AS Unit 2 – TheNational Economy

Revision Guide

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11.1 Performance of the UK Economy and GovernmentPolicy Objectives

Indicators of National Economic PerformanceAQA Syllabus - Candidates should be able to compare the performance of the UnitedKingdom economy with other national economies, taking into account economic growth,employment and unemployment, inflation and the balance of payments. Candidates shouldbe familiar with the data which is commonly used to measure the performance of aneconomy and should understand the use of index numbers.

Key termsPolicy Objective: A target or goal that policy makers aim to hitPolicy instrument: A tool or set of tools used to try and achieve a policy objectivePolicy conflict: When two policy objectives cannot be achieved at the same timeTrade-off: Satisfactory combination if two cannot be achievedPolicy indicators: Information about what is happening in the economy

Questions to consider (http://www.economicshelp.org/blog/)Evaluate the view that ‘trade-offs will be required over the period of the cycle’?In the economic cycle there are often trade offs between different macroeconomicobjectives.

The main macroeconomic objectives include:

* Low inflation * Higher economic growth * Low unemployment * Low current account deficit

For example, if the government attempts to increase AD by implementing expansionaryfiscal policy, we will get an increase in real GDP and therefore lower unemployment butat a cost of higher inflation.

However, not all economists believe there is a trade off, through supply side policies youcan reduce unemployment and increase economic growth without causing inflation.

In the current climate, lower interest rates are trying to increase economic growth.However, the downturn is so severe they are not causing inflation, but, at moment are notcausing economic growth. Quantitative easing may be used to print money as anemergency means to avoid deflation and avoid economic downturn, but, it will cause somedegree of inflation

What are the main problems in UK since the recession started?

Decline in GDP. The IMF recently forecast UK GDP would decline by 3.8% in 2009. Thismakes the recession very deep.

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Rise in Unemployment. Unemployment figures recently passed 2 million and there isevery likelyhood it will rise to 3 million by the start of 2010. Unemployment is the biggestcause of relative poverty in the UK. Unemployment is the most damaging event topeople’s quality of life. It is not just the decline in income, but the stress and depressionassociated with periods of unemployment.Bank Lending. At the core of this current recession is an unwillingness / in ability forbanks to lend. Due to global credit constraints banks have cut back on lending to firms,households and for mortgages. It has effected investment and demand for housing.

Rise in Government Borrowing. The recession has caused a rapid rise in governmentborrowing. Public sector debt has risen to 47% of GDP and could rise to nearly 60% ofGDP by the end of the recession. Including the liabilities of nationalised banks and thefigures look even worse. Higher government borrowing has been a factor in the weakerPound and raises the prospect of future tax rises. Yet, at the same time governmentborrowing is a key factor in limiting the depth of the recession

Key Charts

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UK Unemployment

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The Objectives of Government Economic PolicyAQA Syllabus - Candidates should know that the control of inflation, minimizingunemployment, achieving a steady rate of economic growth and a satisfactory balance ofpayments position are the main objectives of the government’s macroeconomic policy.

Key termsFull Employment: When unemployment falls to 3% of the labour forceEconomic Growth: Steady growthControlling inflation: Bank of England target for CPI 2%Satisfactory Balance of Payments: Current account is in equilibrium

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Economic GrowthAQA syllabus - Candidates should understand that economic growth occurs when theproductive capacity of the economy is increasing and that the principal indicator ofeconomic growth is the rate at which real national income is changing. They should beable to use a production possibility diagram to illustrate economic growth. They shouldunderstand the main factors that influence the rate of economic growth. Candidates shouldunderstand that supply-side policies may be used to attempt to influence the underlyinglong-run trend rate of economic growth.

Key termsEconomic growth: An increase in the economy’s potential level of real output, and anoutward movement of the economy’s production possibility frontierNational Output: Is the flow of new output produced by the economy in a yearGross Domestic Product (GDP): is the value of all final goods and services produced.Gross National Product (GNP): GDP plus the income earned by domestic residents as aresult of investmentsEconomic cycle: fluctuations of real output above and below the trend line of economicgrowthRecession: a fall in real output for 6 months or moreOutput gap: the difference between actual output and the trend growth level of output

Questions to consider (http://www.economicshelp.org/blog/)When do recessions end?A recession is a period of negative economic growth. Falling output leads to higherunemployment, and this rise in unemployment causes a negative multiplier effect. e.g.those made unemployed will spend less causing even less demand in the economy. Thusthere are many factors which make it difficult to get out of a recession. What needs tooccur for a recession to end?

1. Interest rate cuts take time. The MPC have cut interest rates from 5% to 0% with littleseeming effect. However, over time, people may start responding to lower interest ratesand increase spending and increase investment. e.g. people on fixed rate mortgages mayfind a decrease in mortgage payments next time they remortgage.2. Fiscal Policy takes time. Government spending has increased, but again it takes timefor this to filter through into the economy.3. Banks Restore liquidity. This recession was steep because banks were very exposed tosubprime losses. It meant they had little funds to lend. They have held back on lending toimprove their liquidity. Consumers are also saving more and overpaying mortgages. Thismeans in a few months time banks may be in a position to start lending again. This willincrease investment and consumption4. House prices stop falling. Falling house prices has a big effect on reducing consumerspending. As house prices fall they become more affordable and so there will come a pointwhen they stop falling (or fall at a slower rate) this will encourage spending again.5. Time. In a recession, consumers and firms delay spending and investments which arenon-essential. e.g. consumers wait an extra 12 months to replace their TV. But, it stillneeds replacing, therefore although some decisions are delayed there comes a time whenfirms and consumers can’t wait any more.6. Global Recovery

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Key ChartsProduction possibility frontier

Economic cycle

InflationAQA syllabus - Candidates should understand that inflation can be caused by excessiveaggregate demand and sustained increases in costs. They should also understand that theBank of England attempts to control inflation by using interest rates to try to preventaggregate demand increasing more rapidly than the underlying trend rate of growth ofoutput. Candidates should also have an understanding of the concept of deflation (i.e. inthis context, a situation in which prices are falling in an economy or sector of aneconomy).

Key termsInflation: a persistent or continuing rise in the average price levelDeflation: a persistent or continuing fall in the average price levelReflation: an increase in the level of output following an increase in aggregate demand.

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RPI: is compiled using more than 650 separate representative items.CPI: All items in the RPI except council tax and a number of housing costsIndex-linked: The coupling of salaries and pensions etc to the retail price index in orderto make sure that the income from them keeps pace with inflationDemand-Pull inflation: Caused by an increase in Aggregate DemandCost-Push inflation: Caused by an increase in the costs of productionStagflation: Rising prices and falling output

Questions to consider (http://www.economicshelp.org/blog/)How can we have both inflation and deflation in the economy at the same time? (theRPI falling to 0% and CPI rising to 3.2%)

Deflation requires a fall in prices. We would need a negative inflation rate (e.g -0.3%) tohave deflation. Note if the inflation rate fell from 4% to 3%, this is not deflation, but, itmeans prices increase at a slower rate. RPI used to be the official statistic, but recently itwas changed to CPI. The main reason that RPI is currently much lower than CPI is thefact RPI includes the impact of mortgage interest payments. Therefore since interest rateshave fallen many people have seen a decline in the cost of mortgage payments. Thisexplains why RPI could become negative when other prices are still rising.

CPI is a more reliable guide to a typical basket of goods. (unaffected by interest rates). Ifeel that CPI is a better guide to underlying inflation. If CPI becomes negative then thiswill be the best evidence that we are experiencing widespread deflation.

Key ChartsDemand-Pull inflation

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Cost-Push inflation

Employment and UnemploymentAQA syllabus - Candidates should understand how employment and unemployment maybe influenced by both aggregate demand and supply-side factors. They should be able touse a production possibility diagram to illustrate unemployed resources. They shouldunderstand that, at least in the short run, if the growth of aggregate demand is less than theunderlying trend rate of growth of output unemployment is likely to occur. They shouldunderstand the concept of the output gap and its significance for both inflation andunemployment.

Key termsClaimant Count: Those people who are claiming unemployment related benefits(jobseeker’s allowance)Labour Force Survey: is a continuous household survey in which 60,000 households areinterviewed each quarter, providing information on employment, unemployment andeconomic activity rates.Full employment: 3% or less of the labour force unemployedFrictional unemployment: transitional unemployment due to people moving betweenjobs:Structural unemployment: occurs when there is a long run decline in demand in anindustry leading to a reduction in employment perhaps because of increasing internationalcompetition.Cyclical unemployment/demand-deficient: involuntary unemployment due to a lack ofdemand for goods and services. This is also known as Keynesian "demand deficient"unemployment.Classical/Real wage unemployment: the result of real wages being above their marketclearing level leading to an excess supply of labour.

Questions to consider (http://www.economicshelp.org/blog/)Why are there large differences in the unemployment rate across different regions ofthe UK?

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In the 1980s regional differences in unemployment were greater. To some extent regionaldifferences in unemployment have narrowed in recent years. However, differences stillexist. Some reasons include:

1. Decline of Industry. Some areas relied on certain industries to provide a large % of jobs.If these industries close down then areas suffer from a high rate of unemployment. A goodexample, was when coal mines closed down in certain areas. It led to high unemploymentin certain areas such as South Yorkshire and South Wales.2. Negative Multiplier Effect. Depressed areas often struggle to attract investment. e.g. ifan industry closes down then related to businesses suffer e.g. cafes, pubs which used toservice the old industries.3. Labour Immobility. One question is if unemployment in one part of the country is high,why don’t people move to areas where there are jobs? One issue is the difficulty ofmoving. For example it is:

4. Lack of skills / qualifications. Some inner city areas may have low numbers of qualifiedpeople who therefore struggle to gain employment.

5. Higher unemployment amongst ethnic minorities. Sometimes unemployment rates arehigher in certain boroughs or areas of cities. These areas may have a high ratio of first orsecond generation immigrants. They may be more likely to be unemployed because ofpoor skills / language barriers/ discrimination e.t.c

Key chartsCyclical unemployment/demand-deficient

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Unemployment on the PPF

Classical/Real-Wage Unemployment

The Balance of Payments on Current AccountAQA syllabus - Candidates should understand that the current account comprises: trade ingoods, trade in services, investment income and transfers. They should understand themeaning of a deficit and a surplus on current account.

Key TermsCurrent account: part of the balance of payments measuringtrade in goods/visibles, (such as oil, agricultural products, machinery, white goods andclothing)trade in services/invisibles, (such as travel, financial and business services)investment income, (such as investment in shares debt securities and loans)transfers, (such as foreign aid)Current account deficit: when currency outflows exceed currency inflowsCurrent account surplus: when currency inflows exceed currency outflows

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Questions to consider (http://www.economicshelp.org/blog/)What causes a current Account deficit to increase?

* Rise in domestic consumption. As consumption rises, US consumers buy more imports.This rise in consumption often mirrors a decline in saving rates. For example in 1996, USgross savings rates were 15%, by 2004, this had fallen to 11%* Capital Flows. To finance a current account deficit of $800bn, the US needed to attractcapital flows equivalent to $4bn a day. Without these capital flows, the US could notfinance the deficit and it would cause depreciation in the dollar. One reason why UScurrent account deficit has persisted is because Japan and China have large currencysurpluses and so are looking to buy up US capital (e.g. Treasury bills)* Decline in competitiveness. A decline in relative competitiveness and productivitywould cause a decrease in demand for US exports. * Overvalued exchange Rate. If the dollar was overvalued this would make US exportsmore expensive. However, on purchasing power parity, this is not really the case.

Key chartsIncrease in exports

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11.2 How the Macroeconomy works

Aggregate Demand/Aggregate Supply AnalysisAQA syllabus: Candidates should understand that changes in the price level arerepresented by movements along the AD and AS curves. They should also understand thevarious factors that shift the short-run AD and AS curves, and that economic growth isrepresented by a rightwards shift in the long-run AS curve. Candidates should be able touse AD/AS analysis to help them explain macroeconomic problems and issues. Forexample, they should be able to use AD/AS diagrams to illustrate causes of inflation,demand deficient unemployment and economic growth.

Key termsMacroeconomic equilibrium: the level of real national output at which AD=ASAggregate demand: total planned spending on real output produced within the economyAggregate supply: level of real national output that producers are prepared to supply atdifferent average price levels

Key chartsMacroeconomic equilibrium

Economic growth

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The Determinants of Aggregate DemandCandidates should be able to explain and analyse the determinants of consumption,investment and the other components of aggregate demand. They should also be able toexplain and analyse the determinants of savings and the demand for imports.

Key termsFormula: AD = C+I+G+(X-M)Consumption: total planned spending by households on real output produced within aneconomyInvestment: total planned spending by firms on real output produced within an economyGovernment: total planned spending by governmentsExports: Exports (net of imports)Interest rate: reward for lending savings to somebody elseWealth: the stock of assets or things that have value, which people ownPersonal savings ratio: personal savings/personal disposable incomeThe accelerator: a change in the level of investment in new capital goods induced by achange in national income or output

Aggregate Demand and the Level of Economic ActivityAQA syllabus: Candidates should recognise the role of aggregate demand in influencingthe level of economic activity.

Key terms:The Multiplier or National income multiplier: An initial change in AD can have agreater final impact on equilibrium national income.Government spending multiplier: The relationship between a change in governmentspending and the resulting change in national incomeInvestment multiplier: The relationship between a change in investment and the resultingchange in national income

Questions to consider (http://www.economicshelp.org/blog/)Why do Keynesians argue that demand management policies are the most effectiveway of increasing the equilibrium level of output?

Keynesian Model of AD / AS

Keynesian theory argues demand management policies are most effective when theeconomy is in recession - when output is significantly below full employment.

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Note: Keynesians wouldn’t argue for increase in AD if the economy was near fullcapacity. Nor do Keynesians ignore the role of supply side policies for long term growth.

Keynesians believe that the economy can remain below full capacity and highunemployment for a long time. (They believe LRAS is elastic as above. They reject theMonetarist view of an inelastic LRAS curve) They state in a recession resources canbecome idle and therefore it is necessary for the government to inject funds into theeconomy to boost Aggregate Demand and increase growth.

Paradox of Thrift. Keynes noted that in a recession, low confidence caused a rise inprivate sector saving. This caused an even bigger fall in consumer spending. Therefore, heargued that it is was necessary for government spending to increase to offset the decline inprivate sector spending. The government needs to borrow from the private sector tofinance more spending. This doesn’t cause crowding out because the government ismerely utilising the private sector saving. They are effectively utilising unemployedresources.

Multiplier effect. An increase in injections into the economy can cause a positivemultiplier effect. Meaning initial government spending can cause a bigger final increase inReal GDP

What factors affect consumer expenditure?Consumer expenditure is determined by many factors. Some of the most important are:

* Disposable income. Disposable income can be determined by taxes, wages and livingcosts. For example, a cut in VAT should increase disposable incomes and encouragespending. Rise in living costs not matched by wages would cause a fall in consumerexpenditure* Interest rates. Lower interest rates reduce mortgage interest payments increasingdisposable income. Lower interest rates also make it cheaper to borrow and give lessincentive to save therefore encouraging spending. Some savers may have less incomebecause interest rates are lower, but, in the UK lower rates have a bigger effect onborrowers than savers.* Confidence about future. If consumers have low confidence e.g. fear unemploymentthey will spend less now and save. This explains why low interest rates in 2009, have notencouraged spending. People fear unemployment so are preferring to save rather thanspend.* House prices. When house prices are rising, people feel wealthier and are moreconfident to spend. When house prices rises people can also take part in equitywithdrawal, which is where they remortgage to be able to spend more* Inflation / Deflation. If there is deflation, people know that prices will be cheaper in thefuture, therefore this often causes people to delay spending and buy goods later this cancause a fall in consumer expenditure.* Availability of Credit. If banks are reluctant to give loans for buying a car, spending onthese big items decreases.

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Key chartsAggregate demand and the circular flow

The Long-run Aggregate Supply CurveAQA syllabus: Candidates should be able to discuss the fundamental determinants oflong-run aggregate supply such as technology, productivity, attitudes, enterprise, factormobility, the institutional structure of the economy and economic incentives.

Key termsAggregate Supply: the level of real national output that producers are prepared to supplyat different price levelsShort run aggregate supply: the time frame during which firms can change the amountof labour used but not capital (such as building new factories).Long run aggregate supply: In the long run we assume that supply is independent of theprice level (money is neutral) - the productive potential of an economy (measured byLRAS) is driven by improvements in productivity and by an expansion of the availablefactor inputs (more firms, a bigger capital stock, an expanding active labour force etc).

Key chartsExpansion & contraction in SRAS

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Shifts in SRAS

Shifts in LRAS

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11.3 The Main Instruments of GovernmentMacroeconomic Policy

Fiscal Policy:AQA syllabus: Candidates should understand how fiscal policy could be used to influenceaggregate demand and aggregate supply. They should also understand that governmentexpenditure and taxation can affect the pattern of economic activity.

Key terms:Fiscal policy; involves the use of government spending, taxation and borrowing toinfluence both the pattern of economic activity and also the level and growth of aggregatedemand, output and employment.Balanced budget: when government spending equals government revenueBudget deficit: when government spending exceeds government revenueBudget surplus: when government spending is less than government revenueDeficit financing: deliberately running a budget deficit and borrowing to finance thedeficitDemand-side fiscal policy: used to increase or decrease the level of ADExpansionary fiscal policy: uses fiscal policy to increase ADContractionary fiscal policy: uses fiscal policy to decrease ADDiscretionary fiscal policy: Making discrete changes to G, T to fine tune ADCrowding out: To finance the increased government spending, the government need toborrow from the private sector. The Bank of England sell bonds, gilts and other securitiesto the private sector. Therefore, the private sector lend their money to the government.Therefore, it is argued that the government is increasing their spending, but, only byreducing private sector spending. Or interest rates are used to attract investors whichlowers private sector spending.National debt: the stock of all past government borrowing that has not been paid backProgressive tax: where the proportion of income paid in tax rises as income increases

Questions to consider (http://www.economicshelp.org/blog/)What are the Problems of High Government Borrowing?

There are many theoretical problems of high levels of government borrowing. But, usuallythese problems don’t materialise under normal circumstances. However, as governmentborrowing as a % of GDP increases, the problems of government borrowing areexacerbated. With UK facing an annual budget deficit of over 11% of GDP, there aremany potential problems.

Higher Debt Interest Payments. As borrowing increases, the cost of servicing debt rises.The government is currently helped by low interest rates, which have kept interestpayments low. However, as inflation and interest rates pick up, the cost of paying interestpayments will rise in future years. Currently, the UK pays approximately £35bn in interestpayments.

Inflationary Pressure. It is rare for government borrowing to cause inflation. But, thecombination of quantitative easing and very high levels of borrowing make inflation morelikely.

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If markets fail to buy enough gilts to finance the deficit, the deficit can always befinanced through ‘monetisation’. i.e. creating money. This creation of money createsinflation, reduces the value of exchange rate and makes foreign investors unwilling to holdUK debt. So far quantitative easing has not caused inflation because of the falling velocityof circulation. But, the economy could swing from deflationary to inflationary pressuresquite quickly.

Higher Interest rates. The government need to sell a lot of gilts to finance the budgetdeficit. The debt management office could be trying to sell £150bn worth of gilts this year.That is a lot - and the market may not want to buy that amount. The failed gilt auction lastmonth was a worrying signal. If the markets don’t want to buy debt, the response will beto offer higher interest rates on gilts. This tends to push up other interest rates in theeconomy and reduces spending and investment. (This impact of higher interest rates inreducing private sector spending is known as crowding out)

Crowing Out. A classical monetarist argument is that high levels of governmentborrowing cause ‘crowding out’. What they mean is that the government borrow from theprivate sector by selling bonds. Therefore, the private sector have less money to spend andinvest. Therefore although government spending increases, private sector spending fallsand there is no boost to the economy.

Higher taxes in the future. The government will need to reduce borrowing as a % ofGDP. It means future budgets will need to increase taxes and / or limit spending. Thedanger is that if taxes are increased too early too quickly it could snuff out the recoveryand cause a further downturn. If they don’t raise taxes markets may be alarmed at size ofborrowing. There will be difficult choices for the future chancellors; it is a difficultsituation to be in.

Key chartsExpansionary fiscal policy

Monetary PolicyAQA syllabus: Candidates should know that monetary policy involves the use of interestrates, the money supply and exchange rates. They should understand how the Bank ofEngland uses interest rates to influence the economy. They should also be aware that a fallin the exchange rate will reduce the price of exports, raise import prices and stimulatedomestic demand affecting output, employment and the balance of payments on currentaccount.

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Key termsBank of England’s interest rate: the rate of interest at which the Bank of England lendscash out to commercial banks to increase their liquidityReal interest Rate: nominal interest rate - inflationLiquidity: measures the ease with which assets can be turned into cash quicklyMortgage: long-term loan to a house owner that is secured by the propertyLender of last resort: Bank of England’s willingness to lend cash to commercial banks toincrease their liquidityMoney supply: the stock of money in the economy that mainly takes the form of cash andbank depositsLIBOR: London interbank offered rate. The rate at which commercial banks lend toeachother.Monetarism: the belief that controlling the money supply is the best way to controlinflationTransmission mechanism: When the Bank of England changes the official interest rate itis attempting to influence the overall level of expenditure in the economy.Contractionary monetary policy: Raising interest rates in order to shift AD to the leftExpansionary monetary policy: Cutting interest rates in order to shift AD to the right

Questions to consider (http://www.economicshelp.org/blog/)How Does Quantitative Easing Work?There are different forms of quantitative easing. But one form is where.

1. The Central Bank creates reserves. This is creating money electronically. Basically, theBank just decides to inflate its cash reserves by say £50bn.2. With this extra cash the Central Bank will buy a range of government gilts and privatesector assets such as corporate bonds.3. Private banks sell their assets to the Central Bank and see an increase in their cashreserves. With these cash reserves they should be more willing to lend money. 4. By buying government bonds, the Central Bank increases the value of bonds pushinglong term interest rates down. This fall in long term interest rates also has a reflationaryeffect.

Why does a weak Sterling exchange rate help the economy?* Weak Sterling makes exports cheaper. Increasing exports.* It makes imports less attractive encouraging domestic consumers to buy more domesticproduced goods.* In a recession this boost to aggregate demand can be beneficial.

Weak sterling tends to cause inflation because:1. Imports more expensive2. Export demand rises.

However, if the economy is in recession with threat of deflation this is seen as a not aproblem.

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Key chartsTransmission mechanism

Supply-side PoliciesAQA syllabus: Candidates should understand the role of supply-side policies ininfluencing the underlying trend rate of economic growth and the potential output of theeconomy and their contribution in reducing unemployment, inflation and improving thebalance of payments

Key termsSupply side economics: a branch of free-market economics, arguing that governmentpolicy should be used to improve the competitiveness and efficiency of marketsDeregulation: removing regulations that hold back productivity and efficiencyPrivatisation: involves shifting ownership of state-owned assets to the private sector

Questions to consider (http://www.economicshelp.org/blog/)Why do new classical economists argue that supply-side policies are the mosteffective way of increasing the equilibrium level of output?

New Classical economists base their analysis on neoclassical lines. This is a simplificationof the theory, but neo classical economics makes many assumptions including:

* Consumers / firms are rational * Markets operate efficiently * People act independently with perfect information.

In macro Economics the main assumption of Neo Classical economics is the idea RealOutput is determined by supply side (micro) factors. They argue Long Run AggregateSupply is inelastic. They argue an increase in Aggregate Demand (faster than growth ofLRAS) will be inflationary and not affect the Real Level of Output. Basically, neoclassical economists argue that it is supply side factors that influence the growth ofproductive capacity and Real Output.

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Neo Classical economists dismiss the role of expansionary fiscal policy. They arguegovernment attempts to boost aggregate demand merely cause crowding out (Highergovernment spending leads to higher borrowing from the private sector so the privatesector have less to spend)

Key chartsLaffer Curve