiscal Policy: Goal is to stimulate the economy (increase aggregate demand)

Stimulate economic ● Increased gov spending → more jobs in the public sector → lower unemployment
growth rates & higher aggregate demand
● Increased gov spending on infrastructure roads, schools, airports) → factors of
production become more mobile → increased productivity
● Cut taxes → households have more disposable income → higher aggregate
demand → suppliers produce more to meet demand

Reduce ● increased gov spending → funds towards hiring + public sector workers or funding
unemployment infrastructure projects that require contracted labour → reduced unemployment
● Increased gov spending or tax cuts - increase aggregate demand → suppliers
boost production to meet demand - additional workers are hired for the increase in
production

Protect environment ● Gov subsidies → encourage 'green' economic activity

Contractionary Fiscal Policy: Goal is to cool off the economy (decrease aggregate demand)

Reduce inflation ● Reduce gov spending → less gov funding for education, healthcare, infrastructure,
etc → fewer public sector jobs → less AD
● Raise taxes → consumers have less disposable income → less aggregate demand
→ less inflation

Reduce current ● Higher taxes or reduced gov spending → reduced aggregate demand → reduce
account deficit demand for imports → lower current account deficit

Protect the ● Higher taxes on polluting businesses → discourage 'non-green' economic activity
environment
2.1.32 Monetary Policy
Key terms:

Interest rates: (price paid to lenders for borrowed money)

How do interest rates vary?
● Different banks charge different rates to compete
● Higher interest rate if you borrow money without security
● Borrowers pay more than savers
● High rates of interest on credit cards

Reasons for different rates of interest:

● Different banks charge different rates as they compete with each other for business
● Rates are higher if money is borrowed without security
● The amount paid to borrowers is higher than the amount given to savers. This allows
moneylenders such as banks to make a profit
● Some of the highest rates of interest are charged to credit card users

The role of central banks in setting interest rates:

● Implementing the gov’s monetary policy and regulating the bank policy
● Can lend money to commercial banks as last resort
● Controlling inflation and stabilising a nation’s currency
● Setting interest rates
 IMPACT OF INTEREST RATE CHANGES ON MACROECONOMIC OBJECTIVES

Inflation ● Monetarists believe inflation happens due to money supply growing too quickly
● To reduce inflation - slow down speed of money supply
● To do this, you would raise interest - which will mean borrowing levels fall - money supply
stops growing so fast
● This will reduce AD(aggregate demand) in economy

Unemployment ● Lowering interest rates will incentivise firms and individuals to take out loans & take more
risks
● Therefore spending increases, so aggregate demand increases
● More workers are hired so that businesses can increase supply to meet high demand

Economic ● Monetary policy can be used to influence the natural economic cycle
growth ● Eg. interest rates are lowered to encourage spending, stimulate the economy and lift a
country out of recession (most countries did this after the 2008 crash)

The current ● To reduce a CA deficit: increase interest rates → lower aggregate demand → less
balance demand for imports
● However, if interest rates are raised, this may also increase the exchange rate, making
exports more expensive and imports cheaper, resulting in a larger CA deficit
● So how can we know how the CA will be affected by higher interest rates? Factors
include:
➔ The strength of link between interest rates & exchange rates: If strong link, higher
interest rates will raise exchange rates. Exports become expensive & imports
cheaper - bad for current balance
➔ Income Elasticity of Imports: If demand for imports were income elastic, higher
interest rates would reduce demand, improving the current balance
➔ Price Elasticity of demand for imports & exports: If both are price elastic and
exchange rates rise when interest rates do, imports would be cheaper and
exports would be more expensive. This would worse the current balance

THE MECHANISM BY WHICH INTEREST RATES CHANGES AFFECT CONSUMERS AND FIRMS

Consumers If interest rates fall:

● Consumers are more likely to borrow for goods - higher aggregate demand
● Mortgage payments fall - they have more money to spend - increase AD
● If interest rates are lower, the reward to savers is also lower - encourage people to spend
rather to save

If interest rates increase:

● Consumers try to reduce borrowing because it becomes expensive - AD falls
● Mortgage payments rise - household will have less disposable income to spend

Firms If interest rates fall:

● Interest payments on current borrowing will fall
● Raise levels of business confidence and stimulate more investment
● Returns in investment rates are higher - more investment may be undertaken
If interest rates increase:
● Raise costs, lower profits, reduce business confidence and make entrepreneurs more
cautious - investment in the economy may fall
2.1.33 Supply Side Policies and Government Controls
Key terms:

Supply Side Policies: Government measures designed to increase aggregate supply in the
economy (tend to be ‘business friendly’ and increase economic growth)

They aim to:

Increase flexibility in the labour market by removing restrictions
Restoring the incentive to work by lowering taxes
Promote competition through privatisation, deregulation, and helping small firms
Increase investment by improving the flow of capital in a capital market

Impact of Supply Side Policies on Productivity and Total Output

1. PRODUCTIVITY
Generally improve the productivity of production factors → resources are used more
effectively so potential of economy can be increased

- Improve Flexibility: Previously, it was believed that workers were inflexible. Trade
Unions were an obstacle to this change (forced up wages and resisted the
introduction of new working practices/technology)
- U.K 1980s, legislation to remove trade union power so labour markets could
work more freely (fewer strikes related to wages & less disruption)
- Training & Education: Quality of workforce will increase with more training and
education. Labour productivity will increase therefore so will aggregate supply
- SS Policies promote more competition. This will pressure firms to be more
cost effective and innovative, raising productivity (privatisation & deregulation
play a role in this aim)
- Productivity can increase with more investment. By purchasing technology
and updating facilities, efficiency will improve
- Competition: Some Supply Side Policies aim to promote competition, giving firms
incentive to innovate and cut costs, raising productivity.

2. TOTAL OUTPUT

- SS policies (increasing productive potential of the economy) lead to increased

volume of output → national income will rise along with living standards
- Less chance of demand pull inflation if supply is increased → lower unemployment
rates
PPC can be used to show the impact of SS policies on Total Output.

In this example, the country will be able to produce greater quantities (capital & consumer
goods) when SS policies are used to increase aggregate demand

Video: The theory of supply-side economics

Government controls (LAST section of Chapter: Red table 1st)

In addition to fiscal policy, monetary policy and SS policies, governments can use other
controls when managing the economy to achieve Macroeconomic objectives.
● Eg. Pass new legislation to protect environment, fines for those who exploit
consumers/workers & introduce controls as means of maintaining standards in
business conduct
These controls have advantages because they reduce the exploitation of vulnerable
groups/sectors. However, they impose costs on firms that may limit their growth &
development.
 IMPACT OF SUPPLY SIDE POLICIES ON MACROECONOMIC OBJECTIVES
These are used to increase economic growth,
some of these measures are taken which will have a variety of effects on the economy:

1. Privatisation
● Helps to break up state monopolies, reduce inefficiencies and promote competition (Private sector = profit
to survive) → Competitive pressure should improve quality and choice
● Public services were contracted out (Eg. meals & cleaning services in schools/hospitals)
● State monopolies become private → consumers might be exploited = price increases and poor quality
services (water supply & energy distribution)

2. Deregulation
● This relaxes laws and rules the government uses to control the market
● This reduces: Excessive paperwork, obtaining unnecessary licences, having lots of committees to approve
a decision, various ‘trivial’ rules that slow down business development
● Inadequate/insufficient regulations may cause problems as business are left unchecked (Eg, Financial
crisis, food safety recalls)

3. Education & Training

● Governments and firms invest in education and training → more skilled workers → higher employability
○ Gov can invest in schools, unis, etc
○ Gov can provide tax incentives to invest in training
● Investment in education is very expensive and returns (results) are not seen for years; many developing
countries have inadequate education programmes due to the cost

4. Policies to Boost Regions with High Unemployment

● Supply side policies are very selective so can be used specifically
● Gov organises policies to help labour markets - made easier to hire and fire
● Countries struggling with high unemployment can be helped by getting money from organisations (Eg. EU)
for job creation in worst hit areas (eg. technology park in Andalusia)

5. Infrastructure Spending
● Gov. invest more in infrastructure to improve economic growth & aggregate supply
○ Improve transportation and communication systems → better geographic mobility; easier
distribution of goods
○ Improve education & healthcare → improve quality of human capital which benefit firms
(Eg. Building roads will allow for trade for many years into the future)

6. Lower Business Taxes to Stimulate Investment

● Economic growth can be accelerated if businesses are encouraged to invest more. (confident about the
future, funds available for investment, government maintaining a stable economy…)
○ About half of all investments are funded by profits; lower taxes on profits → more willing investors
● Firms can offset the cost of investment against tax (Eg. they can claim allowances when buying machines
and equipment)
● Tax incentives: Encourage people to save more and buy shares in companies (Eg. tax relief for those who
invest in new/IT companies)
○ Both of these are Tax-Deductible: Reduce the taxes a person owes in a given year

7. Lower Income Taxes to encourage Working

● Some argue high taxes on income and profit reduce output because people are discouraged from working
/ setting up their own businesses
○ Workers will take more holidays, retire earlier
○ Entrepreneurs are less likely to undertake risky business opportunities
34. Relationships between objectives and policies

Impact of policy measures on macroeconomic objectives

● Policies are used to achieve macroeconomic objectives
○ Promoting economic growth, keep inflation and unemployment down, prevent
large deficit on the current account and protect the environment
● There are positives and negatives which sometimes don’t allow the government to
achieve macroeconomic objectives (eg. contractionary fiscal policy to reduce inflation
may result in more unemployment - If they cut expenditure on social care, fewer
social workers will be required)
○ Therefore, governments may have to accept trade-offs between
macroeconomic objectives (eg. tolerate high inflation to have lower
unemployment)

1. UNEMPLOYMENT and INFLATION

Policies to reduce inflation
● Monetary policy: quickly increase interest rates if they have been given an
inflationary target to meet
○ High interest rates = lower aggregate demand (help reduce inflation

There might by some negative effects of high interest rates:

1. Discourages consumers/firms from borrowing = fall on consumption and investment.
This will reduce aggregate demand and lower economic growth (unemployment
rises)
2. Higher mortgage payment for many households. This will reduce spending power =
less aggregate demand. Therefore firms will lay off workers (unemployment)
3. This will raise firms’ costs and reduce their profits. They might invest less = less
aggregate demand
4. Discourage firms to borrow for investment in technology and expansion, hampering
their long term development. They may also lose their competitive edge in foreign
markets (if it only affects their country)
5. If higher interest rates result in higher exchange rates it may be harder for firms to
sell abroad (exporters will most likely lay off staff = unemployment)

Even if a government favoured the use of FISCAL POLICY to reduce inflation, there is still
negative effects:
1. Higher taxes and low government spending = unemployment (eg. if consumption falls
because of higher taxes, businesses will see a fall in demand for their products - may
react by cutting production and laying off workers / Lower government spending
means that some services are likely to be cut - teachers/nurses/and more must be
laid off)
2. People may suffer from poorer government services after the cuts in expenditure (eg.
waiting times rise, facilities worsen, etc)

Possible Trade-Off (conclusion)

● It is clear that both anti-inflationary fiscal policy and anti-inflationary monetary policy
can have some unwelcome effects on the economy
 ● Normally, when governments try to reduce inflation, unemployment rises - suggesting
that trade-off exists between inflation and unemployment
Economists suggest that governments will have to accept these terms to reduce inflation.
Even if they try to reduce inflation very quickly, rise in unemployment may be even higher

● However, SUPPLY SIDE measures to reduce inflation may avoid rising

unemployment: they’re designed to increase supply of output rather than decrease
aggregate demand.
● Unfortunately, Supply Side measures are very slow to have an impact on the
economy, so governments are more likely to use Monetary and Fiscal measures

2. ECONOMIC GROWTH and INFLATION

Policies to promote Economic Growth
● Expansionary Fiscal Policy: lowering taxes or increasing government expenditure
○ If taxes are lowered people will have more disposable income - spending this
on goods and services will increase aggregate demand so firms will produce
more, raising output levels = ECONOMIC GROWTH
○ If government spends more, by employing more teachers, social workers and
health workers (as an example) = extra demand in the economy - firms will
respond by producing more = national income grows = ECONOMIC
GROWTH

● Moneta Policy: if interest rates are lower, people will borrow and spend more / firms
invest more
○ Businesses will develop new products, expand and set up new ventures -
extra investment will drive economic growth
○ They may also use quantitative easing to stimulate growth - helping increase
money supply = increase in aggregate demand

Possible Trade-Off
● These policies may go too expansionary: economy may overheat - firms will not be
able to meet the rising aggregate demand and respond by raising their prices instead
of producing more = demand pull inflation
○ stimulating economy too much = inflation so there’s another trade-off between
these factors
● Inflation is more likely to be caused if their is limited capacity in the economy / factors
of production are immobile
○ If firms have nearly in full capacity and don’t have enough resources =
inflation more likely to occur

● However, SUPPLY SIDE measures are business friendly so they’ll help firms
increase supply (eg. government training schemes = skilled labour to helps firms
meet rising demand

3. ECONOMIC GROWTH and ENVIRONMENTAL PROTECTION

Growth and the environment
● As businesses produce more output = more pollution
 ● Extra wealth and income that comes with Economic Growth = people buy more
cars/vehicles = pollution and congestion
● Dangerous for health of society (eg. In China water is so polluted it’s not safe to
drink)
● As more land is taken for business development, less is available for wildlife (habitats
disappear)

In developed countries where environmental issues are more pressing, governments use:
legislation, fines and pollution permits to protect the environment
● HOWEVER, many restrict business development - it is difficult to find the right
balance in this trade-off

4. INFLATION and CURRENT ACCOUNT ON THE BALANCE OF PAYMENTS

Measures to reduce inflation
● If prices are rising - price of exports rise - reduce demand for exports = pressure on
CA Balance
○ Consumers might switch from expensive domestic goods to cheap imports -
making CA even worse
● Consequently, high inflation rates have damaging effect on country’s CA Balance

WHY NOT TO USE MONETARY POLICY:

Using Monetary Policy to reduce inflation: balance of payments situation becomes worse
○ Using higher interest rates to reduce inflation = strengthen exchange rate
○ When interest rates are high - demand for domestic currency may rise and
drive up exchange rate - exports become dearer and imports cheaper
(creating further pressure on CA balance)

Possible Trade-Off
● Reducing inflation by raising interest rates = CA Balance will worsen for a period of
time
○ Although, the impact of price changes for demand of Imports and Exports will
depend on their elasticity

● However, Fiscal Policy to reduce inflation is better for the CA Balance

○ If the gov cuts spending / raises taxes their may be a fall in demand with no
direct effect on the exchange rate = prices of exports and imports will be
stable and CA relatively unaffected
● The use of Supply Side are not likely to affect exchange rates and are business
friendly
○ Businesses will be able to produce more at lower prices - helps boost exports
= benefit on CA